UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[ X ] Quarterly Report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended August 31, 2006
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to ___________
Commission file number 1-8989
The Bear Stearns Companies Inc.
(Exact name of registrant as specified in its charter)
Delaware 13-3286161
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
383 Madison Avenue, New York, New York 10179
(Address of Principal Executive Offices) (Zip Code)
(212) 272-2000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange
Act. Large Accelerated Filer [X] Accelerated Filer [ ] Non-Accelerated Filer
[ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of October 6, 2006, the latest practicable date, there were 117,311,064
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
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Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Income (Unaudited) for
the three months and nine months ended August 31, 2006 and August 31, 2005 4
Condensed Consolidated Statements of Financial Condition
as of August 31, 2006 (Unaudited) and November 30, 2005 (Audited) 5
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the nine months ended August 31, 2006 and August 31, 2005 6
Notes to Condensed Consolidated Financial Statements (Unaudited) 7
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 29
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 30
Introduction 30
Certain Factors Affecting Results of Operations 30
Forward-Looking Statements 31
Executive Overview 31
Results of Operations 33
Liquidity and Capital Resources 40
Off-Balance-Sheet Arrangements 50
Derivative Financial Instruments 50
Critical Accounting Policies 51
Accounting and Reporting Developments 54
Effects of Inflation 55
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 56
Item 4. CONTROLS AND PROCEDURES 61
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 62
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 63
Item 6. EXHIBITS 64
Signature 65
2
AVAILABLE INFORMATION
The Bear Stearns Companies Inc. and its subsidiaries ("Company") files current,
annual and quarterly reports, proxy statements and other information required by
the Securities Exchange Act of 1934, as amended ("Exchange Act"), with the
Securities and Exchange Commission ("SEC"). You may read and copy any document
the Company files at the SEC's public reference room located at 100 F Street,
NE, Room 1580, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for
further information on the public reference room. The Company's SEC filings are
also available to the public from the SEC's internet site at http://www.sec.gov.
Copies of these reports, proxy statements and other information can also be
inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street,
New York, New York 10005.
The Company's public internet site is http://www.bearstearns.com. The Company
makes available free of charge through its internet site, via a link to the
SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements
and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any
amendments to those reports filed or furnished pursuant to the Exchange Act, as
soon as reasonably practicable after it electronically files such material with,
or furnishes it to, the SEC.
In addition, the Company currently makes available on http://www.bearstearns.com
its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q
for the current fiscal year and its most recent proxy statement, although in
some cases these documents are not available on that site as soon as they are
available on the SEC's internet site. Also posted on the Company's website, and
available in print upon request of any stockholder to the Investor Relations
Department, are charters for the Company's Audit Committee, Compensation
Committee, Corporate Governance Committee, Nominating Committee and Qualified
Legal Compliance Committee. Copies of the Corporate Governance Guidelines and
the Code of Business Conduct and Ethics governing our directors, officers and
employees are also posted on the Company's website within the "Corporate
Governance" section under the heading "About Bear Stearns." You will need to
have the Adobe Acrobat Reader software on your computer to view these documents,
which are in the .PDF format.
3
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited) (Unaudited)
Three Months Ended Nine Months Ended
----------------------------------------------------------
August 31, August 31, August 31, August 31,
(in thousands, except share and per share data) 2006 2005 2006 2005
--------------------------------------------------------------------------------------------------------------
REVENUES
Commissions $ 280,033 $ 290,799 $ 871,355 $ 901,784
Principal transactions 1,093,997 883,142 3,736,907 2,841,954
Investment banking 283,507 315,897 939,510 800,033
Interest and dividends 2,322,992 1,344,089 6,157,857 3,557,493
Asset management and other income 155,158 91,467 372,225 270,079
------------ ------------ ------------ ------------
Total revenues 4,135,687 2,925,394 12,077,854 8,371,343
Interest expense 2,006,552 1,113,114 5,264,074 2,847,851
------------ ------------ ------------ ------------
Revenues, net of interest expense 2,129,135 1,812,280 6,813,780 5,523,492
------------ ------------ ------------ ------------
NON-INTEREST EXPENSES
Employee compensation and benefits 1,024,748 850,985 3,291,814 2,680,668
Floor brokerage, exchange and clearance fees 58,621 55,029 168,485 169,609
Communications and technology 126,938 97,668 349,141 296,950
Occupancy 52,976 43,354 143,025 123,704
Advertising and market development 38,243 32,784 108,009 95,933
Professional fees 78,110 60,018 197,451 168,015
Other expenses 82,261 92,287 302,065 367,691
------------ ------------ ------------ ------------
Total non-interest expenses 1,461,897 1,232,125 4,559,990 3,902,570
------------ ------------ ------------ ------------
Income before provision for income taxes 667,238 580,155 2,253,790 1,620,922
Provision for income taxes 229,682 201,850 762,745 565,702
------------ ------------ ------------ ------------
Net income $ 437,556 $ 378,305 $ 1,491,045 $ 1,055,220
============ ============ ============ ============
Net income applicable to common shares $ 432,240 $ 372,357 $ 1,474,939 $ 1,036,351
============ ============ ============ ============
Basic earnings per share $ 3.34 $ 2.96 $ 11.38 $ 8.22
Diluted earnings per share $ 3.02 $ 2.69 $ 10.28 $ 7.42
============ ============ ============ ============
Weighted average common shares outstanding:
Basic 132,086,016 130,194,452 132,539,603 130,716,960
Diluted 148,899,406 147,051,538 149,484,747 148,041,526
============ ============ ============ ============
Cash dividends declared per common share $ 0.28 $ 0.25 $ 0.84 $ 0.75
============ ============ ============ ============
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
August 31, November 30,
(in thousands, except share data) 2006 2005
---------------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 4,725,977 $ 5,859,133
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 8,845,358 5,269,676
Securities purchased under agreements to resell 40,457,197 42,647,603
Securities received as collateral 17,480,124 12,426,383
Securities borrowed 73,959,757 62,915,010
Receivables:
Customers 29,969,736 33,254,980
Brokers, dealers and others 5,614,021 3,544,806
Interest and dividends 649,728 433,305
Financial instruments owned, at fair value 111,895,526 93,364,088
Financial instruments owned and pledged as collateral, at fair value 10,890,739 12,880,333
------------- -------------
Total financial instruments owned, at fair value 122,786,265 106,244,421
Assets of variable interest entities and mortgage loan special
purpose entities 25,075,409 15,151,699
Property, equipment and leasehold improvements, net of accumulated
depreciation and amortization of $1,115,098 and $1,011,036
as of August 31, 2006 and November 30, 2005, respectively 483,064 451,247
Other assets 4,713,684 4,436,970
------------- -------------
Total Assets $ 334,760,320 $ 292,635,233
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 25,781,755 $ 20,015,727
Securities sold under agreements to repurchase 66,873,544 66,131,617
Obligation to return securities received as collateral 17,480,124 12,426,383
Securities loaned 10,127,250 10,104,325
Payables:
Customers 80,628,490 73,231,067
Brokers, dealers and others 1,619,331 2,657,178
Interest and dividends 1,026,527 796,956
Financial instruments sold, but not yet purchased, at fair value 41,058,913 35,004,333
Liabilities of variable interest entities and mortgage loan
special purpose entities 24,199,703 14,321,285
Accrued employee compensation and benefits 2,331,573 1,853,416
Other liabilities and accrued expenses 1,709,765 1,811,898
Long-term borrowings 50,201,398 43,489,616
------------- -------------
Total Liabilities 323,038,373 281,843,801
------------- -------------
Commitments and contingencies (Note 10)
STOCKHOLDERS' EQUITY
Preferred stock 359,156 372,326
Common stock, $1.00 par value; 500,000,000 shares authorized and 184,805,847
shares issued as of both August 31, 2006 and November 30, 2005 184,806 184,806
Paid-in capital 4,511,041 4,109,166
Retained earnings 8,861,718 7,492,951
Employee stock compensation plans 2,095,820 2,600,186
Unearned compensation (146,463) (143,302)
Treasury stock, at cost:
Common stock: 66,254,688 and 70,937,640 shares as of August
31, 2006 and November 30, 2005, respectively (4,144,131) (3,824,701)
------------- -------------
Total Stockholders' Equity 11,721,947 10,791,432
------------- -------------
Total Liabilities and Stockholders' Equity $ 334,760,320 $ 292,635,233
============= =============
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Nine Months Ended
-------------------------------
August 31, August 31,
(in thousands) 2006 2005
--------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 1,491,045 $ 1,055,220
Adjustments to reconcile net income to cash used in operating
activities:
Non-cash items included in net income:
Depreciation and amortization 265,040 196,330
Deferred income taxes (6,184) (66,071)
Employee stock compensation plans 15,211 48,834
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations (3,575,682) (1,284,691)
Securities borrowed, net of securities loaned (11,021,822) 7,003,958
Net receivables from customers 10,682,667 (7,908,346)
Net receivables from brokers, dealers and others (3,107,062) (2,181,220)
Financial instruments owned (15,889,956) (21,449,291)
Other assets (447,228) (690,020)
Securities sold under agreements to repurchase, net of
securities purchased under agreements to resell 2,932,333 8,078,803
Financial instruments sold, but not yet purchased 5,549,652 3,098,148
Accrued employee compensation and benefits 466,265 200,610
Other liabilities and accrued expenses 127,438 885,546
------------ ------------
Cash used in operating activities (12,518,283) (13,012,190)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (144,081) (152,876)
------------ ------------
Cash used in investing activities (144,081) (152,876)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from short-term borrowings 5,766,028 6,242,620
Proceeds from issuance of long-term borrowings 13,396,397 11,666,823
Payments for retirement/repurchase of long-term borrowings (7,574,980) (5,781,374)
Proceeds from issuances of derivatives with a financing element,
net 504,928 158,563
Issuance of common stock 228,326 158,382
Cash retained resulting from tax deductibility under share-based
payment arrangements 321,432 320,698
Redemption of preferred stock (13,116) (75,821)
Treasury stock purchases - common stock (982,695) (505,844)
Cash dividends paid (117,112) (105,463)
------------ ------------
Cash provided by financing activities 11,529,208 12,078,584
------------ ------------
Net decrease in cash and cash equivalents (1,133,156) (1,086,482)
Cash and cash equivalents, beginning of year 5,859,133 4,173,385
------------ ------------
Cash and cash equivalents, end of period $ 4,725,977 $ 3,086,903
============ ============
Supplemental Disclosure of Cash Flow Information:
Cash payments for interest were $5.61 billion and $2.86 billion during the nine
months ended August 31, 2006 and 2005, respectively.
Cash payments for income taxes, net of refunds, were $592.4 million and $112.7
million for the nine months ended August 31, 2006 and 2005, respectively.
Cash payments for income taxes, net of refunds, would have been $913.8 million
and $433.4 million for the nine months ended August 31, 2006 and 2005,
respectively, if increases in the value of equity instruments issued under
share-based payment arrangements had not been deductible in determining taxable
income.
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
6
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
The Bear Stearns Companies Inc. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets comprises
the institutional equities, fixed income and investment banking areas.
Global Clearing Services provides clearance-related services for prime
brokerage clients and clearance on a fully disclosed basis for introducing
broker-dealers. Wealth Management comprises the private client services
("PCS") and asset management areas. See Note 12, "Segment Data," in the
Notes to Condensed Consolidated Financial Statements. The Company also
conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited; Custodial Trust Company;
Bear Stearns Financial Products Inc.; Bear Stearns Capital Markets Inc.;
Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.; EMC Mortgage
Corporation; and Bear Stearns Commercial Mortgage, Inc. and through its
majority-owned subsidiary Bear Hunter Holdings LLC. As used in this
report, the "Company" refers (unless the context requires otherwise) to
The Bear Stearns Companies Inc. and its subsidiaries.
Basis of Presentation
The condensed consolidated financial statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling interest. In accordance with Financial
Accounting Standards Board ("FASB") Interpretation ("FIN") No. 46 (R),
"Consolidation of Variable Interest Entities" ("FIN No. 46 (R)"), the
Company also consolidates any variable interest entities ("VIEs") for
which it is the primary beneficiary. The assets and related liabilities of
such variable interest entities have been shown in the Condensed
Consolidated Statements of Financial Condition in the captions "Assets of
variable interest entities and mortgage loan special purpose entities" and
"Liabilities of variable interest entities and mortgage loan special
purpose entities." See Note 5, "Variable Interest Entities and Mortgage
Loan Special Purpose Entities," in the Notes to Condensed Consolidated
Financial Statements.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
The Condensed Consolidated Statement of Financial Condition as of August
31, 2006, the Condensed Consolidated Statements of Income for the three
and nine months ended August 31, 2006 and August 31, 2005 and the
Condensed Consolidated Statements of Cash Flows for the nine months ended
August 31, 2006 and August 31, 2005 are unaudited. The Condensed
Consolidated Statement of Financial Condition at November 30, 2005 and
related information was derived from the audited consolidated financial
statements.
The condensed consolidated financial statements are prepared in accordance
with the rules and regulations of the Securities and Exchange Commission
("SEC") with respect to the Form 10-Q and reflect all adjustments which,
in the opinion of management, are normal and recurring, 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 financial statements should be read together with the
Company's Annual Report on Form 10-K for the fiscal year ended November
30, 2005, as amended by Amendment No. 1 thereto on Form 10-K/A, each as
filed by the Company under the Securities Exchange Act of 1934, as amended
("Exchange Act") (together, the "Form 10-K").
The condensed consolidated financial statements are prepared in conformity
with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions, including those regarding inventory valuations, stock-based
compensation, certain accrued liabilities
7
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
and the potential outcome of litigation and tax matters, which may affect
the amounts reported in the condensed consolidated financial statements
and accompanying notes. Actual results could differ materially from these
estimates. The nature of the Company's business is such that the results
of any interim period may not be indicative of the results to be expected
for an entire fiscal year. All material intercompany transactions and
balances have been eliminated in consolidation. Certain prior period
amounts have been reclassified to conform to the current period's
presentation.
Financial Instruments
Proprietary securities, futures and other derivative transactions are
recorded on a trade date basis. Financial instruments owned and financial
instruments sold, but not yet purchased, including contractual commitments
arising pursuant to futures, forward and option contracts, interest rate
swaps and other derivative contracts, are recorded at fair value with the
resulting net unrealized gains and losses reflected in "Principal
transactions" revenues in the Condensed Consolidated Statements of Income.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined
based on other relevant factors, including dealer price quotations, price
activity for equivalent instruments and valuation pricing models.
Valuation pricing models consider time value, yield curve and volatility
factors, prepayment speeds, default rates, loss severity, current market
and contractual prices for the underlying financial instruments, as well
as other measurements.
The Company follows Emerging Issues Task Force ("EITF") Statement No.
02-3, "Issues Involved in Accounting for Derivative Contracts Held for
Trading Purposes and Contracts Involved in Energy Trading and Risk
Management Activities." This guidance prohibits recognizing profit at the
inception of a derivative contract unless the fair value of the derivative
is obtained from a quoted market price in an active market or is otherwise
evidenced by comparison to other observable current market transactions or
based on a valuation technique that incorporates observable market data.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the condensed consolidated
financial statements at their fair value. Fair value is generally defined
as an investment's initial cost until significant transactions or
developments indicate that a change in the carrying value of the
investment is appropriate. Generally, the carrying values of these
securities will be increased in those instances where market values are
readily ascertainable by reference to substantial transactions occurring
in the marketplace or quoted market prices. Reductions to the carrying
value of these securities are made when the Company's estimate of net
realizable value has declined below the carrying value.
Derivative Instruments and Hedging Activities
The Company follows Statement of Financial Accounting Standards ("SFAS")
No. 133, "Accounting for Derivative Instruments and Hedging Activities,"
as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments
and Certain Hedging Activities," and SFAS No. 149, "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," which establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities, and hedging
activities. Accordingly, all derivatives, whether stand-alone or embedded
within other contracts or securities (except in narrowly defined
circumstances), are carried in the Company's Condensed Consolidated
Statements of Financial Condition at fair value, with changes in fair
value recorded in current earnings in "Principal transactions" revenues.
Designated hedged items in fair value hedging relationships are marked for
the risk being hedged, with such changes recorded in current earnings.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on a settlement date basis,
which is generally three business days after trade date, while the related
commission
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
revenues and expenses are recorded on a trade date basis. Receivables from
and payables to customers include amounts related to both cash and margin
transactions. Securities owned by customers, including those that
collateralize margin or other similar transactions, are generally not
reflected in the Condensed Consolidated Statements of Financial Condition.
Mortgage Servicing Assets, Fees and Advances
Mortgage servicing rights ("MSRs"), which are included in "Other assets"
on the Condensed Consolidated Statements of Financial Condition, are
reported at the lower of amortized cost or market. MSRs are amortized in
proportion to and over the period of estimated net servicing income. MSRs
are periodically evaluated for impairment based on the fair value of those
rights determined by using market-based models that discount anticipated
future net cash flows considering loan prepayment estimates, interest
rates, default rates, servicing costs and other economic factors. For
purposes of impairment evaluation and measurement, the Company stratifies
MSRs by predominant risk characteristics. The excess of amortized cost
over market value is reflected as a valuation allowance at balance sheet
dates.
Contractual servicing fees, late fees and other ancillary servicing fees
earned for servicing mortgage loans are reflected net of MSR amortization
and impairment/recovery 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.
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a Replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a Qualifying Special Purpose Entity ("QSPE") or has the right to pledge
or exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. The Company derecognizes
financial assets transferred in securitizations provided that such
transfer meets all of these criteria.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities with a market value in
excess of the principal amount loaned plus the accrued interest thereon,
in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities to counterparties to
collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for
additional collateral to be obtained, or excess collateral returned. It is
the Company's policy to value collateral and to obtain additional
collateral, or to retrieve excess collateral from counterparties, when
deemed appropriate.
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Securities borrowed and securities loaned are recorded based upon the
amount of cash collateral advanced or received. Securities borrowed
transactions facilitate the settlement process and require the Company to
deposit cash, letters of credit or other collateral with the lender. With
respect to securities loaned, the Company receives collateral in the form
of cash or other collateral. The amount of collateral required to be
deposited for securities borrowed, or received for securities loaned, is
an amount generally in excess of the market value of the applicable
securities borrowed or loaned. The Company monitors the market value of
securities borrowed and loaned, with excess collateral retrieved or
additional collateral obtained, when deemed appropriate.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized.
Asset Management and Other Income
The Company receives advisory fees for investment management. Advisory
fees are recognized over the period that the related service is provided
based upon the net asset value. Unearned advisory fees are treated as
deferred revenues and are included in "Other liabilities" in the
accompanying Condensed Consolidated Statements of Financial Condition. In
addition, the Company receives performance incentive fees for managing
certain funds based upon the achievement of specified performance targets.
These fees are accrued as earned during the period when the assets under
management exceed the applicable specific investment performance target.
Fixed Assets
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
Goodwill and Identifiable Intangible Assets
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets."
Earnings Per Share
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share." Basic EPS is computed by dividing net income
applicable to common shares, adjusted for costs related to vested shares
under the Capital Accumulation Plan for Senior Managing Directors, as
amended ("CAP Plan"), as well as the effect of the redemption of preferred
stock, by the weighted average number of common shares outstanding. Common
shares outstanding includes vested units issued under certain stock
compensation plans, which will be distributed as shares of common stock.
Diluted EPS includes the determinants of basic EPS and, in addition, gives
effect to dilutive potential common shares related to stock compensation
plans.
Stock-Based Compensation
Effective December 1, 2002, the Company elected to adopt fair value
accounting for stock-based compensation consistent with SFAS No. 123,
"Accounting for Stock-Based Compensation," using the prospective method
with guidance provided by SFAS No. 148, "Accounting for Stock-Based
Compensation--Transition and Disclosure." As a result, commencing with
options granted after November 30, 2002, the Company expenses the fair
value of stock
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
options issued to employees over the related vesting period. Prior to
December 1, 2002, the Company had elected to account for its stock-based
compensation plans using the intrinsic value method prescribed by
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB No. 25"), as permitted by SFAS No. 123. Under
the provisions of APB No. 25, compensation cost for stock options is
measured as the excess, if any, of the quoted market price of the
Company's common stock at the date of grant over the amount an employee
must pay to acquire the stock. Accordingly, no compensation expense had
been recognized for stock option awards granted prior to December 1, 2002
because the exercise price was at the fair market value of the Company's
common stock on the grant date.
The cost related to stock-based compensation included in the determination
of net income for the three and nine months ended August 31, 2006 has been
fully determined under the fair value-based method, and for the three and
nine months ended August 31, 2005 is less than that which would have been
recognized if the fair value-based method had been applied to stock option
awards since the original effective date of SFAS No. 123.
The following table illustrates the effect on net income and earnings per
share for the three and nine months ended August 31, 2005 if the fair
value-based method under SFAS No. 123 had been applied to stock options
granted for the year ended November 30, 2002.
Three Months Nine Months
ended ended
---------------------------------------------------------------------------------------------
August 31, August 31,
(in millions, except per share amounts) 2005 2005
---------------------------------------------------------------------------------------------
Net income, as reported $ 378.3 $ 1,055.2
Add:
Stock-based employee compensation plans expense
included in reported net income, net of related tax effects 7.2 27.9
Deduct:
Total stock-based employee compensation plans expense
determined under the fair value based method, net of related
tax effects (10.7) (38.4)
---------- ------------
Pro forma net income $ 374.8 $ 1,044.7
========== ============
Earnings per share:
Basic - as reported $ 2.96 $ 8.22
Basic - pro forma $ 2.94 $ 8.14
Diluted - as reported $ 2.69 $ 7.42
Diluted - pro forma $ 2.66 $ 7.35
========== ============
In December 2004, the FASB issued SFAS No. 123 (R), "Share-Based Payment."
SFAS No. 123 (R) is a revision of SFAS No. 123 and supersedes APB No. 25
and amends SFAS No. 95, "Statement of Cash Flows." SFAS No. 123 (R)
eliminates the ability to account for share-based compensation
transactions using APB No. 25 and requires all share-based payments to
employees, including grants of employee stock options, to be recognized in
the financial statements using a fair value-based method. The Company
adopted SFAS No. 123 (R), as required, on December 1, 2005, using the
modified prospective method with no material impact on the consolidated
financial statements of the Company.
The Company has various employee stock compensation plans designed to
increase the emphasis on stock-based incentive compensation and align the
compensation of its key employees with the long-term interests of
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
stockholders. Such plans provide for annual grants of stock units and
stock options. The Company intends to offset the potentially dilutive
impact of the annual grants by purchasing common stock throughout the year
in open market and private transactions.
Cash Equivalents
The Company has defined cash equivalents as liquid investments with
original maturities of three months or less that are not held for sale in
the ordinary course of business as part of the Company's trading
inventory.
Income Taxes
The Company and certain of its subsidiaries file a US consolidated federal
income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
period end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Gains or
losses resulting from foreign currency transactions are included in net
income.
Accounting and Reporting Developments
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5,
"Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights." The EITF consensus requires a general
partner in a limited partnership to consolidate the limited partnership
unless the presumption of control is overcome. The general partner may
overcome this presumption of control and not consolidate the entity if the
limited partners have: (a) the substantive ability to dissolve or
liquidate the limited partnership or otherwise remove the general partner
without having to show cause; or (b) substantive participating rights in
managing the partnership. This guidance became effective upon ratification
by the FASB on June 29, 2005 for all newly formed limited partnerships and
for existing limited partnerships for which the partnership agreements
have been modified. For all other limited partnerships, the guidance is
effective no later than the beginning of the first reporting period in
fiscal years beginning after December 15, 2005. For newly formed and
modified limited partnerships, the adoption of the EITF did not have a
material impact on the consolidated financial statements of the Company.
For previously existing limited partnerships, the Company does not expect
the EITF consensus to have a material impact on the consolidated financial
statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments." SFAS No. 155 is an amendment of SFAS No.
133 and SFAS No. 140. SFAS No. 155 permits companies to irrevocably elect,
on a deal by deal basis, to apply a fair value remeasurement to any hybrid
financial instruments that contain an embedded derivative that would
otherwise require bifurcation. SFAS No. 155 is effective for the Company
on December 1, 2006. The Company does not expect the adoption of SFAS No.
155 to have a material impact on the consolidated financial statements of
the Company.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets." SFAS No. 156 amends SFAS No. 140. SFAS No. 156 requires
that all separately recognized servicing assets and servicing liabilities
be initially measured at fair value. For subsequent measurements, SFAS No.
156 permits companies to choose between using an amortization method or a
fair value measurement method for reporting purposes. SFAS No. 156 is
effective as of the beginning of a company's first fiscal year that begins
after September 15, 2006. The Company does not expect the adoption of SFAS
No. 156 to have a material impact on the consolidated financial statements
of the Company.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
In April 2006, the FASB issued FASB Staff Position ("FSP") FIN No. 46
(R)-6 "Determining the Variability to Be Considered in Applying
Interpretation No. 46(R)." This FSP addresses how a reporting enterprise
should determine the variability to be considered in applying FIN No. 46
(R). The variability that is considered affects the determination of (a)
whether the entity is a variable interest entity, (b) which interests are
variable interests in the entity, and (c) which party, if any, is the
primary beneficiary of the VIE. This FSP states that the variability to be
considered shall be based on an analysis of the design of the entity. This
analysis includes reviewing the nature of the risks in the entity as well
as determining the purpose for which the entity was created. This analysis
also includes a determination of the variability that the entity was
designed to create and pass along to its interest holders. The Company
adopted FSP FIN46(R)-6 on September 1, 2006 on a prospective basis to all
entities that the Company first becomes involved with and to all entities
previously required to be analyzed under FIN No. 46 (R) when a
reconsideration event has occurred. The Company does not expect the
adoption of FSP FIN46(R)-6 to have a material impact on the consolidated
financial statements of the Company.
In July 2006, the FASB issued Interpretation No. 48, "Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN 48"). This Interpretation clarifies the accounting for uncertainty
in income taxes recognized in an enterprise's financial statements in
accordance with SFAS No. 109. FIN 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. This Interpretation also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. FIN 48 must be implemented for fiscal years
beginning after December 15, 2006. The Company is currently quantifying
what impact, if any, the adoption of FIN 48 is expected to have on the
consolidated financial statements of the Company.
In September 2006, the FASB issued 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. SFAS No. 157 requires companies to disclose the fair
value of its financial instruments according to a fair value hierarchy
(i.e., levels 1, 2, and 3, as defined). Additionally, companies are
required to provide enhanced disclosure regarding instruments in the level
3 category, including a reconciliation of the beginning and ending
balances separately for each major category of assets and liabilities.
SFAS No. 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007 and interim periods within those fiscal
years. The Company is currently assessing whether it will early adopt SFAS
No. 157 as of the first quarter of fiscal 2007 as permitted, and is
currently evaluating the impact adoption may have on the consolidated
financial statements of the Company.
13
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:
August 31, November 30,
(in thousands) 2006 2005
--------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED:
US government and agency $ 6,818,959 $ 9,914,866
Other sovereign governments 262,385 1,159,265
Corporate equity and convertible debt 26,756,232 18,601,132
Corporate debt and other 31,949,428 21,571,914
Mortgages, mortgage- and asset-backed 41,851,588 40,297,016
Derivative financial instruments 15,147,673 14,700,228
------------ ------------
$122,786,265 $106,244,421
============ ============
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED:
US government and agency $ 13,099,272 $ 10,115,133
Other sovereign governments 604,720 1,617,998
Corporate equity and convertible debt 10,834,996 6,900,004
Corporate debt and other 3,590,791 3,274,034
Mortgages, mortgage- and asset-backed 209,039 139,988
Derivative financial instruments 12,720,095 12,957,176
------------ ------------
$ 41,058,913 $ 35,004,333
============ ============
As of August 31, 2006 and November 30, 2005, all financial instruments
owned that were pledged to counterparties where the counterparty has the
right, by contract or custom, to rehypothecate those securities are
classified as "Financial instruments owned and pledged as collateral" in
the Condensed Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased, represent obligations
of the Company to purchase the specified financial instrument at the then
current market price. Accordingly, these transactions result in
off-balance-sheet risk as the Company's ultimate obligation to repurchase
such securities may exceed the amount recognized in the Condensed
Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At August 31, 2006 and November 30, 2005,
the Company's most significant concentrations are related to US government
and agency inventory positions, including those of the Federal National
Mortgage Association and the Federal Home Loan Mortgage Corporation. In
addition, a substantial portion of the collateral held by the Company for
securities purchased under agreements to resell consists of securities
issued by the US government and agencies.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate and equity price risk. Derivative financial instruments represent
contractual
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
commitments between counterparties that derive their value from changes in
an underlying interest rate, currency exchange rate, index (e.g., Standard
& Poor's 500 Index), reference rate (e.g., London Interbank Offered Rate,
or LIBOR), or asset value referenced in the related contract. Some
derivatives, such as futures contracts, certain options and
index-referenced warrants, can be traded on an exchange. Other
derivatives, such as interest rate and currency swaps, caps, floors,
collars, swaptions, equity swaps and options, credit derivatives,
structured notes and forward contracts, are negotiated in the
over-the-counter markets. Derivatives generate both on- and
off-balance-sheet risks depending on the nature of the contract.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to purchase or sell a financial instrument at a specific price
on or before an established date or dates. Financial instruments sold, but
not yet purchased may result in market and/or credit risk in excess of
amounts recorded in the Condensed Consolidated Statements of Financial
Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk, whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of a
particular financial instrument in excess of the amounts currently
reflected in the Condensed Consolidated Statements of Financial Condition.
The Company's exposure to market risk is influenced by a number of
factors, including the relationships among and between financial
instruments with off-balance-sheet risk, the Company's proprietary
securities, futures and derivatives inventories as well as the volatility
and liquidity in the markets in which the financial instruments are
traded. The Company attempts to mitigate its exposure to market risk by
entering into hedging transactions, which may include over-the-counter
derivative contracts or the purchase or sale of interest-bearing
securities, equity securities, financial futures and forward contracts. In
this regard, the utilization of derivative instruments is designed to
reduce or mitigate market risks associated with holding dealer inventories
or in connection with arbitrage-related trading activities.
Derivatives Credit Risk
Credit risk arises from the potential inability of counterparties to
perform in accordance with the terms of the contract. At any point in
time, the Company's exposure to credit risk associated with counterparty
non-performance is generally limited to the net replacement cost of
over-the-counter contracts, net of the value of collateral held. Such
financial instruments are reported at fair value on a net-by-counterparty
basis pursuant to enforceable netting agreements. Exchange-traded
financial instruments, such as futures and options, generally do not give
rise to significant unsecured counterparty exposure due to the Company's
margin requirements, which may be greater than those prescribed by the
individual exchanges. Options written 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.
Non-Trading Derivatives Activity
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued US dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
payments. In addition, for foreign currency debt obligations that are not
used to fund assets in the same currency, the Company has entered into
currency swap agreements that effectively convert the debt into US dollar
obligations. Such transactions are accounted for as fair value hedges.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's
market-making and trading activities. The Company has similar controls in
place to monitor these risks.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether stand-alone or
embedded within other contracts or securities (except in very defined
circumstances) be carried on the Company's Condensed Consolidated
Statement of Financial Condition at fair value. SFAS No. 133 also requires
items designated as being fair value hedged to be recorded at fair value,
as defined in SFAS No. 133, provided that the intent to hedge is fully
documented. Any resultant net change in value for both the hedging
derivative and the hedged item is recognized in earnings immediately, such
net effect being deemed the "ineffective" portion of the hedge. The gains
and losses associated with the ineffective portion of the fair value
hedges are included in "Principal transactions" revenues in the Condensed
Consolidated Statements of Income. These amounts were immaterial for the
three and nine months ended August 31, 2006 and 2005.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. Retained interests in securitizations
are generally not held to maturity and typically are sold shortly after
the settlement of a securitization. The weighted average holding period
for retained interest positions in inventory at August 31, 2006 and
November 30, 2005 was approximately 120 days and 90 days, respectively.
These retained interests are included in "Financial instruments owned" 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.
16
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
Nine months ended August 31, 2006 $ 17.6 $ 73.9 $ 91.5
Nine months ended August 31, 2005 $ 20.5 $ 69.7 $ 90.2
Retained interests
As of August 31, 2006 $ 2.6 $ 4.2 $ 6.8 (1)
As of November 30, 2005 $ 1.8 $ 3.7 $ 5.5 (2)
--------------------------------------------------------------------------------
(1) Includes approximately $1.1 billion in non-investment-grade and
unrated retained interests.
(2) Includes approximately $0.8 billion in non-investment-grade and
unrated retained interests.
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the nine months ended August
31, 2006 and August 31, 2005:
Agency Other Mortgage-
(in Millions) Mortgage-Backed and Asset-Backed Total
--------------------------------------------------------------------------------
Cash flows received from retained interests
Nine months ended August 31, 2006 $ 208.4 $ 670.9 $ 879.3
Nine months ended August 31, 2005 $ 288.9 $ 240.5 $ 529.4
Cash flows from servicing
Nine months ended August 31, 2006 $ 0.1 $ 55.9 $ 56.0
Nine months ended August 31, 2005 $ 0.7 $ 34.4 $ 35.1
--------------------------------------------------------------------------------
The Company is an active market maker in these securities and therefore
may retain interests in assets it securitizes, predominantly highly rated
or government agency-backed securities. The models employed in the
valuation of retained interests use discount rates that are based on the
Treasury curve plus a spread. Key points on the constant maturity Treasury
curve at August 31, 2006 were 4.78% for 2-year Treasuries and 4.80% for
10-year Treasuries, and ranged from 4.64% to 5.08%. These models also
consider prepayment speeds as well as credit losses. Credit losses are
considered through option-adjusted spreads that also incorporate
additional factors such as liquidity and optionality.
Key economic assumptions used in measuring the fair value of retained
interests in assets the Company securitized at August 31, 2006 were as
follows:
Agency Other Mortgage-
Mortgage-Backed and Asset-Backed
--------------------------------------------------------------------------------
Weighted average life (years) 7.1 3.3
Average prepayment speeds (annual rate) 7%-30% 8%-51%
Credit losses - 0%-9%
--------------------------------------------------------------------------------
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following hypothetical sensitivity analysis as of August 31, 2006
illustrates the potential adverse change in fair value of these retained
interests due to a specified change in the key valuation assumptions. The
interest rate changes represent a parallel shift in the Treasury curve.
This shift considers the effect of other variables, including prepayments.
The remaining valuation assumptions are changed independently. Retained
interests in securitizations are generally not held to maturity and are
typically sold shortly after the settlement of a securitization. The
Company considers the current and expected credit profile of the
underlying collateral in determining the fair value and periodically
updates the fair value for changes in credit, interest rate, prepayment
and other pertinent market factors. Actual credit losses on retained
interests have not been significant.
Agency Other Mortgage-
(in millions) Mortgage-Backed and Asset-Backed
--------------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (61.8) $ (89.4)
Impact of 100 basis point adverse change (129.5) (203.3)
--------------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (2.9) (34.9)
Impact of 20% adverse change (5.0) (66.2)
--------------------------------------------------------------------------------
Credit spread
Impact of 10% adverse change (6.4) (76.2)
Impact of 20% adverse change (12.7) (146.5)
--------------------------------------------------------------------------------
In the normal course of business, the Company originates and purchases
conforming and non-conforming, conventional fixed-rate and adjustable-rate
residential mortgage loans and sells such loans to investors. In
connection with these activities, the Company may retain MSRs that entitle
the Company to a future stream of cash flows based on the contractual
servicing fee. In addition, the Company may purchase and sell MSRs. At
August 31, 2006, the key economic assumptions and the sensitivity of the
current fair value of MSRs to immediate changes in those assumptions were
as follows:
Fixed- Adjustable-Rate
Sub- Rate Prime Prime &
(in millions) Prime Loans & Alt-A Loans Alt-A Loans
--------------------------------------------------------------------------------
Fair Value of MSRs $ 154.0 $ 98.7 $ 215.7
Constant prepayment rate (in CPR) 17% - 42% 13% - 38% 20% - 56%
Impact on fair value of:
5 CPR adverse change $ (16.6) $ (9.2) $ (11.6)
10 CPR adverse change (30.2) (16.3) (19.8)
Discount Rate 15% 13% 13%
Impact on fair value of:
5% adverse change $ (12.3) $ (9.1) $ (11.0)
10% adverse change (22.5) (17.2) (22.6)
--------------------------------------------------------------------------------
The previous tables should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the tables. Changes in fair value based on 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 tables do not consider the change in fair value
of hedging positions, which would generally offset the changes detailed in
the tables, nor do they consider any corrective action that the Company
may take in response to changes in these conditions. The impact of hedges
is not presented because hedging positions are established on a portfolio
level and allocating the impact would not be practicable.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
MSRs are included in "Other assets" on the Condensed Consolidated
Statements of Financial Condition. The Company's MSRs activities for the
nine months ended August 31, 2006 and 2005 were as follows:
August 31, August 31,
(in millions) 2006 2005
------------------------------------------------------
Balance, beginning of period $ 431.1 $ 230.2
Additions 280.6 287.8
Sales (99.3) (47.1)
Amortization (143.3) (93.6)
(Impairment)/Recovery (0.7) 2.7
-------- --------
Balance, end of period $ 468.4 $ 380.0
======== ========
Changes in the MSR valuation allowance for the nine months ended August 31, 2006
and 2005 were as follows:
August 31, August 31,
(in millions) 2006 2005
-----------------------------------------------------
Balance, beginning of period $ (10.6) $ (33.7)
(Impairment)/Recovery (0.7) 2.7
------- -------
Balance, end of period $ (11.3) $ (31.0)
======= =======
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be VIEs.
These entities are an essential part of its securitization, asset
management and structured finance businesses. In addition, the Company
purchases and sells financial instruments that may be variable interests.
The Company adopted FIN No. 46 (R) for its variable interests in fiscal
2004. The Company consolidates those VIEs in which the Company is the
primary beneficiary.
The Company may perform various functions, including being the seller,
servicer, investor, structurer or underwriter in securitization
transactions. These transactions typically involve entities that are
considered to be QSPEs as defined in SFAS No. 140. QSPEs are exempt from
the requirements of FIN No. 46 (R). For securitization vehicles that do
not qualify as QSPEs, the holders of the beneficial interests have no
recourse to the Company, only to the assets held by the related VIE. In
certain of these VIEs, the Company is the primary beneficiary often
through its ownership of certain beneficial interests, and is, therefore,
required to consolidate the assets and liabilities of the VIE.
The Company has a limited number of mortgage securitizations that did not
meet the criteria for sale treatment under SFAS No. 140 because the
securitization vehicles were not QSPEs. The assets in these mortgage
securitizations approximated $12.0 billion and $5.3 billion at August 31,
2006 and November 30, 2005, respectively. At August 31, 2006 and November
30, 2005, the Company's maximum exposure to loss as a result of its
relationship with mortgage securitizations is approximately $486.2 million
and $299.4 million, respectively, which represents the fair value of its
interests in the mortgage securitizations.
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company has retained call options on a limited number of
securitization transactions that require the Company to continue
recognizing the assets subject to the call options. The total assets in
these transactions approximated $11.2 billion and $8.7 billion, at August
31, 2006 and November 30, 2005, respectively.
Assets held by VIEs, which are currently consolidated because the Company
is the primary beneficiary, approximated $1.4 billion and $1.2 billion at
August 31, 2006 and November 30, 2005, respectively. At August 31, 2006
and November 30, 2005, the Company's maximum exposure to loss as a result
of its relationship with these VIEs is approximately $375.6 million and
$531.0 million, respectively, which represents the fair value of its
interests in the VIEs.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations or asset securitizations for
which the Company is not the primary beneficiary and therefore does not
consolidate these entities. In aggregate, these VIEs have assets
approximating $10.9 billion and $4.7 billion at August 31, 2006 and
November 30, 2005, respectively. At August 31, 2006 and November 30, 2005,
the Company's maximum exposure to loss from these entities approximated
$141.0 million and $29.6 million, respectively, which represents the fair
value of its interests and is reflected on 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. Therefore, the Company's variable interests included above may
not be held by the Company in future periods. As a result of these
activities, it is reasonably possible that such entities may be
consolidated and deconsolidated at various points in time.
The Company was the general partner of certain limited partnerships in
which the limited partners did not have sufficient voting or control
rights. Under EITF No. 04-5, the Company was required to consolidate these
limited partnerships. The assets held by the limited partnerships
approximated $422.8 million as of August 31, 2006. The Company's maximum
exposure to loss as a result of its relationship with these limited
partnerships is approximately $13.9 million as of August 31, 2006, which
represents the fair value of its interests and is reflected on the
Condensed Consolidated Statements of Financial Condition.
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 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 August 31, 2006 and November 30, 2005, the fair value of securities
received as collateral by the Company that can be repledged, delivered or
otherwise used was approximately $258.8 billion and $254.6 billion,
respectively. Of these securities received as collateral, those with a
fair value of approximately $183.5 billion and $184.3 billion were
delivered or repledged at August 31, 2006 and November 30, 2005,
respectively.
The Company also pledges financial instruments owned to collateralize
certain financing arrangements and permits the counterparty to pledge or
rehypothecate the securities. These securities are recorded as "Financial
instruments owned and pledged as collateral, at fair value" in the
Condensed Consolidated Statements of Financial Condition. The carrying
value of securities and other inventory positions owned that have been
pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$29.8 billion and $20.8 billion at August 31, 2006 and November 30, 2005,
respectively.
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. LONG-TERM BORROWINGS
The Company's long-term borrowings (which have original maturities of at
least 12 months) at August 31, 2006 and November 30, 2005 consisted of the
following:
August 31, November 30,
(in thousands) 2006 2005
----------------------------------------------------------------
Fixed rate notes due 2006 to 2036 $21,108,324 $21,973,171
Floating rate notes due 2006 to 2036 20,570,080 14,208,786
Index/equity/credit-linked notes 8,522,994 7,307,659
----------- -----------
Total long-term borrowings $50,201,398 $43,489,616
=========== ===========
The Company's long-term borrowings include fair value adjustments in
accordance with SFAS No. 133. During the nine months ended August 31,
2006, the Company issued and retired/repurchased $13.4 billion and $7.6
billion of long-term borrowings, respectively. The weighted average
maturity of the Company's long-term borrowings, based upon stated maturity
dates, was approximately 4.2 years at August 31, 2006.
8. EARNINGS PER SHARE
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the CAP Plan, as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock compensation plans, which will be
distributed as shares of common stock. Diluted EPS includes the
determinants of basic EPS and, in addition, gives effect to dilutive
potential common shares related to stock compensation plans.
The computations of basic and diluted EPS are set forth below:
Three Months Ended Nine Months Ended
----------------------------------------------------------------------------------------------------------------
August 31, August 31, August 31, August 31,
(in thousands, except per share amounts) 2006 2005 2006 2005
----------------------------------------------------------------------------------------------------------------
Net income $ 437,556 $ 378,305 $ 1,491,045 $ 1,055,220
Preferred stock dividends (5,316) (5,948) (16,106) (18,869)
Redemption of preferred stock 28 - 55 -
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 8,793 13,659 33,166 38,520
----------- ----------- ----------- -----------
Net earnings used for basic EPS 441,061 386,016 1,508,160 1,074,871
Income adjustment (net of tax) applicable to deferred
compensation arrangements-nonvested shares 8,057 8,903 28,523 23,740
----------- ----------- ----------- -----------
Net earnings used for diluted EPS $ 449,118 $ 394,919 $ 1,536,683 $ 1,098,611
=========== =========== =========== ===========
Total basic weighted average common
shares outstanding (1) 132,086 130,194 132,540 130,717
----------- ----------- ----------- -----------
Effect of dilutive securities:
Employee stock options 5,966 3,949 5,842 4,066
CAP and restricted units 10,847 12,909 11,103 13,259
----------- ----------- ----------- -----------
Dilutive potential common shares 16,813 16,858 16,945 17,325
----------- ----------- ----------- -----------
Weighted average number of common shares
outstanding and dilutive potential common shares 148,899 147,052 149,485 148,042
=========== =========== =========== ===========
Basic EPS $ 3.34 $ 2.96 $ 11.38 $ 8.22
Diluted EPS $ 3.02 $ 2.69 $ 10.28 $ 7.42
=========== =========== =========== ===========
(1) Includes 12,949,398 and 17,313,461 vested units for the three months
ended August 31, 2006 and August 31, 2005, respectively, and
12,059,414 and 18,351,893 vested units for the nine months ended
August 31, 2006 and August 31, 2005, respectively, issued under
stock compensation plans which will be distributed as shares of
common stock.
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
9. REGULATORY REQUIREMENTS
Effective December 1, 2005, the Company became regulated by the SEC as a
consolidated supervised entity ("CSE"). As a CSE, the Company is subject
to group-wide supervision and examination by the SEC and is required to
compute allowable capital and allowances for market, credit and
operational risk on a consolidated basis. As of August 31, 2006, the
Company was in compliance with the CSE capital requirements.
Bear Stearns and BSSC are registered broker-dealers and futures commission
merchants and, accordingly, are subject to Rule 15c3-1 under the
Securities Exchange Act of 1934 ("Net Capital Rule") and Rule 1.17 under
the Commodity Futures Trading Commission. Effective December 1, 2005, the
SEC approved Bear Stearns' use of Appendix E of the Net Capital Rule which
establishes alternative net capital requirements for broker-dealers that
are part of consolidated supervised entities. Appendix E allows Bear
Stearns to calculate net capital charges for market risk and
derivatives-related credit risk based on mathematical models provided that
Bear Stearns holds tentative net capital in excess of $1 billion and net
capital in excess of $500 million. At August 31, 2006, Bear Stearns' net
capital of $5.55 billion exceeded the minimum requirement by $5.00
billion. Bear Stearns' net capital computation, as defined, includes
$830.4 million, which is net capital of BSSC in excess of 5.5% of
aggregate debit items arising from customer transactions.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the U.K.'s Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Financial Regulator.
Custodial Trust Company ("CTC"), a Federal Deposit Insurance Corporation
("FDIC") insured New Jersey state chartered bank, offers a range of trust,
lending and securities-clearance services. CTC provides the Company with
banking powers including access to the securities and funds-wire services
of the Federal Reserve System. CTC is subject to the regulatory capital
requirements of the FDIC.
At August 31, 2006, Bear Stearns, BSSC, BSIL, BSIT, BSB and CTC are 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 August 31, 2006,
these other subsidiaries were in compliance with their applicable local
capital adequacy requirements.
10. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At August 31, 2006, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years 2006 through 2010
and the aggregate amount thereafter, are as follows:
(in thousands)
-----------------------------
FISCAL YEAR
2006 (remaining) $ 20,490
2007 89,547
2008 90,972
2009 86,845
2010 89,427
Thereafter 572,002
----------
Total $ 949,283
==========
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Lending - Related Commitments
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment-grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment-grade borrowers
aggregated approximately $3.2 billion and $2.4 billion at August 31, 2006
and November 30, 2005, respectively. Of these amounts, approximately
$825.0 million and $652.5 million were economically hedged at August 31,
2006 and November 30, 2005, respectively. Lending-related commitments to
non-investment-grade borrowers approximated $2.5 billion and $1.4 billion
at August 31, 2006 and November 30, 2005, respectively.
The Company also had contingent commitments to investment-grade and
non-investment-grade companies of approximately $5.2 billion and $3.9
billion as of August 31, 2006 and November 30, 2005, respectively.
Generally, these commitments are provided in connection with leveraged
acquisitions. These commitments are not indicative of the Company's actual
risk because the borrower may never draw upon the commitment. In fact, the
borrower may not be successful in the acquisition, the borrower may access
the capital markets instead of drawing on the commitment, or the Company's
portion of the commitment may be reduced through the syndication process.
Additionally, the borrower's ability to draw may be subject to there being
no material adverse change in either market conditions or the borrower's
financial condition, among other factors. These commitments generally
contain certain flexible pricing features to adjust for changing market
conditions prior to closing.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At August 31, 2006 and November 30, 2005, such
commitments aggregated $729.2 million and $222.1 million, respectively.
These commitments will be funded, if called, through the end of the
respective investment periods, with the longest of such periods ending in
2017.
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income underwriting, the Company had commitments to purchase new issues of
securities aggregating $218.1 million and $943.1 million, respectively, at
August 31, 2006 and November 30, 2005.
Commercial and Residential Loans
The Company participates in the acquisition, origination, securitization,
servicing, financing and disposition of commercial and residential loans.
At August 31, 2006 and November 30, 2005, the Company had entered into
commitments to purchase or finance mortgage loans of $4.8 billion and $5.1
billion, respectively.
Letters of Credit
At August 31, 2006 and November 30, 2005, the Company was contingently
liable for unsecured letters of credit of approximately $3.2 billion and
$2.5 billion, respectively, and letters of credit of $1.8 billion and
$985.6 million, respectively, secured by financial instruments, primarily
used to provide collateral for securities borrowed and to satisfy margin
requirements at option and commodity exchanges.
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Litigation
In the normal course of business, the Company has been named as a
defendant in various legal actions, including arbitrations, class actions
and other litigation. Certain of the legal actions include claims for
substantial compensatory and/or punitive damages or claims for
indeterminate amounts of damages. The Company is also involved in other
reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of
which may result in adverse judgments, settlements, fines, penalties,
injunctions or other relief.
Because litigation is inherently unpredictable, particularly in cases
where claimants seek substantial or indeterminate damages or where
investigations and proceedings are in the early stages, the Company cannot
predict with certainty the loss or range of loss related to such matters,
how such matters will be resolved, when they will ultimately be resolved,
or what the eventual settlement, fine, penalty or other relief might be.
Consequently, the Company cannot estimate losses or ranges of losses for
matters where there is only a reasonable possibility that a loss may have
been incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after
consultation with counsel, that the resolution of the foregoing matters
will not have a material adverse effect on the financial condition of the
Company, taken as a whole; such resolution may, however, have a material
effect on the operating results in any future period, depending on the
level of income for such period.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies." The ultimate resolution may differ
materially from the amounts reserved.
Tax
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly evaluates the likelihood of additional assessments
in each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as information becomes available or when an event
requiring a change to the reserve occurs.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $98.1 million and $159.8 million, respectively, at August
31, 2006 and November 30, 2005.
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 reflect the actual future cash
funding requirements.
11. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others," requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 August 31, 2006:
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) $ 97,825 $ 359,721 $ 284,368 $ 443,378 $1,185,292
Municipal securities 2,459 388 - - 2,847
Residual value guarantee - - 570 - 570
------------------------------------------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $1.3 billion as
of August 31, 2006.
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. These derivative
contracts are recorded at fair value, which approximated $1.3 billion at
August 31, 2006.
In connection with these activities, the Company attempts to mitigate 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 August 31, 2006 was approximately $2.85 billion, which
represents the outstanding amount of all trust certificates. This exposure
to loss is mitigated by the underlying municipal bonds held by trusts. The
underlying municipal bonds in the trusts are either AAA or AA rated,
insured or escrowed to maturity. Such bonds had a market value, net of
related hedges, approximating $2.94 billion at August 31, 2006.
25
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 12, 2011 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 August 31, 2006, there was no expected shortfall and the
maximum residual value guarantee approximated $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third-party
originators upon acquisition of such assets. The Company generally
performs due diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to some counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse interpretation of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications, and the contingencies
triggering the obligation to indemnify are not expected to occur.
Maximum payout information under these indemnifications is not readily
available because of the number, size and duration of these transactions.
In implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that the Company will have to make significant
payments under these arrangements.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. If a member becomes unable to satisfy its
obligations to the clearinghouse, other members would be required to meet
these shortfalls. To mitigate these performance risks, the exchanges and
clearinghouses often require members to post collateral. The Company's
maximum potential liability under these arrangements cannot be quantified.
However, the potential for the Company to be required to make payments
under these arrangements is remote. Accordingly, no contingent liability
is recorded in the consolidated financial statements for these
arrangements.
12. SEGMENT DATA
The Company operates in three principal segments -- Capital Markets,
Global Clearing Services and Wealth Management. These segments offer
different products and services and are managed separately as different
levels and types of expertise are required to effectively manage the
segments' transactions.
The Capital Markets segment comprises the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates
as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses work in tandem to deliver these
services to institutional and corporate clients.
Institutional equities consists of research, sales and trading in areas
such as domestic and international equities, block trading, convertible
bonds, over-the-counter equities, equity derivatives, risk and convertible
arbitrage and
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
the NYSE, American Stock Exchange and International Securities Exchange
specialist activities. Fixed income includes sales, trading and research
provided to institutional clients across a variety of products such as
mortgage- and asset-backed securities, corporate and government bonds,
municipal bonds, high yield products, foreign exchange, and interest rate
and credit derivatives. Investment banking provides services in capital
raising, strategic advice, mergers and acquisitions and merchant banking.
Capital raising encompasses the Company's underwriting of equity,
investment-grade, municipal and high yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is composed of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the US and
abroad.
The three business segments comprise many business areas, with
interactions among each. Revenues and expenses include those that are
directly related to each segment. Revenues from intersegment transactions
are based upon specific criteria or agreed upon rates with such amounts
eliminated in consolidation. Individual segments also include revenues and
expenses relating to various items, including corporate overhead and
interest, which are internally allocated by the Company primarily based on
balance sheet usage or expense levels. The Company generally evaluates
performance of the segments based on net revenues and profit or loss
before provision for income taxes.
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months ended Nine Months ended
-------------------------------------------------------
August 31, August 31, August 31, August 31,
(in thousands) 2006 2005 2006 2005
---------------------------------------------------------------------------------------
NET REVENUES
Capital Markets
Institutional Equities $ 435,543 $ 333,620 $ 1,478,506 $ 1,037,013
Fixed Income 877,910 739,242 2,933,956 2,412,762
Investment Banking 232,253 299,935 807,252 749,264
----------- ----------- ----------- -----------
Total Capital Markets 1,545,706 1,372,797 5,219,714 4,199,039
Global Clearing Services 269,351 258,042 822,866 804,594
Wealth Management
Private Client Services (1) 127,304 113,897 384,987 333,409
Asset Management 104,040 55,686 220,697 161,149
----------- ----------- ----------- -----------
Total Wealth Management 231,344 169,583 605,684 494,558
Other (2) 82,734 11,858 165,516 25,301
----------- ----------- ----------- -----------
Total net revenues $ 2,129,135 $ 1,812,280 $ 6,813,780 $ 5,523,492
=========== =========== =========== ===========
PRE-TAX INCOME
Capital Markets $ 499,824 $ 492,155 $ 1,836,580 $ 1,429,614
Global Clearing Services 113,968 127,486 382,585 408,249
Wealth Management 20,737 4,894 39,593 25,927
Other (2) 32,709 (44,380) (4,968) (242,868)
----------- ----------- ----------- -----------
Total pre-tax income $ 667,238 $ 580,155 $ 2,253,790 $ 1,620,922
=========== =========== =========== ===========
Three Months ended Nine Months ended
------------------------------------- ---------------------------------------
August 31, August 31, August 31, August 31,
2006 2005 2006 2005
----------------- ----------------- ----------------- -------------------
(1) Private Client Services detail:
Gross revenues, before
transfer to Capital Markets segment $ 148,404 $ 138,987 $ 454,496 $ 402,566
Revenue transferred
to Capital Markets segment (21,100) (25,090) (69,509) (69,157)
----------------- ----------------- ----------------- -------------------
Private Client Services net revenues $ 127,304 $ 113,897 $ $384,987 $ 333,409
================= ================= ================= ===================
(2) Includes consolidation and elimination entries, unallocated revenues
(predominantly interest), and certain corporate administrative functions,
including certain legal costs and costs related to the CAP Plan. CAP Plan costs
were $29.5 million and $39.5 million for the three months ended August 31, 2006
and August 31, 2005, respectively and $108.0 million and $109.0 million for the
nine months ended August 31, 2006 and August 31, 2005, respectively.
As of
-----------------------------------------------------------
August 31, November 30, August 31,
(in thousands) 2006 2005 2005
-----------------------------------------------------------------------------------------------------
SEGMENT ASSETS
Capital Markets $ 225,635,555 $ 195,292,625 $ 186,104,876
Global Clearing Services 98,194,112 85,625,396 88,909,593
Wealth Management 3,032,653 2,751,749 2,440,003
Other 7,898,000 8,965,463 7,072,216
-----------------------------------------------------------------------------------------------------
Total segment assets $ 334,760,320 $ 292,635,233 $ 284,526,688
=====================================================================================================
28
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of
financial condition of The Bear Stearns Companies Inc. and subsidiaries as of
August 31, 2006, and the related condensed consolidated statements of income
for the three-month and nine-month periods ended August 31, 2006 and 2005 and
cash flows for the nine-month periods ended August 31, 2006 and 2005. These
interim financial statements are the responsibility of The Bear Stearns
Companies Inc.'s management.
We conducted our reviews 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.
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 Bear Stearns Companies Inc. and
subsidiaries as of November 30, 2005, and the related consolidated statements
of income, cash flows and changes in stockholders' equity for the fiscal year
then ended (not presented herein) included in The Bear Stearns Companies
Inc.'s Annual Report on Form 10-K for the fiscal year ended November 30,
2005, as amended by Amendment No. 1 thereto on Form 10-K/A; and in our report
dated February 10, 2006, we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth
in the accompanying condensed consolidated statement of financial condition
as of November 30, 2005 is fairly stated, in all material respects, in
relation to the consolidated statement of financial condition from which it
has been derived.
/s/ Deloitte & Touche LLP
New York, New York
October 9, 2006
29
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company") is a holding company that
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is a leading investment banking, securities and derivatives trading, clearance
and brokerage firm serving corporations, governments, institutional and
individual investors worldwide. BSSC, a subsidiary of Bear Stearns, provides
professional and correspondent clearing services in addition to clearing and
settling customer transactions and certain proprietary transactions of the
Company. The Company also conducts significant activities through other wholly
owned subsidiaries, including: Bear Stearns Global Lending Limited; Custodial
Trust Company; Bear Stearns Financial Products Inc.; Bear Stearns Capital
Markets Inc.; Bear Stearns Credit Products Inc.; Bear Stearns Forex Inc.; EMC
Mortgage Corporation; and Bear Stearns Commercial Mortgage, Inc. and through its
majority owned subsidiary Bear Hunter Holdings LLC. The Company is primarily
engaged in business as a securities broker-dealer operating in three principal
segments: Capital Markets, Global Clearing Services and Wealth Management. As
used in this report, the "Company" refers (unless the context requires
otherwise) to The Bear Stearns Companies Inc. and its subsidiaries. Unless
specifically noted otherwise, all references to the three and nine months of
2006 and 2005 refer to the three and nine months ended August 31, 2006 and
August 31, 2005, respectively, and all references to quarters are to the
Company's fiscal quarters.
For a description of the Company's business, including its trading in cash
instruments and derivative products, its underwriting and trading policies, and
their respective risks, and the Company's risk management policies and
procedures, see the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2005, as amended by Amendment No. 1 thereto on Form 10-K/A,
each as filed by the Company under the Securities Exchange Act of 1934, as
amended ("Exchange Act") (together, the "Form 10-K").
The Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read together with the Management's Discussion and Analysis
of Financial Condition and Results of Operations and the Consolidated Financial
Statements in the Form 10-K.
CERTAIN FACTORS AFFECTING RESULTS OF OPERATIONS
The Company's principal business activities--investment banking, securities and
derivatives sales and trading, clearance, brokerage and asset management--are,
by their nature, highly competitive and subject to various risks, including
volatile trading markets and fluctuations in the volume of market activity.
Consequently, the Company's net income and revenues have been, and are likely to
continue to be, subject to wide fluctuations, reflecting the effect of many
factors, including general economic conditions, securities market conditions,
the level and volatility of interest rates and equity prices, competitive
conditions, liquidity of global markets, international and regional political
conditions, regulatory and legislative developments, monetary and fiscal policy,
investor sentiment, availability and cost of capital, technological changes and
events, outcome of legal proceedings, changes in currency values, inflation,
credit ratings and the size, volume and timing of transactions.
These and other factors can affect the Company's volume of security new issues,
mergers and acquisitions and business restructurings; the stability and
liquidity of securities and futures markets; and ability of issuers, other
securities firms and counterparties to perform on their obligations. A decrease
in the volume of security new issues, mergers and acquisitions or restructurings
generally results in lower revenues from investment banking and, to a lesser
extent, reduced principal transactions. A reduced volume of securities and
futures transactions and reduced market liquidity generally results in lower
revenues from principal transactions and commissions. Lower price levels for
securities may result in a reduced volume of transactions, and may also result
in losses from declines in the market value of securities held in proprietary
trading and underwriting accounts. In periods of reduced sales and trading or
investment banking activity, profitability may be adversely affected because
certain expenses remain relatively fixed. The Company's securities trading,
derivatives, arbitrage, market-making, specialist, leveraged lending, leveraged
buyout and underwriting activities are conducted on a principal basis and expose
the Company to significant risk of loss. Such risks include market, credit and
liquidity risks. For a discussion of how the Company seeks to manage risks, see
the "Risk Management" and "Liquidity and Capital Resources" sections of the Form
10-K.
30
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
difficult regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements concerning management's expectations, strategic
objectives, business prospects, anticipated economic performance and financial
condition and other similar matters are subject to risks and uncertainties,
including those described in the prior paragraphs, which could cause actual
results to differ materially from those discussed in the forward-looking
statements. Forward-looking statements speak only as of the date of the document
in which they are made. We disclaim any obligation or undertaking to provide any
updates or revisions to any forward-looking statement to reflect any change in
our expectations or any change in events, conditions or circumstances on which
the forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
Revenues, net of interest expense ("net revenues") for the three months ended
August 31, 2006 increased 17.5% to $2.13 billion from $1.81 billion for the
three months ended August 31, 2005, while pre-tax earnings increased 15.0%
during the same period. The pre-tax profit margin for the 2006 quarter decreased
to 31.3% when compared with 32.0% in the 2005 quarter. Annualized return on
average common equity was 15.8% for the quarter ended August 31, 2006 versus
16.9% in the prior year quarter.
Capital Markets net revenues increased 12.6% to $1.55 billion for the 2006
quarter compared to $1.37 billion for the 2005 quarter. Within the Capital
Markets segment, institutional equities net revenues increased 30.6% to $435.5
million for the 2006 quarter from $333.6 million for the 2005 quarter. Energy
and commodity revenues contributed to the increase in institutional equities net
revenues, reflecting gains from the sale of certain commodity assets. Equity
derivatives net revenues increased on strong market conditions and active
institutional and corporate customer volumes. International equity sales and
trading net revenues also increased, benefiting from continued strength in
European and Asian equities. Fixed income net revenues increased 18.8% to $877.9
million for the 2006 quarter from $739.2 million for the 2005 quarter. The
Company's credit derivatives business reached record levels in the 2006 quarter
on higher levels of customer activity. Net revenues from the leveraged finance
area also increased on higher levels of acquisition related finance activity.
Mortgage-backed securities revenues increased despite the 175 basis point
increase in short-term rates and significant flattening of the yield curve.
Commercial mortgage and collateralized debt obligations ("CDO") net revenues
increased significantly when compared to the prior year quarter as
securitization volumes rose on favorable investor demand and market share gains.
Investment banking revenues decreased 22.6% to $232.3 million for the 2006
quarter from $299.9 million for the 2005 quarter, primarily reflecting a
decrease in merchant banking revenues as well as a decrease in equity
underwriting activity as the volume of lead and co-managed initial public
offerings ("IPO") and equity follow-on offerings declined in a less favorable
market environment. These declines in investment banking were partially offset
by an increase in mergers and acquisitions ("M&A") fees resulting from higher
levels of completed M&A activity.
Global Clearing Services net revenues increased 4.4% to $269.4 million for the
2006 quarter from $258.0 million for the 2005 quarter. An increase in average
customer margin and short sale balances contributed to an increase in net
interest revenues, partially offset by a decline in commission revenues.
Wealth Management net revenues increased 36.4% to $231.3 million for the 2006
quarter from $169.6 million for the 2005 quarter, reflecting growth in fee-based
assets in the Company's private client services ("PCS") business. Asset
management revenues also increased in the 2006 quarter, primarily due to
increased performance fees on proprietary hedge fund products and increased
management fees on higher levels of assets under management.
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Business Environment
Fiscal 2006 Quarter
The business environment during the third quarter ended August 31, 2006 was
generally favorable due to a combination of factors including an expanding US
economy, low interest rates and low unemployment. The Federal Reserve Board (the
"Fed") met twice during the quarter and raised the federal funds rate from 5.00%
to 5.25% during its first meeting and kept the federal funds rate unchanged at
5.25% at its second meeting citing moderating economic growth from its strong
pace earlier in the year, a gradual cooling of the housing market and higher
energy prices. In August 2006, the unemployment rate was at 4.7%, up from 4.6%
at the end of the second quarter. Oil prices declined slightly to close at $70 a
barrel at the end of August, down 1.4% from the prior quarter's close of $71.
The major indices were all up during the third quarter of 2006. The Dow Jones
Industrial Average ("DJIA"), Nasdaq Composite Index ("NASDAQ") and Standard &
Poor's 500 Index ("S&P 500") increased 1.9%, 0.2% and 2.7%, respectively.
Average daily trading volume on the Nasdaq and New York Stock Exchange ("NYSE")
increased 14.9% and 12.8%, respectively, in the 2006 quarter, compared to the
2005 quarter. Industry-wide US announced M&A volumes increased 25.3% while
industry-wide US-completed M&A volumes decreased 19.2% compared to the
comparable prior year quarter. Total equity issuance volumes decreased 27.0%
industry-wide while IPO volumes decreased 55.4% industry-wide compared to the
2005 quarter.
Fixed income activity continued to be robust during the 2006 quarter compared
with the comparable prior year quarter despite the increase in short-term
interest rates and a flattening yield curve. Long-term interest rates, as
measured by the 10-year Treasury bond, decreased during the 2006 quarter. The
10-year Treasury bond yield decreased to 4.73% at the end of the 2006 quarter
from 5.11% at the beginning of the quarter. The housing market experienced
declines in refinancing and purchasing levels during the 2006 quarter. Overall,
US mortgage-backed securities new issue volume decreased 3.9% industry-wide
during the 2006 quarter compared with the 2005 quarter. Agency collateralized
mortgage obligation ("CMO") volumes increased 8.2%, while non-agency
mortgage-backed and commercial mortgage-backed origination volumes decreased
approximately 0.1% and 32.4%, respectively, industry-wide during the 2006
quarter from the levels reached in the 2005 quarter.
Fiscal 2005 Quarter
The business environment during the Company's third quarter ended August 31,
2005 was generally favorable due to a combination of factors including an
expanding US economy, continued low interest rates and low inflation. Favorable
job reports and an active housing market provided ongoing support to economic
activity. The unemployment rate dropped to 4.9% in August 2005. Oil prices,
however, soared during the 2005 quarter. The price per barrel increased from $54
at the beginning of the quarter to $69 at August 31, 2005 raising concerns about
the effect on overall economic activity. The Fed met twice during the quarter
and continued its measured pace of interest rate increases, raising the federal
funds rate, in 25 basis point increments, from 3.00% to 3.50%. They were the 9th
and 10th straight 25 basis point increase since June 2004.
The major equity indices all increased during the third quarter of 2005. The
DJIA, the NASDAQ and the S&P 500 increased 0.1%, 4.1% and 2.4%, respectively,
during the 2005 quarter, compared to the 2004 quarter. Average daily trading
volume on the NYSE and Nasdaq increased 8.3% and 5.3%, respectively, compared to
the 2004 quarter. Industry-wide announced M&A volumes increased 35.9% while
industry-wide completed M&A volumes increased 31.3% in the 2005 quarter compared
to the 2004 quarter. Total equity issuance increased 38.5% in the 2005 quarter
compared with the 2004 quarter.
Fixed income activity was robust during the 2005 quarter despite a more
challenging environment associated with higher short-term interest rates and a
flattening yield curve. While the Fed continued to raise the federal funds rate
during the 2005 quarter, long-term interest rates, as measured by the 10-year
Treasury bond, remained relatively stable during the 2005 quarter. The 10-year
Treasury bond yield was 4.01% at the end of the third quarter, approximately the
same level it was at the beginning of the quarter. The mortgage purchase index
increased approximately 11% compared to the 2004 quarter reflecting low interest
rates and the strong home purchasing market. Agency CMO and non-agency volumes
continued to achieve high levels during the quarter. Overall mortgage-backed
securities new issue volume increased 7.6% during the 2005 quarter compared with
the 2004 quarter.
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended Nine Months Ended
(in thousands, except per share amounts, ------------------------------------------------------------------------------------
pre-tax profit margin and return on average August 31, August 31, August 31, August 31,
common equity) 2006 2005 % Increase 2006 2005 % Increase
-------------------------------------------- ------------ ------------ ---------- ------------- ------------- ----------
Revenues, net of interest expense $ 2,129,135 $ 1,812,280 17.5% $ 6,813,780 $ 5,523,492 23.4%
Income before provision for income taxes $ 667,238 $ 580,155 15.0% $ 2,253,790 $ 1,620,922 39.0%
Net Income $ 437,556 $ 378,305 15.7% $ 1,491,045 $ 1,055,220 41.3%
Diluted earnings per share $ 3.02 $ 2.69 12.3% $ 10.28 $ 7.42 38.5%
Pre-tax profit margin 31.3% 32.0% 33.1% 29.3%
Return on average common equity (annualized) 15.8% 16.9% 18.7% 16.1%
-------------------------------------------- ------------ ------------ ---------- ------------- ------------- ----------
The Company reported net income of $437.6 million, or $3.02 per share (diluted),
for the 2006 quarter, which represented an increase of 15.7% from $378.3
million, and an increase of 12.3% from $2.69 per share (diluted), for the 2005
quarter. Net revenues increased 17.5% to $2.13 billion for the 2006 quarter from
$1.81 billion for the 2005 quarter, due to increases in principal transactions
revenues, net interest revenues, and asset management and other revenues,
partially offset by decreases in investment banking revenues and commission
revenues.
The Company reported net income of $1.49 billion, or $10.28 per share (diluted),
for the nine months ended August 31, 2006, which represented an increase of
41.3% from $1.06 billion, and 38.5% from $7.42 per share (diluted), for the nine
months ended August 31, 2005. Net revenues increased 23.4% to $6.81 billion for
the 2006 period from $5.52 billion for the 2005 period, due to increases in
principal transactions revenues, net interest revenues, investment banking
revenues, and asset management and other revenues, partially offset by a
decrease in commission revenues.
The Company's commission revenues by reporting category were as follows:
Three Months Ended Nine Months Ended
-----------------------------------------------------------------------------
August 31, August 31, % Increase/ August 31, August 31, % Increase/
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
----------------- ---------- ---------- ----------- ---------- ---------- -----------
Institutional $ 193,203 $ 188,600 2.4 % $ 587,179 $ 581,938 0.9 %
Clearance 54,882 62,882 (12.7%) 176,685 197,494 (10.5%)
Retail 31,948 39,317 (18.7%) 107,491 122,352 (12.1%)
----------------- ---------- ---------- ----------- ---------- ---------- -----------
Total commissions $ 280,033 $ 290,799 (3.7%) $ 871,355 $ 901,784 (3.4%)
================= ========== ========== =========== ========== ========== ===========
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Commission revenues decreased 3.7% to $280.0 million for the 2006 quarter from
$290.8 million for the 2005 quarter. Institutional commissions increased 2.4% to
$193.2 million for the 2006 quarter from $188.6 million for the 2005 quarter due
to increased average trading volumes. Clearance commissions decreased 12.7% to
$54.9 million for the 2006 quarter from $62.9 million for the 2005 quarter,
reflecting lower volumes and average rates from prime brokerage clients and
lower average rates from fully disclosed clients. Retail commissions were $31.9
million in the 2006 quarter, down 18.7% from $39.3 million in the 2005 quarter
due to the business shifting some accounts from a commission to fee-based
structure.
Commission revenues decreased 3.4% to $871.4 million for the nine months ended
August 31, 2006 from $901.8 million for the 2005 period. Institutional
commissions increased 0.9% to $587.2 million for the 2006 period from $581.9
million for the 2005 period due to increased average trading volumes. Clearance
commissions decreased 10.5% to $176.7 million for the 2006 period from $197.5
million for the 2005 period, reflecting lower volumes and average rates from
prime brokerage clients and lower average rates from fully disclosed clients.
Retail commissions decreased 12.1% to $107.5 million in the 2006 period from
$122.4 million in the 2005 period due to the business shifting some accounts
from a commission to fee-based structure.
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended Nine Months Ended
------------------------------------------------------------------------------
August 31, August 31, August 31, August 31,
(in thousands) 2006 2005 % Increase 2006 2005 % Increase
---------------------------- ---------- ---------- ----------- ---------- ---------- -----------
Fixed income $ 789,335 $ 694,812 13.6% $2,655,894 $2,242,740 18.4%
Equities 304,662 188,330 61.8% 1,081,013 599,214 80.4%
---------------------------- ---------- ---------- ----------- ---------- ---------- -----------
Total principal transactions $1,093,997 $ 883,142 23.9% $3,736,907 $2,841,954 31.5%
============================ ========== ========== =========== ========== ========== ===========
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
Revenues from principal transactions increased 23.9% to $1.09 billion for the
2006 quarter from $883.1 million for the 2005 quarter. Fixed income revenues
increased 13.6% to $789.3 million for the 2006 quarter from $694.8 million for
the 2005 quarter. Net revenues from the Company's credit derivatives area
increased, as a result of increased customer volumes. Net revenues from the
Company's leveraged finance area also increased. Mortgage-backed securities
revenues continued to be strong in the 2006 quarter. While revenues from agency
and non-agency mortgage-backed securities were largely unchanged in the 2006
quarter compared with the 2005 quarter, revenues from commercial mortgages and
CDO's increased on higher securitization volumes reflecting favorable investor
demand and market share gains. Revenues derived from equities activities
increased 61.8% to $304.7 million for the 2006 quarter from $188.3 million for
the 2005 quarter. The 2006 quarter included significant gains on the Company's
sale of certain commodity assets. Net revenues from the equity derivatives
business area rose as a result of increased customer demand. Net revenues from
the Company's international equity sales and trading also rose, reflecting
continued strength in European and Asian equities. In addition, net revenues
from the risk arbitrage business increased on higher global announced M&A
volumes.
Revenues from principal transactions increased 31.5% to $3.74 billion for the
nine months ended August 31, 2006 from $2.84 billion for the comparable prior
year period. Fixed income revenues increased 18.4% to $2.66 billion for the 2006
period from $2.24 billion for the comparable prior year period. Mortgage-backed
securities revenues increased in the 2006 period when compared to the 2005
period on higher origination volumes from asset-backed securities and adjustable
rate mortgage ("ARM") securities and increased secondary trading revenues,
particularly in non-agency mortgage-backed securities and ARMS. Net revenues
from distressed trading also contributed to the increase in fixed income
revenues as corporate credit spreads tightened during the 2006 period.
Additionally, credit derivatives net revenues rose on increased customer
activities reflecting favorable market conditions. Revenues derived from
equities activities increased 80.4% to $1.08 billion for the 2006 period from
$599.2 million for the 2005 period. The 2006 period also included gains on the
Company's sale of certain commodity assets as well as gains on the Company's
investment in NYSE Group Inc. Net revenues from equity derivatives rose on
increased customer activity. Net revenues from the Company's international
equity sales and trading area also rose, reflecting higher trading volumes as
well as market share gains in both European and Asian equities. In addition, net
revenues from the risk arbitrage business increased on higher global announced
M&A volumes.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended Nine Months Ended
-------------------------------------------------------------------------------
August 31, August 31, % Increase/ August 31, August 31, % Increase/
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
Underwriting $ 86,280 $ 114,509 (24.7%) $ 349,779 $ 366,547 (4.6%)
Advisory and other fees 187,334 108,290 73.0% 512,881 285,639 80.0%
Merchant banking 9,893 93,098 (89.4%) 76,850 147,847 (48.0%)
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
Total investment banking $ 283,507 $ 315,897 (10.3%) $ 939,510 $ 800,033 17.4%
======================== ========== ========== =========== ========== ========== ===========
Investment banking revenues decreased 10.3% to $283.5 million for the 2006
quarter from $315.9 million for the 2005 quarter. Underwriting revenues
decreased 24.7% to $86.3 million for the 2006 quarter from $114.5 million for
the 2005 quarter. Equity underwriting revenues decreased as lower levels of
equity underwriting activity reflected a less favorable market environment.
Advisory and other fees increased 73.0% to $187.3 million for the 2006 quarter
from $108.3 million for the 2005 quarter, reflecting an increase in completed
M&A assignments. In addition, mortgage servicing revenues increased during the
2006 quarter, reflecting growth in loan servicing volumes. Merchant banking
revenues, which include realized and unrealized investment gains and performance
fees on managed merchant banking funds, decreased 89.4% to $9.9 million for the
2006 quarter from $93.1 million for the 2005 quarter, reflecting lower net gains
on the Company's portfolio of investments and lower performance fees on managed
merchant banking funds.
Investment banking revenues increased 17.4% to $939.5 million for the nine
months ended August 31, 2006 from $800.0 million for the nine months ended
August 31, 2005. Underwriting revenues decreased 4.6% to $349.8 million for the
2006 period from $366.5 million for the 2005 period, primarily due to lower
levels of equity underwriting activity. Advisory and other fees increased 80.0%
to $512.9 million for the 2006 period from $285.6 million for the 2005 period,
reflecting a significant increase in completed M&A assignments as well as an
increase in mortgage servicing fees. Merchant banking revenues decreased 48.0%
to $76.9 million for the 2006 period from $147.8 million for the 2005 period,
reflecting lower net gains on the Company's portfolio of investments and lower
performance fees on managed merchant banking funds.
Net interest revenues (interest and dividend revenue less interest expense)
increased 37.0% to $316.4 million for the 2006 quarter from $231.0 million for
the 2005 quarter. The increase in net interest revenues was primarily
attributable to higher average customer margin and short sale balances and
improved net interest margins and asset liability composition. Average customer
margin debt balances increased 8.5% to $68.8 billion for the 2006 quarter from
$63.4 billion for the 2005 quarter. Average customer short balances increased
1.0% to $82.1 billion for the 2006 quarter from $81.3 billion for the 2005
quarter and average securities borrowed balances decreased 2.5% to $54.7 billion
for the 2006 quarter from $56.1 billion for the 2005 quarter.
Net interest revenues increased 25.9% to $893.8 million for the nine months
ended August 31, 2006 from $709.6 million for the nine months ended August 31,
2005. The increase in net interest revenues was primarily attributable to
improved net interest margins. Average customer margin debt balances increased
4.5% to $67.2 billion for the 2006 period from $64.4 billion for the 2005
period. Average customer short balances decreased 8.5% to $80.2 billion for the
2006 period from $87.7 billion for the 2005 period and average securities
borrowed balances decreased 15.7% to $54.1 billion for the 2006 period from
$64.3 billion for the 2005 period.
Asset management and other revenues increased 69.6% to $155.2 million for the
2006 quarter from $91.5 million for the 2005 quarter. Asset management and other
revenues increased 37.8% to $372.2 million for the nine months ended August 31,
2006 from $270.1 million for the nine months ended August 31, 2005. These
increases were due to increased performance fees on proprietary hedge fund
products and increased management fees on traditional assets under management.
Private client services net revenues also increased due to higher levels of
fee-based assets.
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended Nine Months Ended
-------------------------------------------------------------------------------
August 31, August 31, % Increase/ August 31, August 31, % Increase/
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
-------------------------------------------- ---------- ---------- ----------- ---------- ---------- -----------
Employee compensation and benefits $1,024,748 $ 850,985 20.4% $3,291,814 $2,680,668 22.8%
Floor brokerage, exchange and clearance fees 58,621 55,029 6.5% 168,485 169,609 (0.7%)
Communications and technology 126,938 97,668 30.0% 349,141 296,950 17.6%
Occupancy 52,976 43,354 22.2% 143,025 123,704 15.6%
Advertising and market development 38,243 32,784 16.7% 108,009 95,933 12.6%
Professional fees 78,110 60,018 30.1% 197,451 168,015 17.5%
Other expenses 82,261 92,287 (10.9%) 302,065 367,691 (17.8%)
-------------------------------------------- ---------- ---------- ----------- ---------- ---------- -----------
Total non-interest expenses $1,461,897 $1,232,125 18.6% $4,559,990 $3,902,570 16.8%
============================================ ========== ========== =========== ========== ========== ===========
Employee compensation and benefits includes the cost of salaries, benefits and
incentive compensation, including CAP units, restricted stock units and option
awards. Employee compensation and benefits increased 20.4% to $1.02 billion for
the 2006 quarter from $851.0 million for the 2005 quarter, and increased 22.8%
to $3.29 billion for the nine months ended August 31, 2006 from $2.68 billion
for the nine months ended August 31, 2005, primarily due to higher discretionary
compensation associated with the increase in net revenues. Employee compensation
and benefits as a percentage of net revenues increased to 48.1% for the 2006
quarter from 47.0% for the 2005 quarter, and decreased to 48.3% for the nine
months ended August 31, 2006 from 48.5% for the nine months ended August 31,
2005. Full-time employees increased to 13,134 at August 31, 2006 from 11,498 at
August 31, 2005. The growth in headcount is primarily due to the expansion of
the Company's fixed income, wealth management, global clearing and derivatives
areas, resulting from increased business activities and growth initiatives.
Non-compensation expenses increased 14.7% to $437.1 million for the 2006 quarter
from $381.1 million for the 2005 quarter and increased 3.8% to $1.27 billion for
the nine months ended August 31, 2006 from $1.22 billion for the nine months
ended August 31, 2005. Non-compensation expenses as a percentage of net revenues
decreased to 20.5% for the 2006 quarter compared with 21.0% for the 2005
quarter, and decreased to 18.6% for the nine months ended August 31, 2006
compared with 22.1% for the nine months ended August 31, 2005. Communications
and technology costs increased 30.0% and 17.6% for the three and nine months
ended August 31, 2006, respectively, compared with the corresponding prior year
periods, as increased headcount resulted in higher voice and market data-related
costs. Occupancy costs increased 22.2% and 15.6% for the three and nine months
ended August 31, 2006, respectively, compared with the corresponding prior year
periods, reflecting additional office space requirements and higher leasing
costs associated with the Company's headquarters building at 383 Madison Avenue
in New York City. Professional fees increased 30.1% and 17.5% for the three and
nine months ended August 31, 2006, respectively, compared with the corresponding
prior year periods, due to higher levels of temporary help and consulting fees.
Other expenses decreased 10.9% and 17.8% for the three and nine months ended
August 31, 2006, respectively, compared with the corresponding prior year
periods. CAP Plan related costs decreased 25.3% to $29.5 million for the 2006
quarter from $39.5 million in the 2005 quarter, and decreased 0.9% to $108.0
million for the nine months ended August 31, 2006 from $109.0 million for the
nine months ended August 31, 2005, due to fewer CAP units outstanding, partially
offset by higher levels of earnings, particularly in the current nine month
period. The decrease in other expenses for the nine months ended August 31, 2006
reflects a reduction in litigation related costs. Pre-tax profit margin was
31.3% and 33.1% for the three and nine months ended August 31, 2006,
respectively, versus 32.0% and 29.3% for the corresponding prior year periods.
The Company's effective tax rate decreased to 34.4% for the 2006 quarter from
34.8% for the 2005 quarter. The Company's effective tax rate for the nine months
ended August 31, 2006 decreased to 33.8% from 34.9% for the nine months ended
August 31, 2005. During the nine month period ended August 31, 2006, the Company
experienced favorable audit settlements which resulted in a reduction in the
consolidated effective tax rate.
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Business Segments
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments.
The following segment operating results exclude certain unallocated revenues
(predominantly interest) as well as certain corporate administrative functions,
such as certain legal costs and costs related to the CAP Plan. See Note 12,
"Segment Data" in the Notes to Condensed Consolidated Financial Statements for
complete segment information.
Capital Markets
---------------
Three Months Ended Nine Months Ended
-------------------------------------------------------------------------------
August 31, August 31, % Increase/ August 31, August 31,
(in thousands) 2006 2005 (Decrease) 2006 2005 % Increase
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
Net revenues
Institutional equities $ 435,543 $ 333,620 30.6% $1,478,506 $1,037,013 42.6%
Fixed income 877,910 739,242 18.8% 2,933,956 2,412,762 21.6%
Investment banking 232,253 299,935 (22.6%) 807,252 749,264 7.7%
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
Total net revenues $1,545,706 $1,372,797 12.6% $5,219,714 $4,199,039 24.3%
Pre-tax income $ 499,824 $ 492,155 1.6% $1,836,580 $1,429,614 28.5%
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
The Capital Markets segment comprises the institutional equities, fixed income
and investment banking areas. The Capital Markets segment operates as a single
integrated unit that provides the sales, trading and origination effort for
various fixed income, equity and advisory products and services. Each of the
three businesses work in tandem to deliver these services to institutional and
corporate clients.
Institutional equities consists of sales, trading and research, in areas such as
domestic and international equities, block trading, convertible bonds,
over-the-counter equities, equity derivatives, risk and convertible arbitrage
and through a majority-owned joint venture, specialist activities on the NYSE,
American Stock Exchange and International Securities Exchange. Fixed income
includes sales, trading and research provided to institutional clients across a
variety of products such as mortgage and asset-backed securities, corporate,
government and municipal bonds, high yield products, foreign exchange and
interest rate and credit derivatives. Investment banking provides services in
capital raising, strategic advice, mergers and acquisitions and merchant
banking. Capital raising encompasses the Company's underwriting of equity,
investment-grade, municipal and high yield debt products.
Net revenues for Capital Markets increased 12.6% to $1.55 billion for the 2006
quarter compared to $1.37 billion for the 2005 quarter. Pre-tax income for
Capital Markets increased 1.6% to $499.8 million for the 2006 quarter from
$492.2 million for the 2005 quarter.
Institutional equities net revenues increased 30.6% to $435.5 million for the
2006 quarter from $333.6 million for the 2005 quarter. The 2006 quarter included
significant gains from the sale of certain commodity assets. Equity derivatives
net revenues increased on improved market conditions and increased customer
volumes. Net revenues from the Company's international equity sales and trading
also rose, reflecting continued strength in European and Asian equities and risk
arbitrage revenues increased on higher announced M&A volumes.
Fixed income net revenues increased 18.8% to $877.9 million for the 2006 quarter
from $739.2 million for the 2005 quarter. Record level results from the
Company's credit derivatives business resulting from increased customer volumes
contributed to the increase in fixed income net revenues. Net revenues from the
leveraged finance area also increased on higher levels of acquisition related
finance activities. Mortgage-backed securities revenues increased in the 2006
quarter when compared to the 2005 quarter despite
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
the 175 basis point increase in short-term rates and significant flattening of
the yield curve. Commercial mortgage and CDO net revenues increased as
securitization volumes rose on favorable investor demand and market share gains.
For the quarter ended August 31, 2006, Bear Stearns ranked as the #1 underwriter
of US mortgage-backed securities.
Investment banking revenues decreased 22.6% to $232.3 million for the 2006
quarter from $299.9 million for the 2005 quarter. Underwriting revenues
decreased 24.4% to $92.7 million for the 2006 quarter from $122.6 million for
the 2005 quarter, as equity underwriting revenues decreased, reflecting a
decrease in the volume of IPO's and follow-on offerings. Advisory and other fees
increased 53.9% to $129.7 million for the 2006 quarter from $84.2 million for
the 2005 quarter, reflecting a significant increase in completed M&A
assignments. Merchant banking revenues decreased to $9.9 million in the 2006
quarter from $93.1 million during the 2005 quarter. Merchant banking revenues
include realized and unrealized investment gains and performance fees on managed
merchant banking funds. The decrease in merchant banking revenues was due to
lower net gains on the Company's portfolio of investments and lower performance
fees on managed merchant banking funds.
Net revenues for Capital Markets increased 24.3% to $5.22 billion for the nine
months ended August 31, 2006 compared to $4.20 billion for the nine months ended
August 31, 2005. Pre-tax income for Capital Markets increased 28.5% to $1.84
billion for the 2006 period from $1.43 billion for the 2005 period. Pre-tax
profit margin was 35.2% for the 2006 period compared with 34.0% for the 2005
period.
Institutional equities net revenues increased 42.6% to $1.48 billion for the
2006 period from $1.04 billion for the 2005 period. Equity derivatives net
revenues increased due to increased customer activity resulting from rising
equity markets. Net revenues from the Company's international equity sales and
trading area also rose, reflecting higher trading volumes as well as higher
volatility and strong international M&A activity. In addition, revenues from the
Company's energy and commodity activities increased, reflecting gains from the
sale of certain commodity assets and increased revenues from the Company's
energy activities. The 2006 period also included gains on the Company's
investment in NYSE Group Inc.
Fixed income net revenues increased 21.6% to $2.93 billion for the 2006 period
from $2.41 billion for the 2005 period. Mortgage-backed securities revenues
increased on higher origination volumes and active secondary trading markets.
Net revenues from asset-backed securities and ARMS increased, reflecting
increased securitization activity and generally tighter mortgage spreads. The
Company also achieved strong results from its credit derivatives and leveraged
finance areas.
Investment banking revenues increased 7.7% to $807.3 million for the 2006 period
from $749.3 million for the 2005 period. Underwriting revenues decreased 3.6% to
$378.1 million for the 2006 period from $392.4 million for the 2005 period as
equity underwriting revenues decreased, reflecting lower industry new issue
volume. Advisory and other fees for the 2006 period increased 68.5% to $352.3
million from $209.0 million for the 2005 period, reflecting increased M&A fees
due to a significant increase in completed M&A assignments. Merchant banking
revenues decreased to $76.9 million in the 2006 period from $147.9 million
during the 2005 period, attributable to a decrease in net gains from the
Company's principal investments and a decrease in performance fees on merchant
banking funds.
Global Clearing Services
------------------------
Three Months Ended Nine Months Ended
-------------------------------------------------------------------------------
August 31, August 31, % Increase/ August 31, August 31, % Increase/
(in thousands) 2006 2005 (Decrease) 2006 2005 (Decrease)
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
Net revenues $ 269,351 $ 258,042 4.4% $ 822,866 $ 804,594 2.3%
Pre-tax income $ 113,968 $ 127,486 (10.6%) $ 382,585 $ 408,249 (6.3%)
------------------------ ---------- ---------- ----------- ---------- ---------- -----------
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At August 31, 2006 and August 31, 2005, the Company held approximately
$282.0 billion and $255.6 billion, respectively, in equity in Global Clearing
Services client accounts.
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net revenues for Global Clearing Services increased 4.4% to $269.4 million for
the 2006 quarter from $258.0 million for the 2005 quarter. Net interest revenues
increased 6.9% to $205.7 million for the 2006 quarter from $192.5 million for
the 2005 quarter, reflecting an increase in average customer margin and short
sale balances from clearance clients. These results were partially offset by a
decline in commission and other revenues of 2.9% to $63.7 million for the 2006
quarter from $65.5 million for the 2005 quarter, reflecting lower volumes and
average rates from prime brokerage clients and lower average rates from fully
disclosed clients. Pre-tax income decreased 10.6% to $114.0 million, from $127.5
million for the 2005 quarter. Pre-tax profit margin was 42.3% for the 2006
quarter compared to 49.4% for the 2005 quarter.
Net revenues for Global Clearing Services increased 2.3% to $822.9 million for
the nine months ended August 31, 2006 from $804.6 million for the nine months
ended August 31, 2005. Net interest revenues increased 5.0% to $616.3 million
for the 2006 period from $586.6 million for the 2005 period, primarily due to an
increase in average customer margin balances. Commission and other revenues
decreased 7.5% to $201.6 million for the 2006 period from $218.0 million for the
2005 period, reflecting lower volumes and average rates from prime brokerage
clients and lower average rates from fully disclosed clients. Pre-tax income
decreased 6.3% to $382.6 million, from $408.2 million for the 2005 period.
Pre-tax profit margin was 46.5% for the 2006 period compared to 50.7% for the
2005 period.
The following table presents the Company's interest-bearing balances for the
fiscal periods ended:
Three Months ended Nine Months ended
-----------------------------------------------------
August 31, August 31, August 31, August 31,
(in billions) 2006 2005 2006 2005
--------------------------------------------- ----------- ----------- ----------- -----------
Margin debt balances, average for period $ 68.8 $ 63.4 $ 67.2 $ 64.4
Margin debt balances, at period end 68.9 65.9 68.9 65.9
Customer short balances, average for period 82.1 81.3 80.2 87.7
Customer short balances, at period end 85.6 80.6 85.6 80.6
Securities borrowed, average for period 54.7 56.1 54.1 64.3
Securities borrowed, at period end 53.1 50.0 53.1 50.0
Free credit balances, average for period 35.9 28.6 32.2 30.9
Free credit balances, at period end 36.5 29.6 36.5 29.6
Equity held in client accounts, at period end 282.0 255.6 282.0 255.6
--------------------------------------------- ----------- ----------- ----------- -----------
Wealth Management
-----------------
Three Months Ended Nine Months Ended
-----------------------------------------------------------------------------------
August 31, August 31, % Increase/ August 31, August 31,
(in thousands) 2006 2005 (Decrease) 2006 2005 % Increase
---------------------------------------------- ---------- ---------- ----------- ---------- ---------- -----------
Private client services revenues $ 148,404 $ 138,987 6.8% $ 454,496 $ 402,566 12.9%
Revenue transferred to Capital Markets segment (21,100) (25,090) (15.9%) (69,509) (69,157) 0.5%
---------- ---------- ----------- ---------- ---------- -----------
Private client services net revenues 127,304 113,897 11.8% 384,987 333,409 15.5%
Asset management 104,040 55,686 86.8% 220,697 161,149 37.0%
---------- ---------- ----------- ---------- ---------- -----------
Total net revenues $ 231,344 $ 169,583 36.4% $ 605,684 $ 494,558 22.5%
Pre-tax income $ 20,737 $ 4,894 323.7% $ 39,593 $ 25,927 52.7%
---------------------------------------------- ---------- ---------- ----------- ---------- ---------- -----------
The Wealth Management segment is composed of the PCS and asset management areas.
PCS provides high-net-worth individuals with an institutional level of
investment service, including access to the Company's resources and
professionals. At August 31, 2006, PCS had approximately 500 account executives
in its principal office, six regional offices and two international offices.
Asset management manages equity, fixed income and alternative assets for
corporate pension plans, public systems, endowments, foundations, multi-employer
plans, insurance companies, corporations, families and high-net-worth
individuals in the US and abroad.
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net revenues for Wealth Management increased 36.4% to $231.3 million for the
2006 quarter from $169.6 million for the 2005 quarter. PCS revenues increased
11.8% to $127.3 million for the 2006 quarter from $113.9 million for the 2005
quarter, reflecting higher levels of fee-based income attributable to the
Company's private client advisory services products. Asset management revenues
increased 86.8% to $104.0 million for the 2006 quarter from $55.7 million for
the 2005 quarter, primarily reflecting increased performance fees on proprietary
hedge fund products and increased management fees across all product lines
resulting from the growth in assets under management.
Net revenues for Wealth Management increased 22.5% to $605.7 million for the
nine months ended August 31, 2006 from $494.6 million for the nine months ended
August 31, 2005. PCS revenues increased 15.5% to $385.0 million for the 2006
period from $333.4 million for the 2005 period, reflecting higher levels of
fee-based income attributable to the Company's private client advisory services
products. Asset management revenues increased 37.0% to $220.7 million for the
2006 period from $161.1 million for the 2005 period, reflecting increased
management fees resulting from growth in assets under management and increased
performance fees on proprietary hedge fund products.
Assets under management were $50.2 billion at August 31, 2006, reflecting a
24.5% increase from $40.3 billion in assets under management at August 31, 2005.
The increase in assets under management reflects continued growth in traditional
assets attributable to market appreciation and net inflows. Assets under
management at August 31, 2006 include $7.4 billion of assets from alternative
investment products, an increase from $6.1 billion at August 31, 2005.
LIQUIDITY AND CAPITAL RESOURCES
Financial Leverage
------------------
Asset Composition
The Company's actual level of capital, capital requirements and thereby the
level of financial leverage, is a function of numerous variables, including
asset composition, rating agency/creditor perception, business prospects,
regulatory requirements, balance sheet liquidity, cost/availability of capital
and risk of loss. The Company consistently maintains a highly liquid balance
sheet, with the vast majority of the Company's assets consisting of cash,
marketable securities inventories and collateralized receivables arising from
customer-related and proprietary securities transactions.
Collateralized receivables consist of resale agreements secured predominantly by
US government and agency securities, customer margin loans and securities
borrowed, which are typically secured by marketable corporate debt and equity
securities. The nature of the Company's business as a securities dealer requires
it to carry significant levels of securities inventories to meet its customer
and proprietary trading needs. Additionally, the Company's role as a financial
intermediary for customer activities, which it conducts on a principal basis,
together with its customer-related activities in its clearance business, results
in significant levels of customer-related balances, including customer margin
debt, securities borrowed and repurchase activity. The Company's total assets
and financial leverage can and do fluctuate, depending largely on economic and
market conditions, volume of activity and customer demand.
The Company's total assets at August 31, 2006 increased to $334.8 billion from
$292.6 billion at November 30, 2005. The increase was primarily attributable to
increases in securities borrowed, securities received as collateral, financial
instruments owned, at fair value and assets of variable interest entities and
mortgage loan special purpose entities, partially offset by decreases in
securities purchased under agreements to resell and customer receivables. The
Company's total capital base, which consists of long-term debt, preferred equity
issued by subsidiaries and total stockholders' equity, increased to $61.9
billion at August 31, 2006 from $54.3 billion at November 30, 2005. This change
was primarily due to a net increase in long-term debt and an increase in
stockholders' equity due to earnings as well as income tax benefits attributable
to the distribution of common stock under the Company's deferred compensation
plans.
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's total capital base as of August 31, 2006 and November 30, 2005 was
as follows:
August 31, November 30,
(in millions) 2006 2005
--------------------------------------------------------------------------------
Long-term borrowings:
Senior debt $ 49,938 $ 43,227
Subordinated debt (1) 263 263
--------------------------------------------------------------------------------
Total long-term borrowings $ 50,201 $ 43,490
Stockholders' equity:
Preferred stockholders' equity $ 359 $ 372
Common stockholders' equity 11,363 10,419
--------------------------------------------------------------------------------
Total stockholders' equity $ 11,722 $ 10,791
--------------------------------------------------------------------------------
Total capital $ 61,923 $ 54,281
================================================================================
(1) Represents junior subordinated deferrable interest debentures issued by the
Company, held by Bear Stearns Capital Trust III.
The amount of long-term debt and total capital that the Company maintains is
driven by a number of factors, with particular focus on asset composition. The
Company's ability to support increases in total assets is a function of its
ability to obtain short-term secured and unsecured funding, as well as its
access to longer-term sources of capital (i.e., long-term debt and equity). The
Company regularly measures and monitors its total capital requirements, which
are primarily a function of the self-funding ability of its assets. The equity
portion of total capital is primarily a function of on- and off-balance-sheet
risks (i.e., market, credit and liquidity) and regulatory capital requirements.
As such, the liquidity and risk characteristics of assets being held are
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at quarter end are lower than would be observed on an
average basis. At the end of each quarter, the Company typically uses excess
cash to finance high-quality, highly liquid securities inventory that otherwise
would be funded via the repurchase agreement market. In addition, the Company
reduces its matched book repurchase and reverse repurchase activities at quarter
end. Finally, the Company may reduce the aggregate level of inventories through
ordinary course, open market activities in the most liquid portions of the
balance sheet, which are principally US government and agency securities and
agency mortgage pass-through securities. At August 31, 2006 and November 30,
2005, total assets of $334.8 billion and $292.6 billion were approximately 1.8%
and 5.6%, respectively, lower than the average of the month-end balances
observed over the trailing 12-month period. Despite reduced total assets at
quarter end, the Company's overall market, credit and liquidity risk profile
does not change materially, since the reduction in asset balances is
predominantly in highly liquid, short-term instruments that are financed on a
secured basis. This periodic reduction verifies the inherently liquid nature of
the balance sheet and provides consistency with respect to creditor
constituents' evaluation of the Company's financial condition.
Leverage Ratios
Balance sheet leverage measures are one approach to assessing the capital
adequacy of securities firms. The following table presents total assets and net
adjusted assets with the resultant leverage ratios at August 31, 2006 and
November 30, 2005. Gross leverage equals total assets divided by stockholders'
equity, inclusive of preferred and trust preferred equity. The Company views its
trust preferred equity as a component of its equity capital base given the
equity-like characteristics of the securities. The Company also receives rating
agency equity credit for these securities. Net adjusted leverage equals net
adjusted assets divided by tangible equity capital, which excludes goodwill and
intangible assets from both the numerator and denominator, as equity used to
support goodwill and intangible assets is not available to support the balance
of the Company's net assets. With respect to a comparative measure of financial
risk and capital adequacy, the Company believes that the low-risk,
collateralized nature of its securities purchased under agreements to resell,
securities borrowed, securities received as collateral, customer receivables and
segregated cash assets renders net adjusted leverage as the relevant measure.
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
August 31, November 30,
(in millions, except ratios) 2006 2005
--------------------------------------------------------------------------------
Total assets $ 334,760 $ 292,635
Deduct:
Cash and securities deposited
with clearing organizations
or segregated in compliance
with federal regulations 8,845 5,270
Securities purchased under
agreements to resell 40,457 42,648
Securities received as collateral 17,480 12,426
Securities borrowed 73,960 62,915
Receivables from customers 29,970 33,255
Goodwill & intangible assets 381 355
--------------------------------------------------------------------------------
Subtotal 163,667 135,766
--------------------------------------------------------------------------------
Add:
Financial instruments sold, but
not yet purchased 41,059 35,004
Deduct:
Derivative financial instruments 12,720 12,957
--------------------------------------------------------------------------------
Net adjusted assets $ 192,006 $ 157,813
================================================================================
Stockholders' equity
Common equity $ 11,363 $ 10,419
Preferred stock 359 372
--------------------------------------------------------------------------------
Total stockholders' equity 11,722 10,791
--------------------------------------------------------------------------------
Add:
Trust preferred equity 263 263
--------------------------------------------------------------------------------
Subtotal - leverage equity 11,985 11,054
--------------------------------------------------------------------------------
Deduct:
Goodwill & intangible assets 381 355
--------------------------------------------------------------------------------
Tangible equity capital $ 11,604 $ 10,699
================================================================================
Gross leverage 27.9 x 26.5 x
Net adjusted leverage 16.5 x 14.8 x
--------------------------------------------------------------------------------
Funding Strategy & Liquidity Risk Management
--------------------------------------------
General Funding Strategy
Liquidity is extraordinarily important for financial services firms in general
and for securities firms in particular, given their reliance on market
confidence and funding. Consequently, the Company focuses on management of
funding and liquidity risk. The Company's overall objective and general funding
strategy seeks to ensure liquidity and diversity of funding sources to meet the
Company's financing needs at all times and under all market environments. In
financing its balance sheet, the Company maximizes its use of secured funding
where economically competitive. Short-term sources of cash consist principally
of collateralized borrowings, including repurchase transactions, sell/buy
arrangements, securities lending arrangements and customer free credit balances.
Short-term unsecured funding sources expose the Company to rollover risk, as
providers of credit are not obligated to refinance the instruments at maturity.
For this reason, the Company prudently manages its reliance on short-term
unsecured borrowings by maintaining an adequate total capital base and extensive
use of secured funding. In addition to this strategy, the Company places
emphasis on diversification by product, geography, maturity and instrument to
further ensure prudent, moderate usage of more credit-sensitive, potentially
less stable, funding. Short-term unsecured funding sources include commercial
paper, bank loans and other borrowings, which generally have maturities ranging
from overnight to one year. The Company views its secured funding as inherently
less credit sensitive and therefore a more stable source of funding due to the
collateralized nature of the borrowing.
In addition to short-term funding sources, the Company utilizes equity and
long-term debt, including floating- and fixed-rate notes, as longer-term sources
of unsecured financing. The Company regularly monitors and analyzes the size,
composition and liquidity characteristics of its asset base in the context of
each asset's ability to be used to obtain secured financing. This analysis helps
the Company in determining its aggregate need for longer-term funding sources
(i.e., long-term debt and
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
equity). The Company views long-term debt as a stable source of funding, which
effectively strengthens its overall liquidity profile and mitigates liquidity
risk.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective of this
strategy is to maintain sufficient cash capital (i.e., equity plus long-term
debt maturing in more than 12 months) and funding sources to enable the Company
to refinance short-term, unsecured borrowings with fully secured borrowings. As
such, the Company is not reliant upon nor does it contemplate forced balance
sheet reduction to endure a period of constrained funding availability. This
underlying approach is supported by maintenance of a formal contingency funding
plan, which includes a detailed delegation of authority and precise action steps
for managing an event-driven liquidity crisis. The plan identifies the crisis
management team, details an effective internal and external communication
strategy, and facilitates the greater information flow required to effect a
rapid and efficient transition to a secured funding environment.
As it relates to the alternative funding strategy discussed above, the Company
prepares an analysis that focuses on a 12-month time period and assumes that the
Company does not liquidate assets and cannot issue any new unsecured debt,
including commercial paper. Under these assumptions, the Company monitors its
cash position and the borrowing value of unencumbered, unhypothecated financial
instruments in relation to its unsecured debt maturing over the next 12 months,
striving to maintain the ratio of liquidity sources to maturing debt at 110% or
greater. Also within this strategy, the Company seeks to maintain cash capital
in excess of that portion of its assets that cannot be funded on a secured basis
(i.e., positive net cash capital). These two measures, liquidity ratio and net
cash capital, are complementary and constitute the core elements of the
Company's alternative funding strategy and, consequently, its approach to
funding and liquidity risk management.
The borrowing value advance rates used in the Company's liquidity ratio
calculation and the haircuts incorporated in the cash capital model are
symmetrical. These advance rates are considered readily available, even in a
stressed environment. In the vast majority of circumstances/asset classes, they
are derived from committed secured bank facilities, whereby a bank or group of
banks are contractually obligated to lend to the Company at a pre-specified
advance rate on specific types of collateral regardless of the "market
environment." As such, the advance rates/haircuts in the alternative liquidity
models are typically worse than those the Company realizes in normalized repo
and secured lending markets. The advance rates in the liquidity ratio reflect
what can be reliably realized in a stressed liquidity environment. The haircuts
used in the cash capital model are consistent with the advance rates in the
liquidity ratio in that the haircut is equal to one minus the advance rate.
As of August 31, 2006, the market value of unencumbered, unhypothecated
financial instruments owned by the Company was approximately $47.6 billion with
a borrowing value of $36.0 billion. The assets are composed of primarily
mortgage- and asset-backed securities, investment-grade municipal and corporate
bonds, US equities, and residential and commercial mortgage whole loans. The
average advance rate on these different asset types ranges from 44% to 96% and,
as described above, is based predominantly on committed, secured facilities that
the Company and its subsidiaries maintain in different regions globally. The
liquidity ratio, explained above, based solely on Company owned securities, has
averaged 132% over the previous 12 months including unused committed unsecured
bank credit, and 124% excluding the unsecured portion of the Company's $4.0
billion committed revolving credit facility. On this same basis, the liquidity
ratio was 137% as of August 31, 2006 and 130% excluding committed unsecured
bank credit.
While The Bear Stearns Companies Inc. ("Parent Company") is the primary issuer
of unsecured debt in the marketplace, the collateral referred to in the
preceding paragraph is held in various subsidiaries, both regulated and
unregulated. A subsidiary's legal entity status and the Company's intercompany
funding structure may constrain liquidity available to the Parent Company, as
regulators may prevent the flow of funds and/or securities from a regulated
subsidiary to its parent company or other subsidiaries. In recognition of this
potential for liquidity to be trapped in subsidiaries, the Company maintains a
minimum $5.0 billion of liquidity immediately accessible by the Parent Company
at all times. This liquidity reserve takes the
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
form of cash deposits and money market instruments that are held at the Parent
Company and high-quality collateral (corporate bonds, municipal bonds, equity
securities) that is owned by subsidiaries and explicitly pledged to and
segregated for the benefit of the Parent Company and maintained at a third-party
custodian. For purposes of calculating the aggregate value of the liquidity
reserve, the contractually obligated advance rates described herein are used to
determine the borrowing value of collateral pledged. In addition to this
immediately available liquidity, the Company monitors unrestricted liquidity
available to the Parent Company via the ability to monetize unencumbered assets
held in unregulated and regulated entities. As of August 31, 2006, approximately
$30.4 billion of the market value identified in the liquidity ratio data above
was held in unregulated entities and thus likely to be available to the Parent
Company, while an additional $4.0 billion market value had been pledged to the
Parent Company as collateral for inter-company borrowings and was thus readily
available. The remaining $13.2 billion market value of unencumbered securities
was held in regulated entities, a portion of which may be available to provide
liquidity to the Parent Company.
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. For
purposes of broadly classifying the drivers of cash capital requirements, cash
capital usage can be delineated across two very broad categories as (1) firmwide
haircuts and (2) illiquid assets/long-term investments. More precisely, the
Company holds cash capital to support longer-term funding requirements,
including, but not limited to, the following:
o That portion of financial instruments owned that cannot be funded on
a secured basis (i.e., the haircuts);
o Margin loans and resale principal in excess of the borrowing value
of collateral received;
o Operational cash deposits required to support the regular activities
of the Company (e.g., exchange initial margin);
o Unfunded committed funding obligations, such as corporate loan
commitments;
o Less liquid and illiquid assets, such as goodwill and fixed assets;
o Uncollateralized funded loans and funded loans secured by illiquid
and/or non-rehypothecatable collateral;
o Merchant banking assets and other long-term investments; and
o Regulatory capital in excess of a regulated entity's cash capital
based longer-term funding requirements.
At August 31, 2006, the Company's net cash capital position was $1.4 billion.
Fluctuations in net cash capital are common and are a function of variability in
total assets, balance sheet composition and total capital. The Company attempts
to maintain cash capital sources in excess of the aggregate longer-term funding
requirements of the firm (i.e., positive net cash capital). Over the previous 12
months, the Company's net cash capital position has averaged $2.5 billion.
In addition to the alternative funding measures above, the Company monitors the
maturity profile of its unsecured debt to minimize refinancing risk, maintains
relationships with a broad global base of debt investors and bank creditors,
establishes and adheres to strict short-term debt investor concentration limits,
and periodically tests its secured and unsecured committed credit facilities. An
important component of the Company's funding and liquidity risk management
efforts involves ongoing dialogues with a large number of creditor constituents.
Strong relationships with a diverse base of creditors and debt investors are
crucial to the Company's liquidity. The Company also maintains available sources
of short-term funding that exceed actual utilization, thus allowing it to endure
changes in investor appetite and credit capacity to hold the Company's debt
obligations.
With respect to the management of refinancing risk, the maturity profile of the
long-term debt portfolio of the Company is monitored on an ongoing basis and
structured within the context of two diversification guidelines. The Company has
a general guideline of no more than 20% of its long-term debt portfolio maturing
in any one year, as well as no more than 10% maturing in any one quarter over
the next five years. As of August 31, 2006, the weighted average maturity of the
Company's long-term debt was 4.2 years.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility") totaling $4.0
billion, which permits borrowing on a secured basis by the Parent Company, BSSC,
BSIL and certain other subsidiaries. The Facility also allows the Parent Company
and BSIL to borrow up to $2.0 billion of the Facility on an unsecured basis.
Secured borrowings can be collateralized by both investment-grade and
non-investment-grade financial instruments as the Facility provides for defined
advance rates on a wide range of financial instruments eligible to be pledged.
The Facility contains financial covenants, the
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
most significant of which require maintenance of specified levels of
stockholders' equity of the Company and net capital of BSSC. The facility
terminates in February 2007, with all loans outstanding at that date payable no
later than February 2008. There were no borrowings outstanding under the
Facility at August 31, 2006.
The Company has a $1.50 billion committed revolving securities repo facility
("Repo Facility"), which permits borrowings secured by a broad range of
collateral under a repurchase arrangement by the Parent Company, BSIL, Bear
Stearns International Trading Limited ("BSIT") and BSB. The Repo Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Repo Facility
terminates in August 2007, with all repos outstanding at that date payable no
later than August 2008. There were no borrowings outstanding under the Repo
Facility at August 31, 2006.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis by the Parent Company,
BSSC and Bear Stearns Japan Limited ("BSJL"). The Pan Asian Facility contains
financial covenants that require, among other things, maintenance of specified
levels of stockholders' equity of the Company and net capital of BSSC. The Pan
Asian Facility terminates in December 2006 with all loans outstanding at that
date payable no later than December 2007. There were no borrowings outstanding
under the Pan Asian Facility at August 31, 2006.
The Company has a $350 million committed revolving credit facility ("Tax Lien
Facility"), which permits borrowing on a secured basis by the Parent Company,
Plymouth Park Tax Services and Madison Tax Capital LLC. The Tax Lien Facility
contains financial covenants that require, among other things, maintenance of
specified levels of stockholders' equity of the Company. The Tax Lien Facility
terminates in March 2007 with all loans outstanding at that date payable no
later than March 2008. There were no borrowings outstanding under the Tax Lien
Facility at August 31, 2006.
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 2007. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $4.4 billion. At August 31, 2006, the borrowings outstanding
under these committed credit facilities were $167.1 million.
Capital Resources
-----------------
The Parent Company, operating as the centralized unsecured funding arm of the
Company, raises the vast majority of the Company's unsecured debt, including
both commercial paper and long-term debt. The Parent Company is thus the
"central bank" of the Company, where all capital is held and from which capital
is deployed. The Parent Company advances funds in the form of debt or equity to
subsidiaries to meet their operating funding needs and regulatory capital
requirements. In addition to the primary regulated subsidiaries, the Company
also conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited, Custodial Trust Company, Bear
Stearns Financial Products Inc., Bear Stearns Capital Markets Inc., Bear Stearns
Credit Products Inc., Bear Stearns Forex Inc., EMC Mortgage Corporation, Bear
Stearns Commercial Mortgage, Inc. and Bear Hunter Holdings LLC. In connection
with all of the Company's operating activities, a substantial portion of the
Company's long-term borrowings and equity has been used to fund investments in,
and advances to, these subsidiaries, including subordinated debt advances.
Within this funding framework, the Company attempts to fund equity investments
in subsidiaries with equity from the Parent Company (i.e., utilize no equity
double leverage). At August 31, 2006, the Parent Company's equity investment in
subsidiaries was $8.2 billion versus common stockholders' equity and preferred
equity of $11.4 billion and $359.2 million, respectively. As such, at August 31,
2006, the ratio of the equity investment in subsidiaries to Parent Company
equity (equity double leverage) was approximately 0.72 based on common equity
and 0.70 including preferred equity. At November 30, 2005, these measures were
0.69 based on common equity and 0.67 including preferred equity. Additionally,
all subordinated debt advances to regulated subsidiaries for use as regulatory
capital, which totaled $10.4 billion at August 31, 2006, are funded with
long-term debt issued by the Company having a remaining maturity equal to or
greater than the maturity of the subordinated debt advance. The Company
regularly monitors the nature and significance of assets or activities conducted
in all subsidiaries and attempts to
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
fund such assets with both capital and/or borrowings having a maturity profile
and relative mix consistent with the nature and self-funding ability of the
assets being financed. The funding mix also takes into account regulatory
capital requirements for regulated subsidiaries.
Long-term debt totaling $43.9 billion and $37.0 billion had remaining maturities
beyond one year at August 31, 2006 and November 30, 2005, respectively. The
Company accesses funding in a variety of markets in the United States, Europe
and Asia. The Company issues debt through syndicated US registered offerings, US
registered and 144A medium-term note programs, other US and non-US bond and note
offerings and other methods. The Company's access to external sources of
financing, as well as the cost of that financing, is dependent on various
factors and could be adversely affected by a deterioration of the Company's
long- and short-term debt ratings, which are influenced by a number of factors.
These factors include, but are not limited to: material changes in operating
margins; earnings trends and volatility; the prudence of funding and liquidity
management practices; financial leverage on an absolute basis and/or relative to
peers; the composition of the balance sheet and/or capital structure; geographic
and business diversification; and the Company's market share and competitive
position in the business segments in which it operates. Material deterioration
in any one or a combination of these factors could result in a downgrade of the
Company's credit ratings, thus increasing the cost of and/or limiting the
availability of unsecured financing. Additionally, a reduction in the Company's
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of August 31, 2006,
a downgrade by either Moody's Investors Service or Standard & Poor's in the
Company's long-term credit ratings to the level of A3 or A- would have resulted
in the Company needing to post $56.3 million in additional collateral pursuant
to contractual arrangements for outstanding over-the-counter derivatives
contracts. A downgrade to Baa1 or BBB+ would have resulted in needing to post an
additional $334.3 million in collateral.
At August 31, 2006, the Company's long-term/short-term debt ratings were as
follows:
Rating
--------------------------------------------------------------------------------
Dominion Bond Rating Service Limited A(high)/R-1(middle)
Fitch Ratings A+/F1+
Japan Credit Rating Agency, Ltd AA/NR
Moody's Investors Service A1/P-1
Rating & Investment Information, Inc. AA-/NR
Standard & Poor's Ratings Services A/A-1
--------------------------------------------------------------------------------
NR - does not assign a short-term rating
In October 2005, Standard & Poor's Ratings Services changed the outlook on The
Bear Stearns Companies Inc. from stable to positive. Simultaneously, the A/A-1
ratings were affirmed. Standard & Poor's cited the outlook change reflects the
Company's high profitability with low earnings volatility during the past
several years. Standard & Poor's also cited the strength of the Company's
various franchises, conservative management team and low tolerance for risk.
Standard & Poor's cited the outlook change indicates that the rating could be
raised during the next one to two years if the Company continues to perform
well.
In June 2006, Japan Credit Rating Agency, Ltd. assigned a rating of AA to The
Bear Stearns Companies Inc. senior long-term debt with a stable outlook.
In August 2006, the Japanese-based rating agency Rating & Investment
Information, Inc. upgraded the issuer rating of The Bear Stearns Companies Inc.
to AA- from A+ with a stable outlook. Rating & Investment Information, Inc.
cited the firm's continued dominant market position in the prime brokerage area
and successful diversification of the Company's revenue sources in fixed income
and institutional equities.
Stock Repurchase Program
------------------------
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
the annual grants by purchasing common stock throughout the year in open market
and private transactions.
The Company has two authorizations to purchase its common stock in fiscal 2006.
On December 12, 2005, the Board of Directors of the Company approved an
amendment to the Stock Repurchase Program ("Repurchase Program") to replenish
the previous authorization to allow the Company to purchase up to $1.5 billion
of common stock in fiscal 2006 and beyond. During the quarter ended August 31,
2006, the Company purchased under the current authorization a total of 2,947,682
shares at a cost of approximately $401.1 million. The Company may, depending
upon price and other factors, acquire additional shares in excess of that
required for annual share awards. Approximately $648.8 million was available to
be purchased under the current authorization as of August 31, 2006.
Under the second stock repurchase authorization, during the quarter ended August
31, 2006, the Company purchased a total of 380,791 shares of its common stock at
a total cost of $52.0 million pursuant to a $200 million CAP Plan Earnings
Purchase Authorization, which was approved by the Compensation Committee of the
Board of Directors of the Company on December 9, 2005. Approximately $68.5
million was available to be purchased under the current authorization as of
August 31, 2006.
On September 5, 2006, the Company entered into a series of forward contracts
pursuant to the CAP Plan with a number of CAP Plan participants. Under these
forward contracts such participants have agreed to sell up to 1,006,613 common
shares of the Company's common stock that are due to be distributed on or about
November 30, 2006. The forward contracts will settle on November 30, 2006. The
purchase price will be based on the daily volume weighted average price of the
common stock of the Company as reported on the NYSE on each day that the
weighted average price is between $122 and $152 per share during the 61 business
day period from September 5, 2006 through November 29, 2006, less $.05 per
share. The shares will be purchased pursuant to the Repurchase Program.
Cash Flows
----------
Cash and cash equivalents decreased $1.13 billion to $4.73 billion at August 31,
2006 from $5.86 billion at November 30, 2005. Cash used in operating activities
was $12.5 billion, primarily attributable to increases in financial instruments
owned and securities borrowed, net of securities loaned, partially offset by a
decrease in net receivables from customers and an increase in financial
instruments sold, but not yet purchased, which occurred in the normal course of
business as a result of changes in customer needs, market conditions and trading
strategies. Cash used in investing activities of $144.1 million reflected
purchases of property, equipment and leasehold improvements. Cash provided by
financing activities of $11.5 billion reflected proceeds from the issuance of
long-term borrowings of $13.4 billion and net proceeds relating to short-term
borrowings of $5.8 billion, primarily to fund normal operating activities. This
was partially offset by payments for the retirement/repurchase of long-term
borrowings of $7.6 billion. Treasury stock purchases of $982.7 million were made
to provide for the annual grant of CAP Plan units, restricted stock units and
stock options.
Regulated Subsidiaries
----------------------
Effective December 1, 2005, the Company became regulated by the Securities and
Exchange Commission ("SEC") as a consolidated supervised entity ("CSE"). As a
CSE, the Company is subject to group-wide supervision and examination by the SEC
and is required to compute allowable capital and allowances for market, credit
and operational risk on a consolidated basis. As of August 31, 2006, the Company
was in compliance with the CSE capital requirements.
As registered broker-dealers and futures commission merchants, Bear Stearns and
BSSC are subject to the net capital requirements of the Exchange Act and Rule
1.17 under the Commodity Futures Trading Commission. Effective December 1, 2005
the SEC approved Bear Stearns' use of Appendix E of the Net Capital Rule which
establishes alternative net capital requirements for broker-dealers that are
part of consolidated supervised entities. Appendix E allows Bear Stearns to
calculate net capital charges for market risk and derivatives-related credit
risk based on mathematical models provided that Bear Stearns holds tentative net
capital in excess of $1 billion and net capital in excess of $500 million. BSIL
and BSIT, the Company's London-based broker-dealer subsidiaries, are subject to
the regulatory capital requirements of the U.K.'s Financial Services Authority.
Additionally, BSB is subject to the regulatory capital requirements of the
Financial Regulator. Custodial Trust Company ("CTC"), a Federal Deposit
Insurance Corporation ("FDIC") insured New Jersey state chartered bank, is
subject to the capital
47
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
requirements of the FDIC. At August 31, 2006, Bear Stearns, BSSC, BSIL, BSIT,
BSB and CTC were in compliance with their respective regulatory capital
requirements. Certain other subsidiaries are subject to various securities
regulations and capital adequacy requirements promulgated by the regulatory and
exchange authorities of the countries in which they operate. At August 31, 2006,
these other subsidiaries were in compliance with their applicable local capital
adequacy requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 9, "Regulatory
Requirements," in the Notes to Condensed Consolidated Financial Statements.
Merchant Banking and Private Equity Investments
-----------------------------------------------
In connection with the Company's merchant banking activities, the Company has
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At August 31,
2006, the Company held investments with an aggregate recorded value of
approximately $702.2 million, reflected in the Condensed Consolidated Statements
of Financial Condition, primarily in "Other assets." At November 30, 2005, the
Company held investments with an aggregate recorded value of approximately
$658.8 million. In addition to these various direct and indirect principal
investments, the Company has made commitments to invest in private
equity-related investments and partnerships (see the summary table under
"Commitments").
High Yield Positions
--------------------
As part of its fixed income activities, the Company participates in the
underwriting and trading of non-investment-grade corporate debt securities and
also invests in, syndicates and trades in loans to highly leveraged, below
investment-grade rated companies (collectively, "high yield positions").
Non-investment-grade debt securities have been defined as non-investment-grade
corporate debt and emerging market debt rated BB+ or lower, or equivalent
ratings recognized by credit rating agencies. At August 31, 2006 and November
30, 2005, the Company held high yield positions approximating $9.9 billion and
$6.7 billion, respectively, substantially all of which are in "Financial
instruments owned" in the Condensed Consolidated Statements of Financial
Condition, and $1.9 billion and $1.7 billion, respectively, reflected in
"Financial instruments sold, but not yet purchased" in the Condensed
Consolidated Statements of Financial Condition. Included in the high yield
positions are extensions of credit to highly leveraged companies. At August 31,
2006 and November 30, 2005, the amount outstanding to highly leveraged borrowers
totaled $6.9 billion and $4.2 billion, respectively. The largest industry
concentration was the telecommunications industry, which approximated 19.3% and
17.2% of these highly leveraged borrowers' positions at August 31, 2006 and
November 30, 2005, respectively. Additionally, the Company has lending
commitments with highly leveraged borrowers (see the summary table under
"Commitments").
The Company's Risk Management Department and senior trading managers monitor
exposure to market and credit risk for high yield positions and establish limits
and concentrations of risk by individual issuer. High yield positions generally
involve greater risk than investment-grade debt securities due to credit
considerations, liquidity of secondary trading markets and increased
vulnerability to changes in general economic conditions. The level of the
Company's high yield positions, and the impact of such activities on the
Company's results of operations, can fluctuate from period to period as a result
of customer demand, economic conditions and market considerations.
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Contractual Obligations
-----------------------
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At August 31, 2006, the Company's
contractual obligations by maturity, excluding derivative financial instruments,
were as follows:
Payments Due By Period
------------------------------------------------------------
Remaining Fiscal Fiscal
(in millions) Fiscal 2006 2007- 2008 2009- 2010 Thereafter Total
--------------------------------------------------------------------------------------------------------------------------
Long-term borrowings (1) (2) $ 1,081 $ 17,577 $ 14,045 $ 17,498 $ 50,201
Future minimum lease payments (3) (4) 20 181 176 572 949
--------------------------------------------------------------------------------------------------------------------------
(1) Amounts include fair value adjustments in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 133 as well as $262.5 million
of junior subordinated deferrable interest debentures ("Debentures"). The
Debentures will mature on May 15, 2031; however, the Company, at its
option, may redeem the Debentures beginning May 15, 2006. The Debentures
are reflected in the table at their contractual maturity dates.
(2) Included in fiscal 2007 and fiscal 2008 are approximately $3.2 billion and
$0.1 billion, respectively, of floating-rate notes that are redeemable
prior to maturity at the option of the noteholder. These notes contain
certain provisions that effectively enable noteholders to put these notes
back to the Company and, therefore, are reflected in the table at the date
such notes first become redeemable. The final maturity dates of these notes
are during fiscal 2009, fiscal 2010 and thereafter.
(3) Includes 383 Madison Avenue Headquarters in New York City.
(4) See Note 10, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
Commitments
-----------
The Company has commitments(1) under a variety of commercial arrangements. At
August 31, 2006, the Company's commitments associated with lending and
financing, private equity-related investments and partnerships, outstanding
letters of credit, underwriting and other commercial commitments summarized by
period of expiration were as follows:
Amount of Commitment Expiration Per Period
------------------------------------------------------------------------------------
Commitments
Remaining Fiscal Fiscal with no
(in millions) Fiscal 2006 2007-2008 2009-2010 Thereafter stated maturity Total
-------------------------------- ---------- ----------- ----------- ----------- --------------- -----------
Lending-related commitments:
Investment-grade (2) $ 716 $ 819 $ 889 $ 765 $ -- $ 3,189
Non-investment-grade 309 360 484 1,396 -- 2,549
Contingent commitments -- -- -- -- 5,192 5,192
Commitments to invest in private
equity-related investments
and partnerships (3) -- -- -- -- 729 729
Underwriting commitments 218 -- -- -- -- 218
Commercial and residential loans 2,013 2,773 46 -- -- 4,832
Letters of credit 4,181 752 -- 35 -- 4,968
Other commercial commitments 16 82 -- -- -- 98
-------------------------------- ---------- ----------- ----------- ----------- --------------- -----------
(1) See Note 10, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) In order to mitigate the exposure to investment-grade borrowings, the
Company entered into credit default swaps aggregating $825.0 million at
August 31, 2006.
(3) At August 31, 2006, commitments to invest in private equity-related
investments and partnerships aggregated $729.2 million. These commitments
will be funded, if called, through the end of the respective investment
periods, the longest of such periods ending in 2017.
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OFF-BALANCE-SHEET ARRANGEMENTS
In the normal course of business, the Company enters into arrangements with
special purpose entities ("SPEs"), also known as variable interest entities
("VIEs"). SPEs are corporations, trusts or partnerships that are established for
a limited purpose. SPEs, by their nature, are generally not controlled by their
equity owners, as the establishing documents govern all material decisions. The
Company's primary involvement with SPEs relates to securitization transactions
in which transferred assets, including commercial and residential mortgages,
consumer receivables, securities and other financial assets are sold to an SPE
and repackaged into securities or similar beneficial interests. SPEs may also be
used to create securities with a unique risk profile desired by investors and as
a means of intermediating financial risk. The Company, in the normal course of
business, may establish SPEs, sell assets to SPEs, underwrite, distribute and
make a market in securities or other beneficial interests issued by SPEs,
transact derivatives with SPEs, own securities or other beneficial interests,
including residuals, in SPEs, and provide liquidity or other guarantees for
SPEs.
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities--a Replacement of FASB
Statement No. 125," to account for securitizations and other transfers of
financial assets. In accordance with SFAS No. 140, the Company accounts for
transfers of financial assets as sales provided that control has been
relinquished. Control is deemed to be relinquished only when all of the
following conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee is a
Qualifying Special Purpose Entity ("QSPE") or has the right to pledge or
exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. Therefore, the Company
derecognizes financial assets transferred in securitizations, provided that such
transfer meets all of these criteria. See Note 4, "Transfers of Financial Assets
and Liabilities," in the Notes to Condensed Consolidated Financial Statements
for a more complete discussion of the Company's securitization activities.
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company consolidates those VIEs
in which the Company is the primary beneficiary. See Note 5, "Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to Condensed
Consolidated Financial Statements for a complete discussion of the consolidation
of VIEs.
The majority of the SPEs that the Company sponsors or transacts with are QSPEs,
which the Company does not consolidate in accordance with this guidance. QSPEs
are entities that have little or no discretionary activities and may only
passively hold assets and distribute cash generated by the assets they hold. The
Company reflects the fair value of its interests in QSPEs on its balance sheet
but does not recognize the assets or liabilities of QSPEs. QSPEs are employed
extensively in the Company's mortgage and asset securitization business.
Certain other SPEs do not meet the requirements of a QSPE, because their
activities are not sufficiently limited or they have entered into certain
non-qualifying transactions. The Company follows the criteria in FIN No. 46 (R)
in determining whether it should consolidate such entities. These SPEs are
commonly employed in collateralized debt obligation transactions where portfolio
managers require the ability to buy and sell assets or in synthetic credit
transactions.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivatives,
leasing, securitization and other transactions. See Note 11, "Guarantees," in
the Notes to Condensed Consolidated Financial Statements for a complete
discussion on guarantees.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Certain derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into hedging
transactions that may include over-the-counter derivative contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to hedge proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and US Treasury positions to economically
hedge its debt issuances as part of its asset and liability management.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not the amounts actually paid or received, with
the exception of currency swaps, foreign exchange forwards and mortgage-backed
securities forwards. The notional/contract amounts of financial instruments that
give rise to off-balance-sheet market risk are indicative only to the extent of
involvement in the particular class of financial instruments and are not
necessarily an indication of overall market risk.
As of August 31, 2006 and November 30, 2005, the Company had notional/contract
amounts of approximately $7.47 trillion and $5.45 trillion, respectively, of
derivative financial instruments, of which $1.26 trillion and $1.13 trillion,
respectively, were listed futures and option contracts. The aggregate
notional/contract value of derivative contracts is a reflection of the level of
activity and does not represent the amounts that are recorded in the Condensed
Consolidated Statements of Financial Condition. The Company's derivative
financial instruments outstanding, which are used either to hedge trading
positions, modify the interest rate characteristics of its long- and short-term
debt, or are part of its derivative dealer activities, are marked to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 4.7 years and 4.1 years at August 31, 2006 and November 30, 2005,
respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of August 31, 2006 were as follows:
` Less Than One to Three to Greater Than `
(in billions) One Year Three Years Five Years Five Years Total
------------------------------------- --------- ----------- ---------- ------------ --------
Swap agreements, including options,
swaptions, caps, collars and floors $ 398.6 $ 2,099.7 $ 1,215.5 $ 2,323.4 $ 6,037.2
Futures contracts 370.4 233.3 24.7 0.2 628.6
Forward contracts 123.7 -- -- -- 123.7
Options held 362.5 59.3 1.4 0.1 423.3
Options written 222.8 31.4 1.6 0.2 256.0
------------------------------------- --------- ----------- ---------- ------------ ----------
Total $ 1,478.0 $ 2,423.7 $ 1,243.2 $ 2,323.9 $ 7,468.8
===================================== ========= =========== ========== ============ ==========
Percent of total 19.8% 32.5% 16.6% 31.1% 100.0%
===================================== ========= =========== ========== ============ ==========
CRITICAL ACCOUNTING POLICIES
The condensed consolidated financial statements of the Company are prepared in
conformity with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions that could materially affect reported amounts in the financial
statements (see Note 1, "Summary of Significant Accounting Policies," in the
Notes to Condensed Consolidated Financial Statements). Critical accounting
policies are those policies that are the most important to the financial
statements and/or those that require significant management judgment related to
matters that are uncertain.
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex nature of certain of its products, the
degree of judgment required to appropriately value these products and the
pervasive impact of such valuation on the financial condition and earnings of
the Company.
The Company's financial instruments can be aggregated in three broad categories:
(1) those whose fair value is based on quoted market prices or for which the
Company has independent external valuations, (2) those whose fair value is
determined based on internally developed models or methodologies that employ
data that are readily observable from objective sources, and (3) those whose
fair value is estimated based on internally developed models or methodologies
utilizing significant assumptions or other data that are generally less readily
observable from objective sources.
(1) Financial Instruments Valued Based on Quoted Market Prices or for Which the
Company Has Independent External Valuations
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include US Treasuries, most
mortgage-backed securities and corporate, emerging market, high yield and
municipal bonds. Unlike most equities, which tend to be traded on exchanges, the
vast majority of fixed income trading (including US Treasuries) occurs in
over-the-counter markets, and, accordingly, the Company's valuation policy is
based on its best estimate of the prices at which these financial instruments
trade in those markets. The Company is an active dealer in most of the
over-the-counter markets for these financial instruments, and typically has
considerable insight into the trading level of financial instruments held in
inventory and/or related financial instruments that it uses as a basis for its
valuation.
(2) Financial Instruments Whose Fair Value Is Determined Based on Internally
Developed Models or Methodologies That Employ Data That Are Readily Observable
from Objective Sources
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
appropriate models or methodologies as well as appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
non-exchange-traded derivatives such as interest rate swaps, certain
mortgage-backed securities and certain other cash instruments. For an indication
of the Company's involvement in derivatives, including maturity terms, see the
table setting forth notional/contract amounts outstanding in the preceding
"Derivative Financial Instruments" section.
(3) Financial Instruments Whose Fair Value Is Estimated Based on Internally
Developed Models or Methodologies Utilizing Significant Assumptions or Other
Data That Are Generally Less Readily Observable from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company follows Emerging Issues Task Force ("EITF") Statement No. 02-3,
"Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities." This guidance prohibits recognizing profit at the inception of a
derivative contract unless the fair value of the
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
derivative is obtained from a quoted market price in an active market or is
otherwise evidenced by comparison to other observable current market
transactions or based on a valuation technique that incorporates observable
market data.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, real estate assets and certain
residuals. In addition, the Company has a portfolio of Chapter 13 and other
credit card receivables from individuals. Certain of these high yield positions
have limited price observability. In these instances, fair values are determined
by statistical analysis of historical cash flows, default probabilities,
recovery rates, time value of money and discount rates considered appropriate
given the level of risk in the instrument and associated investor yield
requirements.
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other exotic
derivative structures. These non-exchange-traded instruments may trade in
immature or limited markets and, by their nature, involve complex valuation
methodologies and models, which are often refined to correlate with the market
risk of these instruments.
At August 31, 2006 and November 30, 2005, the total value of all financial
instruments whose fair value is estimated based on internally developed models
or methodologies utilizing significant assumptions or other data that are
generally less readily observable from objective sources (primarily fixed income
cash positions) aggregated approximately $9.6 billion and $7.1 billion,
respectively, in "Financial instruments owned" and $5.5 billion and $3.5
billion, respectively, in "Financial instruments sold, but not yet purchased" in
the Condensed Consolidated Statements of Financial Condition.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market Committee ("MTMC"), which is composed of senior management
from the Risk Management and Controllers Departments. The MTMC is responsible
for ensuring that the approaches used to independently validate the Company's
valuations are robust, comprehensive and effective. Typical approaches include
valuation comparisons with external sources, comparisons with observed trading,
independent comparisons of key model valuation inputs, independent trade
modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments in leveraged transactions. As part of these
activities, the Company originates, structures and invests in merger,
acquisition, restructuring and leveraged capital transactions, including
leveraged buyouts. The Company's principal investments in these transactions are
generally made in the form of equity investments, equity-related investments or
subordinated loans and have not historically required significant levels of
capital investment.
Equity interests and securities acquired as a result of leveraged acquisition
transactions are reflected in the condensed consolidated financial statements at
their initial cost until significant transactions or developments indicate that
a change in the carrying value of the securities is appropriate. Generally, the
carrying values of these securities will be increased only in those instances
where market values are readily ascertainable by reference to substantial
transactions occurring in the marketplace or quoted market prices. If quoted
market prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined based on
other relevant factors. Reductions to the carrying value of these securities are
made in the event that the Company's estimate of net realizable value has
declined below the carrying value. See "Merchant Banking and Private Equity
Investments" in Management's Discussion and Analysis for additional details.
Legal, Regulatory and Tax Contingencies
In the normal course of business, the Company has been named as a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive
53
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
damages or claims for indeterminate amounts of damages. The Company is also
involved in other reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of which may
result in adverse judgments, settlements, fines, penalties, injunctions or other
relief.
Reserves for litigation and regulatory proceedings are generally determined on a
case-by-case basis and represent an estimate of probable losses after
considering, among other factors, the progress of each case, prior experience,
and the experience of others in similar cases, and the opinions and views of
internal and external legal counsel. Because litigation is inherently
unpredictable, particularly in cases where claimants seek substantial or
indeterminate damages or where investigations and proceedings are in the early
stages, the Company cannot predict with certainty the loss or range of loss
related to such matters, how such matters will be resolved, when they will
ultimately be resolved, or what the eventual settlement, fine, penalty or other
relief might be.
The Company is subject to the income tax laws of the US, its states and
municipalities and those of the foreign jurisdictions in which the Company has
significant business operations. These tax laws are complex and subject to
different interpretations by the taxpayer and the relevant governmental taxing
authorities. The Company must make judgments and interpretations about the
application of these inherently complex tax laws when determining the provision
for income taxes and must also make estimates about when in the future certain
items may affect taxable income in the various tax jurisdictions. Disputes over
interpretations of the tax laws may be settled with the taxing authority upon
examination or audit. The Company regularly evaluates the likelihood of
assessments in each of the taxing jurisdictions resulting from current and
subsequent years' examinations and tax reserves are established as appropriate.
The Company establishes reserves for potential losses that may arise out of
litigation, regulatory proceedings and tax audits to the extent that such losses
are probable and can be estimated, in accordance with SFAS No. 5, "Accounting
for Contingencies." Once established, reserves are adjusted as additional
information becomes available or when an event requiring a change to the
reserves occurs. Significant judgment is required in making these estimates and
the ultimate resolution may differ materially from the amounts reserved.
ACCOUNTING AND REPORTING DEVELOPMENTS
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5, "Determining
Whether a General Partner, or the General Partners as a Group, Controls a
Limited Partnership or Similar Entity When the Limited Partners Have Certain
Rights." The EITF consensus requires a general partner in a limited partnership
to consolidate the limited partnership unless the presumption of control is
overcome. The general partner may overcome this presumption of control and not
consolidate the entity if the limited partners have: (a) the substantive ability
to dissolve or liquidate the limited partnership or otherwise remove the general
partner without having to show cause; or (b) substantive participating rights in
managing the partnership. This guidance became effective upon ratification by
the FASB on June 29, 2005 for all newly formed limited partnerships and for
existing limited partnerships for which the partnership agreements have been
modified. For all other limited partnerships, the guidance is effective no later
than the beginning of the first reporting period in fiscal years beginning after
December 15, 2005. For newly formed and modified limited partnerships, the
adoption of the EITF did not have a material impact on the consolidated
financial statements of the Company. For previously existing limited
partnerships, the Company does not expect the EITF consensus to have a material
impact on the consolidated financial statements of the Company.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid
Financial Instruments." SFAS No. 155 is an amendment of SFAS No. 133 and SFAS
No. 140. SFAS No. 155 permits companies to irrevocably elect, on a deal by deal
basis, to apply a fair value remeasurement to any hybrid financial instruments
that contain an embedded derivative that would otherwise require bifurcation.
SFAS No. 155 is effective for the Company on December 1, 2006. The Company does
not expect the adoption of SFAS No. 155 to have a material impact on the
consolidated financial statements of the Company.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets." SFAS No. 156 amends SFAS No. 140. SFAS No. 156 requires that
all separately recognized servicing assets and servicing liabilities be
initially measured at fair value. For subsequent measurements, SFAS No. 156
permits companies to choose between using an amortization method or a fair value
measurement method for reporting purposes. SFAS No. 156 is effective as of the
beginning of a company's first fiscal year that begins after September 15, 2006.
The Company does not expect the adoption of SFAS No. 156 to have a material
impact on the consolidated financial statements of the Company.
54
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In April 2006, the FASB issued FASB Staff Position ("FSP") FIN No. 46 (R)-6
"Determining the Variability to Be Considered in Applying Interpretation No.
46(R)." This FSP addresses how a reporting enterprise should determine the
variability to be considered in applying FIN No. 46 (R). The variability that is
considered affects the determination of (a) whether the entity is a variable
interest entity, (b) which interests are variable interests in the entity, and
(c) which party, if any, is the primary beneficiary of the VIE. This FSP states
that the variability to be considered shall be based on an analysis of the
design of the entity. This analysis includes reviewing the nature of the risks
in the entity as well as determining the purpose for which the entity was
created. This analysis also includes a determination of the variability that the
entity was designed to create and pass along to its interest holders. The
Company adopted FSP FIN46(R)-6 on September 1, 2006 on a prospective basis to
all entities that the Company first becomes involved with and to all entities
previously required to be analyzed under FIN No. 46 (R) when a reconsideration
event has occurred. The Company does not expect the adoption of FSP FIN46(R)-6
to have a material impact on the consolidated financial statements of the
Company.
In July 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty
in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"). This
Interpretation clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with SFAS No.
109. FIN 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. This Interpretation also provides guidance
on derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. FIN 48 must be implemented for fiscal years
beginning after December 15, 2006. The Company is currently quantifying what
impact, if any, the adoption of FIN 48 is expected to have on the consolidated
financial statements of the Company.
In September 2006, the FASB issued 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. SFAS No. 157
requires companies to disclose the fair value of its financial instruments
according to a fair value hierarchy (i.e., levels 1, 2, and 3, as defined).
Additionally, companies are required to provide enhanced disclosure regarding
instruments in the level 3 category, including a reconciliation of the beginning
and ending balances separately for each major category of assets and
liabilities. SFAS No. 157 is effective for financial statements issued for
fiscal years beginning after November 15, 2007 and interim periods within those
fiscal years. The Company is currently assessing whether it will early adopt
SFAS No. 157 as of the first quarter of fiscal 2007 as permitted, and is
currently evaluating the impact adoption may have on the consolidated financial
statements of the Company.
EFFECTS OF INFLATION
The Company's assets are primarily recorded at their current market value and,
to a large extent, are liquid in nature. The rate of inflation affects the
Company's expenses, such as employee compensation, office leasing costs,
information technology and communications charges, which may not be readily
recoverable in the price of services offered by the Company. In addition, to the
extent that inflation causes interest rates to rise and has other adverse
effects on the securities markets and on the value of securities held in
inventory, it may adversely affect the Company's financial position and results
of operations.
For a description of the Company's risk management policies, including a
discussion of the Company's primary market risk exposures, which include
interest rate risk, foreign exchange rate risk and equity price risk, as well as
a discussion of the Company's credit risk including how those exposures are
managed, refer to the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2005.
55
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models known
as value-at-risk ("VaR") that seek to predict risk of loss based on historical
and/or market-implied price and volatility patterns. VaR estimates the
probability of the value of a financial instrument rising above or falling below
a specified amount. The calculation uses the simulated changes in value of the
market risk-sensitive financial instruments to estimate the amount of change in
the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
56
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk),
due to the benefit of diversification among the risks. Diversification benefit
equals the difference between aggregate VaR and the sum of the VaRs for the
three risk categories. This benefit arises because the simulated one-day losses
for each of the three primary market risk categories occur on different days and
because of general diversification benefits introduced when risk is measured
across a larger set of specific risk factors than exist in the respective
categories; similar diversification benefits also are taken into account across
risk factors within each category. The following table illustrates the VaR for
each component of market risk as of August 31, 2006, May 31, 2006, February 28,
2006 and November 30, 2005.
August 31, May 31, February 28, November 30,
(in millions) 2006 2006 2006 2005
---------------------------------------- ----------- ----------- ----------- -----------
MARKET RISK
Interest rate $ 37.7 $ 32.5 $ 25.6 $ 22.1
Currency 1.4 1.0 0.4 0.3
Equity 3.9 5.4 3.4 3.6
Diversification benefit (9.1) (8.1) (4.5) (4.6)
---------------------------------------- ----------- ----------- ----------- -----------
Aggregate VaR $ 33.9 $ 30.8 $ 24.9 $ 21.4
======================================== =========== =========== =========== ===========
The table below illustrates the high, low and average VaR for each component of
market risk and aggregate market risk during the quarters ended August 31, 2006
and May 31, 2006.
Quarter Ended August 31, 2006 Quarter Ended May 31, 2006
--------------------------------------------------------------------------------
(in millions) High Low Average High Low Average
--------------------------------------------------------------------------------
MARKET RISK
Interest rate $ 41.3 $ 26.4 $ 33.6 $ 40.6 $ 26.5 $ 33.6
Currency 1.7 0.1 0.8 2.4 0.0 0.7
Equity 6.6 1.5 4.1 9.3 2.5 6.2
Aggregate VaR 37.1 22.2 29.2 44.4 24.0 33.7
--------------------------------------------------------------------------------
As previously discussed, the Company utilizes a wide variety of market risk
management methods, including trading limits; marking all positions to market on
a daily basis; daily profit and loss statements; position reports; daily risk
highlight reports; aged inventory position reports; and independent verification
of inventory pricing. Additionally, management of each trading department
reports positions, profits and losses and notable trading strategies to the Risk
Committee on a weekly basis. The Company believes that these procedures, which
stress timely communication between traders, trading department management and
senior management, are the most important elements of the risk management
process.
Stress testing (also referred to as scenario analysis) measures the risk of loss
over a variety of extreme market conditions that are defined in advance. Stress
testing is a key methodology used in the management of market risk as well as
counterparty credit risk (see "Credit Risk"). Stress tests are calculated at the
firmwide level for particular trading books, customer accounts and individual
positions. Stress tests are performed on a regular basis as well as on an ad hoc
basis, as deemed appropriate. The ongoing evaluation process of trading risks as
well as the consideration of new trading positions commonly incorporates an ad
hoc discussion of "what-if" stressed market conditions and their impact on
profitability. This analysis varies in its degree of formality based on the
judgment of trading department management, risk management and senior managers.
While the Company recognizes that no methodology can perfectly predict future
market conditions, it believes that these tools are an important supplement to
the Company's risk management process. The Company expects to continue to
develop and refine its formal stress testing methodologies.
The following chart represents a summary of the daily principal transactions
revenues and reflects a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the quarters ended August 31,
2006 and 2005.
57
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The chart represents a historical summary of the results generated by the
Company's trading activities as opposed to the probability approach used by the
VaR model. The average daily trading profit was $16.8 million and $13.6 million
for the quarters ended August 31, 2006 and 2005, respectively. There were four
daily trading losses for the quarter ended August 31, 2006 and five daily
trading losses for the quarter ended August 31, 2005. Daily trading losses never
exceeded the reported average VaR amounts during the fiscal quarters ended
August 31, 2006 and 2005. The frequency distribution of the Company's daily net
trading revenues reflects the Company's historical ability to manage its
exposure to market risk and the diversified nature of its trading activities.
Market conditions were favorable for the Company's trading activity in both its
quarters ending August 31, 2006 and 2005. Hedging strategies were generally
effective as established trading relationships remained substantially intact and
volatility tended to be lower than historical norms. No guarantee can be given
regarding future net trading revenues or future earnings volatility. However,
the Company believes that these results are indicative of its commitment to the
management of market trading risk.
58
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarters Ended August 31, 2006 and August 31, 2005
DAILY NET TRADING REVENUES ($ millions)
NUMBER OF TRADING DAYS
August 31, 2006 August 31, 2005
----------------- -----------------
(10)+ 1 (10)+ 1
(10)-(5) 1 (10)-(5) 1
(5)-0 2 (5)-0 3
0-5 2 0-5 7
5-10 17 5-10 14
10-15 15 10-15 14
15-20 12 15-20 11
20-25 5 20-25 4
25-30 3 25-30 6
30+ 7 30+ 4
-------- --------
Total 65 Total 65
59
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Credit Risk
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivative contracts in a
gain position at August 31, 2006 and November 30, 2005 approximated $3.91
billion and $4.41 billion, respectively. Exchange-traded financial instruments,
which typically are guaranteed by a highly rated clearing organization, have
margin requirements that substantially mitigate the risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of August 31, 2006:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage of
Exposure, Net of Exposure, Net
Rating (2) Exposure Collateral (3) Collateral (4) of Collateral
---------------------------------------------------------------------------------------------------------
AAA $ 973 $ 16 $ 966 25%
AA 5,177 3,895 1,418 36%
A 2,643 1,827 999 26%
BBB 364 360 194 5%
BB and lower 1,070 2,624 261 6%
Non-rated 76 5 76 2%
---------------------------------------------------------------------------------------------------------
(1) Excluded are covered transactions structured to ensure that the
market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will,
under all circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's
Credit Department, converted to rating agency equivalents.
(3) For lower-rated counterparties, the Company generally receives
collateral in excess of the current market value of derivative
contracts.
(4) In calculating exposure net of collateral, collateral amounts are
limited to the amount of current exposure for each counterparty.
Excess collateral is not applied to reduce exposure because such
excess in one counterparty portfolio cannot be applied to deficient
collateral in a different counterparty portfolio.
60
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Exchange Act, the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of its disclosure controls and procedures as of the
end of the period covered by this quarterly report. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Exchange Act) were effective as of the end of the period covered by this
quarterly report. As required by Rule 13a-15(d) under the Exchange Act, the
Company's management, including the Company's Chief Executive Officer and Chief
Financial Officer, has evaluated the Company's internal control over financial
reporting to determine whether any changes occurred during the quarter covered
by this quarterly report that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting. Based on
that evaluation, there have been no such changes during the quarter covered by
this quarterly report.
61
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
In the normal course of business, the Company has been named a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental and self-regulatory organizations regarding the
Company's business. Certain of the foregoing could result in adverse judgments,
settlements, fines, penalties or other relief.
Because litigation is inherently unpredictable, particularly in cases where
claimants seek substantial or indeterminate damages or where investigations and
proceedings are in the early stages, the Company cannot predict with certainty
the loss or range of loss related to such matters, how such matters will be
resolved, when they will be ultimately resolved, or what the eventual
settlement, fine, penalty or other relief might be. Consequently, the Company
cannot estimate losses or ranges of losses for matters where there is only a
reasonable possibility that a loss may have been incurred. Although the ultimate
outcome of these matters cannot be ascertained at this time, it is the opinion
of management, that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as a
whole; such resolution may, however, have a material effect on the operating
results in any future period, depending on the level of income for such period.
The Company has provided reserves for such matters in accordance with Statement
of Financial Accounting Standards No. 5, "Accounting for Contingencies." The
ultimate resolution may differ from the amounts reserved.
Certain legal proceedings in which the Company is involved are discussed in Note
17 to the consolidated financial statements included in the Company's 2005
Financial Report; Part I, Item 3, of the Company's Annual Report on Form 10-K
for the fiscal year ended November 30, 2005, as amended by Amendment No. 1
thereto on Form 10-K/A (together the "Form 10-K"); and Note 10 to the
consolidated financial statements and Part II, Item 1, included in the Company's
Form 10-Q for the quarterly periods ended May 31, 2006 and February 28, 2006.
62
Item 2. UNREGISTRERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The table below sets forth the information with respect to purchases made by the
Company of the Company's common stock during the third quarter of fiscal 2006:
Approximate
Total Number of Dollar
Shares Value of
Purchased as Shares that
Part of May Yet Be
Total Average Publicly Purchased
Number of Price Announced Under the
Shares Paid per Plans or Plans or
Period Purchased Share Programs (1) Programs (1)
------------ ---------- ----------------- ---------------
6/1/06 - 6/30/06 903,683 $ 134.00 903,683 $1,049,259,416
7/1/06 - 7/31/06 1,153,896 136.90 1,153,896 891,296,656
8/1/06 - 8/31/06 1,270,894 136.90 1,270,894 717,305,145
------------ -----------------
Total 3,328,473 3,328,473
============ =================
(1) On December 12, 2005, the Board of Directors of the Company approved an
amendment to the Repurchase Program to replenish the previous authorization in
order to allow the Company to purchase up to $1.5 billion of common stock in
fiscal 2006 and beyond. The Repurchase Program has no set expiration or
termination date. On December 9, 2005, the Compensation Committee of the Board
of Directors approved a $200 million CAP Plan Earnings Purchase Authorization to
allow the Company to purchase up to $200 million of common stock in fiscal 2006.
(2) On September 5, 2006, the Company entered into a series of forward contracts
pursuant to the CAP Plan with a number of CAP Plan participants. Under these
forward contracts such participants have agreed to sell up to 1,006,613 common
shares of the Company's common stock that are due to be distributed on or about
November 30, 2006. The forward contracts will settle on November 30, 2006. The
purchase price will be based on the daily volume weighted average price of the
common stock of the Company as reported on the NYSE on each day that the
weighted average price is between $122 and $152 per share during the 61 business
day period from September 5, 2006 through November 29, 2006, less $.05 per
share. The shares will be purchased pursuant to the Repurchase Program.
63
Item 6. EXHIBITS
Exhibits
--------
(11) Computation of Per Share Earnings. (The calculation of per
share earnings is in Note 8, "Earnings Per Share," of Notes
to Condensed Consolidated Financial Statements (Earnings
Per Share) and is omitted here in accordance with Section
(b) (11) of Item 601 of Regulation S-K)
(12) Computation of Ratio of Earnings to Fixed Charges and to
Combined Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information
(31.1) Certification of Chief Executive Officer Pursuant to Rule
13a-14(a) or 15d -14(a) of the Securities Exchange Act of
1934, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to Rule
13a-14(a) or 15d-14(a) of the Securities Exchange Act of
1934, as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
64
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
The Bear Stearns Companies Inc.
-------------------------------
(Registrant)
Date: October 10, 2006 By: /s/ Jeffrey M. Farber
-------------------------------
Jeffrey M. Farber
Controller
(Principal Accounting Officer)
65
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit No. Description Page
----------- ----------- ----
(12) Computation of Ratio of Earnings to Fixed Charges and to Combined 67
Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information 68
(31.1) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) 69
or 15d -14(a) of the Securities Exchange Act of 1934, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) 70
or 15d -14(a) of the Securities Exchange Act of 1934, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to 18 U.S.C. 71
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant to 18 U.S.C. 72
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
66