UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended February 29, 2004
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 an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [X] No [_]
As of April 12, 2004, the latest practicable date, there were 104,929,558
shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
----
Available Information 3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Statements of Income (Unaudited) for
the three months ended February 29, 2004 and February 28,
2003 4
Condensed Consolidated Statements of Financial Condition as
of February 29, 2004 (Unaudited) and November 30, 2003
(Audited) 5
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the three months ended February 29, 2004 and February
28, 2003 6
Notes to Condensed Consolidated Financial Statements
(Unaudited) 7
Independent Accountants' Report 30
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 31
Item 3. Quantitative and Qualitative Disclosures about Market Risk 55
Item 4. Controls and Procedures 61
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 62
Item 2. Changes in Securities, Use of Proceeds, and Issuer Purchases
of Equity Securities 64
Item 5. Other Information 65
Item 6. Exhibits and Reports on Form 8-K 66
Signature 68
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, with the Securities and
Exchange Commission ("SEC"). You may read and copy any document the Company
files at the SEC's public reference room located at 450 Fifth Street, N.W.,
Washington, D.C. 20549, U.S.A. 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, U.S.A.
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 Securities
Exchange Act of 1934, as amended, 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 (the "Code") governing our directors,
officers and employees are also posted on the Company's website within the
"Corporate Governance" section under the heading "About Bear Stearns". You will
need to have on your computer the Adobe Acrobat Reader software to view these
documents, which are in the .PDF format.
3
Part I - Financial Information
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited)
Three Months Ended
---------------------------
February 29, February 28,
(in thousands, except share and per share data) 2004 2003
------------ ------------
REVENUES
Commissions $ 308,103 $ 241,915
Principal transactions 946,862 968,464
Investment banking 260,410 167,583
Interest and dividends 520,464 434,159
Other income 45,606 25,794
------------ ------------
Total revenues 2,081,445 1,837,915
Interest expense 355,522 322,481
------------ ------------
Revenues, net of interest expense 1,725,923 1,515,434
------------ ------------
NON-INTEREST EXPENSES
Employee compensation and benefits 849,148 757,889
Floor brokerage, exchange and clearance fees 56,900 44,680
Communications and technology 93,828 92,740
Occupancy 33,615 34,943
Advertising and market development 25,901 25,210
Professional fees 41,800 28,453
Other expenses 93,753 106,320
------------ ------------
Total non-interest expenses 1,194,945 1,090,235
------------ ------------
Income before provision for income taxes 530,978 425,199
Provision for income taxes 169,913 150,946
------------ ------------
Net income $ 361,065 $ 274,253
============ ============
Net income applicable to common shares $ 353,646 $ 266,261
============ ============
Basic earnings per share $ 2.88 $ 2.21
============ ============
Diluted earnings per share $ 2.57 $ 2.00
============ ============
Weighted average common shares outstanding:
Basic 129,118,964 129,773,603
============ ============
Diluted 147,108,483 147,029,224
============ ============
Cash dividends declared per common share $ 0.20 $ 0.17
============ ============
See Notes to Condensed Consolidated Financial Statements.
4
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
February 29, November 30,
(in thousands, except share data) 2004 2003
------------ ------------
ASSETS
Cash and cash equivalents $ 1,887,895 $ 3,837,570
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 8,626,117 8,657,065
Securities purchased under agreements to resell 37,232,821 33,822,695
Securities received as collateral 6,264,219 5,496,832
Securities borrowed 72,263,959 73,317,962
Receivables:
Customers 22,421,334 19,646,879
Brokers, dealers and others 2,983,471 3,730,306
Interest and dividends 197,685 268,054
Financial instruments owned, at fair value
Pledged as collateral 32,884,545 32,349,781
Not pledged as collateral 36,414,686 26,882,877
Assets of variable interest entities 1,116,405 --
Property, equipment and leasehold improvements, net of accumulated
depreciation and amortization of $854,215 and $816,646 in 2004
and 2003, respectively 376,891 381,262
Other assets 3,980,872 3,776,827
------------ ------------
Total Assets $226,650,900 $212,168,110
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 12,445,140 $ 13,387,662
Securities sold under agreements to repurchase 45,935,573 47,464,156
Obligation to return securities received as collateral 6,264,219 5,496,832
Securities loaned 7,255,021 6,648,165
Payables:
Customers 74,034,432 68,666,893
Brokers, dealers and others 3,607,052 2,676,351
Interest and dividends 544,322 567,575
Financial instruments sold, but not yet purchased, at fair value 33,136,421 27,109,147
Liabilities of variable interest entities 1,116,405 --
Accrued employee compensation and benefits 754,243 1,376,215
Other liabilities and accrued expenses 1,587,166 1,312,061
------------ ------------
186,679,994 174,705,057
------------ ------------
Commitments and contingencies (Note 4)
Long-term borrowings 32,153,129 29,430,465
------------ ------------
Guaranteed Preferred Beneficial Interests in Company Subordinated
Debt Securities -- 562,500
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock 497,452 538,415
Common stock, $1.00 par value; 500,000,000 shares authorized as of
February 29, 2004 and November 30, 2003; 184,805,848 shares issued
as of February 29, 2004 and November 30, 2003 184,806 184,806
Paid-in capital 3,310,047 3,245,380
Retained earnings 5,278,092 4,954,508
Employee stock compensation plans 2,222,835 2,299,170
Unearned compensation (170,005) (188,952)
Treasury stock, at cost:
Common stock: 80,212,203 and 82,233,811 shares as of February 29,
2004 and November 30, 2003, respectively (3,505,450) (3,563,239)
------------ ------------
Total Stockholders' Equity 7,817,777 7,470,088
------------ ------------
Total Liabilities and Stockholders' Equity $226,650,900 $212,168,110
============ ============
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Three Months Ended
----------------------------
February 29, February 28,
(in thousands) 2004 2003
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 361,065 $ 274,253
Adjustments to reconcile net income to cash used in operating
activities:
Noncash items included in net income:
Depreciation and amortization 32,565 36,904
Deferred income taxes (15,536) (7,590)
Employee stock compensation plans 14,364 9,446
Other 2,354 3,527
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 30,948 (377,909)
Securities purchased under agreements to resell (3,410,126) (591,214)
Securities borrowed 1,054,003 3,559,281
Receivables from customers (2,774,455) (2,527,417)
Receivables from brokers, dealers and others 746,835 (318,520)
Financial instruments owned (9,150,789) (6,397,831)
Other assets (699) 80,053
Securities sold under agreements to repurchase (1,528,583) 3,446,906
Securities loaned 606,856 340,455
Payables to customers 5,367,539 (938,390)
Payables to brokers, dealers and others 860,111 (503,756)
Financial instruments sold, but not yet purchased 6,027,274 1,985,832
Accrued employee compensation and benefits (619,055) (521,050)
Other liabilities and accrued expenses 280,606 45,560
------------ ------------
Cash used in operating activities (2,114,723) (2,401,460)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (28,194) (5,113)
Purchases of investment securities and other assets (122,763) (10,159)
Proceeds from sales of investment securities and other assets 21,740 2,925
------------ ------------
Cash used in investing activities (129,217) (12,347)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net (payments for) proceeds from short-term borrowings (942,522) 2,464,422
Net proceeds from issuance of long-term borrowings 3,356,788 2,614,398
Proceeds from issuances of derivatives with a financing element, net 70,590 --
Redemption of preferred stock issued by a subsidiary (300,000) --
Issuance of common stock 99,978 34,711
Redemption of preferred stock (40,963) (9,972)
Payments for retirement of long-term borrowings (1,831,578) (1,945,147)
Treasury stock purchases - common stock (89,580) (122,845)
Cash dividends paid (28,448) (25,159)
------------ ------------
Cash provided by financing activities 294,265 3,010,408
------------ ------------
Net (decrease) increase in cash and cash equivalents (1,949,675) 596,601
Cash and cash equivalents, beginning of year 3,837,570 5,520,285
------------ ------------
Cash and cash equivalents, end of period $ 1,887,895 $ 6,116,886
============ ============
See Notes to Condensed Consolidated Financial Statements.
6
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The Bear Stearns Companies Inc. is a holding company that through its
broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp.
("BSSC"), Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets is
comprised of the institutional equities, fixed income and investment
banking areas. Global Clearing Services is composed of the clearance
business for prime broker and fully disclosed clients. Wealth Management
is comprised of the Private Client Services ("PCS") and asset management
areas. See Note 8, "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., EMC Mortgage Corporation, Bear
Stearns Mortgage Capital Corporation, Bear Stearns Credit Products Inc.
and Bear Stearns Forex Inc.
The condensed consolidated financial statements include the accounts of
The Bear Stearns Companies Inc. and its subsidiaries ("Company"). 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. The Condensed Consolidated
Statement of Financial Condition as of February 29, 2004, the Condensed
Consolidated Statements of Income for the three months ended February 29,
2004 and February 28, 2003 and the Condensed Consolidated Statements of
Cash Flows for the three months ended February 29, 2004 and February 28,
2003 are unaudited. The November 30, 2003 Condensed Consolidated Statement
of Financial Condition and related information was derived from the
audited financial statements.
The condensed consolidated financial statements are prepared in accordance
with the rules and regulations of the Securities and Exchange Commission
("SEC") with respect to the Form 10-Q and reflect all adjustments which in
the opinion of management are normal and recurring, which are necessary
for a fair statement of the results for the interim periods presented. In
accordance with such rules and regulations, certain disclosures that are
normally included in annual financial statements have been omitted. These
financial statements should be read in conjunction with the Company's
Annual Report on Form 10-K for the fiscal year ended November 30, 2003
filed by the Company under the Securities Exchange Act of 1934.
The condensed consolidated financial statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling financial interest. The Company's policy is to
consolidate all entities in which it owns more
7
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
than 50% of the outstanding voting stock unless it does not control the
entity. In accordance with Financial Accounting Standards Board ("FASB")
Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN
No. 46"), or FIN No. 46, as revised ("FIN No. 46 (R)") issued in December
2003, 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 Statement of Financial Condition in the captions
"Assets of variable interest entities" and "Liabilities of variable
interest entities." See Note 10, "Consolidation of Variable Interest
Entities," in the Notes to Condensed Consolidated Financial Statements.
The Company participates, through a majority-owned joint venture, in
specialist activities on the NYSE, AMEX and International Securities
Exchange. Due to the occurrence of a Control Event triggered in December
2003, the Company began consolidating this entity. Included in the
Condensed Consolidated Statements of Financial Condition at February 29,
2004 are total assets of $2.2 billion, including approximately $359
million of goodwill and identifiable intangible assets.
The condensed consolidated financial statements are prepared in conformity
with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions, including those regarding inventory valuations, stock
compensation, certain accrued liabilities and the potential outcome of
litigation, 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.
Financial Instruments
Proprietary securities, futures and other derivatives transactions are
recorded on a trade date basis. Financial instruments owned and financial
instruments sold, but not yet purchased, including contractual commitments
arising pursuant to futures, forward and option contracts, interest rate
swaps and other derivative contracts, are recorded at fair value with the
resulting net unrealized gains and losses reflected in "Principal
Transactions" revenues in the Condensed Consolidated Statements of Income.
Fair value is generally based on quoted market prices. If quoted market
prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined
based on other relevant factors, including dealer price quotations, price
activity for equivalent instruments and valuation pricing models.
Valuation pricing models consider time value, yield curve and volatility
factors, prepayment speeds, default rates, loss severity, current market
and contractual prices for the underlying financial instruments, as well
as other economic measurements.
Equity securities acquired as a result of leveraged acquisition
transactions are reflected in the consolidated financial statements at
their initial costs 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. 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.
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
Customer Transactions
Customer securities transactions are recorded on a settlement date basis,
which is generally three business days after trade date, while the related
commission revenues and expenses are recorded on a trade date basis.
Receivables from and payables to customers include amounts related to both
cash and margin transactions. Securities owned by customers, including
those that collateralize margin or other similar transactions, are
generally not reflected in the Condensed Consolidated Statements of
Financial Condition.
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 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.
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 additional collateral obtained, or
excess collateral retrieved, when deemed appropriate.
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
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 Statement of Financial Accounting Standards ("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."
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
fiscal year-end rates of exchange, while income statement items are
translated at daily average rates of exchange for the fiscal year. Gains
or losses resulting from foreign currency transactions are included in net
income.
Income Taxes
The Company and certain of its subsidiaries file a 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.
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,
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
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 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
employee stock compensation plans.
Statement of Cash Flows
For purposes of the Condensed Consolidated Statements of Cash Flows, the
Company has defined cash equivalents as liquid investments not held for
sale in the ordinary course of business with original maturities of three
months or less. Cash payments for interest approximated interest expense
for the three months ended February 29, 2004 and February 28, 2003. Income
taxes paid totaled $53.2 million and $74.0 million for the three months
ended February 29, 2004 and February 28, 2003, respectively.
Stock-Based Compensation
In December 2002, the FASB issued SFAS No. 148 "Accounting for Stock-Based
Compensation--Transition and Disclosure," which amends SFAS No. 123,
"Accounting for Stock-Based Compensation." SFAS No. 148 provides three
alternative methods for a voluntary change to fair value accounting for
stock-based compensation as permitted under SFAS No. 123. Effective
December 1, 2002, the Company elected to adopt fair value accounting for
stock-based compensation consistent with SFAS No. 123 using the
prospective method with guidance provided by SFAS No. 148. As a result,
commencing with options granted after November 30, 2002, the Company
expenses the fair value of stock options issued to employees over the
related vesting period. Prior to December 1, 2002, the Company elected to
account for its stock-based compensation plans using the intrinsic value
method prescribed by Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB No. 25"), as permitted by
SFAS No. 123. Under the provisions of APB No. 25, compensation cost for
stock options is measured as the excess, if any, of the quoted market
price of the Company's common stock at the date of grant over the amount
an employee must pay to acquire the stock. Accordingly, no compensation
expense had been recognized for stock option awards granted prior to
December 1, 2002 because the exercise price was at the fair market value
of the Company's common stock on the grant date.
The cost related to stock-based compensation included in the determination
of net income for the three months ended February 29, 2004 and February
28, 2003 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.
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
The following table illustrates the effect on net income and earnings per
share if the fair value based method had been applied to all outstanding
awards in each period.
Three Months Ended
----------------------------
February 29, February 28,
(in millions, except per share amounts) 2004 2003
------------ ------------
Net income, as reported $ 361.1 $ 274.3
Add: Stock-based employee compensation plans expense
included in reported net income, net of related
tax effects 8.2 6.4
Deduct: Total stock-based employee compensation plans
expense determined under the fair value based
method, net of related tax effects (16.4) (19.7)
------------ ------------
Pro forma net income $ 352.9 $ 261.0
============ ============
Earnings per share:
Basic - as reported $ 2.88 $ 2.21
Basic - pro forma $ 2.81 $ 2.11
Diluted - as reported $ 2.57 $ 2.00
Diluted - pro forma $ 2.52 $ 1.91
============ ============
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.
Derivative Instruments and Hedging Activities
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," establishes accounting and reporting standards for
stand-alone derivative instruments, derivatives embedded within other
contracts or securities, and hedging activities. It requires that all
derivatives, whether stand-alone or embedded within other contracts or
securities (except in narrowly defined circumstances), be carried in the
Company's Condensed Consolidated Statements of Financial Condition at
their then fair value, with changes in fair value recorded in current
earnings. It also requires designated hedged items not carried at fair
value to be marked (to the extent of the profit or loss on the derivative)
for the risk being hedged, with such changes in the fair value recorded in
current earnings.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued)
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.
In addition, specific implementation guidelines have been established to
further distinguish transfers of financial assets that are sales from
transfers that are secured borrowings.
New Accounting Pronouncements
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities--an Interpretation of ARB No. 51." FIN No. 46 provides
guidance on the consolidation of certain entities in which equity
investors do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to
finance its activities without additional subordinated financial support.
Such entities are referred to as variable interest entities ("VIEs"). FIN
No. 46 requires the primary beneficiary of a VIE to consolidate the
entity. On December 24, 2003, the FASB published FIN No. 46 (R), a
replacement of FIN No. 46. FIN No. 46 (R) provides technical corrections
and addresses certain implementation issues.
In fiscal 2003, the Company adopted FIN No. 46 for VIEs in which it
acquired an interest after January 31, 2003. As of February 29, 2004, the
Company adopted FIN No. 46 or FIN No. 46 (R) for VIEs in which it held a
variable interest as of February 29, 2004. Such adoption did not have a
material effect on the condensed consolidated financial statements. See
Note 10, "Consolidation of Variable Interest Entities," in the Notes to
Condensed Consolidated Financial Statements for a further discussion.
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:
February 29, November 30,
(in thousands) 2004 2003
------------ ------------
FINANCIAL INSTRUMENTS OWNED:
US government and agency $ 4,730,545 $ 4,963,125
Other sovereign governments 1,300,530 1,019,394
Corporate equity and convertible debt 16,552,034 12,531,849
Corporate debt and other 10,875,368 9,554,939
Mortgages, mortgage- and asset-backed 24,266,332 21,377,386
Derivative financial instruments 11,574,422 9,785,965
------------ ------------
$ 69,299,231 $ 59,232,658
============ ============
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED:
US government and agency $ 10,720,755 $ 9,991,764
Other sovereign governments 1,404,236 740,052
Corporate equity and convertible debt 7,847,732 6,301,051
Corporate debt and other 2,701,656 1,477,448
Mortgages, mortgage- and asset-backed 328,007 278,294
Derivative financial instruments 10,134,035 8,320,538
------------ ------------
$ 33,136,421 $ 27,109,147
============ ============
As of February 29, 2004 and November 30, 2003, all financial instruments
owned that were pledged to counterparties where the counterparty has the
right, by contract or custom, to rehypothecate these securities are
classified as "Financial Instruments Owned, Pledged as Collateral" in the
Condensed Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased, represent obligations
of the Company to deliver the specified financial instrument at the
contracted price and thereby create a liability to purchase the financial
instrument in the market at prevailing prices. 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.
3. DERIVATIVES AND HEDGING ACTIVITIES
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," 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
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
3. DERIVATIVES AND HEDGING ACTIVITIES (continued)
Condensed Consolidated Statement of Financial Condition at their then fair
value. SFAS No. 133 requires that all derivatives be carried at fair
value, including those used as hedges. SFAS No. 133 also requires items
designated as being hedged, previously carried at accrued values, now be
marked to market for the risk being hedged, 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 and were not material for the
three months ended February 29, 2004 and February 28, 2003.
To measure derivative activity, notional or contract amounts are
frequently used. Notional/contract amounts are used to calculate
contractual cash flows to be exchanged and are generally not actually paid
or received, with the exception of currency swaps, foreign exchange
forwards and mortgage-backed securities forwards. The notional/contract
amounts of financial instruments that give rise to off-balance-sheet
market risk are indicative only to the extent of involvement in the
particular class of financial instrument and are not necessarily an
indication of overall market risk.
As of February 29, 2004 and November 30, 2003, the Company had
notional/contract amounts of approximately $2.51 trillion and $2.15
trillion, respectively, of derivative financial instruments, of which
$552.7 billion and $413.1 billion, respectively, were listed futures and
option contracts. The aggregate notional/contract value of derivative
contracts is a reflection of the level of activity and does not represent
the amounts that are recorded in the Condensed Consolidated Statements of
Financial Condition. The Company's derivative financial instruments
outstanding, which either are used to hedge trading positions, fixed-rate
debt, or are part of its derivative dealer activities, are marked to fair
value.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
3. DERIVATIVES AND HEDGING ACTIVITIES (continued)
The Company's derivatives had a weighted average maturity of approximately
4.0 years and 4.2 years at February 29, 2004 and November 30, 2003,
respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of February 29, 2004 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 $ 348.0 $ 470.5 $ 441.7 $ 580.3 $1,840.5
Futures contracts 137.2 69.3 9.3 -- 215.8
Forward contracts 87.1 -- -- -- 87.1
Options held 203.5 17.8 0.6 0.1 222.0
Options written 133.7 10.8 0.6 -- 145.1
--------- ----------- ---------- ------------ --------
Total $ 909.5 $ 568.4 $ 452.2 $ 580.4 $2,510.5
========= =========== ========== ============ ========
Percent of total 36.2% 22.7% 18.0% 23.1% 100.0%
========= =========== ========== ============ ========
4. 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:
Commercial Lending
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. Commercial lending commitments to investment-grade borrowers
aggregated approximately $1.37 billion at February 29, 2004 (gross
commitments of $1.98 billion less $608.5 million of associated hedges).
Commercial lending commitments to non-investment-grade borrowers
approximated $1.08 billion at February 29, 2004.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At February 29, 2004, such commitments
aggregated $466.9 million. These commitments will be funded, if called,
through the end of the respective investment periods, the longest of such
periods ending in 2013.
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. COMMITMENTS AND CONTINGENCIES (continued)
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income underwriting, the Company had commitments to purchase and sell new
issues of securities aggregating $425.4 million at February 29, 2004.
Commercial and Residential Loans
The Company participates in the acquisition, securitization, servicing,
financing and disposition of commercial and residential loans. At February
29, 2004, the Company had entered into commitments to purchase or finance
mortgage loans of $2.0 billion.
Letters of Credit
At February 29, 2004, the Company was contingently liable for unsecured
letters of credit of approximately $2.18 billion and letters of credit of
$1.09 billion secured by financial instruments, primarily used to provide
collateral for securities borrowed and to satisfy margin requirements at
option and commodity exchanges.
Borrow Versus Pledge
At February 29, 2004, the Company had pledged securities, primarily US
government and agency securities with a market value of approximately
$2.64 billion as collateral for securities borrowed, with an approximate
market value of $2.57 billion.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $131.5 million at February 29, 2004.
The Company has entered into agreements with providers of hardware,
software, data processing and systems consulting services. At February 29,
2004, commitments over the remaining life of these agreements aggregated
$58.8 million.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
Litigation
In the normal course of business, the Company has been named as a
defendant in various lawsuits that involve claims for substantial amounts.
Also, the Company is involved from
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
4. COMMITMENTS AND CONTINGENCIES (continued)
time to time in investigations and proceedings by governmental agencies
and self-regulatory organizations. Although the ultimate outcome of the
various 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.
5. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. The guarantees covered by FIN No.
45, "Guarantors Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others," include
contracts that contingently require the guarantor to make payments to the
guaranteed party based on changes related to an asset, a liability or an
equity security of the guaranteed party, contracts that contingently
require the guarantor to make payments to the guaranteed party based on
another entity's failure to perform under an agreement and indirect
guarantees of the indebtedness of others, even though the payment to the
guaranteed party may not be based on changes to an asset, liability or
equity security of the guaranteed party. In addition, FIN No. 45 covers
certain indemnification agreements that contingently require the guarantor
to make payments to the indemnified party, such as an adverse judgment in
a lawsuit or the imposition of additional taxes due to either a change in
the tax law or an adverse interpretation of the tax law.
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of February 29, 2004:
Amount of Guarantee Expiration Per Period
------------------------------------------------------------
Greater
Less Than One to Three Three to than Five
(in millions) One Year Years Five Years Years Total
--------- ------------ ---------- --------- --------
Derivative contracts (notional) (1) $ 241,474 $ 154,955 $ 125,940 $ 73,253 $595,622
Municipal securities 1,522 909 -- -- 2,431
Residual value guarantee -- -- 570 -- 570
(1) The carrying value of these derivatives approximated $8.33 billion.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. GUARANTEES (continued)
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), certain written call and put
options, swaptions, 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
floors 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 $8.33 billion at
February 29, 2004.
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. For a discussion of
derivatives, see Risk Management and Management's Discussion and Analysis
of Financial Condition and Results of Operations in the Company's Annual
Report on Form 10-K for the fiscal year ended November 30, 2003.
Municipal Securities
In 1997, the Company established a program whereby it has created a series
of municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at February 29, 2004 was approximately $2.42 billion,
which represents the outstanding amount of all trust certificates. This
exposure to loss is mitigated by the underlying municipal bonds. The
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. GUARANTEES (continued)
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 $2.44 billion at February 29, 2004.
Residual Value Guarantee
The Company has entered into an operating lease arrangement for its
worldwide headquarters at 383 Madison Avenue (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 15, 2008, after which the Company may
request a renewal. If the lease renewal cannot be negotiated, the Company
has the right to purchase the building for the amount of the then
outstanding indebtedness of the lessor or to arrange for the sale of the
property with the proceeds of the sale to be used to satisfy the lessor's
debt obligation. If the sale of the property does not generate sufficient
proceeds to satisfy the lessor's debt obligation, the Company is required
to fund the shortfall up to a maximum residual value guarantee. As of
February 29, 2004, there was no expected shortfall and the residual value
guarantee approximated $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third party
originators upon acquisition of such assets. The Company generally
performs due-diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to some counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications, and the contingencies
triggering the obligation to indemnify are not expected to occur.
Maximum payout information under these indemnifications is not readily
available because of the number, size, and lives of these transactions. In
implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that the Company will have to make significant
payments under these arrangements.
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
5. GUARANTEES (continued)
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Additionally, if a member becomes unable to
satisfy its obligations to the clearinghouse, other members would be
required to meet 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 unlikely. Accordingly, no contingent
liability is recorded in the Condensed Consolidated Financial Statements
for these arrangements.
6. REGULATORY REQUIREMENTS
Bear Stearns and BSSC are registered broker-dealers and, accordingly, are
subject to Rule 15c3-1 under the Securities Exchange Act of 1934 ("Net
Capital Rule") and the capital rules of the New York Stock Exchange, Inc.
("NYSE"), the Commodity Futures Trading Commission ("CFTC") and other
principal exchanges of which Bear Stearns and BSSC are members. Included
in the computation of net capital of Bear Stearns, as defined, is $808.5
million, which is net capital of BSSC in excess of 5.5% of aggregate debit
items arising from customer transactions, as defined. At February 29,
2004, Bear Stearns' net capital of $2.34 billion exceeded the minimum
requirement by $2.28 billion.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the Financial Services Authority.
BSB, an Ireland-based bank principally involved in the trading and sales
of fixed income products, is registered in Ireland and is subject to the
regulatory capital requirements of the Irish Financial Services Regulatory
Authority.
At February 29, 2004, Bear Stearns, BSSC, BSIL, BSIT and BSB were in
compliance with their respective regulatory capital requirements.
7. 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
21
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. EARNINGS PER SHARE (continued)
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.
The computations of Basic and Diluted EPS are set forth below:
Three Months Ended
----------------------------
February 29, February 28,
(in thousands, except per share amounts) 2004 2003
------------ ------------
Net income $ 361,065 $ 274,253
Preferred stock dividends (7,419) (7,992)
Redemption of preferred stock -- 78
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 17,754 20,285
------------ ------------
Net earnings used for Basic EPS $ 371,400 286,624
Income adjustment (net of tax) applicable to deferred
compensation arrangements-non-vested shares 7,378 7,132
------------ ------------
Net earnings used for Diluted EPS $ 378,778 $ 293,756
============ ============
Total basic weighted average common
shares outstanding (1) 129,119 129,774
------------ ------------
Effect of dilutive securities:
Employee stock options 3,494 1,657
CAP and restricted units 14,495 15,598
------------ ------------
Dilutive potential common shares 17,989 17,255
------------ ------------
Weighted average number of common shares
outstanding and dilutive potential common shares 147,108 147,029
============ ============
Basic EPS $ 2.88 $ 2.21
Diluted EPS $ 2.57 $ 2.00
============ ============
(1) Includes 25,908,503 and 30,232,542 vested units for the three months ended
February 29, 2004 and February 28, 2003, respectively, issued under
certain stock compensation plans which will be distributed as shares of
common stock.
8. 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.
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
8. SEGMENT DATA (continued)
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 works in tandem to deliver
these services to institutional and corporate clients.
Institutional equities consists of research, sales and trading and 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 subsidiary, the NYSE,
American Stock Exchange, Inc. ("AMEX") 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 comprised of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. 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.
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months Ended
----------------------------
February 29, February 28,
2004 2003
------------ ------------
(in thousands)
NET REVENUES
Capital Markets
Institutional Equities $ 297,400 $ 276,461
Fixed Income 822,268 791,217
Investment Banking 253,179 187,764
------------ ------------
Total Capital Markets 1,372,847 1,255,442
Global Clearing Services 217,614 175,778
Wealth Management
Private Client Services (1) 110,897 84,153
Asset Management 41,890 31,432
------------ ------------
Total Wealth Management 152,787 115,585
Other (2) (17,325) (31,371)
------------ ------------
Total net revenues $ 1,725,923 $ 1,515,434
============ ============
PRE-TAX INCOME
Capital Markets $ 516,369 $ 465,919
Global Clearing Services 78,502 52,150
Wealth Management 20,867 5,719
Other (2) (84,760) (98,589)
------------ ------------
Total pre-tax income $ 530,978 $ 425,199
============ ============
As of
--------------------------------------------
February 29, November 30, February 28,
2004 2003 2003
------------ ------------ ------------
(in thousands)
SEGMENT ASSETS
Capital Markets $157,673,967 $143,866,138 $133,110,159
Global Clearing Services 72,324,677 69,974,025 61,470,497
Wealth Management 3,685,298 3,705,922 3,589,940
Other (7,033,042) (5,377,975) (4,394,519)
------------ ------------ ------------
Total Segment Assets $226,650,900 $212,168,110 $193,776,077
============ ============ ============
Three months ended
February 29, 2004 February 28, 2003
----------------- -----------------
(1) Private Client Services Detail:
Gross revenues, before transfer to
Capital Markets segment $ 137,629 $ 103,469
Revenue transferred to
Capital Markets segment (26,732) (19,316)
----------------- -----------------
Private Client Services net revenues $ 110,897 $ 84,153
================= =================
(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 approximated $44.0 million and $48.0 million for the three months
ended February 29, 2004 and February 28, 2003, respectively.
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
9. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Interests in these
securitized assets may be retained in the form of senior or subordinated
securities or as residual interests. These retained interests are included
in "Financial Instruments Owned" in the Condensed Consolidated Statements
of Financial Condition and are carried at fair value. Securitization
transactions are generally treated as sales, with resulting gain or loss
included in "Principal Transactions" revenue in the Condensed Consolidated
Statements of Income. 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
primarily based on observable transactions in similar securities and are
further verified by external pricing sources, when available.
The Company's securitization activity is detailed below:
Agency Other Other
Mortgage- Mortgage- Asset-
Backed Backed Backed
--------- --------- ------
(in billions)
Total securitizations
Quarter ended February 29, 2004 $ 4.7 $ 12.8 $ 0.6
Quarter ended February 28, 2003 $ 22.3 $ 13.3 $ 3.4
Retained interests
As of February 29, 2004 $ 2.7 $ 0.8 $ 0.2
As of November 30, 2003 $ 1.8 $ 1.4 $ 0.2
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
swap curve plus a spread. Key points on the swap curve at February 29,
2004 were 1.97% for 2-year swaps and 4.38% for 10-year swaps. These models
also consider prepayment speeds, as well as credit losses. Credit losses
are considered through option-adjusted spreads that also utilize
additional factors such as liquidity and optionality.
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
9. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES (continued)
Key valuation assumptions used in measuring the current fair value of
retained interests in assets the Company securitized at February 29, 2004
were as follows:
Agency Other Other
Mortgage-Backed Mortgage-Backed Asset-Backed
--------------- --------------- ------------
Weighted average life (years) 6.54 6.77 2.67
Average prepayment speeds (annual rate) 9% - 47% 0% - 65% N/A
Credit losses 0.38% 8.46% 2.43%
The following hypothetical sensitivity analysis as of February 29, 2004
illustrates the potential 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 swap curve. This shift
considers the effect of other variables, including prepayments. The
remaining valuation assumptions are changed independently.
Agency Other Other
(in millions) Mortgage-Backed Mortgage-Backed Asset-Backed
--------------- --------------- ------------
Interest rates
50 basis point increase $ (60.5) $ 0.6 $ (0.1)
100 basis point increase (130.8) (6.9) (1.1)
50 basis point decrease 44.6 (5.4) 0.5
*80 basis point decrease 60.6 (7.8) 1.2
Prepayment speeds
10% increase 0.3 (3.8) N/A
20% increase 0.6 (7.2) N/A
10% decrease (0.3) 4.2 N/A
20% decrease (0.7) 9.1 N/A
Credit losses
10% increase (4.2) (11.1) (1.2)
20% increase (8.4) (21.3) (2.8)
10% decrease 4.3 12.3 1.7
20% decrease 8.8 25.9 2.7
* In previous quarters this table presented a 100 basis point shift in the
swap curve, however, the level of interest rates at February 29, 2004 made
such an assumption impractical.
The previous table should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. In addition, the table does not consider the change
in fair value of hedging positions which would generally offset the
changes detailed in the table, nor does it consider any corrective action
that the Company may take in response to changes in these conditions. The
impact of hedges is not presented because hedging positions are
established on a macro level and allocating the effect would not be
practicable.
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
9. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES (continued)
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the quarter ended February
29, 2004:
Agency Other Other
(in millions) Mortgage-Backed Mortgage-Backed Asset-Backed
--------------- --------------- ------------
Cash flows received from retained interests $ 57.3 $ 51.7 $ 0.8
Cash flows from servicing N/A $ 0.8 N/A
Collateralized Financing Arrangements
The Company enters into secured borrowing or lending agreements to obtain
collateral necessary to effect settlements, finance inventory positions,
meet customer needs or re-lend as part of its dealer operations.
The Company receives collateral under reverse repurchase agreements,
securities borrowing transactions, derivative transactions, customer
margin loans and other secured money-lending activities. In many
instances, the Company is permitted to rehypothecate such securities. The
Company also pledges financial instruments owned to collateralize certain
financing arrangements. These securities are recorded as "Financial
Instruments Owned, Pledged As Collateral" in the Condensed Consolidated
Statements of Financial Condition.
At February 29, 2004 and November 30, 2003, the Company had received
securities pledged as collateral that can be repledged, delivered or
otherwise used with a fair value of approximately $238.6 billion and
$223.1 billion, respectively. This collateral was generally obtained under
reverse repurchase, securities borrowing or margin lending agreements. Of
these securities received as collateral, those with a fair value of
approximately $149.8 billion and $140.7 billion were delivered or
repledged, generally as collateral under repurchase or securities lending
agreements or to cover short sales at February 29, 2004 and November 30,
2003, respectively.
10. CONSOLIDATION OF VARIABLE INTEREST ENTITIES
The Company regularly creates or transacts with entities that may be VIEs.
These entities are an essential part of its securitization, asset
management and structured finance businesses. In addition, the Company
purchases and sells instruments that may be variable interests.
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
10. CONSOLIDATION OF VARIABLE INTEREST ENTITIES (continued)
In fiscal 2003, the Company adopted the provisions of FIN No. 46 for VIEs
created after January 31, 2003 and for VIEs in which the Company acquired
an interest after January 31, 2003, with no material effect on the
consolidated financial statements. In October 2003, the FASB deferred the
effective date of FIN No. 46 for arrangements with VIEs existing prior to
February 1, 2003 to fiscal periods ending after December 15, 2003. In
December 2003, the FASB issued FIN No. 46 (R), a revision of FIN No. 46 to
address certain technical corrections and implementation issues that have
arisen. As of February 29, 2004, the Company has adopted FIN No. 46 or FIN
No. 46 (R) for its variable interests. For these variable interests, the
Company has consolidated those VIEs in which the Company is the primary
beneficiary. In accordance with FIN No. 46 (R) the Company has
deconsolidated Capital Trust III, which had issued $262.5 million of
Preferred Securities as of February 29, 2004. As a result, the junior
subordinated deferrable interest debentures issued by the Company to
Capital Trust III are included within long term borrowings. In addition,
the Preferred Securities issued by Capital Trust III will no longer be
included in the Company's condensed consolidated statement of financial
condition. The adoption of FIN No. 46 and FIN No. 46 (R) did not have a
material effect on the Company's condensed consolidated financial
statements. As required the Company will apply FIN No. 46 (R) to those
variable interests that were previously accounted for under FIN No. 46.
The Company acts as transferor, seller, investor, structurer, underwriter
or derivative counterparty in securitization transactions. These
transactions typically involve entities that are qualifying special
purpose entities as defined in SFAS No. 140. However, occasionally such
entities are VIEs. The VIEs in these transactions own the securitized
assets and issue beneficial interests in the assets. The holders of the
beneficial interest have no recourse to the Company, only to the assets
held by the VIE. In certain of these VIEs, the Company is the primary
beneficiary through its ownership of certain beneficial interests, which
it may sell in the normal course of business.
The Company also acts as portfolio manager and/or underwriter in several
collateralized debt obligation transactions. In these transactions, the
Company establishes a trust that purchases a portfolio of assets and
issues trust certificates that represent interests in the portfolio of
assets. In addition to receiving variable compensation for managing the
portfolio, the Company may also retain certain trust certificates. In
certain of these transactions these interests result in the Company
becoming the primary beneficiary of these entities. The holders of the
trust certificates have recourse only to the underlying assets of the
trusts and not to other assets of the Company.
Assets held by VIEs, which are currently consolidated, in which the
Company is the primary beneficiary, as discussed in the preceding two
paragraphs, approximated $1.1 billion. The Company's maximum exposure to
loss as a result of its relationship with these VIEs is approximately $25
million which represents the fair value of its interests.
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 $2.9 billion. At February 29, 2004, the Company's maximum
exposure to loss from these entities approximates $6 million, which
represents the fair value of its interests and is reflected in the
consolidated financial statements.
28
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
10. CONSOLIDATION OF VARIABLE INTEREST ENTITIES (continued)
The Company purchases and sells interests in entities that may be deemed
to be VIEs in its market-making capacity in the ordinary course of
business. As a result of these activities, it is reasonably possible that
such entities may be consolidated and deconsolidated at various points in
time. Therefore, the Company's variable interests included above may not
be consolidated or even held by the Company in future periods.
11. PREFERRED STOCK ISSUED BY SUBSIDIARIES
On December 15, 2003, the Company exercised its option and prepaid all of
the outstanding Debentures, resulting in the corresponding redemption of
$300.0 million aggregate principal amount of preferred securities issued
by Bear Stearns Capital Trust II.
Bear Stearns Capital Trust III ("Capital Trust III"), a wholly owned
subsidiary of the Company, has issued $262.5 million (10,500,000 shares)
of Guaranteed Preferred Beneficial Interests in Company Subordinated Debt
Securities ("Preferred Securities"). The Preferred Securities are
fixed-rate securities, which have a liquidation value of $25 per security.
Holders of the Preferred Securities are entitled to receive quarterly
preferential cash distributions at an annual rate of 7.8% through May 15,
2031. The proceeds of the issuance of the Preferred Securities were used
to acquire junior subordinated deferrable interest debentures
("Debentures") issued by the Company. The Debentures have terms that
correspond to the terms of the Preferred Securities and are the sole
assets of Capital Trust III. The Preferred Securities will mature on May
15, 2031. The Company, at its option, may redeem the Preferred Securities
at their principal amount plus accrued distributions beginning May 15,
2006.
In accordance with Fin No. 46 (R) the Company has deconsolidated Capital
Trust III as of February 29, 2004. As a result, the Debentures issued by
the Company to Capital Trust III are included within long-term borrowings.
In addition, the Preferred Securities issued by Capital Trust III will no
longer be included in the Company's Condensed Consolidated Statements of
Financial Condition.
29
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of financial
condition of The Bear Stearns Companies Inc. and subsidiaries as of February 29,
2004, and the related condensed consolidated statements of income and cash flows
for the three month periods ended February 29, 2004 and February 28, 2003. These
financial statements are the responsibility of The Bear Stearns Companies Inc.'s
management.
We conducted our review in accordance with standards established by the American
Institute of Certified Public Accountants. A review of interim financial
information consists principally of applying analytical procedures to financial
data and making inquiries of persons responsible for financial and accounting
matters. It is substantially less in scope than an audit conducted in accordance
with auditing standards generally accepted in the United States of America, 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 auditing standards generally
accepted in the United States of America, the consolidated statement of
financial condition of The Bear Stearns Companies Inc. and subsidiaries as of
November 30, 2003, 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, 2003; and in our report dated
February 13, 2004, (which reports express unqualified opinions and explanatory
paragraphs relating to the adoption of Statement of Financial Accounting
Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation," as
amended by SFAS No. 148, "Accounting for Stock-Based Compensation--Transition
and Disclosure, an amendment of FASB Statement No. 123," in 2003, discussed in
Note 1 to the consolidated financial statements) 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, 2003 is fairly stated, in all material
respects, in relation to the consolidated statement of financial condition from
which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
April 13, 2004
30
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Bear Stearns Companies Inc. ("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. 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., EMC Mortgage Corporation, Bear Stearns Mortgage Capital
Corporation, Bear Stearns Credit Products Inc. and Bear Stearns Forex Inc. The
Company is primarily engaged in business as a securities broker and dealer
operating in three principal segments: Capital Markets, Global Clearing Services
and Wealth Management.
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, 2003.
Certain Factors Affecting Results of Operations
The Company's principal business activities -- investment banking, securities
and derivatives sales and trading, clearance and brokerage -- 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.
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 paragraph, 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.
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Executive Overview
Net revenues and pre-tax earnings for the quarter ended February 29, 2004 were
up 14% and 25%, respectively, from the quarter ended February 28, 2003. The
results achieved by the Company in the first quarter of fiscal 2004 are the
result of the steps the Company took in the past few years to broaden its
product and service offerings and expand its operating platform. These steps,
combined with favorable market conditions resulted in (a) 13.9% increase in net
revenues to $1.73 billion from $1.52 billion. In addition, pre-tax profit
margins increased by almost 300 basis points to 30.8% when compared to the
fiscal 2003 quarter. Annualized return on average common equity increased to
21.3% in the 2004 quarter from 19.9% in the 2003 quarter.
Capital Markets net revenues increased 9.4% to $1.37 billion from $1.26 billion.
In Institutional Equities, net revenues were up 8% in the first quarter of
fiscal 2004 from the first quarter of fiscal 2003, as market indices showed
significant improvement and average daily trading volumes increased. The Fixed
Income area achieved record revenues for the quarter, up 4% from a year ago,
with each of the three major product areas--mortgages, credit and interest rate
products--reporting year-over-year improvement. Investment banking revenues were
up 35% as merger and acquisition fees increased on positive market conditions.
Global Clearing Services net revenues increased 24% due to increased customer
activity and higher customer margin debt balances. In Wealth Management,
revenues from the Private Client Services and asset management areas rose 32%,
primarily due to the rebound in the equity markets and increased customer
activity.
Business Environment
Global and US economic conditions continued to improve during the first quarter
of fiscal 2004. Economic data indicated a relatively robust US economy, but the
lack of job growth raised concerns about the sustainability of any recovery.
Consumer confidence declined during the first quarter of fiscal 2004 amid
concerns about weak job growth. However, mortgage rates remained at historically
low levels, continuing to fuel consumer spending and a strong housing market.
The Federal Reserve Board ("Fed") met twice during the first quarter of fiscal
2004 and left the federal funds rate unchanged at 1.00%, where it has been since
June 2003 when the Fed cut rates for the thirteenth consecutive time in an
effort to boost the economy.
Equity valuations continued to climb with all major indices up strongly during
the first quarter of fiscal 2004. The Dow Jones Industrial Average ("DJIA") and
the Standard & Poor's 500 Index ("S&P 500") each increased 8.2% during the
quarter ended February 29, 2004, while the Nasdaq Composite Index ("NASDAQ")
increased 3.5% during the quarter ended February 29, 2004, reaching a 2 1/2 year
high in January 2004. Average daily trading volume on the New York Stock
Exchange, Inc. ("NYSE") and Nasdaq increased 9.0% and 40.2%, respectively,
compared with the fiscal quarter ended February 28, 2003. Favorable equity
market conditions served to
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
increase equity new issue activity during the 2004 quarter as well as US
announced and completed mergers and acquisition volumes, which increased more
than 100% industry-wide compared to the February 2003 quarter.
The fixed income markets continued to perform extremely well in the first
quarter of fiscal 2004, benefiting from the combination of the low level of
interest rates, steep yield curve and narrow corporate credit spreads. However,
higher interest rates and diminished refinancing activity resulted in a
significant decline in agency collateralized mortgage obligation ("CMO")
activity with industry-wide issuance down approximately 72%. This decline was
partially offset by active origination in certain sectors of the whole loan
markets and higher secondary mortgage-backed securities activity levels. These
factors led to the industry's improved performance in the first quarter of
fiscal 2004. The yield on the 10-year treasuries dropped approximately 35 basis
points from late February to mid-March. Consequently, the weekly mortgage
refinance index increased from 3532 at quarter-end to almost 5000 by mid-March.
Weak global and US economic conditions existed in the first quarter of fiscal
2003 as heightened geopolitical risks and reduced investor confidence created a
difficult operating environment. The Fed met twice during the fiscal quarter and
left the federal funds rate unchanged at 1.25% citing that the risks between
price stability and economic growth remained balanced. The major indices were
all down for the quarter ended February 28, 2003. The DJIA decreased 11.3%,
while the S&P 500 and the NASDAQ decreased 10.2% and 9.6%, respectively. Weak
equity market conditions negatively impacted equity-related businesses,
resulting in a decline in average daily trading volume. Average daily trading
volume on the NYSE decreased 0.7%, while average daily trading volume on the
Nasdaq declined 22.1% from the quarter ended February 28, 2002. Declining market
valuations and lack of investor demand adversely impacted global equity
underwriting activity. Global and US announced mergers and acquisition volumes
were at low levels. However, low interest rates and a steep yield curve provided
favorable conditions for fixed income activities reflecting strong demand for
domestic debt issuances and strong secondary market activity. Mortgage-backed
securities underwriting benefited from high levels of residential mortgage
refinancing.
Results of Operations
In the discussion to follow, results for the quarter ended February 29, 2004
will be compared with the results for the quarter ended February 28, 2003.
The following table sets forth an overview of the Company's financial results:
Three Months Ended
----------------------------
(in thousands, except per share amounts, February 29, February 28,
pre-tax profit margin and return on average common equity) 2004 2003
------------ ------------
Revenues, net of interest expense $ 1,725,923 $ 1,515,434
Income before provision for income tax $ 530,978 $ 425,199
Net Income $ 361,065 $ 274,253
Diluted earnings per share $ 2.57 $ 2.00
Pre-tax profit margin 30.8% 28.1%
Return on average common equity (annualized) 21.3% 19.9%
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company reported net income of $361.1 million, or $2.57 per share (diluted),
for the quarter ended February 29, 2004 which represented an increase of 31.7%
from $274.3 million, or $2.00 per share (diluted), for the quarter ended
February 28, 2003.
Revenues, net of interest expense ("net revenues") increased 13.9% to $1.73
billion for the quarter ended February 29, 2004 from $1.52 billion for the
quarter ended February 28, 2003 due to an increase in commission revenues,
investment banking revenues and net interest revenues, partially offset by a
decrease in principal transactions revenues.
The Company's commission revenues were as follows:
Three Months Ended
------------------------------------------
February 29, February 28,
(in thousands) 2004 2003 % Increase
------------ ------------ ------------
Institutional $ 163,026 $ 122,634 32.9%
Clearance 79,558 71,488 11.3%
Retail & other 65,519 47,793 37.1%
------------ ------------ ------------
Total commissions $ 308,103 $ 241,915 27.4%
============ ============ ============
Note: Certain prior period items have been reclassified within commission
revenues to conform to the current period's presentation.
Commission revenues for the 2004 quarter increased 27.4% to $308.1 million from
$241.9 million for the 2003 quarter. Institutional commissions increased 32.9%
to $163.0 million for the 2004 quarter from $122.6 million for the 2003 quarter.
The increase in institutional commissions is primarily due to increased trading
volumes and improved market share for US listed and over-the-counter securities.
In addition, commencing in the first quarter of 2004, the results of Bear Wagner
Specialists, LLC have been consolidated with those of the Company due to the
occurrence of a change of control event in December 2003. Clearance commissions
increased 11.3% to $79.6 million for the 2004 quarter from $71.5 million for the
2003 quarter due primarily to increased levels of prime broker and fully
disclosed customer activity resulting from an improvement in global equity
market conditions. Retail and other commissions increased 37.1% to $65.5 million
in the 2004 quarter from $47.8 million in the 2003 quarter due to individual
customer activity levels.
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended
------------------------------------------
February 29, February 28, % (Decrease)
(in thousands) 2004 2003 Increase
------------ ------------ ------------
Fixed income $ 673,551 $ 730,765 (7.8)%
Equities 122,032 90,395 35.0%
Derivative financial instruments 151,279 147,304 2.7%
------------ ------------ ------------
Total principal transactions $ 946,862 $ 968,464 (2.2)%
============ ============ ============
Note: Certain prior period items have been reclassified within principal
transactions revenues to conform to the current period's presentation.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Revenues from principal transactions for the 2004 quarter decreased 2.2% to
$946.9 million from $968.5 million for the 2003 quarter, due to a decrease in
the Company's fixed income activities, partially offset by increases in equities
activities. Fixed income revenues decreased 7.8% to $673.6 million for the 2004
quarter from $730.8 million for the 2003 quarter attributable to a decline from
record revenues in the corporate bond area in the 2003 quarter and a small
decline in the mortgage-backed securities area. During the 2004 quarter, higher
interest rates and diminished refinancing activity resulted in a significant
decline in agency CMO issuance, with industry-wide issuance down approximately
72%. However, this decline was largely offset by strong issuances in certain
sectors of the whole loan market and higher secondary mortgage-backed securities
trading levels. Overall, mortgage-backed securities revenues achieved near
record levels with strong performances across many sectors. The decrease in
corporate bonds and mortgage-backed securities areas was partially offset by an
increase in the high yield area, reflecting favorable market conditions and
increased customer volume. Revenues derived from equities activities increased
35.0% to $122.0 million during the 2004 quarter from $90.4 million in the 2003
quarter. Included in principal transactions revenues for the 2004 quarter are
specialist trading revenues from the Company's majority-owned specialist
subsidiary, Bear Wagner Specialists, LLC. Equities-related businesses,
particularly the over-the-counter stock, risk arbitrage and international
equities revenues increased during the 2004 quarter, in addition to specialist
trading revenues, as a result of higher average daily trading volumes and
increased announced mergers and acquisition activity. These increases were
partially offset by decreased revenues in convertible and equity arbitrage due
to decreased levels of market volatility. Revenues from derivative financial
instruments increased 2.7% to $151.3 million in the 2004 quarter from $147.3
million in the 2003 quarter, primarily due to increases in the foreign exchange,
credit derivatives and fixed income derivatives areas as a result of the
favorable market environment and expansion of the Company's market share. These
results were partially offset by a decrease in equity derivatives, which
declined due to low levels of equity volatility.
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended
------------------------------------------
February 29, February 28,
(in thousands) 2004 2003 % Increase
------------ ------------ ------------
Underwriting $ 160,935 $ 99,039 62.5%
Advisory services 96,769 75,199 28.7%
Merchant banking 2,706 (6,655) 140.7%
------------ ------------ ------------
Total investment banking $ 260,410 $ 167,583 55.4%
============ ============ ============
Investment banking revenues increased 55.4% to $260.4 million for the 2004
quarter from $167.6 million for the 2003 quarter. Investment banking revenues
include fees earned for underwriting public and private offerings of fixed
income and equity securities and advising clients on mergers and acquisition and
other services, and merchant banking revenues. Underwriting revenues increased
62.5% to $160.9 million for the 2004 quarter from $99.0 million for the 2003
quarter, reflecting an increase in equity underwriting on strong new issue
activity and improved market share in initial public offerings and follow-on
offerings. High yield underwriting revenues also improved significantly on
strong new issue activity and increased market share. These increases were
partially offset by reduced municipal underwriting revenues, reflecting the
impact of lower new issue activity. Advisory services revenues for the 2004
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
quarter increased 28.7% to $96.8 million from $75.2 million for the 2003 quarter
reflecting an increase in US completed mergers and acquisition activity.
Merchant banking revenues were $2.7 million for the 2004 quarter, compared to a
loss of $6.7 million for the 2003 quarter. The 2003 quarter reflected
write-downs on certain principal investments.
Net interest revenues (interest and dividend revenue less interest expense)
increased 47.7% to $164.9 million for the 2004 quarter, up from $111.7 million
for the 2003 quarter. Interest and dividends revenue and interest expense are a
function of the level and mix of total assets and liabilities, including
financial instruments owned, financial instruments sold but not yet purchased,
customer related balances and the prevailing level of interest rates. The
increase in net interest revenues was primarily attributable to higher levels of
customer interest-bearing balances reflecting improved US equity market
conditions. Average customer margin debt balances increased 28.4% to $46.6
billion for the 2004 quarter from $36.3 billion for the 2003 quarter. Average
customer short balances increased 30.4% to $74.3 billion for the 2004 quarter
from $57.0 billion for the 2003 quarter and average stock borrowed balances
increased 29.7% to $58.5 billion for the 2004 quarter from $45.1 billion for the
2003 quarter.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended
------------------------------------------
February 29, February 28, % Increase
(in thousands) 2004 2003 (Decrease)
------------ ------------ ------------
Employee compensation and benefits $ 849,148 $ 757,889 12.0%
Floor brokerage, exchange and clearance fees 56,900 44,680 27.4%
Communications and technology 93,828 92,740 1.2%
Occupancy 33,615 34,943 (3.8)%
Advertising and market development 25,901 25,210 2.7%
Professional fees 41,800 28,453 46.9%
Other expenses 93,753 106,320 (11.8)%
------------ ------------ ------------
Total non-interest expenses $ 1,194,945 $ 1,090,235 9.6%
============ ============ ============
Employee compensation and benefits includes the cost of salaries and benefits
and incentive compensation, including restricted stock and option awards.
Employee compensation and benefits increased 12.0% to $849.1 million for the
2004 quarter from $757.9 million for the 2003 quarter, primarily due to higher
discretionary compensation associated with the increase in net revenues.
Employee compensation and benefits as a percentage of net revenues was 49.2% for
the 2004 quarter compared to 50.0% for the 2003 quarter. Full-time employees
decreased to 10,431 at February 29, 2004 from 10,506 at February 28, 2003.
Non-compensation expenses increased 4.0% to $345.8 million for the 2004 quarter
from $332.3 million for the 2003 quarter. Non-compensation expenses as a
percentage of net revenues decreased to 20.0% for the 2004 quarter, compared
with 21.9% for the 2003 quarter, which is attributable to a relatively stable
cost base combined with significantly increased net revenues.
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The increase in non-compensation expenses of 4.0% when compared to the
comparable prior year quarter primarily reflects the consolidation of Bear
Wagner Specialists, LLC beginning in the 2004 quarter. Non-compensation expenses
related to Bear Wagner Specialists, LLC amounted to $27.3 million for the 2004
quarter. Excluding the impact of the consolidation of Bear Wagner Specialists,
LLC, non-compensation expenses declined 4.2% to $318.5 million in the 2004
quarter. Specifically, the decline in non-compensation expenses is primarily
related to a reduction in other expenses of $29.5 million, attributable to a
$20.5 million charge for impairment of goodwill associated with our electronics
options market making business recorded in the 2003 quarter and a reduction in
CAP Plan related costs to $44.0 million for the 2004 quarter, a decrease from
$48.0 million in the comparable prior year quarter. Offsetting these declines
was a 12.1% increase in floor brokerage, exchange and clearance fees, excluding
specialist related costs, reflecting increased volume. In addition, professional
fees have increased 46.9% to $41.8 million in the 2004 quarter from $28.5
million in the 2003 quarter due to increased temporary help and professional
expenses. The Company achieved a pre-tax profit margin of 30.8% for the 2004
quarter versus 28.1% for the 2003 quarter.
The Company's effective tax rate decreased to 32.0% for the 2004 quarter
compared to 35.5% for the 2003 quarter principally as a result of increased tax
preference items relative to the level of income.
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. Certain reclassifications have
been made to prior period amounts to conform to the current period's
presentation, including the reclassification of certain revenues within the
Wealth Management segment from asset management to private client services.
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.
Capital Markets
Three Months Ended
------------------------------------------
February 29, February 28,
(in thousands) 2004 2003 % Increase
------------ ------------ ------------
Net revenues
Institutional equities $ 297,400 $ 276,461 7.6%
Fixed income 822,268 791,217 3.9%
Investment banking 253,179 187,764 34.8%
------------ ------------ ------------
Total net revenues $ 1,372,847 $ 1,255,442 9.4%
============ ============ ============
Pre-tax income $ 516,369 $ 465,919 10.8%
============ ============ ============
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 works 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 through a majority-owned subsidiary, the NYSE, AMEX 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.
Net revenues for Capital Markets increased 9.4% to $1.37 billion for the 2004
quarter from $1.26 billion for the 2003 quarter. Pre-tax income for Capital
Markets increased 10.8% to $516.4 million for the 2004 quarter from $465.9
million for the 2003 quarter. Pre-tax profit margin was 37.6% for the 2004
quarter compared to 37.1% for the 2003 quarter.
Institutional equities net revenues for the 2004 quarter increased 7.6% to
$297.4 million from $276.5 million for the 2003 quarter. During the 2004
quarter, market indices showed significant improvement when compared to the 2003
quarter and average daily trading volumes increased on the NYSE and Nasdaq. As a
result, institutional equities commissions in the Company's US-listed and
over-the-counter businesses increased, reflecting increased trading volume and
improved market share. International equity sales and trading net revenues also
increased significantly, reflecting increased customer order flow and market
share gains. Risk arbitrage revenues also increased, reflecting a significant
increase in the total value of announced mergers and acquisition activity.
Included within the Company's institutional equities revenues for the 2004
quarter are the revenues of the Company's majority-owned specialist subsidiary,
Bear Wagner Specialists, LLC. These results were consolidated beginning with the
first quarter of 2004 which resulted in an increase in net revenues from
specialist activities of approximately $33 million over the 2003 quarter. A
decline in customer activity levels and reduced market volatility resulted in
lower levels of equity derivative and convertible arbitrage revenues.
Fixed income net revenues increased 3.9% to a record $822.3 million for the 2004
quarter from $791.2 million from the 2003 quarter, primarily reflecting strong
results from the Company's mortgage, credit and interest rate product areas. In
particular, high yield, distressed, foreign exchange and interest rate
derivatives areas increased during the quarter when compared to the prior year
quarter. These businesses benefited from the low level of interest rates, a
steep yield curve, interest rate volatility and narrowing of corporate credit
spreads. Although primary CMO issuances decreased significantly from the 2003
quarter due to higher interest rates and diminishing residential mortgage
refinancing activity, an increase in issuances in certain sectors of the whole
loan markets helped mitigate the decline. Secondary trading revenues also
remained at high levels due to increased customer activity as mortgage-backed
securities spreads tightened substantially. As a result,
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
mortgage-backed securities revenues achieved near record levels. In addition,
the Company's interest rate businesses again achieved record results on
increased customer order flow and a favorable market environment. In particular,
interest rate derivatives, foreign exchange and credit product businesses
continued to deliver strong results reflecting increased volatility levels,
customer volumes and market share. High yield revenues rose reflecting favorable
market conditions and increased customer volume. Distressed securities net
revenues also increased significantly on improved customer activity and
tightening credit spreads. These results were partially offset by reduced net
revenues from investment grade debt activities, when compared to the record
results in the February 2003 quarter.
Investment banking revenues increased 34.8% to $253.2 million for the 2004
quarter from $187.8 million for the 2003 quarter. Investment banking revenues
include fees earned for underwriting public and private offerings of fixed
income and equity securities and advising clients on mergers and acquisition and
other services, and merchant banking revenues. Underwriting revenues increased
32.6% to $165.3 million for the 2004 quarter from $124.7 million for the 2003
quarter. Equity underwriting revenue improved significantly, reflecting the
increased volume of new issue activity as well as an increase in the Company's
market share of initial public offerings and follow-on offerings. High yield
underwriting revenues also improved significantly on strong new issue activity
and increased market share. These results were partially offset by lower
municipal underwriting revenues, reflecting the impact of lower new issue
activity and decreased market share. Advisory services revenues increased 22.2%
to $85.2 million from $69.8 million for the 2003 quarter due to increased volume
of US-completed mergers and acquisitions activity. Merchant banking revenues
were $2.7 million for the 2004 quarter, compared to a loss of $6.7 million for
the 2003 quarter. The 2003 quarter reflected write-downs on certain principal
investments.
Global Clearing Services
Three Months Ended
------------------------------------------
February 29, February 28,
(in thousands) 2004 2003 % Increase
------------ ------------ ------------
Net revenues $ 217,614 $ 175,778 23.8%
Pre-tax income $ 78,502 $ 52,150 50.5%
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At February 29, 2004 and February 28, 2003, the Company held
approximately $218.5 billion and $159.2 billion, respectively, in equity in
Global Clearing Services client accounts.
Net revenues for Global Clearing Services increased 23.8% to $217.6 million for
the 2004 quarter from $175.8 million in the 2003 quarter. Commission revenues
increased 11.3% to $79.6
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
million for the 2004 quarter, from $71.5 million for the 2003 quarter reflecting
increased prime broker and fully disclosed customer activity. Net interest
revenues increased 32.1% from $133.0 million for the 2004 quarter, from $100.6
million for the 2003 quarter, primarily reflecting increased margin balances
from prime brokerage and fully disclosed clearance clients due to improving US
equity market conditions. Pre-tax income increased 50.5% to $78.5 million, from
$52.2 million for the 2003 quarter, reflecting higher net revenues. Pre-tax
profit margin was 36.1% for the 2004 quarter compared to 29.7% for the quarter
ended February 28, 2003.
Average customer margin balances were $46.6 billion during the 2004 quarter
compared to $36.3 billion during the 2003 quarter. Customer margin balances
totaled $47.9 billion at February 29, 2004, an increase from $38.1 billion at
February 28, 2003. Average customer short balances were $74.3 billion during the
2004 quarter compared to $57.0 billion during the 2003 quarter and totaled $77.0
billion at February 29, 2004, an increase from $56.5 billion at February 28,
2003. Average stock borrowed balances were $58.5 billion during the 2004 quarter
compared to $45.1 billion for the 2003 quarter and totaled $57.0 billion at
February 29, 2004, an increase from $41.7 billion at February 28, 2003. Average
free credit balances were $26.5 billion during the 2004 quarter compared to
$18.9 billion during the 2003 quarter and totaled $26.1 billion at February 29,
2004, an increase from $18.7 billion at February 28, 2003.
Wealth Management
Three Months Ended
------------------------------------------
February 29, February 28,
(in thousands) 2004 2003 % Increase
------------ ------------ ------------
Net revenues
Private Client Services $ 110,897 $ 84,153 31.8%
Asset Management 41,890 31,432 33.3%
------------ ------------ ------------
Total net revenues $ 152,787 $ 115,585 32.2%
Pre-tax income $ 20,867 $ 5,719 264.9%
The Wealth Management segment is composed of the Private Client Services ("PCS")
and asset management areas. PCS provides high-net-worth individuals with an
institutional level of investment service, including access to the Company's
resources and professionals. At February 29, 2004, PCS has 512 account
executives in its principal office, six regional offices and two international
offices. Asset management manages equity, fixed income and alternative assets
for corporate pension plans, public systems, endowments, foundations,
multi-employer plans, insurance companies, corporations, families and
high-net-worth individuals in the US and abroad.
Net revenues for Wealth Management increased 32.2% to $152.8 million for the
2004 quarter, from $115.6 million for the 2003 quarter. PCS revenues increased
31.8% to $110.9 million for the 2004 quarter from $84.2 million for the 2003
quarter reflecting increased levels of retail customer activity on improving US
equity markets as well as the continued expansion of the Company's PCS sales
force. Broker headcount at February 29, 2004 was 512, up 4.5% from 490 at
February 28, 2003. Asset management revenues increased 33.3% to $41.9 million
for the 2004 quarter, from $31.4 million for the 2003 quarter. This increase
reflects higher management fees attributable to increased assets under
management in both traditional and hedge fund products as
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
well as improved performance fees on alternative investment products,
principally hedge funds. Pre-tax income for Wealth Management approximated $20.9
million in the 2004 quarter compared to pre-tax income of $5.7 million for the
2003 quarter, reflecting higher net revenues.
Assets under management were $29.1 billion at February 29, 2004, reflecting a
24.9% increase from $23.3 billion in assets under management at February 28,
2003. Assets under management include $6.1 billion of assets from alternative
investment products at February 29, 2004, an increase of 7.3% from $5.7 billion
at February 28, 2003.
Liquidity and Capital Resources
Financial Leverage
Asset Composition
The Company's actual level of capital, capital requirements and thereby the
level of financial leverage, are 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 February 29, 2004 increased to $226.7 billion from
$212.2 billion at November 30, 2003. The increase was primarily attributable to
increases in financial instruments owned, securities purchased under agreements
to resell and customer receivables, partially offset by a decrease in cash and
securities borrowed. The Company's total capital base, which consists of
long-term debt, preferred equity issued by subsidiaries and total stockholders'
equity, increased to $40.0 billion at February 29, 2004 from $37.5 billion at
November 30, 2003. This change was primarily due to an increase in equity
associated with net income and a net increase in long-term debt, partially
reduced by the redemption of preferred stock issued by a subsidiary and treasury
stock purchases.
The amount of long-term debt, as well as total capital, that the Company
maintains is driven by a number of factors with particular focus on asset
composition. The Company's ability to support increases in total assets is a
function of its ability to obtain short-term secured and unsecured funding, as
well as its access to longer-term sources of capital (i.e., long-term debt and
equity).
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 especially decisive 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 frequently lower than would be
observed on an average basis. At quarter end, the Company typically uses excess
cash to finance high-quality, highly liquid securities inventory that otherwise
would be funded via the repurchase agreement market. In addition, the Company
reduces its matched book repurchase and reverse repurchase activities at quarter
end. Finally, the Company may reduce the aggregate level of inventories through
ordinary course, open market activities in the most liquid portions of the
balance sheet, which are principally US government and agency securities and
agency mortgage pass-through securities. At February 29, 2004 and November 30,
2003, total assets of $226.7 billion and $212.2 billion were approximately 8.1%
and 10.1% lower than the average of the month-end balances observed over the
trailing twelve-month period. Despite reduced total assets at quarter end, the
Company's overall market, credit and liquidity risk profile is not changed
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
The following table presents total assets, adjusted assets, and net adjusted
assets with the resultant leverage ratios at February 29, 2004 and November 30,
2003. With respect to a comparative measure of financial risk and capital
adequacy, the Company believes that the low-risk, collateralized nature of its
resale, securities borrowed and segregated cash assets renders net adjusted
leverage as the most relevant measure. The Company maintains a financial
statement date guideline for net adjusted leverage ratio of no greater than
15.0, which the Company continued to meet at February 29, 2004.
February 29, November 30,
(in billions, except ratios) 2004 2003
------------ ------------
Total assets $ 226.7 $ 212.2
Adjusted assets (1) $ 174.5 $ 164.2
Net adjusted assets (2) $ 102.3 $ 90.9
Leverage ratio (3) 28.0 26.4
Adjusted leverage ratio (4) 21.6 20.4
Net adjusted leverage ratio(5) 12.7 11.3
(1) Adjusted assets is Total assets less securities purchased under agreements
to resell, securities received as collateral and cash and securities
deposited with clearing organizations or segregated in compliance with
federal regulations ("segregated cash").
(2) Net adjusted assets is Adjusted assets less securities borrowed.
(3) Leverage ratio equals Total assets divided by stockholders' equity and
preferred stock issued by subsidiaries.
(4) Adjusted leverage ratio equals Adjusted assets divided by stockholders'
equity and preferred stock issued by subsidiaries.
(5) Net adjusted leverage ratio equals Net adjusted assets divided by
stockholders' equity and preferred stock issued by subsidiaries.
Note: As of February 29, 2004 the leverage ratio, adjusted leverage ratio and
net adjusted leverage ratio equals total assets, adjusted assets and net
adjusted assets, respectively, divided by stockholders' equity and junior
subordinated debt issued to Capital Trust III. The Company views the junior
subordinated debt issued to Capital Trust III as a component of its equity
capital base given the inherent characteristics of the securities. The Company
also receives rating agency equity credit for these securities.
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Funding Strategy & Liquidity Risk Management
General Funding Strategy
The Company's general funding strategy seeks to ensure liquidity and diversity
of funding sources to meet the Company's financing needs at all times and in all
market environments. The Company attempts to finance its balance sheet by
maximizing, where economically competitive, its use of secured funding.
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. Within this context, the
Company seeks to prudently manage its reliance on short-term unsecured
borrowings by maintaining an adequate total capital base and extensive use of
secured funding. Beyond this, the Company's emphasis on diversification by
product, geography, maturity and instrument seeks to further ensure prudent,
moderate usage of more credit-sensitive, potentially less stable funding.
Short-term unsecured funding includes commercial paper, medium-term notes and
bank borrowings, which generally have maturities ranging from overnight to one
year. Due to the collateralized nature of the borrowing, the Company views its
secured funding as inherently less credit sensitive and therefore a more stable
source of funding.
In addition to short-term funding sources, the Company utilizes equity and
long-term debt, including floating- and fixed-rate notes and medium-term 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 results in a determination of the Company's aggregate
need for longer-term funding sources (i.e., long-term debt and equity). The
Company views long-term debt as a stable source of funding which effectively
strengthens its overall liquidity profile.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective is to maintain
sufficient cash capital (i.e., equity plus long-term debt maturing in more than
twelve 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 or contemplating 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. In light of these assumptions, the Company monitors
its cash position and the borrowing value of unencumbered, unhypothecated
marketable securities in relation to its unsecured debt maturing over the next
12 months, striving to maintain the ratio of liquidity sources to maturing debt
at
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
100% or greater. Also within this strategy, the Company endeavors 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.
As of February 29, 2004, the market value of unencumbered, unhypothecated
securities owned by the Company was approximately $22.7 billion with a borrowing
value of $19.0 billion. The assets are comprised primarily of US government and
agency securities, mortgage-backed and asset-backed securities, investment-grade
corporate debt and US equities. The average advance rate on these different
asset types ranges from 70% to 98% and is based predominantly on committed,
secured facilities that the Company and its subsidiaries maintain in different
regions globally. The liquidity ratio (explained above) has averaged 188% over
the previous twelve months including unused committed unsecured bank credit and
178% excluding the unsecured portion of the Company's $3.4 billion committed
revolving credit facility. The firm's net cash capital position has averaged
just over $2.1 billion over the same twelve-month period.
In addition, 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. 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. The Company has a general guideline of approximately no more
than 20% of its long-term debt portfolio maturing in any one year. As of
February 29, 2004 the weighted average maturity of the firm's long-term debt was
4.0 years.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility") totaling
$3.40 billion, which permits borrowing on a secured basis by Bear, Stearns & Co.
Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"), Bear Stearns
International, Ltd. ("BSIL") and certain other subsidiaries. The Facility also
provides that The Bear Stearns Companies Inc. ("Parent Company") and BSIL may
borrow up to $1.70 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
margin levels on a wide range of financial instruments eligible to be pledged.
The Facility contains financial covenants, the most significant of which require
maintenance of specified levels of stockholders' equity of the Company and net
capital of BSSC. The facility terminates in February 2005, with all loans
outstanding at that date payable no later than February 2006. There were no
borrowings outstanding under the Facility at February 29, 2004.
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 BSIL, Bear Stearns International
Trading Limited ("BSIT") and Bear Stearns Bank plc ("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 2004, with all repos outstanding at that date payable no
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
later than August 2005. There were no borrowings outstanding under the Repo
Facility at February 29, 2004.
The Company has a $350 million committed revolving credit facility ("Pan Asian
Facility"), which permits borrowing on a secured basis collateralized by foreign
securities at pre-specified advance rates. 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 2004 with all loans outstanding at that
date payable no later than December 2005. There were no borrowings outstanding
under the Pan Asian Facility at February 29, 2004.
The Company also maintains a series of committed credit facilities to support
liquidity needs for the financing of non-investment-grade loans, auto loans,
residential mortgages, commercial mortgages and listed options. The facilities
are expected to be drawn from time to time and expire at various dates during
fiscal 2004. All of these facilities contain a term out option of one year or
more for borrowings outstanding at expiration. The banks providing these
facilities are committed to provide up to an aggregate of approximately $2.9
billion.
Capital Resources
The Company conducts a substantial portion of its operating activities within
its regulated subsidiaries Bear Stearns, BSSC, BSIL, BSIT and BSB. 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., EMC Mortgage
Corporation, Bear Stearns Mortgage Capital Corporation, Bear Stearns Credit
Products Inc. and Bear Stearns Forex Inc. In connection with these operating
activities, a substantial portion of the Company's long-term borrowings and
equity has been used to fund investments in, and advances to, these
subsidiaries, including subordinated debt advances. Within this funding
framework, the Company attempts to fund equity investments in subsidiaries with
equity from the Parent Company (i.e., utilize no equity double leverage). At
February 29, 2004, the Parent Company's equity double leverage ratio was
approximately 0.97 based on common equity and 0.91 including preferred equity.
At November 30, 2003, these measures compare to 0.91 based on common equity and
0.84 including preferred equity. Additionally, all subordinated debt advances to
regulated subsidiaries for use as regulatory capital are funded with long-term
debt issued by the Company that have maturities 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 outside the regulated
subsidiaries and attempts to fund such assets with either capital or borrowings
having maturities consistent with the nature and self-funding ability of the
assets being financed.
Long-term debt totaling $27.3 billion and $24.6 billion had remaining maturities
beyond one year at February 29, 2004 and November 30, 2003, respectively. The
Company's access to external sources of financing, as well as the cost of that
financing, is dependent on various factors and could be adversely affected by a
deterioration of the Company's long- and short-term debt ratings, which are
influenced by a number of factors. These include, but are not limited to:
material changes in operating margins; earnings trends and volatility; the
prudence of funding and liquidity management practices; financial leverage on an
absolute basis or relative to peers;
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
the composition of the balance sheet and/or capital structure; geographic and
business diversification; and the Company's market share and competitive
position in the business segments in which it operates. Material deterioration
in any one or a combination of these factors could result in a downgrade of the
Company's credit ratings, thus increasing the cost of and/or limiting the
availability of unsecured financing. Additionally, a reduction in the Company's
credit ratings could also trigger incremental collateral requirements,
predominantly in the over-the-counter derivatives market. As of February 29,
2004, a downgrade by either Moody's Investors Service or Standard & Poor's to
the Company's long-term ratings to the level of A3 or A- would have required the
Company to post approximately $1.1 billion in additional collateral for
outstanding over-the-counter derivatives contracts.
At February 29, 2004, the Company's long-term/short-term debt ratings were as
follows:
Rating
--------------------
Dominion Bond Rating Service Limited(1) A(high)/R-1 (middle)
Fitch(2) A+/F1+
Moody's Investors Service(3) A1/P-1
Rating & Investment Information, Inc. A+/nr
Standard & Poor's(4) A/A-1
nr - does not assign a short-term rating
(1) On August 26, 2003, Dominion Bond Rating Service Limited upgraded the
Company's long-term debt ratings from "A" to "A (high)" with a "stable" trend,
while simultaneously affirming the Company's short-term credit ratings.
(2) On March 28, 2003, Fitch revised the outlook for the Company's long-term
debt ratings from "negative" to "stable," while simultaneously affirming the
Company's credit ratings.
(3) On October 22, 2003, Moody's Investors Service raised the Company's
long-term debt ratings from A2 to A1 placing a "stable" outlook at the higher
rating level, while simultaneously affirming the Company's short-term credit
ratings.
(4) On April 9, 2003, Standard & Poor's revised the outlook for the Company's
long-term debt ratings from "negative" to "stable," while simultaneously
affirming the Company's credit ratings.
Stock Repurchase Program
The Company has various employee stock compensation plans designed to increase
the emphasis on stock-based incentive compensation and align the compensation of
its key employees with the long-term interests of stockholders. Such plans
provide for annual grants of stock units and stock options. The Company intends
to offset the potentially dilutive impact of the annual grants by purchasing
common stock throughout the year in open market and private transactions. On
January 7, 2004, the Board of Directors of the Company approved an amendment to
the Stock Repurchase Program ("Repurchase Program") to replenish the previous
authorizations to allow the Company to purchase up to $1.0 billion of common
stock in fiscal 2004 or beyond. During the quarter ended February 29, 2004, the
Company purchased under the current and prior authorizations a total of 610,009
shares at a cost of approximately $46.8 million. Approximately $992.8 million is
available to be purchased under the current authorization as of February 29,
2004.
During the quarter ended February 29, 2004, the Company purchased a total of
537,962 shares of its common stock at a total cost of approximately $42.8
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 November 24, 2003. Approximately $157.2 million is available to
be purchased under the current authorization as of February 29, 2004.
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cash Flows
Cash and cash equivalents decreased $1.95 billion to $1.89 billion at February
29, 2004. Cash used in operating activities was $2.11 billion, primarily
attributable to increases in financial instruments owned, securities purchased
under agreements to resell, and a decrease in securities sold under agreements
to repurchase, which occurred in the normal course of business as a result of
changes in customer needs, market conditions and trading strategies. These
results were partially offset by increases in financial instruments sold but not
yet purchased, payables to customers and other liabilities and accrued expenses.
Cash used in investing activities of $129.2 million primarily reflected net
purchases of investment securities and other assets in connection with the
Company's merchant banking activities and purchases of property, equipment and
leasehold improvements. Cash provided by financing activities of $294.3 million
reflected net proceeds of $3.4 billion from issuances of long-term borrowings
used primarily to fund normal operating activities and to repay $1.8 billion in
long-term borrowings, the redemption of preferred stock and net payments
relating to short-term borrowings.
Regulated Subsidiaries
As registered broker-dealers, Bear Stearns and BSSC are subject to the net
capital requirements of the Securities Exchange Act of 1934, as amended, the
NYSE and the Commodity Futures Trading Commission, which are designed to measure
the general financial soundness and liquidity of broker-dealers. BSIL and BSIT,
London-based broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the Financial Services Authority. Additionally, BSB is subject
to the regulatory capital requirements of the Irish Financial Services
Regulatory Authority. At February 29, 2004, Bear Stearns, BSSC, BSIL, BSIT and
BSB were in compliance with their respective regulatory capital requirements.
Merchant Banking and Private Equity Investments
At February 29, 2004, the Company held investments in seven transactions with an
aggregate recorded value of approximately $29.0 million, reflected in the
Condensed Consolidated Statements of Financial Condition in "Other Assets." Six
transactions are private principal investments aggregating $20.9 million at
February 29, 2004. One transaction is a principal investment in a public entity,
aggregating $8.1 million at February 29, 2004. At November 30, 2003, the Company
held investments in eight leveraged transactions with an aggregate recorded
value of approximately $19.6 million, reflected in the Condensed Consolidated
Statements of Financial Condition in "Other Assets." Five transactions were
private principal investments aggregating $11.0 million at November 30, 2003.
Three transactions were principal investments in public entities, aggregating
$8.6 million at November 30, 2003.
In connection with the Company's merchant banking activities, the Company had
investments in private equity-related investment funds aggregating $330.0
million and $333.7 million at February 29, 2004 and November 30, 2003. In
addition to the 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").
47
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
High Yield Positions
As part of the Company's fixed income activities, it participates in the
underwriting, securitization and trading of non-investment-grade debt
securities, non-performing mortgage- related assets, non-investment-grade
commercial and leveraged loans and securities of companies that are the subject
of pending bankruptcy proceedings (collectively, "high yield positions"). Also
included in high yield positions is a portfolio of Chapter 13 and other credit
card receivables from individuals. Non-investment-grade debt securities have
been defined as non-investment-grade corporate debt, asset securitization
positions and emerging market debt rated BB+ or lower or equivalent ratings
recognized by credit rating agencies. At February 29, 2004 and November 30,
2003, the Company held high yield positions approximating $6.0 billion and $5.0
billion, respectively, substantially all of which are in "Financial Instruments
Owned" in the Condensed Consolidated Statements of Financial Condition, and
$974.7 million and $847.6 million, respectively, reflected in "Financial
Instruments Sold, But Not Yet Purchased" in the Condensed Consolidated
Statements of Financial Condition. Included in these amounts is a portfolio of
non-performing mortgage-related assets as well as a portfolio of Chapter 13 and
other credit card receivables aggregating $2.1 billion and $1.5 billion at
February 29, 2004 and November 30, 2003, respectively.
Also included in the high yield positions are extensions of credit to highly
leveraged companies. At February 29, 2004 and November 30, 2003, the amount
outstanding to highly leveraged borrowers totaled $1.07 billion (gross position
of $1.10 billion less $30.0 million of associated hedges) and $902.8 million
(gross position of $922.8 million less $20.0 million of associated hedges),
respectively. The largest industry concentration was the telecommunications
industry, which approximated 16.3% at February 29, 2004 and 18.8% at November
30, 2003 of these high yield positions. Additionally, the Company has lending
commitments with these non-investment-grade borrowers (see the summary table
under "Commitments"). The Company also has exposure to non-investment-grade
counterparties through its trading-related derivative activities. These amounts,
net of collateral, were $271.0 million and $214.0 million at February 29, 2004
and November 30, 2003, respectively.
The Company's Risk Management Department and senior trading managers monitor
exposure to market and credit risk for high yield positions and establish limits
for overall market exposure 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 and economic and market considerations.
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Contractual Obligations
The Company's contractual obligations, excluding derivative financial
instruments, as of February 29, 2004:
Payments Due By Period
---------------------------------------------------
Remaining Fiscal Fiscal
Fiscal 2005- 2007-
(in millions) 2004 2006 2008 Thereafter Total
--------- ------- ------ ---------- -------
Long-term borrowings (1) $ 3,524 $12,248 $7,845 $ 8,536 $32,153
Future minimum lease payments (2) 36 100 95 198 429
(1) Amounts include fair value adjustment in accordance with SFAS No. 133 as
well as $262.5 million of junior subordinated deferrable interest
debentures (see Note 11 in the Notes to Condensed Consolidated Financial
Statements).
(2) Includes 383 Madison Avenue in New York City.
Commitments
The Company's commitments (1) as of February 29, 2004:
Amount of Commitment Expiration Per Period
---------------------------------------------------
Remaining Fiscal Fiscal
Fiscal 2005- 2007-
(in millions) 2004 2006 2008 Thereafter Total
--------- ------- ------ ---------- -------
Commercial loan commitments: (2)
Investment-grade $ 1,231 $ 393 $ 341 $ 10 $ 1,975
Non-investment grade 189 416 257 218 1,080
Commitments to invest in private equity-related
investments and partnerships (3) 467
Underwriting commitments 425 -- -- -- 425
Commercial and residential loans 951 1,000 -- -- 1,951
Letters of credit 3,123 74 75 -- 3,272
Other (4) 83 105 2 -- 222
(1) See Note 4, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) Commitments are shown gross of associated hedges of $609 million for
investment-grade borrowers.
(3) At February 29, 2004, commitments to invest in private equity-related
investments and partnerships aggregated $467 million. These commitments
will be funded, if called, through the end of the respective investment
periods, the longest of such periods ending in 2013.
(4) Includes $32 million of commitments with no stated maturity.
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 which could materially affect reported amounts in the financial
statements (see Note 1, "Summary of Significant Accounting Policies," in the
Notes to 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.
49
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 readily observable price levels for similar instruments
and/or models or methodologies that employ data that are observable from
objective sources, and (3) those whose fair value is estimated based on
internally developed models or methodologies utilizing significant assumptions
or other data that are generally less readily observable from objective sources.
(1) Financial Instruments Valued Based on Quoted Market Prices or for Which the
Company Has Independent External Valuations
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include US treasuries, most
mortgage-backed securities and corporate, emerging market, high yield and
municipal bonds. Unlike most equities, which tend to be traded on exchanges, the
vast majority of fixed income trading (including US treasuries) occurs in
over-the-counter markets, and, accordingly, the Company's valuation policy is
based on its best estimate of the prices at which these financial instruments
trade in those markets. The Company is an active dealer in most of the
over-the-counter markets for these financial instruments, and typically has
considerable insight into the trading level of financial instruments held in
inventory and/or 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
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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. At February 29, 2004 and November
30, 2003, such positions (primarily fixed income cash positions) aggregated
approximately $3.3 billion and $3.4 billion, respectively, in "Financial
Instruments Owned" and $881 million and $740 million, respectively, in
"Financial Instruments Sold, But Not Yet Purchased" in the Condensed
Consolidated Statements of Financial Condition.
As part of the Company's fixed income activities, 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.
As a major dealer in derivatives, the Company is engaged in structuring and
acting as principal in complex derivative transactions. Complex derivatives
include certain long-dated equity derivatives, certain credit and municipal
derivatives and other exotic derivative structures. These non-exchange-traded
instruments may have immature or limited markets and, by their nature, involve
complex valuation methodologies and models, which are often refined to correlate
with the market risk of these instruments.
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 (MTM) Committee, which is composed of senior management from
the Risk Management and Controllers Departments. The MTM Committee is
responsible for ensuring that the approaches used to independently validate the
Company's valuations are robust, comprehensive and effective. Typical approaches
include valuation comparisons with external sources, comparisons
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 securities acquired as a result of leveraged acquisition transactions are
reflected in the 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. 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 Investments"
in Management's Discussion and Analysis for additional details.
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 which are established
for a limited purpose. SPEs, by their nature, generally are not controlled by
their equity owners, as the establishing documents govern all material
decisions. The Company's primary involvement with SPEs relates to securitization
transactions in which transferred assets, including commercial and residential
mortgages, consumer receivables, securities and other financial assets are sold
to an SPE and repackaged into securities or similar beneficial interests. SPEs
may also be used to create securities with a unique risk profile desired by
investors and as a means of intermediating financial risk. The Company, in the
normal course of business may establish SPEs, sell assets to SPEs, underwrite,
distribute, and make a market in securities or other beneficial interests issued
by SPEs, transact derivatives with SPEs, own securities or other beneficial
interests, including residuals, in SPEs and provide liquidity or other
guarantees for SPEs.
The Company follows Statement of Financial Accounting Standards ("SFAS") No.
140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities--a Replacement of FASB Statement No. 125," to
account for securitizations and other transfers of financial assets. In
accordance with SFAS No. 140, the Company accounts for transfers of financial
assets as sales provided that control has been relinquished. Control is deemed
to be relinquished only when all of the following conditions have been met: (1)
the assets have been isolated from the transferor, even in bankruptcy or other
receivership; (2) the transferee is a Qualifying Special Purpose Entity ("QSPE")
or has the right to pledge or exchange the assets received and (3) the
transferor has not maintained effective control over the
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
transferred assets. Therefore, the Company derecognizes financial assets
transferred in securitizations provided that such transfer meets all of these
criteria. See Note 9, "Transfers of Financial Assets and Liabilities," in the
Notes to Condensed Consolidated Financial Statements for a complete discussion
of the Company's securitization activities.
As of February 29, 2004, the Company adopted Financial Accounting Standards
Board ("FASB") Interpretation No. 46, "Consolidation of Variable Interest
Entities - an Interpretation of ARB No. 51" ("FIN No. 46") or FIN No. 46 as
revised ("FIN No. 46 (R)") for VIEs in which it held a variable interest as of
February 29, 2004, and uses this guidance to determine whether an SPE should be
consolidated. See Note 10, "Consolidation of Variable Interest 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 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 generally consolidates these entities
under FIN No. 46 if it owns a majority of the variable interests. 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. These transactions typically involve no recourse to the Company.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivative,
leasing, securitization and other transactions. See Note 5, "Guarantees," in the
Notes to Condensed Consolidated Financial Statements for a complete discussion
on guarantees.
New Accounting Pronouncements
In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest
Entities--an Interpretation of ARB No. 51." FIN No. 46 provides guidance on the
consolidation of certain entities in which equity investors do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support. Such entities are referred to as VIEs. FIN No.
46 requires the primary beneficiary of a VIE to consolidate the entity. On
December 24, 2003, the FASB published FIN No. 46 (R), a replacement of FIN No.
46. FIN No. 46 (R) provides technical corrections and addresses certain
implementation issues.
In fiscal 2003, the Company adopted FIN No. 46 for VIEs in which it acquired an
interest after January 31, 2003. As of February 29, 2004, the Company adopted
FIN No. 46 or FIN No. 46 (R) for VIEs in which it held a variable interest as of
February 29, 2004. Such adoption did not have a material effect on the condensed
consolidated financial statements. See Note 10,
53
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
"Consolidation of Variable Interest Entities," in the Notes to Condensed
Consolidated Financial Statements for a further discussion.
Specialist Activities
The Company participates, through a majority-owned joint venture, in specialist
activities on the NYSE, AMEX and International Securities Exchange. Due to the
occurrence of a Control Event triggered in December 2003, the Company began
consolidating this entity. Included in the Condensed Consolidated Statements of
Financial Condition at February 29, 2004 are total assets of $2.2 billion,
including approximately $359 million of goodwill and identifiable intangible
assets.
Effects of Inflation
Since the Company's assets are primarily recorded at their current market value
and to a large extent are liquid in nature, they are not significantly affected
by inflation. However, 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. 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.
54
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
For a description of the Company's risk management policies, including a
discussion of the Company's primary market risk exposures, which include
interest rate risk, foreign exchange rate risk and equity price risk, as well as
a discussion of the Company's credit risk and a discussion of how those
exposures are managed, refer to the Company's Annual Report on Form 10-K for the
fiscal year ended November 30, 2003.
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 seeks 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. Interest rate risk for most desks use a historical simulation
approach for VaR. Foreign exchange rate risk and for a limited number of desks
the interest rate risk, use a "Monte Carlo" value-at-risk approach. Historical
simulation involves the generation of price movements in a portfolio using price
sensitivities, and historical movements of the underlying risk factors to which
the securities are sensitive. Monte Carlo simulation involves the generation of
price movements in a portfolio using a random number generator. The generation
of random numbers is based on the statistical properties of the securities in
the portfolio. For interest rates, each country's yield curve has five factors
that describe possible curve movements, where appropriate. These were generated
from principal component analysis. In addition, volatility and spread risk
factors as well as intercountry correlations were used, where appropriate.
Equity price risk was measured using a combination of historical and Monte Carlo
approaches. Equity and equity derivatives risk were treated as correlated with
various domestic and international indices, of which the Company used
approximately 50 at February 29, 2004 and November 30, 2003. Parameter
estimates, such as volatilities and correlations, were based on daily tests
through February 29, 2004.
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 days. However, the
55
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Company believes VaR models are an appropriate methodology for comparison of
risk profiles across companies in the financial services industry.
The aggregate VaR presented below 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. The following table
illustrates the VaR for each component of market risk as of February 29, 2004,
November 30, 2003 and February 28, 2003. Commodity risk has been excluded due to
immateriality at February 29, 2004, November 30, 2003 and February 28, 2003.
February 29, November 30, February 28,
(in millions) 2004 2003 2003
------------ ------------ ------------
MARKET RISK
Interest rate $ 15.7 $ 14.9 $ 13.8
Currency 1.6 0.9 0.7
Equity 3.9 3.7 5.4
Diversification benefit (4.9) (4.2) (5.0)
------------ ------------ ------------
Aggregate VaR $ 16.3 $ 15.3 $ 14.9
============ ============ ============
The table below illustrates the high, low and average (calculated on a monthly
basis) VaR for each component of market risk and aggregate market risk during
the 2004 quarter:
(in millions) High Low Average
------- ------- -------
MARKET RISK
Interest rate $ 15.9 $ 14.6 $ 15.3
Currency 2.0 0.9 1.5
Equity 3.9 3.5 3.7
Aggregate VaR 16.4 15.2 15.8
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 "Derivatives Credit Risk" below). Stress tests are
calculated at the firmwide level, for particular trading books, for particular
customer accounts and for particular 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
56
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
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 charts represent a summary of the daily principal transactions
revenues and reflect a combination of trading revenues, net interest revenues
for certain trading areas and other revenues for the quarters ended February 29,
2004 and February 28, 2003, respectively. These charts represent 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 $15.5 million and $15.9 million for the quarters ended February 29,
2004 and February 28, 2003, respectively. During the quarter ended February 29,
2004 there was one day with a reported trading loss and the total daily trading
loss did not exceed the reported aggregate period end VaR amount. There were no
daily trading losses for the quarter ended February 28, 2003. The frequency
distribution of the Company's daily net trading revenues reflects the Company's
historical ability to manage its exposure to market risk and the diversified
nature of its trading activities. No guarantee can be given regarding future net
trading revenues or future earnings volatility. The Company believes that these
results are indicative of its commitment to the management of market trading
risk.
57
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarter Ended February 29, 2004
[The following table was depicted as a bar graph in the printed material.]
DAILY NET TRADING REVENUES NUMBER OF TRADING DAYS
-------------------------- ----------------------
($ in millions)
(10)+
(10)-(5)
(5)-0 1
0-5 4
5-10 8
10-15 20
15-20 13
20-25 9
25-30 3
30+ 3
Quarter Ended February 28, 2003
[The following table was depicted as a bar graph in the printed material.]
DAILY NET TRADING REVENUES NUMBER OF TRADING DAYS
-------------------------- ----------------------
($ in millions)
(10)+
(10)-(5)
(5)-0
0-5 5
5-10 12
10-15 19
15-20 7
20-25 10
25-30 2
30+ 6
58
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Derivatives Credit Risk
Derivative financial instruments represent contractual commitments between
counterparties that derive their value from changes in an underlying interest
rate, currency exchange rate, index (e.g., Standard & Poor's 500 Index),
reference rate (e.g., London Interbank Offered Rate "LIBOR"), or asset value
referenced in the related contract. Some derivatives, such as futures contracts,
certain options and indexed 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. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into hedging
transactions 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. The Company also utilizes interest rate and currency swaps as well
as futures contracts and US treasury positions to hedge its debt issuances as
part of its asset and liability management.
Credit risk arises from the potential inability of counterparties to perform in
accordance with the terms of the contract. At any point in time, the Company's
exposure to credit risk associated with counterparty non-performance is
generally limited to the net replacement cost of over-the-counter contracts net
of the value of collateral held. Such financial instruments are reported at fair
value on a net-by-counterparty basis pursuant to enforceable netting agreements.
Exchange-traded financial instruments, such as futures and options, generally do
not give rise to significant unsecured counterparty exposure due to the
Company's margin requirements, which may be greater than those prescribed by the
individual exchanges. Options written generally do not give rise to counterparty
credit risk since they obligate the Company (not its counterparty) to perform.
The Company has controls in place to monitor credit exposures by assessing the
future creditworthiness of counterparties and limiting transactions with
specific counterparties. The Company also seeks to control credit risk by
following an established credit approval process, monitoring credit limits and
requiring collateral where appropriate.
59
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of February 29, 2004:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Exposure, Percentage of
Net of Exposure, Net
Rating (2) Exposure Collateral (3) Collateral (4) of Collateral
------------------ -------- -------------- -------------- -------------
AAA $2,141 $749 $1,420 35%
AA 2,143 846 1,368 34%
A 1,560 869 833 20%
BBB 381 645 173 4%
BB and lower 867 1,937 268 7%
Non-rated 3 -- 3 0%
(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 derivatives contracts.
(4) In calculating exposure net of collateral, collateral amounts are limited
to the amount of current exposure for each counterparty. Excess collateral
is not applied to reduce exposure because such excess in one counterparty
portfolio cannot be applied to deficient collateral in a different
counterparty portfolio.
60
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Securities Exchange Act of 1934 (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
has been no such change during the quarter covered by this quarterly report.
61
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
Fezzani, et al. v. Bear, Stearns & Co. Inc., et al.
As previously reported in the Company's Report on Form 10-K for the fiscal year
ended November 30, 2003 ("Form 10-K"), Bear Stearns, BSSC, and a former officer
of BSSC were named as defendants in a lawsuit in United States District Court
for the Southern District of New York brought by eleven individuals and entities
that allegedly purchased securities underwritten by A.R Baron & Company, Inc., a
firm for which BSSC provided clearing services.
On April 6, 2004, the district court granted motions to dismiss all causes of
action that plaintiffs brought against Bear Stearns, BSSC, and the former
officer of BSSC.
IPO Underwriting Fee Antitrust Litigation
As previously reported in the Company's Form 10-K, Bear Stearns, along with
numerous other financial services firms, is a defendant in several consolidated
class actions currently pending in the United States District Court for the
Southern District of New York.
On February 24, 2004, the district court granted defendants' motion to dismiss
the complaint in the Purchaser Action in part, dismissing plaintiffs' claim for
treble damages under Section 4 of the Clayton Act. However, the court denied
defendants' motion to dismiss plaintiffs' claim for injunctive relief.
Mutual Fund Matters: Pflugrath v. The Bear Stearns Companies Inc., et al.
As previously reported in the Company's Form 10-K, the Company and Bear, Stearns
& Co. Inc. were named as defendants in a purported class action lawsuit, in the
United States District Court for the Southern District of New York.
On March 19, 2004, this action was transferred to the District of Maryland for
coordinated and/or consolidated proceedings as part of MDL 1586-In re: Mutual
Funds Investment Litigation.
Specialist Matters
As previously reported in the Company's Form 10-K, Bear Wagner Specialists, LLC
("Bear Wagner"), an indirect subsidiary of the Company, had entered into an
agreement in principle with the NYSE and the staff of the SEC to settle certain
previously disclosed claims concerning specialist trading activity.
On March 29, 2004, without admitting or denying the allegations, findings or
conclusions of the SEC and the NYSE, Bear Wagner consented to a final settlement
of the claims asserted by these regulatory organizations with respect to certain
specialist trading activities. Under the terms of the settlement, Bear Wagner
entered into consent agreements and other definitive documents with the SEC and
NYSE to resolve their investigations of Bear Wagner relating to those matters.
62
LEGAL PROCEEDINGS
Pursuant to the settlement, Bear Wagner has consented, among other things, to
(i) pay an aggregate of $16,259,446 million as penalties, involving a payment of
$5,534,543 as a penalty and the remaining $10,724,903 as disgorgement to a
distribution fund for the benefit of certain customers and (ii) adopt various
additional policies, systems, procedures and other safeguards to ensure and
further the integrity of Bear Wagner's trading activity.
----------
The Company also is involved from time to time in investigations and proceedings
by governmental agencies and self-regulatory organizations.
63
Item 2: CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES
OF EQUITY SECURITIES
The following table provides information as of February 29, 2004 with respect to
the shares of common stock repurchased by the Company during the first quarter
of fiscal 2004:
Issuer Purchases of Equity Securities
Total Number of Approximate Dollar
Shares Purchased as Value of Shares that
Part of Publicly May Yet Be Purchased
Total Number of Shares Average Price Paid Announced Plans or Under the Plans or
Period Purchased per Share Programs (1) Programs (1)
------------------ ---------------------- ------------------ ------------------- --------------------
12/1/03 - 12/31/03 650,102 $74.97 650,102 $414,489,088
1/1/04 - 1/31/04 325,566 80.86 325,566 1,164,524,352
2/1/04 - 2/29/04 172,303 84.55 172,303 1,149,956,707
---------------------- -------------------
Total 1,147,971 78.08 1,147,971
====================== ===================
(1) On January 8, 2003, the Board of Directors of the Company approved an
amendment to the Repurchase Program to replenish the previous authorizations to
allow the Company to purchase up to $1.0 billion of common stock in fiscal 2003
or beyond. On January 7, 2004, the Board of Directors of the Company approved an
amendment to the Repurchase Program to replenish the previous authorizations to
allow the Company to purchase up to $1.0 billion of common stock in fiscal 2004
or beyond. On November 24, 2003, the Compensation Committee of the Board of
Directors of the Company approved a $200 million CAP Plan Earnings Purchase
Authorization. The Repurchase Programs have no set expiration or termination
date.
64
Item 5. OTHER INFORMATION
In accordance with Section 10A of the Securities Exchange Act of 1934, as
amended by Section 202 of the Sarbanes-Oxley Act of 2002, non-audit services
were approved by the Company's Audit Committee to be performed by Deloitte &
Touche LLP, the Company's independent auditors, principally relating to the
following: 1) agreed upon procedures relating to (a) securitization offerings
and related periodic filings, (b) reports on internal controls, and (c)
compliance by Bear Stearns Financial Products Inc. with certain contractual
requirements; 2) readiness services in connection with Section 404 of the
Sarbanes-Oxley Act of 2002; 3) tax related services; 4) issuance of comfort
letters and consents relating to offerings of the Company's own securities; 5)
reviews of quarterly financial statements; 6) consulting services with respect
to client web-based technology (non-financial systems); and 7) other accounting,
attest and regulatory related services.
65
Item 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(11) Computation of Per Share Earnings. (The calculation of per share
earnings is in Note 7, "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
(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
(b) Reports on Form 8-K
During the quarter, the Company filed the following Current Reports on
Form 8-K.
(i) A Current Report on Form 8-K dated December 15, 2003 and filed on December
17, 2003, announcing its regular quarterly cash dividend on its
outstanding shares of Preferred Stock, Series A, E, F and G and announcing
that it has called for redemption all of its outstanding Series A
Preferred Stock.
(ii) A Current Report on Form 8-K dated and filed on December 17, 2003
pertaining to the Company's results of operations for the three months
ended November 30, 2003.
(iii) A Current Report on Form 8-K dated December 17, 2003 and filed on December
22, 2003, pertaining to the form of Medium-Term Note, Series B (principal
protected notes linked to the Nasdaq-100 Index due December 2009) ("Index
Linked Notes") issued by the Company, the form of Income Notes (linked to
the Consumer Price Index), an opinion of Cadwalader, Wickersham & Taft LLP
as to certain federal income tax consequences in connection with the
offering of the Index Linked Notes and a consent in connection with the
offering of the Index Linked Notes.
66
(iv) A Current Report on Form 8-K dated January 7, 2004 and filed on January 9,
2004, announcing its regular quarterly cash dividend on its outstanding
shares of common stock, and the approval of an amendment to its share
repurchase program to allow the Company to purchase up to $1 billion in
aggregate cost of common stock.
(v) A Current Report on Form 8-K dated January 21, 2004 and filed on January
26, 2004 pertaining to a "Wells Notice" that was received by Bear Wagner
Specialists, LLC from the Securities and Exchange Commission and
notification from the NYSE, relating to alleged violations arising from
specialist trading activity.
67
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
The Bear Stearns Companies Inc.
-------------------------------
(Registrant)
Date: April 14, 2004 By: /s/ Jeffrey M. Farber
Jeffrey M. Farber
Controller
(Principal Accounting Officer)
68
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit No. Description Page
----------- ----------- ----
(12) Computation of Ratio of Earnings to Fixed Charges 70
(15) Letter re: Unaudited Interim Financial Information 71
(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 72
(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 73
(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 74
(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 75
69