UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended August 31, 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 October 12, 2004, the latest practicable date, there were
103,245,302 shares of Common Stock, $1 par value, outstanding.
TABLE OF CONTENTS
Page
----
Available Information 4
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Income (Unaudited)
for the three months and nine months ended August 31, 2004 and
August 31, 2003 5
Condensed Consolidated Statements of Financial Condition
as of August 31, 2004 (Unaudited) and November 30, 2003 (Audited) 6
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the nine months ended August 31, 2004 and August 31, 2003 7
Notes to Condensed Consolidated Financial Statements (Unaudited) 8
Note 1 Summary of Significant Accounting Policies 8
Note 2 Financial Instruments 13
Note 3 Derivatives and Hedging Activities 13
Note 4 Commitments and Contingencies 14
Note 5 Guarantees 16
Note 6 Regulatory Requirements 18
Note 7 Earnings Per Share 18
Note 8 Segment Data 19
Note 9 Transfers of Financial Assets and Liabilities 22
Note 10 Consolidation of Variable Interest Entities 24
Note 11 Preferred Stock Issued by Subsidiaries 25
Note 12 Subsequent Event 25
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM 26
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 27
Introduction 27
Certain Factors Affecting Results of Operations 27
Forward-Looking Statements 27
Executive Overview 28
Business Environment 28
Results of Operations 29
Business Segments 33
Capital Markets 33
Global Clearing Services 35
Wealth Management 36
Liquidity and Capital Resources 37
Financial Leverage 37
Funding Strategy & Liquidity Risk Management 39
2
Capital Resources 40
Stock Repurchase Program 41
Cash Flows 42
Regulated Subsidiaries 42
Merchant Banking and Private Equity Investments 42
High Yield Positions 42
Contractual Obligations 43
Commitments 44
Critical Accounting Policies 44
Off-Balance-Sheet Arrangements 46
New Accounting Pronouncements 47
Specialist Activities 47
Effects of Inflation 47
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 48
Value-At-Risk 48
Distribution of Daily Net Trading Revenues 50
Derivatives Credit Risk 51
Item 4. CONTROLS AND PROCEDURES 53
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS 54
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 56
Item 5. OTHER INFORMATION 57
Item 6. EXHIBITS 58
Signature 59
Exhibit Index 60
3
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.
4
Part I - Financial Information
Item 1. Financial Statements
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Income
(Unaudited)
---------------------------------------------------------
Three Months Ended Nine Months Ended
--------------------------- ---------------------------
August 31, August 31, August 31, August 31,
(in thousands, except share and per share data) 2004 2003 2004 2003
-------------------------------------------------- ------------ ------------ ------------ ------------
REVENUES
Commissions $ 273,722 $ 279,888 $ 888,975 $ 789,485
Principal transactions 848,982 724,023 2,711,313 2,502,402
Investment banking 190,692 298,716 712,666 678,849
Interest and dividends 528,704 503,135 1,547,637 1,459,859
Other income 52,253 36,509 179,005 99,803
------------ ------------ ------------ ------------
Total revenues 1,894,353 1,842,271 6,039,596 5,530,398
Interest expense 359,588 357,211 1,055,370 1,067,184
------------ ------------ ------------ ------------
Revenues, net of interest expense 1,534,765 1,485,060 4,984,226 4,463,214
------------ ------------ ------------ ------------
NON-INTEREST EXPENSES
Employee compensation and benefits 743,038 681,745 2,452,239 2,131,815
Floor brokerage, exchange and clearance
fees 56,822 44,830 173,369 137,050
Communications and technology 92,360 93,047 274,509 276,531
Occupancy 35,843 34,788 104,226 102,819
Advertising and market development 30,030 24,550 85,246 77,267
Professional fees 47,547 36,608 131,717 94,056
Other expenses 85,246 87,315 276,587 308,170
------------ ------------ ------------ ------------
Total non-interest expenses 1,090,886 1,002,883 3,497,893 3,127,708
------------ ------------ ------------ ------------
Income before provision for income taxes 443,879 482,177 1,486,333 1,335,506
Provision for income taxes 160,620 168,762 494,206 467,427
------------ ------------ ------------ ------------
Net income $ 283,259 $ 313,415 $ 992,127 $ 868,079
============ ============ ============ ============
Net income applicable to common shares $ 276,416 $ 305,621 $ 970,671 $ 844,499
============ ============ ============ ============
Basic earnings per share $ 2.31 $ 2.54 $ 7.97 $ 7.02
Diluted earnings per share $ 2.09 $ 2.30 $ 7.16 $ 6.34
============ ============ ============ ============
Weighted average common shares outstanding:
Basic 127,014,483 128,681,694 128,287,500 129,055,575
Diluted 144,201,755 145,599,540 145,992,306 146,316,093
============ ============ ============ ============
Cash dividends declared per common share $ 0.20 $ 0.20 $ 0.60 $ 0.54
============ ============ ============ ============
See Notes to Condensed Consolidated Financial Statements.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
August 31, November 30,
(in thousands, except share data) 2004 2003
----------------------------------------------------------- ------------ ------------
ASSETS
Cash and cash equivalents $ 3,251,599 $ 3,837,570
Cash and securities deposited with clearing organizations
or segregated in compliance with federal regulations 4,717,129 8,657,065
Securities purchased under agreements to resell 39,704,143 33,822,695
Securities received as collateral 7,091,987 5,496,832
Securities borrowed 68,033,511 73,317,962
Receivables:
Customers 31,472,511 19,646,879
Brokers, dealers and others 1,454,856 3,730,306
Interest and dividends 285,979 268,054
Financial instruments owned, at fair value
Pledged as collateral 35,768,684 32,349,781
Not pledged as collateral 40,086,739 26,882,877
Assets of variable interest entities 1,090,550 --
Property, equipment and leasehold improvements, net of
accumulated depreciation and amortization of $809,724
and $816,646 in 2004 and 2003, respectively 368,532 381,262
Other assets 4,002,999 3,776,827
------------ ------------
Total Assets $237,329,219 $212,168,110
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 11,276,500 $ 13,387,662
Securities sold under agreements to repurchase 55,763,958 47,464,156
Obligation to return securities received as collateral 7,091,987 5,496,832
Securities loaned 8,039,491 6,648,165
Payables:
Customers 75,016,991 68,666,893
Brokers, dealers and others 5,209,378 2,676,351
Interest and dividends 558,801 567,575
Financial instruments sold, but not yet purchased, at 28,438,644 27,109,147
fair value
Liabilities of variable interest entities 1,090,550 --
Accrued employee compensation and benefits 1,744,513 1,376,215
Other liabilities and accrued expenses 1,530,688 1,312,061
------------ ------------
195,761,501 174,705,057
------------ ------------
Commitments and contingencies (Note 4)
Long-term borrowings 33,500,199 29,430,465
------------ ------------
Guaranteed Preferred Beneficial Interests in Company
Subordinated Debt Securities -- 562,500
------------ ------------
STOCKHOLDERS' EQUITY
Preferred stock 451,793 538,415
Common stock, $1.00 par value; 500,000,000 shares 184,806 184,806
authorized and 184,805,848 shares issued as of both
August 31, 2004 and November 30, 2003
Paid-in capital 3,366,104 3,245,380
Retained earnings 5,857,726 4,954,508
Employee stock compensation plans 2,133,414 2,299,170
Unearned compensation (145,446) (188,952)
Treasury stock, at cost:
Common stock: 82,410,048 and 82,233,811 shares as of
August 31, 2004 and November 30, 2003, respectively (3,780,878) (3,563,239)
------------ ------------
Total Stockholders' Equity 8,067,519 7,470,088
------------ ------------
Total Liabilities and Stockholders' Equity $237,329,219 $212,168,110
============ ============
See Notes to Condensed Consolidated Financial Statements.
6
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Nine Months Ended
----------------------------
August 31, August 31,
(in thousands) 2004 2003
---------------------------------------------------------------------- ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 992,127 $ 868,079
Adjustments to reconcile net income to cash used in
operating activities:
Noncash items included in net income:
Depreciation and amortization 96,427 106,748
Deferred income taxes (45,188) (19,358)
Employee stock compensation plans 26,093 39,647
Other 6,192 8,445
Changes in operating assets and liabilities:
Cash and securities deposited with clearing
organizations or segregated in compliance
with federal regulations 3,939,936 (554,874)
Securities purchased under agreements to resell (5,881,448) (3,368,237)
Securities borrowed 5,284,451 (5,443,193)
Receivables from customers (11,825,632) (5,393,989)
Receivables from brokers, dealers and others 2,275,450 (3,846,252)
Financial instruments owned (15,452,365) (7,822,946)
Other assets (103,786) (382,439)
Securities sold under agreements to repurchase 8,299,802 2,185,482
Securities loaned 1,391,326 2,742,458
Payables to customers 6,350,098 11,760,857
Payables to brokers, dealers and others 2,278,983 1,026,182
Financial instruments sold, but not yet purchased 1,329,497 4,632,965
Accrued employee compensation and benefits 369,347 352,494
Other liabilities and accrued expenses 283,930 24,630
------------ ------------
Cash used in operating activities (384,760) (3,083,301)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (83,697) (29,187)
Purchases of investment securities and other assets (210,527) (102,527)
Proceeds from sales of investment securities and other assets 151,098 237,196
------------ ------------
Cash (used in) provided by investing activities (143,126) 105,482
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net payments for short-term borrowings (2,111,162) (2,133,509)
Net proceeds from issuance of long-term borrowings 7,564,726 8,916,194
Proceeds from issuances of derivatives with a financing element, net 254,044 --
Redemption of preferred stock issued by a subsidiary (300,000) --
Issuance of common stock 170,132 71,930
Redemption of preferred stock (86,045) (27,660)
Payments for retirement of long-term borrowings (4,970,952) (5,739,402)
Treasury stock purchases - common stock (494,420) (398,785)
Cash dividends paid (84,408) (77,565)
------------ ------------
Cash (used in) provided by financing activities (58,085) 611,203
------------ ------------
Net decrease in cash and cash equivalents (585,971) (2,366,616)
Cash and cash equivalents, beginning of year 3,837,570 5,520,285
------------ ------------
Cash and cash equivalents, end of period $ 3,251,599 $ 3,153,669
============ ============
See Notes to Condensed Consolidated Financial Statements.
7
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 provides clearance related
services for prime brokerage clients and clearance on a fully-disclosed
basis for introducing broker dealers. Wealth Management is comprised of
the Private Client Services ("PCS") and asset management areas. See Note
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
Commercial Mortgage Inc., 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 August 31, 2004, the Condensed
Consolidated Statements of Income for the three and nine months ended
August 31, 2004 and August 31, 2003 and the Condensed Consolidated
Statements of Cash Flows for the nine months ended August 31, 2004 and
August 31, 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 together 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 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 (R),
"Consolidation of Variable Interest Entities" ("FIN No. 46 (R)"), the
Company also consolidates any variable interest entities ("VIEs") for
which it is the primary beneficiary. The assets and related liabilities of
such variable interest entities have been shown in the Condensed
Consolidated 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 New York Stock Exchange ("NYSE") and
International Securities Exchange. Due to the occurrence of a Control
Event triggered in December 2003, the Company began consolidating this
entity beginning in the first quarter of fiscal 2004. Included in the
Condensed Consolidated Statements of Financial Condition at August 31,
2004 are total assets of $1.6 billion, including approximately $353
million of goodwill and identifiable intangible assets.
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 interests and securities acquired as a result of leveraged
acquisition transactions are reflected in the condensed 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.
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 in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities with a market value in
excess of the principal amount loaned plus the accrued interest thereon,
in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities to counterparties to
collateralize repurchase agreements.
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
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
period-end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Gains or
losses resulting from foreign currency transactions are included in net
income.
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" and Emerging Issues Task Force Statement No. 03-6,
"Participating Securities and the Two Class Method Under FASB Statement
No. 128, Earnings Per Share" ("EITF No. 03-6"). Basic EPS is computed by
dividing net income applicable to common shares, adjusted for costs
related to vested shares under the Capital Accumulation Plan for Senior
Managing Directors, as amended ("CAP Plan"), as well as the effect of the
redemption of preferred stock, by the weighted average number of common
shares outstanding. Common shares outstanding includes vested units issued
under certain stock compensation plans, which will be
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
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 nine months ended August 31, 2004 and August 31, 2003. Income
taxes paid totaled $327.2 million and $288.9 million for the nine months
ended August 31, 2004 and August 31, 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 and nine months ended August 31, 2004
and August 31, 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)
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 Nine months Ended
------------------------ ------------------------
August 31, August 31, August 31, August 31,
(in millions, except per share amounts) 2004 2003 2004 2003
--------------------------------------- ---------- ---------- ---------- ----------
Net income, as reported $ 283.3 $ 313.4 $ 992.1 $ 868.1
Add: Stock-based employee
compensation plans expense included
in reported net income, net of
related tax effects 3.0 5.8 15.0 22.7
Deduct: Total stock-based employee
compensation plans expense determined
under the fair value based method,
net of related tax effects (11.0) (19.1) (39.1) (62.6)
---------- ---------- ---------- ----------
Pro forma net income $ 275.3 $ 300.1 $ 968.0 $ 828.2
========== ========== ========== ==========
Earnings per share:
Basic - as reported $ 2.31 $ 2.54 $ 7.97 $ 7.02
Basic - pro forma $ 2.25 $ 2.43 $ 7.78 $ 6.71
Diluted - as reported $ 2.09 $ 2.30 $ 7.16 $ 6.34
Diluted - pro forma $ 2.03 $ 2.20 $ 7.00 $ 6.06
========== ========== ========== ==========
Investment Banking and Advisory Services
Underwriting revenues and fees for M&A 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
The Company follows SFAS No. 133, "Accounting for Derivative Instruments
and Hedging Activities," as amended by SFAS No. 138, "Accounting for
Certain Derivative Instruments and Certain Hedging Activities," and SFAS
No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging
Activities," which establishes accounting and reporting standards for
stand-alone derivative instruments, derivatives embedded within other
contracts or securities, and hedging activities. Accordingly, all
derivatives, whether stand-alone or embedded within other contracts or
securities (except in narrowly defined circumstances), are 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. Designated hedged items not carried at fair value are 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.
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.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
New Accounting Pronouncements
In April 2004, the Emerging Issues Task Force issued EITF No. 03-6. EITF
No. 03-6 addresses a number of questions regarding the computation of
earnings per share by companies that have issued securities other than
common stock that contractually entitle the holder to participate in
dividends and earnings of the company when, and if, it declares dividends
on its common stock. EITF No. 03-6 is effective for fiscal periods
beginning after March 31, 2004 and requires retroactive adjustment of
prior period earnings per share to ensure comparability. The Company
adopted EITF No. 03-6 during the quarter ended August 31, 2004. Such
adoption did not have an effect on basic or diluted earnings per share.
2. Financial Instruments
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, were as follows:
August 31, November 30,
(in thousands) 2004 2003
-------------------------------------------------- ------------ ------------
FINANCIAL INSTRUMENTS OWNED:
US government and agency $ 7,154,595 $ 4,963,125
Other sovereign governments 1,044,778 1,019,394
Corporate equity and convertible debt 14,899,744 12,531,849
Corporate debt and other 12,844,902 9,554,939
Mortgages, mortgage- and asset-backed 28,246,666 21,377,386
Derivative financial instruments 11,664,738 9,785,965
------------ ------------
$ 75,855,423 $ 59,232,658
============ ============
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED:
US government and agency $ 9,110,425 $ 9,991,764
Other sovereign governments 854,385 740,052
Corporate equity and convertible debt 5,422,859 6,301,051
Corporate debt and other 2,886,523 1,477,448
Mortgages, mortgage- and asset-backed 747,632 278,294
Derivative financial instruments 9,416,820 8,320,538
------------ ------------
$ 28,438,644 $ 27,109,147
============ ============
As of August 31, 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. The
Company may incur a loss if the market value of the financial instrument
increases prior to the purchase of the instrument.
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
3. DERIVATIVES AND HEDGING ACTIVITIES
SFAS No. 133 requires that all derivatives, whether stand-alone or
embedded within other contracts or securities (except in very defined
circumstances), be carried on the Company's Condensed Consolidated
Statement of Financial Condition at 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
month and nine month periods ended August 31, 2004 and August 31, 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 August 31, 2004 and November 30, 2003, the Company had
notional/contract amounts of approximately $3.33 trillion and $2.15
trillion, respectively, of derivative financial instruments, of which
$700.7 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.
The Company's derivatives had a weighted average maturity of approximately
3.9 years and 4.2 years at August 31, 2004 and November 30, 2003,
respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of August 31, 2004 were as follows:
Greater
Less Than One to Three to Than
(in billions) One Year Three Years Five Years Five Years Total
------------------------------------- --------- ----------- ---------- ---------- --------
Swap agreements, including options,
swaptions, caps, collars and floors $ 495.8 $ 636.2 $ 666.0 $ 722.5 $2,520.5
Futures contracts 246.0 102.9 14.4 -- 363.3
Forward contracts 72.9 -- -- -- 72.9
Options held 250.6 13.6 0.9 -- 265.1
Options written 102.6 8.5 1.2 -- 112.3
--------- ----------- ---------- ---------- --------
Total $ 1,167.9 $ 761.2 $ 682.5 $ 722.5 $3,334.1
========= =========== ========== ========== ========
Percent of total 35.0% 22.8% 20.5% 21.7% 100.0%
========= =========== ========== ========== ========
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 $2.0 billion at August 31, 2004. In order to
mitigate this exposure, the Company entered into credit default swaps
aggregating $521.8 million resulting in net exposure of $1.48 billion at
August 31, 2004. Commercial lending commitments to non-investment-grade
borrowers approximated $1.3 billion at August 31, 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 August 31, 2004, such commitments
aggregated $378.3 million. These commitments will be funded, if called,
through the end of the respective investment periods, the longest of such
periods ending in 2013.
Commercial and Residential Loans
The Company participates in the acquisition, securitization, servicing,
financing and disposition of commercial and residential loans. At August
31, 2004, the Company had entered into commitments to purchase or finance
mortgage loans of $2.7 billion.
Letters of Credit
At August 31, 2004, the Company was contingently liable for unsecured
letters of credit of approximately $2.34 billion and letters of credit of
$1.21 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 August 31, 2004, the Company had pledged securities, primarily US
government and agency securities with a market value of approximately
$2.82 billion as collateral for securities borrowed, with an approximate
market value of $2.72 billion.
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 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 August 31, 2004:
Amount of Guarantee Expiration Per Period
-------------------------------------------------
Greater
Less Than One to Three to Than
(in millions) One Year Three Years Five Years Five Years Total
------------------------------------------- --------- ----------- ---------- ---------- --------
Certain derivative contracts (notional) (1) $ 246,791 $ 168,740 $ 271,388 $ 81,908 $768,827
Municipal securities 2,358 194 -- -- 2,552
Residual value guarantee -- -- 570 -- 570
(1) The carrying value of these derivatives approximated $9.0 billion.
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts.
In connection with these activities, the Company 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 creates a series of
municipal securities trusts in which it has retained interests. These
trusts purchase fixed-rate, long-term, highly rated, insured or escrowed
municipal bonds financed by the issuance of trust certificates. Certain of
the trust certificates entitle the holder to receive future payments of
principal and variable interest and to tender such certificates at the
option of the holder on a periodic basis. The Company acts as placement
agent and as liquidity provider. The purpose of the program is to allow
the Company's clients to purchase synthetic short-term, floating-rate
municipal debt that does not otherwise exist in the marketplace. In the
Company's capacity as liquidity provider to the trusts, the maximum
exposure to loss at August 31, 2004 was approximately $2.55 billion, which
represents the outstanding amount of all trust certificates. This exposure
to loss is mitigated by the underlying municipal bonds. The underlying
municipal bonds in the trusts are either AAA- or AA-rated, insured or
escrowed to maturity. Such bonds had a market value, net of related
hedges, approximating $2.54 billion at August 31, 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 14, 2009, 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
August 31, 2004, there was no expected shortfall and the maximum residual
value guarantee approximated $570 million.
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
The Company reviewed its experience with the indemnifications on these
structures. Based on such experience, it is unlikely that the Company will
have to make significant payments under these arrangements.
Other Guarantees
The Company is a member of numerous exchanges and clearinghouses. Under
the membership agreements, members are generally required to guarantee the
performance of other members. Additionally, if a member becomes unable to
satisfy its obligations to the clearinghouse, other members would be
required to meet these shortfalls. To mitigate these performance risks,
the exchanges and clearinghouses often require members to post collateral.
The Company's maximum potential liability under these arrangements cannot
be quantified. However, the potential for the Company to be required to
make payments under these arrangements is 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 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 $826.3 million, which is net capital of
BSSC in excess of 5.5% of aggregate debit items arising from customer
transactions. At August 31, 2004, Bear Stearns' net capital of $2.28
billion exceeded the minimum requirement by $2.21 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 August 31, 2004, Bear Stearns, BSSC, BSIL, BSIT and BSB were in
compliance with their respective regulatory capital requirements.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
7. Earnings Per Share
Basic EPS is computed by dividing net income applicable to common shares,
adjusted for costs related to vested shares under the Capital Accumulation
Plan for Senior Managing Directors, as amended ("CAP Plan"), as well as
the effect of the redemption of preferred stock, by the weighted average
number of common shares outstanding. Common shares outstanding includes
vested units issued under certain stock compensation plans, which will be
distributed as shares of common stock. Diluted EPS includes the
determinants of Basic EPS and, in addition, gives effect to dilutive
potential common shares related to stock compensation plans. The
computations of Basic and Diluted EPS are set forth below:
Three Months Ended Nine months Ended
------------------------ -------------------------
August 31, August 31, August 31, August 31,
(in thousands, except per share amounts) 2004 2003 2004 2003
---------------------------------------- ---------- ---------- ----------- ----------
Net income $ 283,259 $ 313,415 $ 992,127 $ 868,079
Preferred stock dividends (6,843) (7,794) (21,456) (23,580)
Redemption of preferred stock 578 -- 578 719
Income adjustment (net of tax)
applicable to deferred compensation
arrangements-vested shares 16,565 21,037 51,580 60,698
---------- ---------- ----------- ----------
Net earnings used for basic EPS 293,559 326,658 1,022,829 905,916
Income adjustment (net of tax)
applicable to deferred compensation
arrangements-nonvested shares 7,425 7,522 22,960 21,554
---------- ---------- ----------- ----------
Net earnings used for diluted EPS $ 300,984 $ 334,180 $ 1,045,789 $ 927,470
========== ========== =========== ==========
Total basic weighted average common
shares outstanding (1) 127,014 128,682 128,288 129,056
---------- ---------- ----------- ----------
Effect of dilutive securities:
Employee stock options 3,359 2,666 3,338 2,229
CAP and restricted units 13,829 14,252 14,366 15,031
---------- ---------- ----------- ----------
Dilutive potential common shares 17,188 16,918 17,704 17,260
---------- ---------- ----------- ----------
Weighted average number of common
shares outstanding and dilutive
potential common shares 144,202 145,600 145,992 146,316
========== ========== =========== ==========
Basic EPS $ 2.31 $ 2.54 $ 7.97 7.02
Diluted EPS $ 2.09 $ 2.30 $ 7.16 6.34
========== ========== =========== ==========
(1) Includes 24,290,697 and 29,608,468 vested units for the three months
ended August 31, 2004 and August 31, 2003, respectively, and
24,809,035 and 29,913,893 vested units for the nine months ended
August 31, 2004 and August 31, 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.
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
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 the NYSE 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 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. 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
between 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.
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months Ended Nine months Ended
---------------------------- ----------------------------
August 31, August 31, August 31, August 31,
(in thousands) 2004 2003 2004 2003
------------------------------ ------------ ------------ ------------ ------------
NET REVENUES
Capital Markets
Institutional Equities $ 239,321 $ 200,506 $ 788,725 $ 666,313
Fixed Income 751,805 720,128 2,418,509 2,276,535
Investment Banking 208,865 299,742 716,916 710,945
------------ ------------ ------------ ------------
Total Capital Markets 1,199,991 1,220,376 3,924,150 3,653,793
Global Clearing Services 214,394 200,929 655,684 564,112
Wealth Management
Private Client Services (1) 103,498 98,410 331,667 273,705
Asset Management 36,320 27,941 137,454 92,636
------------ ------------ ------------ ------------
Total Wealth Management 139,818 126,351 469,121 366,341
Other (2) (19,438) (62,596) (64,729) (121,032)
------------ ------------ ------------ ------------
Total net revenues $ 1,534,765 $ 1,485,060 $ 4,984,226 $ 4,463,214
============ ============ ============ ============
PRE-TAX INCOME
Capital Markets $ 425,703 $ 540,942 $ 1,433,074 $ 1,490,832
Global Clearing Services 83,159 68,456 248,366 158,404
Wealth Management 7,667 9,851 54,253 20,518
Other (2) (72,650) (137,072) (249,360) (334,248)
------------ ------------ ------------ ------------
Total pre-tax income $ 443,879 $ 482,177 $ 1,486,333 $ 1,335,506
============ ============ ============ ============
Three months ended Nine months ended
---------------------------------- ----------------------------------
August 31, 2004 August 31, 2003 August 31, 2004 August 31, 2003
--------------- --------------- --------------- ---------------
(1) Private Client Services Detail:
Gross revenues, before transfer to
Capital Markets segment $ 121,082 $ 129,746 $ 397,977 $ 348,248
Revenue transferred to
Capital Markets segment (17,584) (31,336) (66,310) (74,543)
--------------- --------------- --------------- ---------------
Private Client Services net revenues $ 103,498 $ 98,410 $ 331,667 $ 273,705
=============== =============== =============== ===============
As of
--------------------------------------------
August 31, November 30, August 31,
(in thousands) 2004 2003 2003
------------------------ ------------ ------------ ------------
SEGMENT ASSETS
Capital Markets $156,678,123 $143,866,138 $141,399,233
Global Clearing Services 82,401,603 69,974,025 70,222,923
Wealth Management 3,353,597 3,705,922 3,599,983
Other (3) (5,104,104) (5,377,975) (5,529,139)
------------ ------------ ------------
Total segment assets $237,329,219 $212,168,110 $209,693,000
============ ============ ============
(2) Includes consolidation and elimination entries, unallocated revenues
(predominantly interest), and certain corporate administrative
functions, including certain legal costs and costs related to the
CAP Plan. CAP Plan costs were $42.0 million and $50.0 million for
the three months ended August 31, 2004 and August 31, 2003,
respectively, and $130.5 million and $144.0 million for the nine
months ended August 31, 2004 and August 31, 2003, respectively.
(3) Includes consolidation and elimination entries.
21
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 the 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 which 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 relating to transfers of its
financial assets is detailed below:
Agency Other Other
Mortgage-Backed Mortgage-Backed Asset-Backed
--------------- --------------- ---------------
(in billions)
Total securitizations
Quarter ended August 31, 2004 $6.4 $25.1 $0.1
Quarter ended August 31, 2003 $14.4 $11.3 $0.2
Retained interests
As of August 31, 2004 $2.0 $1.6 $0.1
As of November 30, 2003 $1.8 $1.4 $0.2
The Company is an active market-maker in these securities and as a result,
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 August 31, 2004
were 2.79% for 2-year swaps and 4.58% 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.
Key valuation assumptions used in measuring the current fair value of
retained interests in assets the Company securitized at August 31, 2004
were as follows:
Agency Other Other
Mortgage-Backed Mortgage-Backed Asset-Backed
------------------------------------------- --------------- --------------- ------------
Weighted average life (years) 6.54 5.89 1.64
Average prepayment speeds (annual rate) 8% - 43% 6% - 49% N/A
Credit losses 1.09% 3.80% 2.01%
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following hypothetical sensitivity analysis as of August 31, 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 $(48.2) $(32.2) $0.1
100 basis point increase (103.6) (66.8) (0.3)
50 basis point decrease 33.5 26.1 0.1
100 basis point decrease 52.0 52.7 0.2
Prepayment speeds
10% increase 0.6 (0.5) N/A
20% increase 1.1 (0.9) N/A
10% decrease (3.5) 0.6 N/A
20% decrease (7.3) 1.2 N/A
Credit losses
10% increase (8.4) (17.3) (0.3)
20% increase (16.6) (33.7) (0.6)
10% decrease 8.7 18.4 0.3
20% decrease 17.7 37.9 0.6
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.
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the quarter ended August 31,
2004:
Agency Other Other
(in millions) Mortgage-Backed Mortgage-Backed Asset-Backed
------------------------------------------- --------------- --------------- ------------
Cash flows received from retained interests $32.2 $33.8 $1.5
Cash flows from servicing 0.1 $1.8 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 August 31, 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 $239.3 billion and
$223.1 billion,
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 $144.5 billion and $140.7 billion were delivered or
repledged, generally as collateral under repurchase or securities lending
agreements or to cover short sales at August 31, 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.
In fiscal 2003, the Company adopted the provisions of FIN No. 46,
"Consolidation of Variable Interest Entities - an Interpretation of ARB
No. 51," 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 May 31, 2004, the Company has adopted 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. 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.
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 ("QSPEs") as defined in SFAS No. 140. Under FIN No. 46
(R), these QSPE transactions are generally exempt from the requirements of
FIN No. 46 (R). For securitization transactions that do not qualify as
QSPEs, the holders of the beneficial interest have no recourse to the
Company, only to the assets held by the VIE. In certain instances, the
Company is the primary beneficiary through its ownership of certain
beneficial interests, and is required to consolidate its interests.
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. At August 31, 2004, the Company's
maximum exposure to loss as a result of its relationship with these VIEs
is approximately $30.5 million, which represents the fair value of its
interests and is reflected in the Company's condensed consolidated
financial statements.
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 $3.9 billion. At August 31, 2004, the Company's maximum
exposure to loss from these entities approximates $13.9 million, which
represents the fair value of its interests and is reflected in the
Company's condensed consolidated financial statements.
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 effective beginning with the quarter ended February 29, 2004. As
a result, the Debentures issued by the Company to Capital Trust III are
included within long-term borrowings. The $262.5 million of Preferred
Securities issued by Capital Trust III is still outstanding, providing the
funding for such Debentures. The Preferred Securities issued by Capital
Trust III are no longer included in the Company's Condensed Consolidated
Statements of Financial Condition.
12. SUBSEQUENT EVENT
The Company has an ownership interest, through its investment in its
merchant banking funds, in New York & Company, Inc., a women's clothing
retailer. On October 7, 2004, shares of New York & Company, Inc. began
trading on the NYSE pursuant to an initial public offering. The Company,
through its merchant banking funds, participated in the initial public
offering by selling approximately 1.0 million shares at $17 and realized a
gain of $13.7 million. Subsequent to the sale, the Company retained a
beneficial economic interest approximating 9.3 million shares of New York
& Company, Inc. Such shares are subject to a six-month lockup agreement
ending April 2005.
25
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
The Bear Stearns Companies Inc.
We have reviewed the accompanying condensed consolidated statement of financial
condition of The Bear Stearns Companies Inc. and subsidiaries as of August 31,
2004, and the related condensed consolidated statements of income for the three
month and nine month periods ended August 31, 2004 and 2003 and cash flows for
the nine month periods ended August 31, 2004 and 2003. These interim financial
statements are the responsibility of The Bear Stearns Companies Inc.'s
management.
We conducted our reviews in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with standards
of the Public Company Accounting Oversight Board (United States), the objective
of which is the expression of an opinion regarding the financial statements
taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such condensed consolidated interim financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with standards of the Public Company
Accounting Oversight Board (United States), the consolidated statement of
financial condition of The Bear Stearns Companies Inc. and subsidiaries as of
November 30, 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 report contains an explanatory paragraph 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
October 15, 2004
26
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
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 filed by the Company under the Securities Exchange Act
of 1934.
The Management's Discussion and Analysis of the Financial Condition and Results
of Operations should be read together with the Management's Discussion and
Analysis of Financial Condition and Results of Operations and the Consolidated
Financial Statements in the 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.
Unless otherwise stated, all references in this Management's Discussion and
Analysis of Financial Condition and Results of Operations to the three and nine
months of 2004 and 2003 refer to the three and nine months ended August 31, 2004
and 2003, respectively, and all references to quarters are to the Company's
fiscal quarters.
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.
27
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Executive Overview
Revenues, net of interest expense for the quarter ended August 31, 2004
increased 3.3% from the corresponding 2003 quarter while pre-tax earnings
decreased 7.9% during the same period. Pre-tax profit margins for the 2004
quarter decreased to 28.9% when compared to 32.5% in the corresponding 2003
quarter. Return on equity was 15.9% for the 2004 quarter versus 21.3% in the
corresponding 2003 quarter. The operating environment experienced during the
Company's third quarter of 2004 proved difficult as higher oil prices, mixed
economic data and continued geopolitical concerns depressed market activity. As
a result, equity valuations trended downward on sluggish trading volumes and
declining volatility.
Despite the more difficult operating environment experienced across the equity,
clearance and wealth management areas, the Company continued to deliver solid
results. Excluding merchant banking related gains, net revenues increased across
each of the primary business segments compared to the 2003 quarter and pretax
profit margins remained strong. Within the Capital Markets segment,
Institutional Equities net revenues increased 19.4% when compared to the third
quarter of 2003 primarily reflecting the impact of the consolidation of Bear
Wagner Specialists, LLC commencing in the first quarter of 2004 and increased
international equity sales and trading net revenues. The Fixed Income area
produced strong revenues for the 2004 quarter, up 4.4% from a year ago, with
credit and interest rate products reporting significant year-over-year
improvement. Investment banking revenues were down 30.3% primarily due to a
96.8% decrease in merchant banking revenues. The merchant banking revenues from
the 2003 quarter primarily related to gains associated with the Company's
previous investment in Aeropostale, Inc. Global Clearing Services net revenues
increased 6.7% due to increased customer margin debt and short-sale balances. In
Wealth Management, revenues from private client services increased on higher
levels of margin balances as well as increased fee income from the private
client advisory service product. In addition, asset management revenues rose due
to increased performance fees associated with proprietary hedge fund products.
Business Environment
The business environment during the Company's third quarter ended August 31,
2004 was characterized by moderate growth in the U.S. economy and continued low
inflation. The Federal Reserve Board (the "Fed") met twice during the quarter
and raised the federal funds rate, in 25 basis point increments, from 1.00% to
1.50% citing that the economy was poised to resume a stronger pace of expansion
with inflation remaining relatively low. However, rising oil prices, mixed
economic data and continued geopolitical concerns weighed on the market during
the 2004 quarter and consumer confidence, which had been strong during the first
two months of the quarter, fell sharply in August.
The major equity indices all decreased during the third quarter of 2004. The Dow
Jones Industrial Average ("DJIA"), Nasdaq Composite Index ("NASDAQ") and the
Standard & Poor's 500 Index ("S&P 500") decreased 0.1%, 7.5% and 1.5%,
respectively. Average daily trading volume on the New York Stock Exchange, Inc.
("NYSE") and Nasdaq decreased 3.6% and 7.9%, respectively, compared to the 2003
quarter. Equity valuations trended downward on sluggish trading volumes and
declining volatility. The unfavorable equity market conditions that existed
during the 2004 quarter caused equity issuance activity to decrease
industry-wide. Despite these conditions, industry-wide announced and completed
M&A volumes increased 48% and 149%, respectively, compared to the third quarter
of 2004.
Fixed income activity continued to be robust during the 2004 quarter despite the
increase in short term interest rates and a flattening yield curve. Long-term
interest rates, as measured by the 10-year Treasury bond, declined during the
2004 quarter. On an intra-day basis, the 10-year Treasury bond yield dropped
from 4.87% on June 14, 2004 to 4.10% on August 31, 2004. Reflecting the impact
of higher interest rates, agency CMO volumes declined during the quarter.
However, overall mortgage-backed securities new issue volume rose approximately
14% during the 2004 quarter, reflecting the significant increase in the issuance
of adjustable rate mortgage securities.
The business environment during the third quarter ended August 31, 2003 was
characterized by a strengthening U.S. economy and continued low inflation. The
Fed met twice during the quarter and at its June 25, 2003 meeting cut the
federal funds rate 25 basis points to 1.00% from 1.25%. A shift in sentiment
along with upbeat forecasts for
28
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
economic growth precipitated a sell-off in U.S. Treasuries. Long term interest
rates, as measured by the 10-year Treasury bond, were extremely volatile. On an
intra-day basis, the 10-Year Treasury bond yield climbed from 3.07% on June 16,
2003 to 4.67% on August 14, 2003. The Fed's suggestion that low rates could be
maintained for a considerable period eased the sell-off in the treasury markets.
Better than expected corporate profits along with economic reports evidencing
strong consumer spending and accelerating capital spending served to push the
major U.S. equity indices higher during the August 2003 quarter. For the quarter
ended August 31, 2003, the DJIA increased 6.4%, while the S&P 500 and the NASDAQ
increased 4.6% and 13.4%, respectively. While the major U.S. equity market
indices showed improvement during the August 2003 quarter on positive economic
data, average daily trading volumes declined on both the NYSE and Nasdaq when
compared to the August 2002 quarter. Average daily trading volume on the NYSE
and Nasdaq decreased 13.5% and 4.8%, respectively from the quarter ended August
31, 2002. Equity capital markets activities increased fueled by an increase in
equity market indices. Business conditions were favorable in the fixed income
markets. A combination of low interest rates, a steep yield curve and continued
tightening of corporate credit spreads resulted in strong demand for domestic
debt issuances and strong secondary market activity. Mortgage-backed securities
underwriting continued to benefit from favorable market conditions despite the
drop in residential mortgage refinancings.
Results of Operations
In the discussion to follow, results for the quarter ended August 31, 2004 will
be compared with the results for the quarter ended August 31, 2003 and results
for the nine months ended August 31, 2004 will be compared with the results for
the nine months ended August 31, 2003.
The following table sets forth an overview of the Company's financial results:
Three Months Ended Nine Months Ended
-------------------------------------------- --------------------------------------------
(in thousands, except per share
amounts, pre-tax profit margin and August 31, August 31, % Increase August 31, August 31,
return on average common equity) 2004 2003 (Decrease) 2004 2003 % Increase
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Revenues, net of interest expense $ 1,534,765 $ 1,485,060 3.3% $ 4,984,226 $ 4,463,214 11.7%
Income before provision for income
tax $ 443,879 $ 482,177 (7.9%) $ 1,486,333 $ 1,335,506 11.3%
Net Income $ 283,259 $ 313,415 (9.6%) $ 992,127 $ 868,079 14.3%
Diluted earnings per share $ 2.09 $ 2.30 (9.1%) $ 7.16 $ 6.34 12.9%
Pre-tax profit margin 28.9% 32.5% 29.8% 29.9%
Return on average common equity
(annualized) 15.9% 21.3% 18.9% 20.3%
The Company reported net income of $283.3 million, or $2.09 per share (diluted),
for the quarter ended 2004, which represented a decrease of 9.6% from $313.4
million, or $2.30 per share (diluted), for the quarter ended 2003. Revenues, net
of interest expense ("net revenues") increased 3.3% to $1.53 billion for the
quarter ended 2004 from $1.49 billion for the quarter ended 2003, due to an
increase in principal transactions revenues and net interest revenues partially
offset by decreases in investment banking revenues and commission revenues.
The Company reported net income of $992.1 million, or $7.16 per share (diluted),
for the nine months ended 2004, which represented an increase of 14.3% from
$868.1 million, or $6.34 per share (diluted), for the nine months ended 2003.
Net revenues increased 11.7% to $4.98 billion for the nine months ended 2004
from $4.46 billion for the nine months ended 2003 due to increases in principal
transactions revenues, commission revenues, investment banking revenues, and net
interest revenues.
29
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's commission revenues were as follows:
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31 % Increase August 31, August 31, %
(in thousands) 2004 2003 (Decrease) 2004 2003 Increase
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Institutional $ 142,480 $ 136,317 4.5% $ 461,297 $ 394,416 17.0%
Clearance 71,006 80,175 (11.4)% 233,121 228,787 1.9%
Retail & other 60,236 63,396 (5.0)% 194,557 166,282 17.0%
------------- ------------- ---------- ------------- ------------- ----------
Total commissions $ 273,722 $ 279,888 (2.2)% $ 888,975 $ 789,485 12.6%
============= ============= ========== ============= ============= ==========
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 decreased 2.2% to $273.7 million from
$279.9 million for the comparable prior year quarter. Institutional commissions
increased 4.5% to $142.5 million for the 2004 quarter from $136.3 million for
the comparable prior year quarter. The increase in institutional commissions is
due to the impact of the consolidation of Bear Wagner Specialists, LLC
commencing in the first quarter of 2004. Clearance commissions decreased 11.4%
to $71.0 million for the 2004 quarter from $80.2 million for the comparable
prior year quarter reflecting lower trading volumes from prime brokerage
clients. Retail and other commissions decreased 5.0% to $60.2 million in the
2004 quarter from $63.4 million in the comparable prior year quarter due to a
decrease in retail customer trading volumes.
Commission revenues for the nine months ended 2004 increased 12.6% to $889.0
million from $789.5 million for the corresponding prior year period.
Institutional commissions increased 17.0% to $461.3 million for the 2004 period
from $394.4 million for the 2003 period primarily due to increased trading
volumes as well as the impact of the consolidation of Bear Wagner Specialists,
LLC commencing in the first quarter of 2004. Clearance commissions increased
1.9% to $233.1 million for the 2004 period from $228.8 million for the
corresponding prior year period due primarily to increased levels of fully
disclosed customer activity resulting from an improvement in global equity
market conditions. Retail and other commissions increased 17.0% to $194.6
million in the 2004 period from $166.3 million in the prior year period due to
an increase in individual customer activity levels.
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31, % August 31, August 31, %
(in thousands) 2004 2003 Increase 2004 2003 Increase
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Fixed income $ 626,196 $ 566,739 10.5% $ 1,978,452 $ 1,953,727 1.3%
Equities 58,376 28,217 106.9% 274,092 161,556 69.7%
Derivative financial instruments 164,410 129,067 27.4% 458,769 387,119 18.5%
------------- ------------- ---------- ------------- ------------- ----------
Total principal transactions $ 848,982 $ 724,023 17.3% $ 2,711,313 $ 2,502,402 8.3%
============= ============= ========== ============= ============= ==========
Revenues from principal transactions for the 2004 quarter increased 17.3% to
$849.0 million from $724.0 million for the corresponding prior year quarter due
to an increase in all of the Company's businesses. Fixed income revenues
increased 10.5% to $626.2 million for the 2004 quarter from $566.7 million for
the prior year quarter attributable to an increase in the high yield product
areas, partially offset by declines in the Company's government and corporate
bond areas. Revenues derived from equities activities increased 106.9% to $58.4
million during the 2004 quarter from $28.2 million in the corresponding prior
year quarter due to the impact of the consolidation of Bear Wagner Specialists,
LLC this year. Revenues from derivative financial instruments increased 27.4% to
$164.4 million in the 2004 quarter from $129.1 million in the 2003 quarter, due
to increases in fixed income derivatives and credit derivatives as a result of
increased customer volume.
Revenues from principal transactions for the nine months ended 2004 increased
8.3% to $2.71 billion from $2.50 billion for the nine months ended 2003. Fixed
income revenues increased 1.3% to $1.98 billion during the 2004 period from
$1.95 billion when compared to the corresponding period of the prior year. The
increase is largely due to increased net revenues achieved in the
mortgage-backed securities businesses with strong performances across many
30
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
sectors, particularly in the whole loan, adjustable-rate mortgage securities and
the commercial securitization businesses. Revenues related to the high yield
business, particularly leveraged finance and distressed debt, also increased as
high yield credit spreads continued to tighten. These increases were
substantially offset by reduced net revenues from the corporate bonds and
government bonds areas which were adversely affected by reduced volumes.
Revenues derived from equities activities increased 69.7% to $274.1 million
during the 2004 period from $161.6 million in the corresponding prior year
period primarily due to the impact of the consolidation of Bear Wagner
Specialists, LLC. In addition, equities-related businesses, particularly the
international equities and over-the-counter stock revenues increased during the
2004 period, as a result of higher average daily trading volumes and increased
announced and completed M&A 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
18.5% to $458.8 million in the 2004 period from $387.1 million in the prior year
period, primarily due to increases in fixed income derivatives, foreign exchange
and credit derivatives activities as a result of increased customer volume.
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31, % (Decrease) August 31, August 31, % Increase
(in thousands) 2004 2003 Increase 2004 2003 (Decrease)
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Underwriting $ 92,125 $ 144,000 (36.0)% $ 383,654 $ 332,697 15.3%
Advisory services 95,620 62,741 52.4% 282,029 216,544 30.2%
Merchant banking 2,947 91,975 (96.8)% 46,983 129,608 (63.7)%
------------- ------------- ---------- ------------- ------------- ----------
Total investment banking $ 190,692 $ 298,716 (36.2)% $ 712,666 $ 678,849 5.0%
============= ============= ========== ============= ============= ==========
Investment banking revenues decreased 36.2% to $190.7 million for the 2004
quarter from $298.7 million for the 2003 quarter. Underwriting revenues
decreased 36.0% to $92.1 million for the 2004 quarter from $144.0 million for
the corresponding prior year quarter, reflecting a significant decrease in
equity underwriting revenues. This resulted from decreased volume of new issue
activity based on the weak equity market conditions that existed during the
quarter. Advisory services revenues for the 2004 quarter increased 52.4% to
$95.6 million from $62.7 million for the prior year quarter reflecting the
significant improvement in completed M&A volume. Merchant banking revenues
decreased 96.8% to $2.9 million for the 2004 quarter, compared to $92.0 million
for the 2003 quarter. The Company's results for the third quarter of 2003
include merchant banking gains related primarily to the Company's former
investment in Aeropostale, Inc.
Investment banking revenues increased 5.0% to $712.7 million for the nine months
ended 2004 from $678.8 million for the nine months ended 2003. Underwriting
revenues increased 15.3% to $383.7 million for the 2004 period from $332.7
million for the corresponding prior year period, reflecting an increase in
equity underwriting due to increased volume of new issue activity. High yield
underwriting revenues also improved significantly on increased new issue
activity. These increases were partially offset by reduced municipal
underwriting revenues. Advisory services revenues for the 2004 period increased
30.2% to $282.0 million from $216.5 million for the 2003 period reflecting
increased completed M&A activity. Merchant banking revenues decreased 63.7% to
$47.0 million for the 2004 period, compared to $129.6 million for the prior year
period. The Company's results for the 2003 period include merchant banking gains
related primarily to the Company's former investment in Aeropostale, Inc.
Net interest revenues (interest and dividend revenue less interest expense)
increased 15.9% to $169.1 million for the 2004 quarter from $145.9 million for
the 2003 quarter. The increase in net interest revenues was primarily
attributable to higher levels of customer interest-bearing balances. Average
customer margin debt balances increased 7.6% to $46.6 billion for the 2004
quarter from $43.3 billion for the prior year quarter. Average customer short
balances increased 11.2% to $75.6 billion for the 2004 quarter from $68.0
billion for the 2003 quarter and average stock borrowed balances increased 4.6%
to $56.7 billion for the 2004 quarter from $54.2 billion for the 2003 quarter.
Net interest revenues increased 25.4% to $492.3 million for the nine months
ended 2004 up from $392.7 million for the nine months ended 2003. 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 17.4% to $46.6 billion for the
2004 period from $39.7 billion for the corresponding prior year
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
period. Average customer short balances increased 21.3% to $75.7 billion for the
2004 period from $62.4 billion for the corresponding prior year period and
average stock borrowed balances increased 16.7% to $58.0 billion for the 2004
period from $49.7 billion for the corresponding prior year period.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31, % Increase August 31, August 31, % Increase
(in thousands) 2004 2003 (Decrease) 2004 2003 (Decrease)
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Employee compensation and benefits $ 743,038 $ 681,745 9.0% $ 2,452,239 $ 2,131,815 15.0%
Floor brokerage, exchange and
clearance fees 56,822 44,830 26.7% 173,369 137,050 26.5%
Communications and technology 92,360 93,047 (0.7)% 274,509 276,531 (0.7)%
Occupancy 35,843 34,788 3.0% 104,226 102,819 1.4%
Advertising and market development 30,030 24,550 22.3% 85,246 77,267 10.3%
Professional fees 47,547 36,608 29.9% 131,717 94,056 40.0%
Other expenses 85,246 87,315 (2.4)% 276,587 308,170 (10.2%)
------------- ------------- ---------- ------------- ------------- ----------
Total non-interest expenses $ 1,090,886 $ 1,002,883 8.8% $ 3,497,893 $ 3,127,708 11.8%
============= ============= ========== ============= ============= ==========
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 9.0% to $743.0 million for the 2004
quarter from $681.7 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 48.4% for
the 2004 quarter compared to 45.9% for the 2003 quarter. Compensation as a
percentage of net revenues excluding merchant banking revenues was 48.5% for the
third quarter of 2003. Full-time employees increased to 10,715 at August 31,
2004 from 10,515 at August 31, 2003.
Non-compensation expenses increased 8.3% to $347.8 million for the 2004 quarter
from $321.1 million for the 2003 quarter. Non-compensation expenses as a
percentage of net revenues increased to 22.7% for the 2004 quarter compared with
21.6% for the corresponding prior year quarter. The increase in non-compensation
expenses primarily reflects the impact of the consolidation of Bear Wagner
Specialists, LLC. Excluding the impact of the consolidation of Bear Wagner
Specialists, LLC, non-compensation expenses increased 2.7% to $330.0 million in
the 2004 quarter. Specifically, the increase in non-compensation expenses,
excluding specialist related costs, is primarily related to a 12.8% increase in
floor brokerage, exchange and clearance fees, reflecting increased futures and
foreign exchange volumes. Professional fees, excluding specialist related costs,
increased 27.4% due to employment agency and consulting fees. Partially
offsetting these increases was a decline in other expenses, primarily
attributable to a reduction in CAP Plan related costs, which decreased to $42
million for the 2004 quarter from $50 million in the comparable prior year
quarter. The Company achieved a pre-tax profit margin of 28.9% for the 2004
quarter versus 32.5% for the 2003 quarter.
The Company's effective tax rate increased to 36.2% for the 2004 quarter
compared to 35.0% for the 2003 quarter. The increase in the Company's tax rate
for the 2004 quarter was necessary in order to bring the Company's tax rate for
the nine months ended 2004 to 33.25%.
Employee compensation and benefits increased 15.0% to $2.45 billion for the nine
months ended 2004 from $2.13 billion for the nine months ended 2003 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 period compared to 47.8% for the 2003 period. The increase in
compensation to net revenues when compared to the prior year period primarily
reflects the impact of merchant banking gains recorded in the third quarter of
2003. Excluding the impact of merchant banking, compensation to net revenues for
the full year 2003 was 49.0%.
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Non-compensation expenses increased 5.0% to $1.05 billion for the nine months
ended 2004 from $995.9 million for the nine months ended 2003. Non-compensation
expenses as a percentage of net revenues decreased to 21.0% for the 2004 period
compared with 22.3% for the 2003 period, which is attributable to a relatively
stable cost base combined with increased net revenues. The increase in
non-compensation expenses of 5.0%, when compared to the comparable prior year
period, primarily reflects the consolidation of Bear Wagner Specialists, LLC
beginning in the first quarter of 2004. Excluding the impact of the
consolidation of Bear Wagner Specialists, LLC, non-compensation expenses
declined 2.0% to $976.2 million in the 2004 period. The decline in
non-compensation expenses is primarily attributable to a decline in other
expenses partially offset by increases in professional fees and floor brokerage,
exchange and clearance fees. The decline in other expenses is due to a $20.5
million charge for impairment of goodwill associated with the Company's
electronic options market making business recorded in the 2003 period and
reduced litigation and litigation-related expenses in the current period. CAP
Plan related costs included in other expenses were $131 million for the 2004
period, a decrease from $144 million in the comparable prior year period. The
Company achieved a pre-tax profit margin of 29.8% for the nine months ended 2004
versus 29.9% for the nine months ended 2003.
The Company's effective tax rate decreased to 33.25% for the nine months of 2004
compared to 35.0% for the nine months of 2003 primarily reflecting an increase
in tax preference items.
Business Segments
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments.
The following segment operating results exclude certain unallocated revenues
(predominantly interest) as well as certain corporate administrative functions,
such as certain legal costs and costs related to the CAP Plan. See Note 8,
"Segment Data" in the Notes to Consolidated Financial Statements for complete
segment information.
Capital Markets
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31, % Increase August 31, August 31, % Increase
(in thousands) 2004 2003 (Decrease) 2004 2003 (Decrease)
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Net revenues
Institutional equities $ 239,321 $ 200,506 19.4% $ 788,725 $ 666,313 18.4%
Fixed income 751,805 720,128 4.4% 2,418,509 2,276,535 6.2%
Investment banking 208,865 299,742 (30.3)% 716,916 710,945 0.8%
------------- ------------- ---------- ------------- ------------- ----------
Total net revenues $ 1,199,991 $ 1,220,376 (1.7)% $ 3,924,150 $ 3,653,793 7.4%
Pre-tax income $ 425,703 $ 540,942 (21.3)% $ 1,433,074 $ 1,490,832 (3.9)%
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 sales, trading and research, in areas such as
domestic and international equities, block trading, convertible bonds,
over-the-counter equities, equity derivatives, risk and convertible arbitrage
and through a majority-owned subsidiary, the NYSE 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.
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net revenues for Capital Markets decreased 1.7% to $1.20 billion for the 2004
quarter from $1.22 billion for the 2003 quarter. Pre-tax income for Capital
Markets decreased 21.3% to $425.7 million for the 2004 quarter from $540.9
million for the comparable prior year quarter. Pre-tax profit margin was 35.5%
for the 2004 quarter compared to 44.3% for the comparable prior year quarter.
Institutional equities net revenues for the 2004 quarter increased 19.4% to
$239.3 million from $200.5 million for the comparable prior year quarter.
Included within the Company's institutional equities revenues for the 2004
quarter are the revenues of Bear Wagner Specialists, LLC. These results, which
were consolidated beginning with the first quarter of 2004, resulted in an
increase in net revenues from specialist activities of approximately $30 million
over the 2003 quarter. International equity sales and trading net revenues
increased reflecting increased customer activity. These increases are partially
offset by lower levels of over-the-counter stock and U.S. listed institutional
equity revenues resulting from weaker U.S. equity market conditions. Risk
arbitrage revenues also declined when compared to the comparable prior year
quarter.
Fixed income net revenues increased 4.4% to $751.8 million for the 2004 quarter
from $720.1 million for the comparable prior year quarter. The fixed income
division continued to achieve strong results despite increases in short term
interest rates and a flattening of the yield curve. Revenues from the credit
businesses achieved record levels during the 2004 quarter due to higher revenues
from the distressed debt and leveraged loan areas which benefited from an
increase in market activity during the 2004 quarter. The interest rate business
achieved increased levels of net revenues during the quarter as the Company's
interest rate derivative activities achieved record net revenues on both
increased market share and improved customer order flow. In addition, municipal
revenues increased based on strong secondary trading revenues. Although
mortgage-backed securities new issue activity declined by approximately 22%
industry-wide compared to the 2003 quarter, the Company's mortgage origination
volume rose approximately 14% reflecting the significant increase in the
issuance of adjustable-rate mortgage securities as fixed-rate mortgage
origination declined. As a result, revenues related to mortgage-backed
securities remained relatively unchanged when compared to the 2003 quarter. In
addition, net revenues attributable to the Company's asset-backed and commercial
mortgage securitization activities increased significantly on increased new
issue volumes.
Investment banking revenues decreased 30.3% to $208.9 million for the 2004
quarter from $299.7 million for the comparable prior year quarter. Underwriting
revenues decreased 19.0% to $126.8 million for the 2004 quarter from $156.6
million for the prior year quarter, reflecting a significant decrease in equity
underwriting revenues due to decreased volume of new issue activity. Advisory
services revenues for the 2004 quarter increased 54.8% to $79.1 million from
$51.1 million for the comparable prior year quarter reflecting the significant
improvement in completed M&A volume when compared to the prior year. Merchant
banking revenues decreased 96.8% to $2.9 million for the 2004 quarter compared
to $92.0 million for the 2003 quarter. The revenues from the 2003 quarter are
mostly related to the gains associated with the Company's previous investment in
Aeropostale, Inc.
Net revenues for Capital Markets increased 7.4% to $3.92 billion for the nine
months ended 2004 from $3.65 billion for the nine months ended 2003. Pre-tax
income for Capital Markets decreased 3.9% to $1.43 billion for the 2004 period
from $1.49 billion for the 2003 period. Pre-tax profit margin was 36.5% for the
2004 period compared to 40.8% for the 2003 period.
Institutional equities net revenues for the nine months ended 2004 increased
18.4% to $788.7 million from $666.3 million for the nine months ended 2003.
During the 2004 period, market indices showed improvement when compared to the
corresponding prior year period and average daily trading volumes increased on
the NYSE and Nasdaq. As a result, institutional equities commissions in the
Company's US-listed business increased, reflecting increased trading volume and
market share gains. International equity sales and trading net revenues also
increased significantly caused by more favorable global equity market conditions
and increased customer order flow. Risk arbitrage revenues improved reflecting a
significant increase in the total value of announced M&A activity. Included
within the Company's institutional equities revenues for the 2004 period are the
revenues of Bear Wagner Specialists, LLC. These consolidated results caused an
increase in net revenues from specialist activities of approximately $120
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
million over the 2003 period. The increases were partially offset by lower
levels of equity derivative and convertible arbitrage revenues due to a decline
in customer activity levels and reduced equity market volatility.
Fixed income net revenues increased 6.2% to $2.42 billion for the nine months
ended 2004 from $2.28 billion for the nine months ended 2003 primarily
reflecting strong results from the Company's mortgage and interest rate product
areas. In particular, mortgage-backed securities, interest rate derivatives and
foreign exchange net revenues increased during the 2004 period when compared to
the prior year period. The mortgage-backed securities business achieved strong
levels of net revenues during the period reflecting a significant increase in
the volume of secondary trading activity. In addition, despite the decline in
mortgage origination volume caused by the increase in interest rates, adjustable
rate mortgage volumes increased significantly. In addition, the Company's
interest rate businesses increased revenues based on higher customer order flow
and a favorable market environment. In particular, the interest rate derivatives
and foreign exchange businesses delivered strong results reflecting increased
volatility levels, customer volumes and market share. These results were
partially offset by a decrease in net revenues from the Company's credit
businesses from the strong results they achieved in the 2003 period.
Investment banking revenues increased 0.8% to $716.9 million for the nine months
ended 2004 from $710.9 million for the nine months ended 2003. Underwriting
revenues increased 11.6% to $432.3 million for the 2004 period from $387.5
million for the prior year period reflecting an increase in equity and high
yield underwriting on strong new issue activity. These increases were partially
offset by reduced municipal underwriting revenues reflecting the impact of lower
issuance levels. Advisory services revenues for the 2004 period increased 22.7%
to $237.7 million from $193.8 million for the 2003 period reflecting an increase
in US completed M&A activity. Merchant banking revenues decreased 63.7% to $47.0
million for the 2004 period compared to $129.6 million for the 2003 period. The
revenues from the 2003 period are mostly related to the gains associated with
the Company's previous investment in Aeropostale, Inc.
Global Clearing Services
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31, % August 31, August 31, %
(in thousands) 2004 2003 Increase 2004 2003 Increase
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Net revenues $ 214,394 $ 200,929 6.7% $ 655,684 $ 564,112 16.2%
Pre-tax income $ 83,159 $ 68,456 21.5% $ 248,366 $ 158,404 56.8%
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to clearing
clients worldwide. Prime brokerage clients include hedge funds and clients of
money managers, short sellers, arbitrageurs and other professional investors.
Fully disclosed clients engage in either the retail or institutional brokerage
business. At August 31, 2004 and August 31, 2003, the Company held approximately
$234 billion and $188 billion, respectively, in equity in Global Clearing
Services client accounts.
Net revenues for Global Clearing Services increased 6.7% to $214.4 million for
the 2004 quarter from $200.9 million in the 2003 quarter. Net interest revenues
increased 19.5% to $140.0 million for the 2004 quarter from $117.2 million for
the prior year quarter primarily reflecting increased customer margin and short
sale balances and improved net interest margins. Commission revenues decreased
11.4% to $71.0 million for the 2004 quarter from $80.2 million for the
comparable prior year quarter due to decreased trading volumes from prime
brokerage and fully disclosed clients. Difficult equity market conditions
resulted in reduced prime brokerage customer activity levels resulting in lower
commission volumes and leverage levels. Pre-tax income increased 21.5% to $83.2
million, from $68.5 million for the 2003 quarter, reflecting higher net
revenues. Pre-tax profit margin was 38.8% for the 2004 quarter compared to 34.1%
for the 2003 quarter.
Average customer margin balances were $46.6 billion during the 2004 quarter
compared to $43.3 billion during the 2003 quarter. Customer margin balances
totaled $49.6 billion at August 31, 2004, an increase from $41.6 billion at
August 31, 2003. Average customer short balances were $75.6 billion during the
2004 quarter compared to $68.0 billion during the 2003 quarter and totaled $73.7
billion at August 31, 2004, an increase from $66.3 billion at August 31, 2003.
Average stock borrowed balances were $56.7 billion during the 2004 quarter
compared to $54.2 billion for the 2003 quarter and totaled $53.5 billion at
August 31, 2004, an increase from $52.1 billion at August 31, 2003.
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Average free credit balances were $30.8 billion during the 2004 quarter compared
to $21.2 billion during the 2003 quarter and totaled $29.3 billion at August 31,
2004, an increase from $22.0 billion at August 31, 2003.
Net revenues for Global Clearing Services increased 16.2% to $655.7 million for
the nine months ended 2004 from $564.1 million for the nine months ended 2003.
Net interest revenues increased 25.4% to $407.7 million for the 2004 period from
$325.1 million for the corresponding prior year period, primarily reflecting
increased margin balances from prime brokerage and fully disclosed clearance
clients due to improving US equity market conditions. Commission revenues
increased 1.9% to $233.1 million for the 2004 period from $228.8 million for the
prior year period reflecting increased prime broker and fully disclosed customer
activity. Pre-tax income increased 56.8% to $248.4 million from $158.4 million
for the 2003 period reflecting higher net revenues. Pre-tax profit margin was
37.9% for the 2004 period compared to 28.1% for the period ended 2003.
Average customer margin balances were $46.6 billion during the 2004 period
compared to $39.7 billion during the 2003 period. Customer margin balances
totaled $49.6 billion at August 31, 2004, an increase from $41.6 billion at
August 31, 2003. Average customer short balances were $75.7 billion during the
2004 period compared to $62.4 billion during the 2003 period and totaled $73.7
billion at August 31, 2004, an increase from $66.3 billion at August 31, 2003.
Average stock borrowed balances were $58.0 billion during the 2004 period
compared to $49.7 billion for the 2003 period and totaled $53.5 billion at
August 31, 2004, an increase from $52.1 billion at August 31, 2003. Average free
credit balances were $28.5 billion during the 2004 period compared to $19.3
billion during the 2003 period and totaled $29.3 billion at August 31, 2004, an
increase from $22.0 billion at August 31, 2003.
Wealth Management
Three Months Ended Nine Months Ended
------------------------------------------ ------------------------------------------
August 31, August 31, % Increase August 31, August 31, %
(in thousands) 2004 2003 (Decrease) 2004 2003 Increase
---------------------------------- ------------- ------------- ---------- ------------- ------------- ----------
Net revenues
Private Client Services $ 103,498 $ 98,410 5.2% $ 331,667 $ 273,705 21.2%
Asset Management 36,320 27,941 30.0% 137,454 92,636 48.4%
------------- ------------- ---------- ------------- ------------- ----------
Total net revenues $ 139,818 $ 126,351 10.7% $ 469,121 $ 366,341 28.1%
Pre-tax income $ 7,667 $ 9,851 (22.2)% $ 54,253 $ 20,518 164.4%
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 August 31, 2004, PCS has approximately 500
account executives in its principal office, six regional offices and two
international offices. Asset management manages equity, fixed income and
alternative assets for corporate pension plans, public systems, endowments,
foundations, multi-employer plans, insurance companies, corporations, families
and high-net-worth individuals in the US and abroad.
Net revenues for Wealth Management increased 10.7% to $139.8 million for the
2004 quarter from $126.4 million for the 2003 quarter. PCS revenues increased
5.2% to $103.5 million for the 2004 quarter from $98.4 million for the 2003
quarter reflecting increased net interest revenues associated with higher margin
balances and higher levels of fee income attributable to the Company's private
client advisory services product. However, weaker US equity markets served to
reduce individual investor activity levels and commission volumes. Asset
management revenues increased 30.0% to $36.3 million for the 2004 quarter from
$27.9 million for the 2003 quarter. This increase reflects increased performance
fees on proprietary hedge fund products. Pre-tax income for Wealth Management
decreased 22.2% to $7.7 million in the 2004 quarter from $9.9 million for the
2003 quarter.
Net revenues for Wealth Management increased 28.1% to $469.1 million for the
nine months ended 2004 from $366.3 million for the nine months ended 2003. PCS
revenues increased 21.2% to $331.7 million for the 2004 period from $273.7
million for the 2003 period reflecting increased levels of retail customer
activity on improving US equity markets as well as increased net interest
revenues associated with higher margin balances. Asset management revenues
increased 48.4% to $137.5 million for the 2004 period from $92.6 million for the
2003 period. This increase primarily reflects the sale of the mutual funds
business to Dreyfus, resulting in an increase to net revenues of approximately
$22 million, higher management fees attributable to increased assets under
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
management in both traditional and hedge fund products as well as improved
performance fees on alternative investment products, principally hedge funds.
Pre-tax income for Wealth Management was $54.3 million in the 2004 period, a
164.4% increase compared to pre-tax income of $20.5 million for the 2003 period,
reflecting higher net revenues. The current period included approximately $7
million of non-recurring transaction costs associated with the sale of the
mutual fund business.
Assets under management were $28.1 billion at August 31, 2004, reflecting a 9.3%
increase from $25.7 billion in assets under management at August 31, 2003.
During the second quarter of 2004, the Company sold its mutual fund business to
Dreyfus. Excluding assets that were transferred, assets under management at
August 31, 2004 increased 26.6% from August 31, 2003. Assets under management at
August 31, 2004 include $6.4 billion of assets from alternative investment
products, an increase of 10.3% from $5.8 billion at August 31, 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 August 31, 2004 increased to $237.3 billion from
$212.2 billion at November 30, 2003. The increase was primarily attributable to
increases in financial instruments owned, customer receivables and securities
purchased under agreements to resell 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 $41.6 billion at August 31, 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, common
stock and preferred stock repurchases and cash dividends paid.
The amount of long-term debt, as well as total capital, that the Company
maintains is driven by a number of factors with particular focus on asset
composition. The Company's ability to support increases in total assets is a
function of its ability to obtain short-term secured and unsecured funding as
well as its access to longer-term sources of capital (i.e., long-term debt and
equity). The Company regularly measures and monitors its total capital
requirements, which are primarily a function of the self-funding ability of its
assets. The equity portion of total capital is primarily a function of on- and
off-balance-sheet risks (i.e., market, credit and liquidity) and regulatory
capital requirements. As such, the liquidity and risk characteristics of assets
being held are especially decisive determinants of both total capital and the
equity portion thereof, thus significantly influencing the amount of leverage
that the Company can employ.
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at quarter end are lower than would be observed on an
average basis. At 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 August 31, 2004 and November 30,
2003, total assets of $237.3 billion and $212.2 billion were both approximately
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 did not change
materially, since the reduction in asset balances is predominantly in highly
liquid, short-term instruments that are financed on a secured basis. This
periodic reduction verifies the inherently liquid nature of the balance sheet
and provides consistency with respect to creditor constituents' evaluation of
the Company's financial condition.
Leverage Ratios
The following table presents total assets, adjusted assets, and net adjusted
assets with the resultant leverage ratios at August 31, 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 the net adjusted leverage ratio of no greater than
15.0, which the Company continued to meet at August 31, 2004.
August 31, November 30,
(in billions, except ratios) 2004 2003
------------------------------ ---------- ------------
Total assets $ 237.3 $ 212.2
Adjusted assets (1) $ 185.8 $ 164.2
Net adjusted assets (2) $ 117.8 $ 90.9
Leverage ratio (3) 28.5 26.4
Adjusted leverage ratio (4) 22.3 20.4
Net adjusted leverage ratio(5) 14.1 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 August 31, 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 Bear Stearns Capital Trust III. The Company
views the junior subordinated debt issued to Bear Stearns Capital Trust
III as a component of its equity capital base given the equity-like
characteristics of the securities. The Company also receives rating agency
equity credit for these securities.
38
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 affect 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 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 August 31, 2004, the market value of unencumbered, unhypothecated
securities owned by the Company was approximately $21.8 billion with a borrowing
value of $18.4 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 73% 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 212% over
the previous twelve months including unused committed unsecured bank credit and
200% excluding the unsecured portion of the Company's $3.4 billion
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
committed revolving credit facility. The firm's net cash capital position has
averaged just under $2.2 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 August
31, 2004, the weighted average maturity of the firm's long-term debt was 4.1
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, BSSC,
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 August 31, 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 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
2005, with all repos outstanding at that date payable no later than August 2006.
There were no borrowings outstanding under the Repo Facility at August 31, 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 August 31, 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, the
longest of such periods ending in 2007. All of these facilities contain a
term-out option of one year or more for borrowings outstanding at expiration.
The banks providing these facilities are committed to provide up to an aggregate
of approximately $3.7 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
August 31, 2004, the Parent Company's equity double leverage ratio was
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
approximately 0.95 based on common equity and 0.90 including preferred equity.
At November 30, 2003, these measures were 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 $25.8 billion and $24.6 billion had remaining maturities
beyond one year at August 31, 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; the composition of the balance sheet and/or
capital structure; geographic and business diversification; and the Company's
market share and competitive position in the business segments in which it
operates. Material deterioration in any one or a combination of these factors
could result in a downgrade of the Company's credit ratings, thus increasing the
cost of and/or limiting the availability of unsecured financing. Additionally, a
reduction in the Company's credit ratings could also trigger incremental
collateral requirements, predominantly in the over-the-counter derivatives
market. As of August 31, 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 August 31, 2004, the Company's long-term/short-term debt ratings were as
follows:
Rating
--------------------
Dominion Bond Rating Service Limited A(high)/R-1 (middle)
Fitch A+/F1+
Moody's Investors Service(1) A1/P-1
Rating & Investment Information, Inc. A+/nr
Standard & Poor's (2) A/A-1
nr - does not assign a short-term rating
(1) 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.
(2) On September 29, 2004, Standard & Poor's affirmed the Company's credit
ratings and maintained a "stable" outlook.
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 August 31, 2004, the
Company purchased under the current authorization a total of 2,071,790 shares at
a cost of approximately $171.4 million. Approximately $680.6 million remains
available to be purchased under the current authorization as of August 31, 2004.
During the quarter ended August 31, 2004, the Company purchased a total of
605,978 shares of its common stock at a total cost of approximately $50.6
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 $64.3 million remains available
to be purchased under the current authorization as of August 31, 2004.
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cash Flows
Cash and cash equivalents during the nine month period ended August 31, 2004
decreased $586.0 million to $3.25 billion. Cash used in operating activities was
$384.8 million, primarily attributable to increases in financial instruments
owned, receivables from customers and securities purchased under agreements to
resell and financial instruments owned, 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 securities sold
under agreements to repurchase and payables to customers, along with a decrease
in securities borrowed. Cash used in investing activities of $143.1 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 used in financing
activities of $0.1 million reflected the repayment of long-term borrowings, net
payments relating to short-term borrowings, treasury stock purchases and the
redemption of preferred stock significantly offset by net proceeds from
issuances of long-term borrowings used primarily to fund normal operating
activities.
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 August 31, 2004, Bear Stearns, BSSC, BSIL, BSIT and BSB
were in compliance with their respective regulatory capital requirements.
Merchant Banking and Private Equity Investments
In connection with the Company's merchant banking activities, the Company had
investments in merchant banking and private equity-related investment funds as
well as direct investments in private equity-related investments. At August 31,
2004, the Company held investments with an aggregate recorded value of
approximately $350.6 million, reflected in the Condensed Consolidated Statements
of Financial Condition in "Other Assets." At November 30, 2003, the Company held
investments with an aggregate recorded value of approximately $353.3 million. In
addition to these various direct and indirect principal investments, the Company
has made commitments to invest in private equity-related investments and
partnerships (see the summary table under "Commitments").
High Yield Positions
As part of 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 August 31, 2004 and November 30, 2003,
the Company held high yield positions approximating $7.1 billion and $5.0
billion, respectively, substantially all of which are in "Financial Instruments
Owned" in the Condensed Consolidated Statements of Financial Condition, and
$1.55 billion 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 jointly aggregating $1.48 billion at August 31,
2004 and $1.54 billion at November 30, 2003.
Included in the high yield positions are extensions of credit to highly
leveraged companies. At August 31, 2004 and November 30, 2003, the amount
outstanding to highly leveraged borrowers totaled $2.40 billion and $922.8
million,
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
respectively. The largest industry concentration was the telecommunications
industry, which approximated 20.3% at August 31, 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 $325.0 million and $214.0 million at August 31, 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, reduced 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.
Contractual Obligations
The Company's contractual obligations, excluding derivative financial
instruments, as of August 31, 2004:
Payments Due By Period
-------------------------------------------
Remaining Fiscal Fiscal
Fiscal 2005- 2007-
(in millions) 2004 2006 2008 Thereafter Total
--------------------------------- ---------- ------- ------- ---------- -------
Long-term borrowings (1) $ 1,185 $12,536 $ 8,302 $ 11,477(2) $33,500
Future minimum lease payments (3) 14 104 97 204 419
(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 $800 million of floating rate medium term notes with a stated
final maturity in fiscal 2009. Such notes have an initial maturity date in
fiscal 2005 that may be extended at the option of the noteholder to
various dates until the stated final maturity.
(3) Includes 383 Madison Avenue in New York City.
43
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Commitments
The Company's commitments (1) as of August 31, 2004:
Amount of Commitment Expiration Per Period
------------------------------------------
Remaining Fiscal Fiscal
Fiscal 2005- 2007-
(in millions) 2004 2006 2008 Thereafter Total
-------------------------------- --------- ------- ------- ---------- ------
Commercial loan commitments:
Investment-grade (2) $ 738 $ 620 $ 376 $ 264 $1,998
Non-investment grade 29 391 358 523 1,301
Commitments to invest in private
equity-related investments and
partnerships (3) 378
Underwriting commitments 127 -- -- -- 127
Commercial and residential loans 403 2,147 150 -- 2,700
Letters of credit 2,997 500 25 35 3,557
Other (4) 54 87 4 -- 207
(1) See Note 4, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
(2) In order to mitigate the exposure to investment-grade borrowings the
Company entered into credit default swaps aggregating $521.8 million at
August 31, 2004.
(3) At August 31, 2004, commitments to invest in private equity-related
investments and partnerships aggregated $378 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 $62 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.
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
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
treasuries) occurs in over-the-counter markets, and, accordingly, the Company's
valuation policy is based on its best estimate of the prices at which these
financial instruments trade in those markets. The Company is an active dealer in
most of the over-the-counter markets for these financial instruments, and
typically has considerable insight into the trading level of financial
instruments held in inventory and/or related financial instruments that it uses
as a basis for its valuation.
(2) Financial Instruments Whose Fair Value Is Determined Based on Internally
Developed Models or Methodologies That Employ Data That Are Readily Observable
from Objective Sources
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
appropriate models or methodologies as well as appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
non-exchange-traded derivatives such as interest rate swaps, certain
mortgage-backed securities and certain other cash instruments. For an indication
of the Company's involvement in derivatives, including maturity terms, see the
table setting forth notional contract amounts outstanding in the preceding
"Derivative Financial Instruments" section.
(3) Financial Instruments Whose Fair Value Is Estimated Based on Internally
Developed Models or Methodologies Utilizing Significant Assumptions or Other
Data That Are Generally Less Readily Observable from Objective Sources
Certain complex financial instruments and other investments have significant
data inputs that cannot be validated by reference to readily observable data.
These instruments are typically illiquid, long-dated or unique in nature and
therefore engender considerable judgment by traders and their management who, as
dealers in many of these instruments, have the appropriate knowledge to estimate
data inputs that are less readily observable. For certain instruments,
extrapolation or other methods are applied to observed market or other data to
estimate assumptions that are not observable.
The Company participates in the underwriting, securitization or trading of
non-performing mortgage-related assets, real estate assets and certain
residuals. In addition, the Company has a portfolio of Chapter 13 and other
credit card receivables from individuals. Certain of these high yield positions
have limited price observability. In these instances, fair values are determined
by statistical analysis of historical cash flows, default probabilities,
recovery rates, time value of money and discount rates considered appropriate
given the level of risk in the instrument and associated investor yield
requirements.
The Company is also engaged in structuring and acting as principal in complex
derivative transactions. Complex derivatives include certain long-dated equity
derivatives, certain credit and municipal derivatives and other exotic
derivative structures. These non-exchange-traded instruments may 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.
At August 31, 2004 and November 30, 2003, such positions described above
(primarily fixed income cash positions) aggregated approximately $3.5 billion
and $3.4 billion, respectively, in "Financial Instruments Owned" and $1.2
billion and $740 million, respectively, in "Financial Instruments Sold, But Not
Yet Purchased" in the Condensed Consolidated Statements of Financial Condition.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations.
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 with observed trading, independent comparisons of key model
valuation inputs, independent trade modeling and a variety of other techniques.
Merchant Banking
As part of its merchant banking activities, the Company participates from time
to time in principal investments in leveraged transactions. As part of these
activities, the Company originates, structures and invests in merger,
acquisition, restructuring and leveraged capital transactions, including
leveraged buyouts. The Company's principal investments in these transactions are
generally made in the form of equity investments, equity-related investments or
subordinated loans and have not historically required significant levels of
capital investment.
Equity interests and securities acquired as a result of leveraged acquisition
transactions are reflected in the consolidated financial statements at their
initial cost until significant transactions or developments indicate that a
change in the carrying value of the securities is appropriate. Generally, the
carrying values of these securities will be increased only in those instances
where market values are readily ascertainable by reference to substantial
transactions occurring in the marketplace or quoted market prices. If quoted
market prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined based on
other relevant factors. Reductions to the carrying value of these securities are
made in the event that the Company's estimate of net realizable value has
declined below the carrying value. See "Merchant Banking 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 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.
Effective beginning with the quarter ended February 29, 2004, the Company
adopted Financial Accounting Standards Board ("FASB") Interpretation No. 46,
"Consolidation of Variable Interest Entities - an Interpretation of
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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. However, as of May 31, 2004, the Company
fully adopted FIN No. 46 (R) as it fully superceded FIN No. 46 as of that date.
The Company 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 April 2004, the Emerging Issues Task Force issued Statement No. 03-6
"Participating Securities and the Two Class Method Under FASB Statement No. 128,
Earnings Per Share" ("EITF No. 03-6"). EITF No. 03-6 addresses a number of
questions regarding the computation of earnings per share by companies that have
issued securities other than common stock that contractually entitle the holder
to participate in dividends and earnings of the company when, and if, it
declares dividends on its common stock. EITF No. 03-6 is effective for fiscal
periods beginning after March 31, 2004 and requires retroactive adjustment of
prior period earnings per share to ensure comparability. The Company adopted
EITF No. 03-6 during the quarter ended August 31, 2004. Such adoption did not
have an effect on basic or diluted earnings per share.
Specialist Activities
The Company participates, through a majority-owned joint venture, in specialist
activities on the NYSE 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 August 31, 2004 are total assets of $1.6 billion,
including approximately $353 million of goodwill and identifiable intangible
assets.
Effects of Inflation
The Company's assets are primarily recorded at their current market value and,
to a large extent, are liquid in nature. The rate of inflation affects the
Company's expenses, such as employee compensation, office leasing costs,
information technology and communications charges, which may not be readily
recoverable in the price of services offered by the Company. In addition, to the
extent that inflation causes interest rates to rise and has other adverse
effects on the securities markets and on the value of securities held in
inventory, it may adversely affect the Company's financial position and results
of operations.
47
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 the 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 and equity price risk for most desks use a
historical simulation approach for VaR. Foreign exchange rate risk uses 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.
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 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 August 31, 2004,
November 30, 2003 and August 31, 2003. Commodity risk has been excluded due to
immateriality at August 31, 2004, November 30, 2003 and August 31, 2003.
August 31, November 30, August 31,
(in millions) 2004 2003 2003
------------------------- ---------- ------------ ----------
MARKET RISK
Interest rate $14.6 $14.9 $17.9
Currency 1.9 0.9 0.9
Equity 6.6 3.7 4.3
Diversification benefit (7.0) (4.2) (4.6)
---------- ------------ ----------
Aggregate VaR $16.1 $15.3 $18.5
========== ============ ==========
48
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
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 $16.3 $13.3 $ 15.1
Currency 2.2 0.9 1.6
Equity 6.8 2.7 5.7
Aggregate VaR 17.4 15.0 16.3
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 firm-wide 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 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 August 31,
2004 and August 31, 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 $13.3 million and $11.3 million for the quarters ended August 31,
2004 and August 31, 2003, respectively. During the quarter ended August 31,
2004, there was one day with a reported trading loss and the trading loss on
this day did not exceed the reported aggregate period end VaR amount. There were
no daily trading losses for the quarter ended August 31, 2003. The frequency
distribution of the Company's daily net trading revenues reflects the Company's
historical ability to manage its exposure to market risk and the diversified
nature of its trading activities. No guarantee can be given regarding future net
trading revenues or future earnings volatility. The Company believes that these
results are indicative of its commitment to the management of market trading
risk.
49
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarter Ended August 31, 2004
[The following table was depicted as a bar chart in the printed materials.]
Daily Net Trading Number of
Revenues ($ in millions) Trading Days
------------------------ ------------
(10)+ --
(10)-(5) --
(5)-0 1
0-5 6
5-10 15
10-15 23
15-20 8
20-25 3
25-30 4
30+ 4
--
Total 64
Quarter Ended August 31, 2003
[The following table was depicted as a bar chart in the printed materials.]
Daily Net Trading Number of
Revenues ($ in millions) Trading Days
------------------------ ------------
(10)+ --
(10)-(5) --
(5)-0 --
0-5 9
5-10 20
10-15 20
15-20 8
20-25 6
25-30 --
30+ 1
--
Total 64
50
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.
51
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 August 31, 2004:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage of
Exposure, Exposure, Net
Rating (2) Exposure Collateral (3) Net of Collateral (4) of Collateral
------------ -------- -------------- --------------------- -------------
AAA $1,658 $402 $1,271 31%
AA 1,975 745 1,284 31%
A 1,596 687 1,019 25%
BBB 324 294 201 5%
BB and lower 981 2,105 322 8%
Non-rated 5 14 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.
52
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
have been no such changes during the quarter covered by this quarterly report.
53
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
Fezanni, 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 ("Report on 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 or entities that allegedly purchased securities underwritten by A.R.
Baron & Company, Inc. ("Baron"), a firm for which BSSC provided clearing
services. As previously reported in the Company's Quarterly Report on Form 10-Q
for the quarterly period ended February 29, 2004, 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.
On or about September 23, 2004, the plaintiffs filed an amended complaint
against Bear Stearns, BSSC, a former officer of BSSC and other individuals and
entities, alleging that they participated in misconduct by Baron involving
attempts to manipulate the market for certain securities underwritten by Baron.
The amended complaint, which contains many of the same allegations as the
original complaint, alleges that the Bear Stearns defendants violated Section
10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, violated the
federal RICO statute, aided and abetted breach of fiduciary duty, committed
common law fraud, aided and abetted fraud, and were part of a civil conspiracy
to defraud in connection with providing clearing services and financing to
Baron. The amended complaint seeks to recover compensatory damages of at least
$8.3 million and punitive damages of $125 million from Bear Stearns and BSSC.
Bear Stearns and BSSC deny all allegations of wrongdoing asserted against them
in the amended complaint and believe that they have substantial defenses to
these claims.
Specialist Matters
As previously reported in the Company's Report on Form 10-K, Bear Wagner
Specialists, LLC ("Bear Wagner"), along with numerous other defendants, has been
named in purported class actions commenced in the United States District Court
for the Southern District of New York, on behalf of investors alleging
violations of the federal securities laws in connection with NYSE specialist
activities. In addition, a purported class action, naming Bear Wagner and the
Company as defendants, was filed in December 2003 in California Superior Court,
Los Angeles County, alleging violations of California law in connection with the
NYSE specialist activities. The district court consolidated these purported
class actions under the caption In re NYSE Specialists Securities Litigation,
No. 03 Civ. 8264 (RWS). On September 15, 2004, a consolidated amended complaint
was filed in this action.
Bear Wagner and the Company deny all allegations of wrongdoing in this
litigation and believe they have substantial defenses to these claims.
Municipal Bond Offering Matters
Bear Stearns has been notified by the Chicago office of the Securities and
Exchange Commission of a formal investigation into its municipal bond offering
practices, which has been focused on the municipal underwriting business
conducted through the Chicago office of Bear Stearns. Bear Stearns has also
received subpoenas and requests for information relating to its municipal
underwriting business conducted through the Chicago office of Bear Stearns from
the United States Attorney's Office for the Northern District of Illinois; the
State of Illinois, Office of Executive Inspector General; and the Illinois
Securities Department.
Bear Stearns is cooperating fully with each of these investigations or
inquiries.
Retirement Systems of Alabama, et al., v. J.P. Morgan Chase & Co., et al.
Bear Stearns is one of a number of financial institutions named as defendants in
this action brought by an Alabama pension fund in the Circuit Court for
Montgomery County, Alabama, asserting claims against Bear Stearns for state
securities laws violations and state and common law fraud in connection with
underwriting and sales of securities of WorldCom, Inc. ("WorldCom") or
WorldCom-affiliated companies. Trial of this action is currently scheduled to
54
LEGAL PROCEEDINGS
commence on November 8, 2004. Bear Stearns is not a party to, nor is this case a
part of, any other action relating to WorldCom securities, including the In re
WorldCom, Inc. Securities Litigation consolidated multi-district litigation in
the Southern District of New York.
Bear Stearns denies all allegations of wrongdoing in this litigation and
believes it has substantial defenses to these claims.
Mutual Fund Matters
As previously reported in the Company's Report on Form 10-K, the Company, Bear
Stearns, and/or BSSC (the "Bear Stearns defendants") were named as defendants in
two purported class action lawsuits related to mutual fund trading. Those
lawsuits have been transferred to the District of Maryland for coordinated
and/or consolidated pretrial proceedings as part of MDL 1586-In re Mutual Funds
Investment Litigation. On or about September 29, 2004, thirteen new and/or
amended class action or derivative complaints were filed in MDL-1586 naming as
defendants the Bear Stearns defendants, various mutual fund companies, certain
broker-dealers, and others. Plaintiffs who have brought actions, either directly
or derivatively, against one or more of the Bear Stearns defendants are
shareholders in the following families of mutual funds: AIM, Invesco, PIMCO,
Excelsior, Alliance, Franklin Templeton, One Group, Strong, Columbia, Pilgrim
Baxter, Alger, Janus, and MFS. Among other things, the actions allege that the
defendants violated federal and/or state laws by allowing certain investors to
market time and/or late trade mutual fund shares and seek various forms of
relief including damages of an indeterminate amount.
The Bear Stearns defendants believe they have substantial defenses to the
claims.
Rogers v. Sterling Foster & Co., Inc.
This matter arises out of BSSC's role as clearing broker for Sterling Foster &
Co. Inc. ("Sterling Foster") and is part of the In re Sterling Foster & Co. Inc.
Securities Litigation multidistrict litigation. As previously reported in the
Company's Report on Form 10-K for the fiscal year ending November 30, 2001 and
on the Company's Report on Form 10-Q for the fiscal quarter ending May 31, 2002,
Bear Stearns, BSSC, and a former officer of BSSC were named as defendants in a
purported class action in the United States District Court for the Eastern
District of New York. This case was brought on behalf of a purported class
consisting of all persons who purchased or otherwise acquired certain securities
that were underwritten by Sterling Foster. On June 27, 2002, the court granted
defendants' motion to dismiss and dismissed the claims against Bear Stearns,
BSSC, and the former officer of BSSC in their entirety. On September 29, 2004,
the court granted plaintiffs' motion to vacate the June 27, 2002 dismissal and
granted plaintiffs' request to amend their complaint against Bear Stearns and
BSSC with respect to two securities underwritten by Sterling Foster.
Bear Stearns and BSSC deny all allegations of wrongdoing asserted against them
in this litigation and believe they have substantial defenses to the claims.
------------------------
The Company also is involved from time to time in investigations and proceedings
by governmental agencies and self-regulatory organizations.
55
Item 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table provides information as of August 31, 2004 with respect to
the shares of common stock repurchased by the Company during the third quarter
of fiscal 2004:
Issuer Purchases of Equity Securities
----------------------------------------------------------------------------------------------------
Approximate Dollar
Total Number of Shares Value of Shares that
Purchased as Part of May Yet Be Purchased
Total Number of Average Price Publicly Announced Under the Plans or
Period Shares Purchased Paid per Share Plans or Programs (1) Programs (1)
---------------- ---------------- -------------- ---------------------- --------------------
6/1/04 - 6/30/04 1,337,013 $81.95 1,337,013 $857,459,561
7/1/04 - 7/31/04 734,976 83.86 734,976 795,821,726
8/1/04 - 8/31/04 605,779 84.07 605,779 744,896,220
---------------- ----------------------
Total 2,677,768 82.95 2,677,768
================ ======================
(1) 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 stock repurchase program has no set expiration or termination
date.
56
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 registered public accounting firm,
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); 7)
SAS 70 attest work; and 8) other accounting, attest and regulatory related
services.
57
Item 6. EXHIBITS
Exhibits
(10.1) Form of Forward Purchase Agreement, dated as of September 7, 2004,
between The Bear Stearns Companies Inc. and a number of CAP Plan
participants
(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 and to Combined
Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information
(31.1) Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)
or 15d -14(a) of the Securities Exchange Act of 1934, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(31.2) Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)
or 15d-14(a) of the Securities Exchange Act of 1934, as Adopted
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
(32.1) Certification of Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
(32.2) Certification of Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
58
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 hereunto duly authorized.
The Bear Stearns Companies Inc.
-------------------------------
(Registrant)
Date: October 15, 2004 By: /s/ Jeffrey M. Farber
Jeffrey M. Farber
Controller
(Principal Accounting Officer)
59
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit No. Description Page
----------- ----------- ----
(10.1) Form of Forward Purchase Agreement, dated as of 61
September 7, 2004, between The Bear Stearns Companies
Inc. and a number of CAP Plan participants
(12) Computation of Ratio of Earnings to Fixed Charges and 68
to Combined Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information 69
(31.1) Certification of Chief Executive Officer Pursuant to 70
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 71
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 72
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 73
U.S.C. Section 1350, as Adopted Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
60