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 May 31, 2005
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 July 6, 2005, the latest practicable date, there were 112,478,806
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 six months ended May 31, 2005 and May
31, 2004...........................................................5
Condensed Consolidated Statements of Financial Condition
as of May 31, 2005 (Unaudited) and November 30, 2004
(Audited)..........................................................6
Condensed Consolidated Statements of Cash Flows (Unaudited)
for the six months ended May 31, 2005 and May 31, 2004.............7
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1 Summary of Significant Accounting Policies..............8
Note 2 Financial Instruments..................................15
Note 3 Derivatives and Hedging Activities.....................15
Note 4 Transfers of Financial Assets and Liabilities..........17
Note 5 Variable Interest Entities and Mortgage Loan Special
Purpose Entities......................................20
Note 6 Collateralized Financing Arrangements..................21
Note 7 Earnings Per Share.....................................22
Note 8 Regulatory Requirements................................22
Note 9 Commitments and Contingencies..........................23
Note 10 Guarantees.............................................25
Note 11 Segment Data...........................................27
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM...........30
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Introduction...................................................31
Certain Factors Affecting Results of Operations................31
Forward-Looking Statements.....................................32
Executive Overview.............................................32
Summary of Results..........................................32
Business Environment........................................33
Results of Operations .........................................34
Firmwide Results............................................34
Business Segments...........................................38
Capital Markets............................................38
Global Clearing Services...................................40
Wealth Management..........................................41
Liquidity and Capital Resources................................42
Financial Leverage..........................................42
Funding Strategy & Liquidity Risk Management................44
Capital Resources...........................................46
2
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)
Stock Repurchase Program....................................47
Cash Flows..................................................47
Regulated Subsidiaries......................................47
Merchant Banking and Private Equity Investments.............48
High Yield Positions........................................48
Contractual Obligations.....................................49
Commitments.................................................49
Off-Balance-Sheet Arrangements.................................49
Derivative Financial Instruments...............................50
Critical Accounting Policies...................................51
Valuation of Financial Instruments..........................51
Controls Over Valuation of Financial Instruments............53
Merchant Banking............................................53
Accounting and Reporting Developments..........................53
Effects of Inflation...........................................54
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Value-At-Risk .................................................56
Distribution of Daily Net Trading Revenues.....................59
Credit Risk....................................................60
Item 4. CONTROLS AND PROCEDURES...........................................61
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.................................................62
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES
AND USE OF PROCEEDS............................................65
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............66
Item 6. EXHIBITS..........................................................67
Signature......................................................68
Exhibit Index..................................................69
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. Please call the SEC at 1-800-SEC-0330 for further
information on the public reference room. The Company's SEC filings are also
available to the public from the SEC's internet site at http://www.sec.gov.
Copies of these reports, proxy statements and other information can also be
inspected at the offices of the New York Stock Exchange, Inc., 20 Broad Street,
New York, New York 10005.
The Company's public internet site is http://www.bearstearns.com. The Company
makes available free of charge through its internet site, via a link to the
SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements
and Forms 3, 4 and 5 filed on behalf of directors and executive officers and any
amendments to those reports filed or furnished pursuant to the 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 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 Six Months Ended
---------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands, except share and per share data) 2005 2004 2005 2004
---------------------------------------------------------------------------------------------------------------
REVENUES
Commissions $ 313,608 $ 307,150 $ 610,985 $ 615,253
Principal transactions 980,179 930,525 1,958,812 1,880,061
Investment banking 250,426 231,257 484,136 477,059
Interest and dividends 1,191,785 498,469 2,213,404 1,018,933
Asset management and other income 87,582 96,397 178,612 153,937
---------------------------------------------------------
Total revenues 2,823,580 2,063,798 5,445,949 4,145,243
Interest expense 950,028 340,260 1,734,737 695,782
---------------------------------------------------------
Revenues, net of interest expense 1,873,552 1,723,538 3,711,212 3,449,461
---------------------------------------------------------
NON-INTEREST EXPENSES
Employee compensation and benefits 922,908 860,053 1,829,683 1,709,201
Floor brokerage, exchange and clearance fees 57,262 59,647 114,580 116,547
Communications and technology 100,343 88,321 199,282 182,149
Occupancy 40,756 34,768 80,350 68,383
Advertising and market development 34,577 29,315 63,149 55,216
Professional fees 61,278 42,370 107,997 84,170
Other expenses 193,989 97,588 275,404 191,341
---------------------------------------------------------
Total non-interest expenses 1,411,113 1,212,062 2,670,445 2,407,007
---------------------------------------------------------
Income before provision for income taxes 462,439 511,476 1,040,767 1,042,454
Provision for income taxes 164,329 163,673 363,852 333,586
---------------------------------------------------------
Net income $ 298,110 $ 347,803 $ 676,915 $ 708,868
=========================================================
Net income applicable to common shares $ 291,667 $ 340,609 $ 663,994 $ 694,255
=========================================================
Basic earnings per share $ 2.32 $ 2.77 $ 5.26 $ 5.65
Diluted earnings per share $ 2.09 $ 2.49 $ 4.74 $ 5.07
=========================================================
Weighted average common shares outstanding:
Basic 130,663,337 129,071,295 130,960,364 129,029,761
Diluted 148,037,979 146,921,897 148,612,374 146,945,015
=========================================================
Cash dividends declared per common share $ 0.25 $ 0.20 $ 0.50 $ 0.40
=========================================================
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
5
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Financial Condition
(Unaudited)
May 31, November 30,
(in thousands, except share data) 2005 2004
-------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and cash equivalents $ 7,450,095 $ 4,173,385
Cash and securities deposited with clearing organizations or
segregated in compliance with federal regulations 5,774,007 4,422,698
Securities purchased under agreements to resell 41,726,622 45,395,149
Securities received as collateral 9,325,486 8,823,117
Securities borrowed 63,770,643 69,793,266
Receivables:
Customers 38,323,459 32,114,305
Brokers, dealers and others 4,337,472 128,382
Interest and dividends 330,965 315,686
Financial instruments owned, at fair value 76,338,644 44,296,167
Financial instruments owned and pledged as collateral, at fair value 15,704,841 36,906,933
Assets of variable interest entities and mortgage loan special purpose entities 8,829,618 4,837,121
Property, equipment and leasehold improvements, net of accumulated depreciation
and amortization of $904,790 and $816,646 in 2005 and 2004, respectively 412,482 381,403
Other assets 4,457,275 4,362,282
------------------------------
Total Assets $ 276,781,609 $ 255,949,894
==============================
LIABILITIES AND STOCKHOLDERS' EQUITY
Short-term borrowings $ 19,968,705 $ 12,210,832
Securities sold under agreements to repurchase 54,628,782 58,604,250
Obligation to return securities received as collateral 9,325,486 8,823,117
Securities loaned 11,030,601 10,718,592
Payables:
Customers 85,399,354 79,383,952
Brokers, dealers and others 3,139,021 2,344,731
Interest and dividends 616,312 568,525
Financial instruments sold, but not yet purchased, at fair value 31,863,948 29,475,880
Liabilities of variable interest entities and mortgage loan special purpose entities 8,317,337 4,761,981
Accrued employee compensation and benefits 1,370,111 1,677,655
Other liabilities and accrued expenses 1,791,809 1,546,230
------------------------------
227,451,466 210,115,745
------------------------------
Commitments and contingencies (Note 9)
Long-term borrowings 39,688,629 36,843,277
------------------------------
STOCKHOLDERS' EQUITY
Preferred stock 442,938 448,148
Common stock, $1.00 par value; 500,000,000 shares authorized and
184,805,848 shares issued as of both May 31, 2005 and November 30, 2004 184,806 184,806
Paid-in capital 3,844,737 3,548,379
Retained earnings 6,779,503 6,176,871
Employee stock compensation plans 2,160,169 2,666,879
Unearned compensation (131,831) (158,662)
Treasury stock, at cost:
Common stock: 72,361,248 and 81,018,928 shares as of May 31, 2005 and
November 30, 2004, respectively (3,638,808) (3,875,549)
------------------------------
Total Stockholders' Equity 9,641,514 8,990,872
------------------------------
Total Liabilities and Stockholders' Equity $ 276,781,609 $ 255,949,894
==============================
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
6
THE BEAR STEARNS COMPANIES INC.
Condensed Consolidated Statements of
Cash Flows
(Unaudited)
Six Months Ended
-----------------------------
May 31, May 31,
(in thousands) 2005 2004
-------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 676,915 $ 708,868
Adjustments to reconcile net income to cash used in operating activities:
Noncash items included in net income:
Depreciation and amortization 67,053 65,675
Deferred income taxes (49,912) (30,502)
Employee stock compensation plans 36,258 20,854
Other 3,689 4,306
Changes in operating assets and liabilities:
Cash and securities deposited with clearing organizations or segregated
in compliance with federal regulations (1,351,309) (3,361,809)
Securities borrowed, net of securities loaned 6,334,632 3,324,942
Net receivables from customers (193,752) 6,481,788
Net receivables from brokers, dealers and others (3,566,222) 1,906,018
Financial instruments owned (12,309,150) (10,555,006)
Other assets 46,157 (18,587)
Securities sold under agreements to repurchase, net of securities
purchased under agreements to resell (306,941) (5,054,296)
Financial instruments sold, but not yet purchased 2,388,068 5,015,946
Accrued employee compensation and benefits (312,473) (67,500)
Other liabilities and accrued expenses 576,830 194,625
-----------------------------
Cash used in operating activities (7,960,157) (1,364,678)
-----------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (98,132) (51,095)
-----------------------------
Cash used in investing activities (98,132) (51,095)
-----------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from (payments for) short-term borrowings 7,757,873 (1,435,906)
Net proceeds from issuance of long-term borrowings 7,693,780 5,443,454
Payments for retirement/repurchase of long-term borrowings (3,927,525) (4,026,012)
Proceeds from issuances of derivatives with a financing element, net 151,423 99,335
Issuance of common stock 117,883 135,793
Redemption of preferred stock (5,210) (49,043)
Redemption of preferred stock issued by a subsidiary -- (300,000)
Treasury stock purchases - common stock (382,554) (272,403)
Cash dividends paid (70,671) (56,673)
-----------------------------
Cash provided by (used in) financing activities 11,334,999 (461,455)
-----------------------------
Net increase (decrease) in cash and cash equivalents 3,276,710 (1,877,228)
Cash and cash equivalents, beginning of year 4,173,385 3,837,570
-----------------------------
Cash and cash equivalents, end of period $ 7,450,095 $ 1,960,342
=============================
See Notes to Condensed Consolidated Financial Statements.
Note: Certain prior period items have been reclassified to conform to the
current period's presentation.
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. (the "Company") is a holding company that,
through its broker-dealer and international bank subsidiaries, principally
Bear, Stearns & Co. Inc. ("Bear Stearns"); Bear, Stearns Securities Corp.
("BSSC"); Bear, Stearns International Limited ("BSIL") and Bear Stearns
Bank plc ("BSB"), is primarily engaged in business as a securities
broker-dealer and operates in three principal segments: Capital Markets,
Global Clearing Services and Wealth Management. Capital Markets comprises
the institutional equities, fixed income and investment banking areas.
Global Clearing Services provides clearance-related services for prime
brokerage clients and clearance on a fully disclosed basis for introducing
broker-dealers. Wealth Management comprises the private client services
("PCS") and asset management areas. See Note 11, "Segment Data," in the
Notes to Condensed Consolidated Financial Statements. The Company also
conducts significant activities through other wholly owned subsidiaries,
including: Bear Stearns Global Lending Limited, Custodial Trust Company,
Bear Stearns Financial Products Inc., Bear Stearns Capital Markets Inc.,
Bear Stearns Credit Products Inc., Bear Stearns Forex Inc., EMC Mortgage
Corporation and Bear Stearns Commercial Mortgage, Inc. The Company
participates, through a majority-owned joint venture, in specialist
activities on the New York Stock Exchange ("NYSE") and International
Securities Exchange ("ISE").
The condensed consolidated financial statements include the accounts of
the Company, its wholly owned subsidiaries and other entities in which the
Company has a controlling interest. In accordance with Financial
Accounting Standards Board ("FASB") Interpretation ("FIN") No. 46 (R),
"Consolidation of Variable Interest Entities" ("FIN No. 46 (R)"), the
Company also consolidates any variable interest entities ("VIEs") for
which it is the primary beneficiary. The assets and related liabilities of
such variable interest entities have been shown in the Condensed
Consolidated Statement of Financial Condition in the captions "Assets of
variable interest entities and mortgage loan special purpose entities" and
"Liabilities of variable interest entities and mortgage loan special
purpose entities." See Note 5, "Consolidation of Variable Interest
Entities and Mortgage Loan Special Purpose Entities," in the Notes to
Condensed Consolidated Financial Statements.
When the Company does not have a controlling interest in an entity, but
exerts significant influence over the entity's operating and financial
decisions (generally defined as owning a voting or economic interest of
20% to 50%), the Company applies the equity method of accounting.
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. During the quarter ended May
31, 2005, the Company changed the income statement presentation of certain
servicing fees and asset-based retail investor advisory fees. All net
servicing fees are included in the investment banking line on the
Condensed Consolidated Statements of Income. Asset-based retail investor
advisory fees are included in the asset management and other income line
on the Condensed Consolidated Statements of Income. Within the Capital
Markets segment, certain servicing fees have been reclassified from
Investment Banking to Fixed Income. These reclassifications in both the
Condensed Consolidated Statements of Income and the Capital Markets
segment were made to prior period amounts to conform to the current
period's presentation.
8
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Condensed Consolidated Statement of Financial Condition as of May 31,
2005, the Condensed Consolidated Statements of Income for the three and
six months ended May 31, 2005 and May 31, 2004 and the Condensed
Consolidated Statements of Cash Flows for the six months ended May 31,
2005 and May 31, 2004 are unaudited. The Condensed Consolidated Statement
of Financial Condition at November 30, 2004 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, 2004, filed by the Company under the Securities Exchange Act of 1934.
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 and tax matters, which may affect the amounts reported in the
condensed consolidated financial statements and accompanying notes. Actual
results could differ materially from these estimates. The nature of the
Company's business is such that the results of any interim period may not
be indicative of the results to be expected for an entire fiscal year.
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 measurements.
The Company follows Emerging Issues Task Force ("EITF") Statement No.
02-3, "Issues Involved in Accounting for Derivative Contracts Held for
Trading Purposes and Contracts Involved in Energy Trading and Risk
Management Activities." This guidance generally eliminates the practice of
recognizing profit at the inception of a derivative contract unless the
fair value of the derivative is obtained from a quoted market price in an
active market or is otherwise evidenced by comparison to other observable
current market transactions or based on a valuation technique that
incorporates observable market data.
Equity interests and securities acquired as a result of private equity and
merchant banking activities are reflected in the condensed consolidated
financial statements at their 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.
9
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Derivative Instruments and Hedging Activities
The Company follows Statement of Financial Accounting Standards ("SFAS")
No. 133, "Accounting for Derivative Instruments and Hedging Activities,"
as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments
and Certain Hedging Activities," and SFAS No. 149 "Amendment of Statement
133 on Derivative Instruments and Hedging Activities," which establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities, and hedging
activities. Accordingly, all derivatives, whether stand-alone or embedded
within other contracts or securities (except in narrowly defined
circumstances), are carried in the Company's Condensed Consolidated
Statements of Financial Condition at fair value, with changes in fair
value recorded in current earnings. Designated hedged items in fair value
hedging relationships are marked for the risk being hedged, with such
changes recorded in current earnings.
Customer Transactions
Customer securities transactions are recorded on the Condensed
Consolidated Statements of Financial Condition on a settlement date basis,
which is generally three business days after trade date, while the related
commission 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.
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities--a Replacement of
FASB Statement No. 125," to account for securitizations and other
transfers of financial assets and collateral. SFAS No. 140 establishes
accounting and reporting standards with a financial-components approach
that focuses on control. Under this approach, financial assets or
liabilities are recognized when control is established and derecognized
when control has been surrendered or the liability has been extinguished.
Control is deemed to be relinquished only when all of the following
conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee
is a Qualifying Special Purpose Entity ("QSPE") or has the right to pledge
or exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. Therefore, the Company
derecognizes financial assets transferred in securitizations provided that
such transfer meets all of these criteria.
Collateralized Securities Transactions
Transactions involving purchases of securities under agreements to resell
("reverse repurchase agreements") or sales of securities under agreements
to repurchase ("repurchase agreements") are treated as collateralized
financing transactions and are recorded at their contracted resale or
repurchase amounts plus accrued interest. Resulting interest income and
expense is generally included in "Principal Transactions" revenues in the
Condensed Consolidated Statements of Income. Reverse repurchase agreements
and repurchase agreements are presented in the Condensed Consolidated
Statements of Financial Condition on a net-by-counterparty basis, where
permitted by generally accepted accounting principles. It is the Company's
general policy to take possession of securities with a market value in
excess of the principal amount loaned plus the accrued interest thereon,
in order to collateralize reverse repurchase agreements. Similarly, the
Company is generally required to provide securities to counterparties to
collateralize repurchase agreements. The Company's agreements with
counterparties generally contain contractual provisions allowing for
additional collateral to be obtained, or
10
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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.
Investment Banking and Advisory Services
Underwriting revenues and fees for mergers and acquisitions advisory
services are accrued when services for the transactions are substantially
completed. Transaction expenses are deferred until the related revenue is
recognized.
Fixed Assets
Depreciation of property and equipment is provided by the Company on a
straight-line basis over the estimated useful life of the asset.
Amortization of leasehold improvements is provided on a straight-line
basis over the lesser of the estimated useful life of the asset or the
remaining life of the lease.
Goodwill and Identifiable Intangible Assets
The Company accounts for goodwill and identifiable intangible assets under
the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." In
accordance with this guidance, the Company does not amortize goodwill, but
amortizes identifiable intangible assets over their useful lives. Goodwill
is tested at least annually for impairment and identifiable intangible
assets are tested for potential impairment whenever events or changes in
circumstances suggest that the carrying value of an asset or asset group
may not be fully recoverable in accordance with SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets."
Earnings Per Share
Earnings per share ("EPS") is computed in accordance with SFAS No. 128,
"Earnings Per Share" and EITF Statement No. 03-6, "Participating
Securities and the Two Class Method Under FASB Statement No. 128, Earnings
Per Share." Basic EPS is computed by dividing net income applicable to
common shares, adjusted for costs related to vested shares under the
Capital Accumulation Plan for Senior Managing Directors, as amended ("CAP
Plan"), as well as the effect of the redemption of preferred stock, by the
weighted average number of common shares outstanding. Common shares
outstanding includes vested units issued under certain stock compensation
plans, which will be distributed as shares of common stock. Diluted EPS
includes the determinants of Basic EPS and, in addition, gives effect to
dilutive potential common shares related to stock compensation plans.
Stock-Based Compensation
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
11
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 ("APB") Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB No. 25"), as permitted by SFAS No. 123. Under
the provisions of APB No. 25, compensation cost for stock options is
measured as the excess, if any, of the quoted market price of the
Company's common stock at the date of grant over the amount an employee
must pay to acquire the stock. Accordingly, no compensation expense had
been recognized for stock option awards granted prior to December 1, 2002
because the exercise price was at the fair market value of the Company's
common stock on the grant date.
The cost related to stock-based compensation included in the determination
of net income for the three and six months ended May 31, 2005 and May 31,
2004 is less than that which would have been recognized if the fair
value-based method had been applied to stock option awards since the
original effective date of SFAS No. 123.
The following table illustrates the effect on net income and earnings per
share if the fair value-based method had been applied to all outstanding
awards in each period.
Three Months Ended Six Months Ended
-------------------------------------------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in millions, except per share amounts) 2005 2004 2005 2004
-------------------------------------------------------------------------------------------------------------
Net income, as reported $ 298.1 $ 347.8 $ 676.9 $ 708.9
Add: Stock-based employee compensation plans expense included
in reported net income, net of related tax effects 8.5 3.7 20.7 11.9
Deduct: Total stock-based employee compensation plans expense
determined under the fair value based method, net of related
tax effects (12.0) (11.7) (27.7) (28.1)
-------------------------------------------------------------------------------------------------------------
Pro forma net income $ 294.6 $ 339.8 $ 669.9 $ 692.7
=============================================================================================================
Earnings per share:
Basic - as reported $ 2.32 $ 2.77 $ 5.26 $ 5.65
Basic - pro forma $ 2.29 $ 2.71 $ 5.21 $ 5.53
Diluted - as reported $ 2.09 $ 2.49 $ 4.74 $ 5.07
Diluted - pro forma $ 2.07 $ 2.44 $ 4.69 $ 4.96
=============================================================================================================
Statement of Cash Flows
For purposes of the Condensed Consolidated Statements of Cash Flows, the
Company has defined cash equivalents as liquid investments with original
maturities of three months or less that are not part of the Company's
trading inventory. Cash payments for interest approximated interest
expense for the six months ended May 31, 2005 and May 31, 2004. Income
taxes paid totaled $77.6 million and $301.5 million for the six months
ended May 31, 2005 and May 31, 2004, respectively.
12
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Income Taxes
The Company and certain of its subsidiaries file a US consolidated federal
income tax return. The Company accounts for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes." Under SFAS No.
109, deferred income taxes are based on the net tax effects of temporary
differences between the financial reporting and tax bases of assets and
liabilities. In addition, deferred income taxes are determined by the
enacted tax rates and laws expected to be in effect when the related
temporary differences are expected to be reversed.
The Company is under continuous examination by various tax authorities in
jurisdictions in which the Company has significant business operations.
The Company regularly assesses the likelihood of additional assessments in
each of the tax jurisdictions resulting from these examinations. Tax
reserves have been established, which the Company believes to be adequate
in relation to the potential for additional assessments. Once established,
reserves are adjusted as information becomes available or when an event
requiring a change to the reserve occurs. The resolution of tax matters
could have an impact on the Company's effective tax rate.
Translation of Foreign Currencies
Assets and liabilities denominated in foreign currencies are translated at
period-end rates of exchange, while income statement items are translated
at daily average rates of exchange during the fiscal period. Gains or
losses resulting from foreign currency transactions are included in net
income.
Accounting and Reporting Developments
The American Jobs Creation Act ("the Act"), which was signed into law on
October 22, 2004, provides a temporary incentive for US companies to
repatriate accumulated foreign earnings. A corporation that is a US
shareholder of controlled foreign corporations may (subject to various
limitations) elect to deduct 85% of certain cash dividends that it
receives from those controlled foreign corporations during the election
year. The election year may be either the last taxable year beginning
before the date of enactment or the first taxable year beginning during
the one-year period starting on the date of enactment. With respect to the
Company, the election year could have been either the fiscal year ended
November 30, 2004 or will be the fiscal year ending November 30, 2005.
Since the Act became effective during the fourth quarter of the Company's
fiscal year ended November 30, 2004 and the US Treasury Department had not
yet issued necessary regulatory guidance with respect to these statutory
provisions, the Company was unable to evaluate the effects of the
repatriation provision with respect to any unrepatriated foreign earnings
as of November 30, 2004 and accordingly did not elect to remit qualifying
cash dividends for the November 30, 2004 fiscal year. The US Treasury has
issued some guidance on this provision recently, but additional guidance
is still expected. For the fiscal year ending November 30, 2005, the
Company will complete its evaluation after the US Treasury has issued the
remaining guidance that is expected. However, if the Company decides to
repatriate its current pool of accumulated foreign earnings under these
provisions, it does not expect the income tax on such repatriation, if
any, to be material.
In December 2004, the FASB issued SFAS No. 123 (R), "Share-Based Payment."
SFAS No. 123 (R) is a revision of SFAS No. 123, "Accounting for
Stock-Based Compensation," and supersedes APB Opinion No. 25, "Accounting
for Stock Issued to Employees," and amends SFAS No. 95 "Statement of Cash
Flows." SFAS No. 123 (R) eliminates the ability to account for share-based
compensation transactions using APB Opinion No. 25 and requires all
share-based payments to employees, including grants of employee stock
options, to be recognized in the financial statements using a fair
value-based method. 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. In April 2005, the SEC amended the effective date of SFAS No. 123
(R) to provide additional time for companies to comply with the reporting
13
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
requirements. The Company will adopt SFAS No. 123 (R) on December 1, 2005,
as required and does not expect a material impact on the consolidated
financial statements.
In March 2005, the SEC staff issued Staff Accounting Bulletin No. 107
("SAB No. 107") to provide guidance on SFAS No. 123 (R). SAB No. 107
provides the staff's view regarding the valuation of share-based payment
arrangements for public companies. In particular, this SAB provides
guidance related to share-based payment transactions with non-employees,
the transition from non public to public entity status, valuation methods
(including assumptions such as expected volatility and expected term), the
accounting for certain redeemable financial instruments issued under
share-based payment arrangements, the classification of compensation
expense, non-GAAP financial measures, first time adoption of SFAS No. 123
(R), the modification of employee share options prior to the adoption of
SFAS No. 123 (R) and disclosure in Management's Discussion and Analysis
subsequent to adoption of SFAS No. 123 (R). SAB No. 107 is effective March
29, 2005. The Company does not expect the adoption of this guidance to
have a material impact on the consolidated financial statements.
In June 2005, the EITF reached a consensus on EITF Issue No. 04-5,
"Determining Whether a General Partner, or the General Partners as a
Group, Controls a Limited Partnership or Similar Entity When the Limited
Partners Have Certain Rights." This consensus applies to voting right
entities not within the scope of FIN No. 46(R) in which the investor is
the general partner(s) in a limited partnership or functional equivalent.
The EITF consensus is that the general partner(s) in a limited partnership
is presumed to control that limited partnership and therefore should
include the limited partnership in its consolidated financial statements.
The general partner(s) may overcome this presumption of control and not
consolidate the entity if the limited partners have: (a) the substantive
ability to dissolve (liquidate) the limited partnership or otherwise
remove the general partner through substantive kick-out rights that can be
exercised without having to show cause; or (b) substantive participating
rights in managing the partnership. This guidance became immediately
effective upon ratification by the FASB on June 29, 2005 for all newly
formed limited partnerships and for existing limited partnerships for
which the partnership agreements have been modified. For general partners
in all other limited partnerships, the guidance is effective no later than
the beginning of the first reporting period in fiscal years beginning
after December 15, 2005. The Company does not expect the adoption of this
guidance to have a material impact on the consolidated financial
statements.
14
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
2. FINANCIAL INSTRUMENTS
Financial instruments owned and financial instruments sold, but not yet
purchased, consisting of the Company's proprietary trading inventories, at
fair value, were as follows:
May 31, November 30,
(in thousands) 2005 2004
-------------------------------------------------------------------------------
FINANCIAL INSTRUMENTS OWNED:
US government and agency $ 9,035,412 $ 6,043,204
Other sovereign governments 874,567 1,316,206
Corporate equity and convertible debt 16,703,361 15,788,681
Corporate debt and other 20,715,243 14,857,555
Mortgages, mortgage- and asset-backed 31,129,142 30,485,546
Derivative financial instruments 13,585,760 12,711,908
-------------------------------------------------------------------------------
$92,043,485 $ 81,203,100
===============================================================================
FINANCIAL INSTRUMENTS SOLD, BUT NOT YET PURCHASED:
US government and agency $ 9,109,010 $ 8,851,452
Other sovereign governments 1,281,817 1,240,916
Corporate equity and convertible debt 5,498,759 6,386,064
Corporate debt and other 3,129,363 2,896,233
Mortgages, mortgage- and asset-backed 217,528 428,909
Derivative financial instruments 12,627,471 9,672,306
-------------------------------------------------------------------------------
$31,863,948 $ 29,475,880
===============================================================================
As of May 31, 2005 and November 30, 2004, all financial instruments owned
that were pledged to counterparties where the counterparty has the right,
by contract or custom, to rehypothecate those securities are classified as
"Financial Instruments Owned and Pledged as Collateral, at Fair Value" in
the Condensed Consolidated Statements of Financial Condition.
Financial instruments sold, but not yet purchased represent obligations of
the Company to purchase the specified financial instrument at the then
current market price. Accordingly, these transactions result in
off-balance-sheet risk as the Company's ultimate obligation to repurchase
such securities may exceed the amount recognized in the Condensed
Consolidated Statements of Financial Condition.
Concentration Risk
The Company is subject to concentration risk by holding large positions or
committing to hold large positions in certain types of securities,
securities of a single issuer (including governments), issuers located in
a particular country or geographic area, or issuers engaged in a
particular industry. Positions taken and commitments made by the Company,
including underwritings, often involve substantial amounts and significant
exposure to individual issuers and businesses, including
non-investment-grade issuers. At May 31, 2005, the Company's most
significant concentrations are related to US government and agency
inventory positions, including those of the Federal National Mortgage
Association and the Federal Home Loan Mortgage Corporation. In addition, a
substantial portion of the collateral held by the Company for reverse
repurchase agreements consists of securities issued by the US government
and agencies.
3. DERIVATIVES AND HEDGING ACTIVITIES
The Company, in its capacity as a dealer in over-the-counter derivative
financial instruments and its proprietary market-making and trading
activities, enters into transactions in a variety of cash and derivative
financial instruments for proprietary trading and to manage its exposure
to market and credit risk. These risks include interest rate, exchange
rate and equity price risk. A derivative is defined as a financial
contract whose value is
15
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
based on underlying reference such as interest rates, currencies,
commodities, market indices or securities. This includes futures,
forwards, swap or option contracts, as well as caps, floors and collars.
Generally, these financial instruments represent commitments or rights to
exchange interest payment streams or currencies or to purchase or sell
other securities at specific terms at specified future dates. Option
contracts generally provide the holder with the right, but not the
obligation, to purchase or sell a financial instrument at a specific price
on or before an established date or dates. These financial instruments may
result in market and/or credit risk in excess of amounts recorded in the
Condensed Consolidated Statements of Financial Condition.
Market Risk
Derivative financial instruments involve varying degrees of
off-balance-sheet market risk whereby changes in the level or volatility
of interest rates, foreign currency exchange rates or market values of the
underlying financial instruments may result in changes in the value of the
financial instrument in excess of the amounts currently reflected in the
Condensed Consolidated Statements of Financial Condition. The Company's
exposure to market risk is influenced by a number of factors, including
the relationships among and between financial instruments with
off-balance-sheet risk, the Company's proprietary securities, futures and
derivatives inventories as well as the volatility and liquidity in the
markets in which the financial instruments are traded. In many cases, the
use of financial instruments serves to modify or offset market risk
associated with other transactions and, accordingly, serves to decrease
the Company's overall exposure to market risk. The Company attempts to
control its exposure to market risk through the use of hedging strategies
and various statistical monitoring techniques.
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 derivatives
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.
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.
16
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company has controls in place to monitor credit exposures by assessing
the future creditworthiness of counterparties and limiting transactions
with specific counterparties. The Company also seeks to control credit
risk by following an established credit approval process, monitoring
credit limits and requiring collateral where appropriate.
Non-Trading Derivatives Activity
To modify the interest rate characteristics of its long- and short-term
debt, the Company also engages in non-trading derivatives activities. The
Company has issued US dollar- and foreign currency-denominated debt with
both variable- and fixed-rate interest payment obligations. The Company
has entered into interest rate swaps, primarily based on LIBOR, to convert
fixed-rate interest payments on its debt obligations into variable-rate
payments. In addition, for foreign currency debt obligations that are not
used to fund assets in the same currency, the Company has entered into
currency swap agreements that effectively convert the debt into US dollar
obligations. Such transactions are accounted for as fair value hedges.
These financial instruments are subject to the same market and credit
risks as those that are traded in connection with the Company's
market-making and trading activities. The Company has similar controls in
place to monitor these risks.
SFAS No. 133, as amended by SFAS No. 138 and SFAS No. 149, establishes
accounting and reporting standards for stand-alone derivative instruments,
derivatives embedded within other contracts or securities and for hedging
activities. It requires that all derivatives, whether stand-alone or
embedded within other contracts or securities (except in very defined
circumstances), be carried on the Company's Condensed Consolidated
Statement of Financial Condition at fair value. SFAS No. 133 also requires
items designated as being fair value hedged be recorded at fair value, as
defined in SFAS No. 133, provided that the intent to hedge is fully
documented. Any resultant net change in value for both the hedging
derivative and the hedged item is recognized in earnings immediately, such
net effect being deemed the "ineffective" portion of the hedge. The gains
and losses associated with the ineffective portion of the fair value
hedges are included in "Principal Transactions" revenues in the Condensed
Consolidated Statements of Income. These amounts were immaterial for the
three and six month periods ended May 31, 2005 and May 31, 2004.
4. TRANSFERS OF FINANCIAL ASSETS AND LIABILITIES
Securitizations
The Company is a market leader in mortgage-backed securitization and other
structured financing arrangements. In the normal course of business, the
Company regularly securitizes commercial and residential mortgages,
consumer receivables and other financial assets. Securitization
transactions are generally treated as sales, provided that control has
been relinquished. In connection with securitization transactions, the
Company establishes special-purpose entities ("SPEs"), in which
transferred assets, including commercial and residential mortgages,
consumer receivables and other financial assets are sold to an SPE and
repackaged into securities or similar beneficial interests. Transferred
assets are accounted for at fair value prior to securitization. The
majority of the Company's involvement with SPEs relates to securitization
transactions meeting the definition of a QSPE under the provisions of SFAS
No. 140. Provided it has relinquished control over such assets, the
Company derecognizes financial assets transferred in securitizations and
does not consolidate the financial statements of QSPEs. For SPEs that do
not meet the QSPE criteria, the Company uses the guidance in FIN No. 46
(R) to determine whether the SPE should be consolidated.
In connection with these securitization activities, the Company may retain
interests in securitized assets in the form of senior or subordinated
securities or as residual interests. These retained interests are included
in "Financial Instruments Owned" in the Condensed Consolidated Statements
of Financial Condition and are
17
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
carried at fair value. Consistent with the valuation of similar inventory,
fair value is determined by broker-dealer price quotations and internal
valuation pricing models that utilize variables such as yield curves,
prepayment speeds, default rates, loss severity, interest rate
volatilities and spreads. The assumptions used for pricing variables are
generally based on observable transactions in similar securities and are
further verified by external pricing sources, when available.
The Company's securitization activities are detailed below:
Other
Agency Mortgage- and
Mortgage-Backed Asset-Backed
--------------------------------------------------------------------------------
(in billions)
--------------------------------------------------------------------------------
Total securitizations
Six months ended May 31, 2005 $14.2 $39.6
Six months ended May 31, 2004 $16.4 $28.3
Retained interests
As of May 31, 2005 $1.8 $1.8
As of November 30, 2004 $2.6 $1.9
--------------------------------------------------------------------------------
The following table summarizes cash flows from securitization trusts
related to securitization transactions during the six months ended May 31,
2005 and May 31, 2004:
Other
Agency Mortgage- and
Mortgage-Backed Asset-Backed
--------------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------------
Cash flows received from retained interests
Six months ended May 31, 2005 $ 158.6 $ 115.6
Six months ended May 31, 2004 $ 172.1 $ 67.5
Cash flows from servicing
Six months ended May 31, 2005 $ 0.4 $ 14.0
Six months ended May 31, 2004 $ -- $ 6.8
--------------------------------------------------------------------------------
The Company is an active market maker in these securities and therefore
may retain interests in assets it securitizes, predominantly highly rated
or government agency-backed securities. The models employed in the
valuation of retained interests use discount rates that are based on the
swap curve plus a spread. Key points on the swap curve at May 31, 2005
were 3.96% for two-year swaps, 4.42% for 10-year swaps, and ranged from
3.34% to 4.77%. 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.
Weighted average key economic assumptions used in measuring the fair value
of retained interests in assets the Company securitized at May 31, 2005
were as follows:
Other
Agency Mortgage- and
Mortgage-Backed Asset-Backed
--------------------------------------------------------------------------------
Weighted average life (years) 6.4 3.8
Average prepayment speeds (annual rate) 7% - 38% 0% - 54%
Credit losses 0.31% 5.08%
--------------------------------------------------------------------------------
The following hypothetical sensitivity analysis as of May 31, 2005
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.
18
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Other
Agency Mortgage- and
Mortgage-Backed Asset-Backed
--------------------------------------------------------------------------------
(in millions)
--------------------------------------------------------------------------------
Interest rates
Impact of 50 basis point adverse change $ (25.9) $ (31.9)
Impact of 100 basis point adverse change (31.0) (72.7)
--------------------------------------------------------------------------------
Prepayment speeds
Impact of 10% adverse change (2.7) (28.5)
Impact of 20% adverse change (4.9) (50.9)
--------------------------------------------------------------------------------
Credit losses
Impact of 10% adverse change (2.0) (21.4)
Impact of 20% adverse change (4.0) (41.6)
--------------------------------------------------------------------------------
In the normal course of business, the Company originates and purchases
conforming and non-conforming, fixed-rate and adjustable-rate residential
mortgage loans and sells such loans to investors. In connection with these
activities, the Company may retain mortgage servicing rights ("MSRs") that
entitle the Company to a future stream of cash flows based on the
contractual servicing fee. In addition, the Company may purchase and sell
MSRs. At May 31, 2005, key economic assumptions and the sensitivity of the
current fair value of MSRs to immediate changes in those assumptions were
as follows:
Fixed-Rate Adjustable-
Sub-Prime Prime Rate Prime
Loans & Alt-A Loans & Alt-A Loans
-------------------------------------------------------------------------------
(in millions)
-------------------------------------------------------------------------------
Fair Value of MSRs $ 125.4 $ 67.3 $ 146.4
Constant prepayment rate (in CPR) 15% - 45% 19% - 24% 30% - 35%
Impact on fair value of:
5 CPR adverse change $ (11.6) $ (10.2) $ (21.4)
10 CPR adverse change (21.4) (18.2) (35.4)
Discount Rate 14% 10% 13%
Impact on fair value of:
5% adverse change $ (9.9) $ (8.0) $ (11.2)
10% adverse change (18.1) (14.2) (20.7)
-------------------------------------------------------------------------------
The previous tables should be viewed with caution since the changes in a
single variable generally cannot occur without changes in other variables
or conditions that may counteract or amplify the effect of the changes
outlined in the table. Changes in fair value based on a 10% adverse
variation in assumptions generally cannot be extrapolated because the
relationship of the change in assumptions to the change in fair value is
not usually linear. In addition, the tables do not consider the change in
fair value of hedging positions, which would generally offset the changes
detailed in the tables, nor do they consider any corrective action that
the Company may take in response to changes in these conditions. The
impact of hedges is not presented because hedging positions are
established on a portfolio level and allocating the impact would not be
practicable.
MSRs, which are included in "Other Assets" on the Condensed Consolidated
Statements of Financial Condition, are reported at the lower of amortized
cost or market. MSRs are amortized in proportion to and over the period of
estimated net servicing income. MSRs are periodically evaluated for
impairment based on the fair value of those rights determined by using
market-based models which discounts anticipated future net cash flows
considering loan prepayment predictions, interest rates, default rates,
servicing costs and other economic factors. For purposes of impairment
evaluation and measurement, the Company stratifies MSRs by
securitizations, which are collateralized by loans with similar
predominant risk characteristics. The excess of
19
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
amortized cost over market value is reflected as a valuation allowance at
balance sheet dates. The Company's MSRs activities for the six months
ended May 31, 2005 and May 31, 2004 were as follows:
May 31, 2005 May 31, 2004
-----------------------------------------------------------
(in millions)
-----------------------------------------------------------
Balance, beginning of period $ 230.2 $ 108.0
Additions 154.4 86.2
Amortization (55.4) (21.9)
Recovery/(impairment) 2.7 (13.3)
-----------------------------------------------------------
Balance, end of period $ 331.9 $ 159.0
===========================================================
Changes in the MSR valuation allowance for the six months ended May 31,
2005 and May 31, 2004 were as follows:
May 31, 2005 May 31, 2004
-----------------------------------------------------------
(in millions)
-----------------------------------------------------------
Balance, beginning of period $ (33.7) $ (6.6)
Recovery/(impairment) 2.7 (13.3)
-----------------------------------------------------------
Balance, end of period $ (31.0) $ (19.9)
===========================================================
5. VARIABLE INTEREST ENTITIES AND MORTGAGE LOAN SPECIAL PURPOSE ENTITIES
The Company regularly creates or transacts with entities that may be VIEs.
These entities are an essential part of its securitization, asset
management and structured finance businesses. In addition, the Company
purchases and sells instruments that may be variable interests. The
Company adopted FIN No. 46 (R) for its variable interests in fiscal 2004.
The Company consolidates those VIEs in which the Company is the primary
beneficiary.
The Company may perform various functions, including being the seller,
investor, structurer or underwriter in securitization transactions. These
transactions typically involve entities that are considered to be QSPEs as
defined in SFAS No. 140. Under FIN No. 46 (R), these QSPE entities are
exempt from the requirements of FIN No. 46 (R). For securitization
vehicles 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
related VIE. In certain of these VIEs, the Company is the primary
beneficiary often through its ownership of certain beneficial interests,
and is, therefore, required to consolidate the assets and liabilities of
the VIE.
The Company 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 because the Company
is the primary beneficiary approximated $887 million at May 31, 2005. At
May 31, 2005, the Company's maximum exposure to loss as a result of its
relationship with these VIEs is approximately $350 million, which
represents the fair value of its interests in the VIEs.
The Company also owns significant variable interests in several VIEs
related to collateralized debt obligations or asset securitizations for
which the Company is not the primary beneficiary and therefore does not
consolidate these entities. In aggregate, these VIEs have assets
approximating $3.8 billion. At May 31, 2005, the
20
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Company's maximum exposure to loss from these entities approximates $15.8
million, which represents the fair value of its interests and is reflected
in the condensed consolidated financial statements.
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 held by the Company in future periods.
The Company has retained call options on a limited number of
securitization transactions that require the Company to continue
recognizing the assets subject to the call options, which approximated
$6.6 billion at May 31, 2005.
The Company has a limited number of mortgage securitizations which did not
meet the criteria for sale treatment under SFAS No. 140 as the
securitization vehicles were not QSPEs. The assets in these mortgage
securitizations approximated $1.4 billion at May 31, 2005.
6. 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. The Company also
pledges financial instruments owned to collateralize certain financing
arrangements and permits the counterparty to pledge or rehypothecate the
securities. These securities are recorded as "Financial Instruments Owned
and Pledged As Collateral, at Fair Value" in the Condensed Consolidated
Statements of Financial Condition. In many instances, the Company is also
permitted by contract or custom to rehypothecate securities received as
collateral. These securities may be used to secure repurchase agreements,
enter into securities lending or derivative transactions or cover short
positions.
At May 31, 2005 and November 30, 2004, the Company had received securities
pledged as collateral that can be repledged, delivered or otherwise used
with a fair value of approximately $244.04 billion and $259.01 billion,
respectively. This collateral was generally obtained under reverse
repurchase, securities borrowing or margin lending agreements. Of these
securities received as collateral, those with a fair value of
approximately $178.98 billion and $163.95 billion were delivered or
repledged, generally as collateral under repurchase or securities lending
agreements or to cover short sales at May 31, 2005 and November 30, 2004,
respectively.
The carrying value of securities and other inventory positions owned that
have been pledged or otherwise encumbered to counterparties where those
counterparties do not have the right to sell or repledge was approximately
$26.84 billion at May 31, 2005.
21
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 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 Six Months Ended
---------------------------------------------------------------------------------------------------------
May 31, May 31, May 31, May 31,
(in thousands, except per share amounts) 2005 2004 2005 2004
---------------------------------------------------------------------------------------------------------
Net income $ 298,110 $ 347,803 $ 676,915 $ 708,868
Preferred stock dividends (6,443) (7,194) (12,921) (14,613)
Income adjustment (net of tax) applicable to deferred
compensation arrangements-vested shares 10,894 17,553 24,761 35,178
---------------------------------------------------------------------------------------------------------
Net earnings used for basic EPS 302,561 358,162 688,755 729,433
Income adjustment (net of tax) applicable to deferred
compensation arrangements-nonvested shares 7,099 7,865 14,937 15,372
---------------------------------------------------------------------------------------------------------
Net earnings used for diluted EPS $ 309,660 $ 366,027 $ 703,692 $ 744,805
=========================================================================================================
Total basic weighted average common
shares outstanding (1) 130,663 129,071 130,960 129,030
---------------------------------------------------------------------------------------------------------
Effect of dilutive securities:
Employee stock options 3,879 3,471 4,117 3,471
CAP and restricted units 13,496 14,380 13,535 14,444
---------------------------------------------------------------------------------------------------------
Dilutive potential common shares 17,375 17,851 17,652 17,915
---------------------------------------------------------------------------------------------------------
Weighted average number of common shares
outstanding and dilutive potential common shares 148,038 146,922 148,612 146,945
=========================================================================================================
Basic EPS $ 2.32 $ 2.77 $ 5.26 $ 5.65
Diluted EPS $ 2.09 $ 2.49 $ 4.74 $ 5.07
=========================================================================================================
(1) Includes 17,447,028 and 24,573,060 vested units for the three months
ended May 31, 2005 and May 31, 2004, respectively, and 18,856,095 and
25,171,895 vested units for the six months ended May 31, 2005 and May 31,
2004, respectively, issued under certain stock compensation plans which
will be distributed as shares of common stock.
8. 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. At May 31, 2005, Bear Stearns' net capital
of $1.25 billion exceeded the minimum requirement by $1.17 billion. Bear
Stearns' net capital computation, as defined, includes $604.8 million,
which is net capital of BSSC in excess of 5.5% of aggregate debit items
arising from customer transactions.
BSIL and Bear Stearns International Trading Limited ("BSIT"), London-based
broker-dealer subsidiaries, are subject to the regulatory capital
requirements of the Financial Services Authority.
22
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 May 31, 2005, Bear Stearns, BSSC, BSIL, BSIT and BSB were in compliance
with their respective regulatory capital requirements.
In June 2004, the SEC adopted rule amendments relating to "Alternative Net
Capital Requirements for Broker-Dealers That Are Part of Consolidated
Supervised Entities" that allow investment banks to voluntarily submit to
be regulated by the SEC on a global consolidated basis. These regulations
(referred to as CSE) were in response to what is known as the "Financial
Conglomerates Directive" (2002/87/EC) of the European Parliament, which
served to compel globally active institutions doing business in Europe to
be regulated on a global consolidated basis. The Company is applying to
the SEC during fiscal 2005 to be regulated under this new CSE regime
effective December 1, 2005. The new framework will be a notable change in
the Company's regulation, as activities which are currently transacted
outside of SEC-regulated entities will come under the scope of SEC
regulation and capital adequacy requirements. On becoming subject to the
SEC's consolidated supervision, the Company will be required to report to
the SEC computations of the Company's consolidated capital adequacy.
Although the application process is not yet complete, the Company believes
that it will meet the requirements of the SEC to be regulated on a
consolidated basis.
9. COMMITMENTS AND CONTINGENCIES
In the ordinary course of business, the Company has commitments in
connection with various activities, the most significant of which are as
follows:
Leases
The Company occupies office space under leases that expire at various
dates through 2024. At May 31, 2005, future minimum aggregate annual
rentals payable under non-cancelable leases (net of subleases), including
383 Madison Avenue in New York City, for fiscal years 2005 through 2009
and the aggregate amount thereafter, are as follows:
----------------------------------------------------
(in thousands)
----------------------------------------------------
FISCAL YEAR
2005 (remaining) $ 33,687
2006 72,718
2007 72,320
2008 72,202
2009 60,158
Thereafter 250,050
----------------------------------------------------
Lending - Related Commitments
In connection with certain of the Company's business activities, the
Company provides financing or financing commitments to investment grade
and non-investment-grade companies in the form of senior and subordinated
debt, including bridge financing. Commitments have varying maturity dates
and are generally contingent on the accuracy and validity of certain
representations, warranties and contractual conditions applicable to the
borrower. Lending-related commitments to investment grade borrowers
aggregated approximately $2.08 billion
23
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
at May 31, 2005. Of this amount, approximately $383.5 million was hedged
at May 31, 2005. Lending-related commitments to non-investment-grade
borrowers approximated $2.19 billion at May 31, 2005.
The Company also has contingent commitments to investment grade and
non-investment-grade companies of approximately $1.48 billion as of May
31, 2005. Generally, these commitments are provided in connection with
leveraged acquisitions. These commitments are not indicative of the
Company's actual risk because the borrower may never draw upon the
commitment. In fact, the borrower may not be successful in the
acquisition, the borrower may access the capital markets instead of
drawing on the commitment, or the Company's portion of the commitment may
be reduced through the syndication process. Additionally, the borrower's
ability to draw may be subject to there being no material adverse change
in either market conditions or the borrower's financial condition, among
other factors. These commitments generally contain certain flexible
pricing features to adjust for changing market conditions prior to
closing.
Private Equity-Related Investments and Partnerships
In connection with the Company's merchant banking activities, the Company
has commitments to invest in merchant banking and private equity-related
investment funds as well as commitments to invest directly in private
equity-related investments. At May 31, 2005, such commitments aggregated
$301.2 million. These commitments will be funded, if called, through the
end of the respective investment periods, with the longest of such periods
ending in 2013.
Underwriting
In connection with the Company's mortgage-backed securitizations and fixed
income underwriting, the Company had commitments to purchase new issues of
securities aggregating $1.07 billion at May 31, 2005. In connection with
the Company's equity underwriting, the Company had commitments to purchase
new issues of securities of $32.3 million.
Commercial and Residential Loans
The Company participates in the acquisition, securitization, servicing,
financing and disposition of commercial and residential loans. At May 31,
2005, the Company had entered into commitments to purchase or finance
mortgage loans of $4.7 billion.
Letters of Credit
At May 31, 2005, the Company was contingently liable for unsecured letters
of credit of approximately $2.51 billion and letters of credit of $1.02
billion secured by financial instruments, primarily used to provide
collateral for securities borrowed and to satisfy margin requirements at
option and commodity exchanges.
Other
The Company had commitments to purchase Chapter 13 and other credit card
receivables of $169.5 million at May 31, 2005.
With respect to certain of the commitments outlined above, the Company
utilizes various hedging strategies to actively manage its market, credit
and liquidity exposures. Additionally, since these commitments may expire
unused, the total commitment amount may not necessarily reflect the actual
future cash funding requirements.
24
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Litigation
In the normal course of business, the Company has been named as a
defendant in various legal actions, including arbitrations, class actions
and other litigation. Certain of the legal actions include claims for
substantial compensatory and/or punitive damages or claims for
indeterminate amounts of damages. The Company is also involved in other
reviews, investigations and proceedings by governmental and
self-regulatory agencies regarding the Company's business, certain of
which may result in adverse judgments, settlements, fines, penalties,
injunctions or other relief.
Because litigation is inherently unpredictable, particularly in cases
where claimants seek substantial or indeterminate damages or where
investigations and proceedings are in the early stages, the Company cannot
predict with certainty the loss or range of loss related to such matters,
how such matters will be resolved, when they will ultimately be resolved,
or what the eventual settlement, fine, penalty or other relief might be.
Consequently, the Company cannot estimate losses or ranges of losses for
matters where there is only a reasonable possibility that a loss may have
been incurred. Although the ultimate outcome of these matters cannot be
ascertained at this time, it is the opinion of management, after
consultation with counsel, that the resolution of the foregoing matters
will not have a material adverse effect on the financial condition of the
Company, taken as a whole; such resolution may, however, have a material
effect on the operating results in any future period, depending on the
level of income for such period.
The Company has provided reserves for such matters in accordance with SFAS
No. 5, "Accounting for Contingencies". The ultimate resolution may differ
from the amounts reserved.
10. GUARANTEES
In the ordinary course of business, the Company issues various guarantees
to counterparties in connection with certain derivative, leasing,
securitization and other transactions. FIN No. 45, "Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees
of Indebtedness of Others," requires the Company to recognize a liability
at the inception of certain guarantees and to disclose information about
its obligations under certain guarantee arrangements.
The guarantees covered by FIN No. 45 include contracts that contingently
require the guarantor to make payments to the guaranteed party based on
changes related to an asset, a liability or an equity security of the
guaranteed party, contracts that contingently require the guarantor to
make payments to the guaranteed party based on another entity's failure to
perform under an agreement and indirect guarantees of the indebtedness of
others, even though the payment to the guaranteed party may not be based
on changes to an asset, liability or equity security of the guaranteed
party. In addition, FIN No. 45 covers certain indemnification agreements
that contingently require the guarantor to make payments to the
indemnified party, such as an adverse judgment in a lawsuit or the
imposition of additional taxes due to either a change in the tax law or an
adverse interpretation of the tax law.
25
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The following table sets forth the maximum payout/notional amounts
associated with the Company's guarantees as of May 31, 2005:
Amount of Guarantee Expiration Per Period
--------------------------------------------
One Three Greater
Less Than to Three to Five than Five
(in millions) One Year Years Years Years Total
--------------------------------------------------------------------------------------------------
Certain derivative contracts (notional)(1) $172,547 $178,920 $192,089 $142,396 $685,952
Municipal securities 2,471 154 -- -- 2,625
Residual value guarantee -- -- 570 -- 570
--------------------------------------------------------------------------------------------------
(1) The carrying value of these derivatives approximated $2.7 billion as of
May 31, 2005.
Derivative Contracts
The Company's dealer activities cause it to make markets and trade a
variety of derivative instruments. Certain derivative contracts that the
Company has entered into meet the accounting definition of a guarantee
under FIN No. 45. Derivatives that meet the FIN No. 45 definition of
guarantees include credit default swaps (whereby a default or significant
change in the credit quality of the underlying financial instrument may
obligate the Company to make a payment), put options, as well as floors,
caps and collars. Since the Company does not track the counterparties'
purpose for entering into a derivative contract, it has disclosed
derivative contracts that are likely to be used to protect against a
change in an underlying financial instrument regardless of their actual
use.
On certain of these contracts, such as written interest rate caps and
foreign currency options, the maximum payout cannot be quantified since
the increase in interest rates and foreign exchange rates is not
contractually limited by the terms of the contracts. As such, the Company
has disclosed notional amounts as a measure of the extent of its
involvement in these classes of derivatives rather than maximum payout.
Notional amounts do not represent the maximum payout and generally
overstate the Company's exposure to these contracts. The derivative
contracts are recorded at fair value, which approximated $2.7 billion at
May 31, 2005.
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, 2004.
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 May 31, 2005 was approximately $2.63 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 $2.63 billion at May 31, 2005.
26
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Residual Value Guarantee
The Company has entered into an operating lease arrangement for its
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 unless both parties agree to a
renewal prior to expiration. At the expiration date of the Synthetic
Lease, the Company has the right to purchase the building for the amount
of the then outstanding indebtedness of the lessor or to arrange for the
sale of the property with the proceeds of the sale to be used to satisfy
the lessor's debt obligation. If the sale of the property does not
generate sufficient proceeds to satisfy the lessor's debt obligation, the
Company is required to fund the shortfall up to a maximum residual value
guarantee. As of May 31, 2005, there was no expected shortfall and the
maximum residual value guarantee approximated $570 million.
Indemnifications
The Company provides representations and warranties to counterparties in
connection with a variety of commercial transactions, including certain
asset sales and securitizations and occasionally indemnifies them against
potential losses caused by the breach of those representations and
warranties. To mitigate these risks with respect to assets being
securitized that have been originated by third parties, the Company seeks
to obtain appropriate representations and warranties from such third party
originators upon acquisition of such assets. The Company generally
performs due-diligence on assets purchased and maintains underwriting
standards for assets originated. The Company may also provide
indemnifications to some counterparties to protect them in the event
additional taxes are owed or payments are withheld, due either to a change
in or adverse application of certain tax laws. These indemnifications
generally are standard contractual terms and are entered into in the
normal course of business. Generally, there are no stated or notional
amounts included in these indemnifications, and the contingencies
triggering the obligation to indemnify are not expected to occur.
Maximum payout information under these indemnifications is not readily
available because of the number, size, and lives of these transactions. In
implementing this accounting interpretation, the Company reviewed its
experience with the indemnifications on these structures. Based on such
experience, it is unlikely that the Company will have to make significant
payments under these arrangements.
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 remote. Accordingly, no
contingent liability is recorded in the Condensed Consolidated Statements
of Financial Condition for these arrangements.
11. 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.
27
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Capital Markets segment comprises the institutional equities, fixed
income and investment banking areas. The Capital Markets segment operates
as a single integrated unit that provides the sales, trading and
origination effort for various fixed income, equity and advisory products
and services. Each of the three businesses works in tandem to deliver
these services to institutional and corporate clients.
Institutional equities consists of research, sales and trading in areas
such as domestic and international equities, block trading, convertible
bonds, over-the-counter equities, equity derivatives, risk and convertible
arbitrage and the NYSE and ISE specialist activities. Fixed income
includes sales, trading and research provided to institutional clients
across a variety of products such as mortgage- and asset-backed
securities, corporate and government bonds, municipal bonds, high yield
products, foreign exchange and interest rate and credit derivatives.
Investment banking provides services in capital raising, strategic advice,
mergers and acquisitions and merchant banking. Capital raising encompasses
the Company's underwriting of equity, investment grade, municipal and high
yield debt products.
The Global Clearing Services segment provides execution, clearing, margin
lending and securities borrowing to facilitate customer short sales to
clearing clients worldwide. Prime brokerage clients include hedge funds
and clients of money managers, short sellers and other professional
investors. Fully disclosed clients engage in either the retail or
institutional brokerage business.
The Wealth Management segment is comprised of the PCS and asset management
areas. PCS provides high-net-worth individuals with an institutional level
of investment service, including access to the Company's resources and
professionals. Asset management manages equity, fixed income and
alternative assets for leading corporate pension plans, public systems,
endowments, foundations, multi-employer plans, insurance companies,
corporations, families and high-net-worth individuals in the US and
abroad.
The three business segments comprise many business areas with interactions
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.
Within the Capital Markets segment, certain servicing fees have been
reclassified from Investment Banking to Fixed Income during the quarter
ended May 31, 2005. These reclassifications within the Capital Market
segment were made to prior period amounts to conform to the current
period's presentation.
28
THE BEAR STEARNS COMPANIES INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Three Months Ended Six Months Ended
---------------------- -----------------------
May 31, May 31, May 31, May 31,
(in thousands) 2005 2004 2005 2004
-------------------------------------------------------------------------------------------
NET REVENUES (1)
Capital Markets
Institutional Equities $ 390,453 $ 245,752 $ 703,393 $ 538,963
Fixed Income 808,013 860,443 1,673,520 1,699,742
Investment Banking 231,935 233,597 449,329 466,215
-------------------------------------------------------------------------------------------
Total Capital Markets 1,430,401 1,339,792 2,826,242 2,704,920
Global Clearing Services 276,160 235,196 546,552 460,529
Wealth Management
Private Client Services (2) 105,637 117,272 219,512 228,169
Asset Management 50,148 59,244 105,463 101,134
-------------------------------------------------------------------------------------------
Total Wealth Management 155,785 176,516 324,975 329,303
Other (3) 11,206 (27,966) 13,443 (45,291)
-------------------------------------------------------------------------------------------
Total net revenues $ 1,873,552 $ 1,723,538 $ 3,711,212 $ 3,449,461
===========================================================================================
PRE-TAX INCOME
Capital Markets $ 455,776 $ 479,482 $ 937,459 $ 988,132
Global Clearing Services 142,989 98,225 280,763 184,446
Wealth Management 6,054 25,719 21,033 46,586
Other (3) (142,380) (91,950) (198,488) (176,710)
-------------------------------------------------------------------------------------------
Total pre-tax income $ 462,439 $ 511,476 $ 1,040,767 $ 1,042,454
===========================================================================================
(1) Certain prior period items have been reclassified to conform to the
current period's presentation.
Three months ended Six months ended
May 31, 2005 May 31, 2004 May 31, 2005 May 31, 2004
---------------------------------------------------------
(2) Private Client Services Detail:
Gross revenues, before transfer to
Capital Markets segment $ 130,284 $ 139,266 $ 263,579 $ 276,895
Revenue transferred to
Capital Markets segment (24,647) (21,994) (44,067) (48,726)
---------- ---------- ---------- ----------
Private Client Services net revenues $ 105,637 $ 117,272 $ 219,512 $ 228,169
========== ========== ========== ==========
(3) 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 $31.5 million and $44.5 million for the three months ended May
31, 2005 and May 31, 2004, respectively, and $69.5 million and $88.5
million for the six months ended May 31, 2005 and May 31, 2004,
respectively.
As of
------------------------------------------
May 31, November 30, May 31,
(in thousands) 2005 2004 2004
----------------------------------------------------------------------
SEGMENT ASSETS (4)
Capital Markets $158,526,191 $157,141,644 $143,655,769
Global Clearing Services 103,978,620 87,793,151 89,247,591
Wealth Management 2,719,933 2,679,697 2,493,542
Other 11,556,865 8,335,402 6,197,871
----------------------------------------------------------------------
Total segment assets $276,781,609 $255,949,894 $241,594,773
======================================================================
(4) Certain prior period items have been reclassified within segment assets to
conform to the current period's presentation.
29
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 May 31,
2005, and the related condensed consolidated statements of income for the three
month and six month periods ended May 31, 2005 and 2004 and cash flows for the
six month periods ended May 31, 2005 and 2004. 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, 2004, 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, 2004; and in our report dated
February 11, 2005, 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, 2004 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
July 8, 2005
30
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The Bear Stearns Companies Inc. (the "Company") is a holding company that
through its broker-dealer and international bank subsidiaries, principally Bear,
Stearns & Co. Inc. ("Bear Stearns"), Bear, Stearns Securities Corp. ("BSSC"),
Bear, Stearns International Limited ("BSIL") and Bear Stearns Bank plc ("BSB"),
is a leading investment banking, securities and derivatives trading, clearance
and brokerage firm serving corporations, governments, institutional and
individual investors worldwide. BSSC, a subsidiary of Bear Stearns, provides
professional and correspondent clearing services, in addition to clearing and
settling customer transactions and certain proprietary transactions of the
Company. The Company also conducts significant activities through other wholly
owned subsidiaries including: Bear Stearns Global Lending Limited, Custodial
Trust Company, Bear Stearns Financial Products Inc., Bear Stearns Capital
Markets Inc., Bear Stearns Credit Products Inc., Bear Stearns Forex Inc., EMC
Mortgage Corporation and Bear Stearns Commercial Mortgage, Inc. The Company is
primarily engaged in business as a securities broker-dealer operating in three
principal segments: Capital Markets, Global Clearing Services and Wealth
Management. As used in this report, the "Company" refers (unless the context
requires otherwise) to The Bear Stearns Companies Inc. and its subsidiaries.
Unless specifically noted otherwise, all references to the three and six months
of 2005 and 2004 refer to the three and six months ended May 31, 2005 and May
31, 2004, respectively, and all references to quarters are to the Company's
fiscal quarters.
For a description of the Company's business, including its trading in cash
instruments and derivative products, its underwriting and trading policies, and
their respective risks, and the Company's risk management policies and
procedures, see the Company's Annual Report on Form 10-K for the fiscal year
ended November 30, 2004 filed by the Company under the Securities Exchange Act
of 1934 ("Exchange Act").
The Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read together with the Management's Discussion and Analysis
of Financial Condition and Results of Operations and the Consolidated Financial
Statements in the Company's Annual Report on Form 10-K for the fiscal year ended
November 30, 2004 filed by the Company under the Exchange Act.
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.
These and other factors can affect the Company's volume of security new issues,
mergers and acquisitions and business restructurings; the stability and
liquidity of securities and futures markets; and ability of issuers, other
securities firms and counterparties to perform on their obligations. A decrease
in the volume of security new issues, mergers and acquisitions or restructurings
generally results in lower revenues from investment banking and, to a lesser
extent, reduced principal transactions. A reduced volume of securities and
futures transactions and reduced market liquidity generally results in lower
revenues from principal transactions and commissions. Lower price levels for
securities may result in a reduced volume of transactions, and may also result
in losses from declines in the market value of securities held in proprietary
trading and underwriting accounts. In periods of reduced sales and trading or
investment banking activity, profitability may be adversely affected because
certain expenses remain relatively fixed. The Company's securities trading,
derivatives, arbitrage, market-making, specialist, leveraged lending, leveraged
buyout and underwriting activities are conducted by it on a principal basis and
expose the Company to significant risk of loss. Such risks include market,
counterparty credit and liquidity risks. For a discussion of how the Company
seeks to manage risks, see the "Risk Management" and "Liquidity and Capital
Resources" sections of the Company's Annual Report on Form 10-K for the fiscal
year ended November 30, 2004 filed by the Company under the Exchange Act.
31
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Substantial legal liability or a significant regulatory action against the
Company could have a material adverse effect or cause significant reputational
harm to the Company, which in turn could seriously harm the Company's business
prospects. Firms in the financial services industry have been operating in a
difficult regulatory environment. The Company faces significant legal risks in
its businesses, and the volume of claims and amount of damages and penalties
claimed in litigation and regulatory proceedings against financial institutions
have been increasing.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this discussion are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements concerning management's expectations, strategic
objectives, business prospects, anticipated economic performance and financial
condition and other similar matters are subject to risks and uncertainties,
including those described in the prior paragraphs, which could cause actual
results to differ materially from those discussed in the forward-looking
statements. Forward-looking statements speak only as of the date of the document
in which they are made. We disclaim any obligation or undertaking to provide any
updates or revisions to any forward-looking statement to reflect any change in
our expectations or any change in events, conditions or circumstances on which
the forward-looking statement is based.
EXECUTIVE OVERVIEW
Summary of Results
The Company achieved record net revenues during the quarter ended May 31, 2005.
Net revenues for the 2005 quarter increased 8.7% from the quarter ended May 31,
2004 while pre-tax earnings decreased 9.6% during the same period. Pre-tax
profit margin for the 2005 quarter decreased to 24.7% when compared with 29.7%
in the 2004 quarter. Annualized return on average common equity was 13.5% for
the quarter ended May 31, 2005 versus 19.6% in the prior year quarter. The
decline in pre-tax earnings compared to the 2004 quarter is principally the
result of a $100 million increase in litigation related reserves. Excluding the
charge, pre-tax earnings would have increased 9.0% in the 2005 quarter when
compared to the 2004 quarter and pre-tax profit margin for the 2005 quarter
would have been 29.8%.
Capital Markets net revenues increased 6.8% to $1.43 billion for the 2005
quarter compared to $1.34 billion for the 2004 quarter. Within the Capital
Markets segment, institutional equities net revenues for the 2005 quarter
increased 58.9% to $390.5 million from $245.8 million for the comparable prior
year quarter. Equity derivatives revenues increased during the 2005 quarter
reflecting increased customer activity. US listed and international equity sales
and trading net revenues increased due to higher trading volumes and increased
market share. In addition, the 2005 quarter includes principal gains of
approximately $48 million associated with the Company's investment in the
International Securities Exchange ("ISE"). Fixed income net revenues decreased
6.1% to $808.0 million for the 2005 quarter from $860.4 million for the
comparable prior year quarter primarily due to a decline in mortgage-backed
securities revenues from the record levels reached in the prior year quarter.
This decrease was partially offset by an increase in the credit product
businesses which reached record levels as credit derivatives revenues increased
during the 2005 quarter on significantly higher volume and increased structured
origination activity. Investment banking revenues decreased 0.7% to $231.9
million for the 2005 quarter from $233.6 million for the 2004 quarter,
reflecting a decline in underwriting revenues, partially offset by an increase
in advisory services and merchant banking revenues.
Global Clearing Services net revenues increased 17.4% to $276.2 million for the
2005 quarter from $235.2 million in the 2004 quarter. Increased average customer
margin and short sale balances resulted in an increase in net interest revenues
of 34.2% to $196.1 million from $146.1 million in the 2004 quarter. Partially
offsetting the increase in net interest revenues was a 18.3% decline in
clearance commission revenues to $67.5 million in the 2005 quarter from $82.6
million in the 2004 quarter resulting from lower average rates from prime
brokerage and fully disclosed clients and slightly lower trading volumes from
prime brokerage clients.
Wealth Management net revenues decreased 11.7% to $155.8 million for the 2005
quarter from $176.5 million in the quarter ended May 31, 2004. Revenues from
private client services decreased due to lower levels of investor
32
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
activity. Asset management revenues during the 2005 quarter also decreased
compared to the 2004 quarter which included a gain on the sale of the mutual
funds business to Dreyfus of $21.5 million. Excluding the gain on the sale,
asset management revenues increased during the 2005 quarter reflecting increased
management fees on higher levels of traditional and alternative assets under
management.
Business Environment
Fiscal 2005 Quarter
The business environment during the Company's second quarter ended May 31, 2005
was generally favorable due to an expanding US economy and continued low
interest rates. Favorable job reports and an active housing market provided
ongoing support to economic activity. However, concerns about rising energy
prices and inflation caused consumer confidence to decline from the levels
reached during the Company's first fiscal quarter. The Federal Reserve Board
(the "Fed") met twice during the quarter and raised the federal funds rate, in
25 basis point increments, from 2.50% to 3.00% while continuing to maintain its
position of taking a "measured" approach to monetary policy.
The major equity indices were mixed during the second quarter of 2005. The Dow
Jones Industrial Average ("DJIA"), and the Standard & Poor's 500 Index ("S&P
500") decreased 2.8% and 1.0%, respectively, while the Nasdaq Composite Index
("NASDAQ") increased 0.8% during the quarter. Average daily trading volume on
the New York Stock Exchange ("NYSE") and Nasdaq increased 7.2% and 0.1%,
respectively, compared to the 2004 quarter. Industry-wide announced mergers and
acquisitions ("M&A") volumes increased 29.7% while industry-wide completed M&A
volumes decreased 39.8% in the 2005 quarter compared to the second quarter of
2004.
Fixed income activity continued to be strong during the 2005 quarter despite
increased volatility associated with higher short term interest rates, a
flattening yield curve and the significant widening of corporate credit spreads
following the downgrade of General Motors. While the Fed continued to raise the
federal funds rate during the 2005 quarter, long-term interest rates, as
measured by the 10-year Treasury bond decreased during the 2005 quarter. At the
close of the Company's second quarter of 2005, the 10-year Treasury bond yield
was 4.00%, compared to 4.36% at the beginning of the quarter. Interest rates on
30-year fixed rate mortgages also decreased, causing home purchasing and
refinance activity to remain at relatively high levels. However, agency
collateralized mortgage obligation ("CMO") activity experienced an industry-wide
decline from the levels achieved during the 2004 quarter. This decline was
partially offset by growth in non-agency volumes.
Fiscal 2004 Quarter
The business environment during the Company's second quarter ended May 31, 2004
was characterized by a strengthening US economy and low inflation. Consumer
confidence increased during the second quarter of fiscal 2004 reflecting the
largest job growth rate in four years. Despite the Federal Reserve Board's
decision to leave the federal funds rate unchanged at 1.00%, the expectation of
higher interest rates pushed the rate on the benchmark 10-year treasury from
3.98% to 4.66% during the quarter. As a result, refinancing volumes slowed from
previous record levels as mortgage rates continued to slowly rise.
The major indices were all slightly down during the quarter ended May 31, 2004.
The DJIA and the S&P 500 decreased 3.7% and 2.1%, respectively, while the NASDAQ
decreased 2.1%. Average daily trading volume on the NYSE and Nasdaq increased
4.2% and 15.8%, respectively, compared to the 2003 quarter. Continued fiscal and
monetary stimulus and encouraging corporate profit reports served to increase
equity new issue activity as well as US announced and completed M&A volumes,
which increased 26.7% industry-wide compared to the May 2003 quarter.
The fixed income markets continued to perform extremely well in the second
quarter of fiscal 2004, benefiting from the combination of a steep yield curve
and the continued low level of interest rates. However diminished refinancing
activity resulted in a significant decline in agency CMO activity with agency
industry-wide issuance down approximately 40%. The decline in CMO activity was
substantially offset by higher secondary mortgage-backed securities activity
levels. Also, the steepening yield curve and favorable housing market
experienced during the 2004 second quarter resulted in mortgage origination
volume shifting to adjustable rate mortgages, contributing to strong
33
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
non-agency CMO activity. These factors led to the industry's continued solid
performance in the second quarter of fiscal 2004.
RESULTS OF OPERATIONS
During the 2005 quarter, the Company changed the income statement presentation
of certain servicing fees and asset-based retail investor advisory fees. All net
servicing fees are included in the investment banking line on the Condensed
Consolidated Statements of Income. Asset-based retail investor advisory fees are
included in the asset management and other income line on the Condensed
Consolidated Statements of Income. Within the Capital Markets segment, certain
servicing fees have been reclassified from Investment Banking to Fixed Income.
These reclassifications in both the Condensed Consolidated Statements of Income
and the Capital Market segment were made to prior period amounts to conform to
the current period's presentation.
Firmwide Results
The following table sets forth an overview of the Company's financial results:
Three Months Ended Six Months Ended
(in thousands, except per share ---------------------------------------------------------------------------------------
amounts, pre-tax profit margin and May 31, May 31, % Increase May 31, May 31, % Increase
return on average common equity) 2005 2004 (Decrease) 2005 2004 (Decrease)
--------------------------------------------------------------------------------------------------------------------------------
Revenues, net of interest expense $ 1,873,552 $ 1,723,538 8.7% $ 3,711,212 $ 3,449,461 7.6%
Income before provision for income tax $ 462,439 $ 511,476 (9.6)% $ 1,040,767 $ 1,042,454 (0.2)%
Net Income $ 298,110 $ 347,803 (14.3)% $ 676,915 $ 708,868 (4.5)%
Diluted earnings per share $ 2.09 $ 2.49 (16.1)% $ 4.74 $ 5.07 (6.5)%
Pre-tax profit margin 24.7% 29.7% 28.0% 30.2%
Return on average common equity
(annualized) 13.5% 19.6% 15.6% 20.5%
The Company reported net income of $298.1 million, or $2.09 per share (diluted),
for the quarter ended May 31, 2005, which represented a decrease of 14.3% from
$347.8 million, and 16.0% from $2.49 per share (diluted), for the quarter ended
in 2004. The decline in net income and earnings per share is principally the
result of a $100 million increase in litigation reserves related to the mutual
fund matter. Excluding the charge, the Company would have reported net income of
$365.1 million, or $2.56 per share (diluted), for the quarter ended 2005, which
represented an increase of 5.0% from $347.8 million, and 2.8% from $2.49 per
share (diluted), for the quarter ended 2004. Revenues, net of interest expense
("net revenues") increased 8.7% to $1.87 billion for the second quarter of 2005
from $1.72 billion for the 2004 quarter, due to increases in net interest
revenues, principal transactions revenues, investment banking revenues and
commission revenues, partially offset by a decrease in asset management and
other income.
The Company reported net income of $676.9 million, or $4.74 per share (diluted),
for the six months ended May 31, 2005, which represented a decrease of 4.5% from
$708.9 million, and 6.5% from $5.07 per share (diluted), for the six months
ended May 31, 2004. The 2005 period results include a pre-tax charge of $100.0
million related to the mutual fund trading legal matter. Excluding the charge,
the Company would have reported net income of $743.9 million, or $5.21 per share
(diluted), for the six months ended May 31, 2005, which represented an increase
of 4.9% from $708.9 million, and 2.8% from $5.07 per share (diluted), for the
six months ended May 31, 2004. Net revenues increased 7.6% to $3.71 billion for
the six months ended May 31, 2005 from $3.45 billion for the six months ended
May 31, 2004, due to increases in net interest revenues, principal transactions
revenues, asset management and other income revenues and investment banking
revenues, partially offset by a slight decrease in commission revenues.
34
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's commission revenues by reporting category were as follows:
Three Months Ended Six Months Ended
------------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2005 2004 (Decrease) 2005 2004 (Decrease)
-------------------------------------------------------------------------------------------------------
Institutional $ 177,373 $ 155,791 13.9% $ 341,806 $ 318,817 7.2%
Clearance 67,469 82,557 (18.3)% 134,612 162,115 (17.0)%
Retail & other 68,766 68,802 (0.1)% 134,567 134,321 0.2%
-------------------------------------------------------------------------------------------------------
Total commissions $ 313,608 $ 307,150 2.1% $ 610,985 $ 615,253 (0.7)%
=======================================================================================================
Commission revenues for the 2005 quarter increased 2.1% to $313.6 million from
$307.2 million for the comparable prior year quarter. Institutional commissions
increased 13.9% to $177.4 million for the 2005 quarter from $155.8 million for
the comparable prior year quarter. The increase in institutional commissions is
due to increased average daily trading volume on the NYSE and significant market
share improvement. Clearance commissions decreased 18.3% to $67.5 million for
the 2005 quarter from $82.6 million for the comparable prior year quarter
reflecting lower average rates from both prime brokerage and fully disclosed
clients and slightly lower trading volumes from prime brokerage clients. Retail
and other commissions remained flat at $68.8 million in the 2005 quarter from
the comparable prior year quarter.
Commission revenues for the six months ended May 31, 2005 decreased 0.7% to
$611.0 million from $615.3 million for the comparable prior year period.
Institutional commissions increased 7.2% to $341.8 million for the 2005 period
from $318.8 million for the comparable prior year period. The increase in
institutional commissions is due to increased average daily trading volume on
the NYSE and significant market share improvement. Clearance commissions
decreased 17.0% to $134.6 million for the six months ended May 31, 2005 from
$162.1 million for the 2004 period reflecting lower average rates from prime
brokerage and fully disclosed clients and slightly lower trading volumes from
prime brokerage clients. Retail and other commissions increased slightly to
$134.6 million in the 2005 period from $134.3 million in the comparable prior
year period.
The Company's principal transactions revenues by reporting category were as
follows:
Three Months Ended Six Months Ended
----------------------------------------------------------------------------
May 31, May 31, %(Decrease) May 31, May 31, %(Decrease)
(in thousands) 2005 2004 Increase 2005 2004 Increase
---------------------------------------------------------------------------------------------------------------
Fixed income $ 546,836 $ 693,761 (21.2)% $1,177,706 $1,369,986 (14.0)%
Equities 132,719 93,684 41.7% 229,860 215,716 6.6%
Derivative financial instruments 300,624 143,080 110.1% 551,246 294,359 87.3%
---------------------------------------------------------------------------------------------------------------
Total principal transactions $ 980,179 $ 930,525 5.3% $1,958,812 $1,880,061 4.2%
===============================================================================================================
Revenues from principal transactions for the 2005 quarter increased 5.3% to
$980.2 million from $930.5 million for the corresponding prior year quarter due
to an increase in derivative financial instruments revenues and equities
revenues, partially offset by a decrease in fixed income revenues. Fixed income
net revenues decreased 21.2% to $546.8 million for the 2005 quarter from $693.8
million for the comparable prior year quarter. Mortgage-backed securities net
revenues declined when compared to the record results achieved during the 2004
quarter as a flattening yield curve and interest rate volatility created a more
challenging operating environment. The Company's agency CMO volumes declined
over 30% when compared to the 2004 quarter. The Company's non-agency CMO
volumes, however, increased 12.9% when compared to the 2004 quarter, reflecting
the strength of purchase mortgage activity and a significant increase in
adjustable rate mortgage volumes. Overall, mortgage-backed securities
origination revenues declined from the robust levels of the 2004 quarter due to
the shifting market conditions. Secondary mortgage-backed securities revenues
also declined from the 2004 quarter as an increase in hedging costs resulting
from volatile market conditions offset increased volumes. The decrease in
mortgage-backed securities revenues was partially offset by an increase in net
revenues from the leveraged finance, distressed and high grade areas which
benefited from increased volumes. Revenues derived from equities activities
increased 41.7% to $132.7 million during the 2005 quarter from $93.7 million.
The 2005 quarter included principal gains of $56.7 million associated with the
Company's
35
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
investment in the ISE. Also contributing to the increase in revenues from
equities activities was an increase in energy related net revenues. Partially
offsetting these increases was a decline in net revenues from convertible
arbitrage and NYSE specialist activities reflecting lower market volatility and
volume levels. Revenues from derivative financial instruments increased 110.1%
to $300.6 million in the 2005 quarter from $143.1 million in the 2004 quarter,
as credit derivatives revenues increased on significantly higher customer
volumes and increased structured origination activity. Equity derivatives net
revenues also increased when compared to the 2004 quarter, benefiting from
substantially higher customer volumes.
Revenues from principal transactions for the six months ended May 31, 2005
increased 4.2% to $1.96 billion from $1.88 billion for the corresponding prior
year period due to an increase in derivative financial instruments and equities
revenues, partially offset by a decrease in fixed income revenues. Fixed income
revenues decreased 14.0% to $1.18 billion for the 2005 period from $1.37 billion
for the prior year period attributable to a decrease in mortgage-backed
securities, partially offset by an increase in net revenues from the leveraged
finance and distressed areas. Despite an increase in short term interest rates,
flattening of the yield curve and the widening of credit spreads, the Company's
fixed income revenues remained strong. Mortgage-backed securities origination
revenues declined from the robust levels of the 2004 period due to the shifting
market conditions. Secondary mortgage-backed securities revenues also declined
from the 2004 period as an increase in hedging costs resulting from volatile
market conditions offset increased volumes. This decrease was partially offset
by an increase in revenues from the leveraged finance and distressed areas which
benefited from increased volumes. Revenues derived from equities activities
increased 6.6% to $229.9 million during the 2005 period from $215.7 million in
the corresponding prior year period due primarily to principal gains associated
with the Company's investment in the ISE of $56.7 million, partially offset by a
decrease in convertible arbitrage revenues and NYSE specialist revenues.
Revenues from derivative financial instruments increased 87.3% to $551.2 million
in the 2005 period from $294.4 million in the 2004 period, due to increases in
equity, credit and fixed income derivatives as a result of increased customer
volume.
The Company's investment banking revenues by reporting category were as follows:
Three Months Ended Six Months Ended
------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2005 2004 (Decrease) 2005 2004 (Decrease)
---------------------------------------------------------------------------------------------
Underwriting $108,048 $117,424 (8.0)% $252,038 $264,885 (4.9)%
Advisory and other fees 97,219 72,503 34.1% 177,349 168,138 5.5%
Merchant banking 45,159 41,330 9.3% 54,749 44,036 24.3%
---------------------------------------------------------------------------------------------
Total investment banking $250,426 $231,257 8.3% $484,136 $477,059 1.5%
=============================================================================================
Investment banking revenues increased 8.3% to $250.4 million for the 2005
quarter from $231.3 million for the 2004 quarter. Underwriting revenues
decreased 8.0% to $108.0 million for the 2005 quarter from $117.4 million for
the corresponding prior year quarter, primarily due to lower levels of high
yield underwriting revenues during the quarter resulting from the widening of
credit spreads. Equity underwriting also decreased modestly compared to the 2004
quarter reflecting the more challenging market conditions offset by the
Company's improved market share of lead managed IPO and follow-on offerings.
Advisory and other fees for the 2005 quarter increased 34.1% to $97.2 million
from $72.5 million for the prior year quarter reflecting a significant increase
in the Company's volume of completed M&A assignments during the quarter.
Merchant banking revenues increased 9.3% to $45.2 million for the 2005 quarter,
from $41.3 million for the prior year quarter.
Investment banking revenues increased 1.5% to $484.1 million for the six months
ended May 31, 2005 from $477.1 million for the 2004 period. Underwriting
revenues decreased 4.9% to $252.0 million for the 2005 period from $264.9
million for the corresponding prior year period, primarily due to lower levels
of high yield underwriting revenues during the period resulting from the
widening of credit spreads. Equity underwriting also decreased modestly compared
to the 2004 period. These decreases were partially offset by an increase in
municipal underwriting revenues during the 2005 period. Advisory and other fees
for the 2005 period increased 5.5% to $177.3 million from $168.1 million for the
prior year period reflecting higher servicing fees. Merchant banking revenues
increased 24.3% to $54.7 million for the 2005 period, from $44.0 million for the
comparable prior year period.
36
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Net interest revenues (interest and dividend revenue less interest expense)
increased 52.8% to $241.8 million for the 2005 quarter from $158.2 million for
the 2004 quarter. The increase in net interest revenues was primarily
attributable to higher levels of customer interest-bearing balances and improved
net interest margins. Average customer margin debt balances increased 25.7% to
$58.7 billion for the 2005 quarter from $46.7 billion for the prior year
quarter. Average customer short balances increased 12.4% to $86.8 billion for
the 2005 quarter from $77.2 billion for the 2004 quarter. Average securities
borrowed balances decreased slightly to $65.1 billion for the 2005 quarter from
$65.3 billion for the 2004 quarter.
Net interest revenues increased 48.1% to $478.7 million for the six months ended
May 31, 2005 from $323.2 million for the comparable 2004 period. The increase in
net interest revenues was primarily attributable to higher levels of customer
interest-bearing balances and improved net interest margins. Average customer
margin debt balances increased 25.1% to $58.4 billion for the 2005 period from
$46.7 billion for the prior year period. Average customer short balances
increased 15.6% to $87.6 billion for the 2005 period from $75.8 billion for the
2004 period and average securities borrowed balances increased 5.2% to $67.3
billion for the 2005 period from $64.0 billion for the 2004 period.
Non-Interest Expenses
The Company's non-interest expenses were as follows:
Three Months Ended Six Months Ended
---------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2005 2004 (Decrease) 2005 2004 (Decrease)
------------------------------------------------------------------------------------------------------------
Employee compensation and
benefits $ 922,908 $ 860,053 7.3% $1,829,683 $1,709,201 7.0%
Floor brokerage, exchange and
clearance fees 57,262 59,647 (4.0)% 114,580 116,547 (1.7)%
Communications and technology 100,343 88,321 13.6% 199,282 182,149 9.4%
Occupancy 40,756 34,768 17.2% 80,350 68,383 17.5%
Advertising and market
development 34,577 29,315 17.9% 63,149 55,216 14.4%
Professional fees 61,278 42,370 44.6% 107,997 84,170 28.3%
Other expenses 193,989 97,588 98.8% 275,404 191,341 43.9%
------------------------------------------------------------------------------------------------------------
Total non-interest expenses $1,411,113 $1,212,062 16.4% $2,670,445 $2,407,007 10.9%
============================================================================================================
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 7.3% to $922.9 million for the 2005
quarter from $860.1 million for the 2004 quarter, primarily due to higher
discretionary compensation associated with the increase in net revenues.
Employee compensation and benefits as a percentage of net revenues was 49.3% for
the 2005 quarter and 49.9% for the 2004 quarter. Full-time employees increased
to 11,141 at May 31, 2005 from 10,469 at May 31, 2004.
Non-compensation expenses increased 38.7% to $488.2 million for the 2005 quarter
from $352.0 million for the 2004 quarter. Non-compensation expenses as a
percentage of net revenues increased to 26.1% for the 2005 quarter compared with
20.4% for the corresponding prior year quarter. The increase in non-compensation
related costs when compared to the May 2004 quarter is principally related to a
$100 million increase in litigation reserves (included in other expenses),
increased communications and technology costs, occupancy and professional fees.
Communications and technology costs increased 13.6% to $100.3 million for the
2005 quarter from $88.3 million for the corresponding prior year quarter, as
increased head count resulted in higher voice and market data related costs.
Occupancy costs increased 17.2% to $40.8 million for the 2005 quarter from $34.8
million for the 2004 quarter reflecting additional office space requirements and
higher leasing costs associated with the Company's headquarters building at 383
Madison Avenue. The increase in professional fees of 44.6% to $61.3 million for
the 2005 quarter from $42.4 million for the 2004 quarter is attributable to
higher levels of legal and audit & tax fees, temporary help and employment
agency fees. Other expenses increased $96.4 million due to the increase in
litigation reserves. CAP Plan related costs decreased to $31.5 million for the
2005 quarter from $44.5 million in
37
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
the comparable prior year quarter due to fewer CAP Plan units outstanding. The
Company achieved a pre-tax profit margin of 24.7% for the 2005 quarter versus
29.7% for the 2004 quarter.
Employee compensation and benefits increased 7.0% to $1.83 billion for the six
months ended May 31, 2005 from $1.71 billion for the comparable 2004 period,
primarily due to higher discretionary compensation associated with the increase
in net revenues. Employee compensation and benefits as a percentage of net
revenues was 49.3% for the 2005 period compared to 49.5% for the 2004 period.
Non-compensation expenses increased 20.5% to $840.8 million for the six months
ended May 31, 2005 from $697.8 million for the comparable 2004 period.
Non-compensation expenses as a percentage of net revenues increased to 22.7% for
the six months ended May 31, 2005 compared with 20.2% for the corresponding
prior year period, primarily due to increased litigation reserves (included in
other expenses). Professional fees increased 28.3% attributable to higher levels
of legal fees, temporary help and employment agency fees. Communications and
technology costs increased 9.4% as increased head count resulted in higher voice
and market data related costs. Also contributing to the increase in
non-compensation expenses is a 17.5% increase in occupancy costs, reflecting
additional office space requirements and higher leasing costs associated with
the Company's headquarters building at 383 Madison Avenue. CAP Plan related
costs decreased to $69.5 million for the 2005 period from $88.5 million in the
comparable prior year period due to fewer CAP Plan units outstanding. The
Company achieved a pre-tax profit margin of 28.0% for the 2005 period versus
30.2% for the 2004 period.
The Company's effective tax rate increased to 35.5% for the three months ended
May 31, 2005 compared to 32.0% for the comparable prior year quarter. The
Company's effective tax rate increased to 35.0% for the six months ended May 31,
2005 compared to 32.0% for the comparable prior year period.
Business Segments
The remainder of "Results of Operations" is presented on a business segment
basis. The Company's three business segments--Capital Markets, Global Clearing
Services and Wealth Management--are analyzed separately due to the distinct
nature of the products they provide and the clients they serve. Certain Capital
Markets products are distributed by the Wealth Management and Global Clearing
Services distribution networks, with the related revenues of such intersegment
services allocated to the respective segments. Certain prior year items have
been reclassified between the Capital Markets and Global Clearing Services
segments to conform to the current period's presentation. In addition, within
the Capital Markets segment, certain servicing fees have been reclassified from
Investment Banking to Fixed Income. These reclassifications in the segments were
made to prior period amounts to conform to the current period's presentation.
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 11,
"Segment Data" in the Notes to Condensed Consolidated Financial Statements for
complete segment information.
Capital Markets
---------------
Three Months Ended Six Months Ended
----------------------------------------------------------------------------
May 31, May 31, % Increase May 31, May 31, % Increase
(in thousands) 2005 2004 (Decrease) 2005 2004 (Decrease)
--------------------------------------------------------------------------------------------------------
Net revenues
Institutional equities $ 390,453 $ 245,752 58.9% $ 703,393 $ 538,963 30.5%
Fixed income 808,013 860,443 (6.1)% 1,673,520 1,699,742 (1.5)%
Investment banking 231,935 233,597 (0.7)% 449,329 466,215 (3.6)%
--------------------------------------------------------------------------------------------------------
Total net revenues $1,430,401 $1,339,792 6.8% $2,826,242 $2,704,920 4.5%
Pre-tax income $ 455,776 $ 479,482 (4.9)% $ 937,459 $ 988,132 (5.1)%
--------------------------------------------------------------------------------------------------------
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
38
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 ISE specialist activities.
Fixed income includes sales, trading and research provided to institutional
clients across a variety of products such as mortgage- and asset-backed
securities, corporate and government bonds, municipal bonds, high yield
products, foreign exchange and interest rate and credit derivatives. Investment
banking provides services in capital raising, strategic advice, mergers and
acquisitions and merchant banking. Capital raising encompasses the Company's
underwriting of equity, investment-grade, municipal and high yield debt
products.
Net revenues for Capital Markets increased 6.8% to $1.43 billion for the 2005
quarter compared to $1.34 billion for the 2004 quarter. Pre-tax income for
Capital Markets decreased 4.9% to $455.8 million for the 2005 quarter from
$479.5 million for the comparable prior year quarter. Pre-tax profit margin was
31.9% for the 2005 period compared with 35.8% for the 2004 period.
Institutional equities net revenues for the 2005 quarter increased 58.9% to
$390.5 million from $245.8 million for the comparable prior year quarter. Net
revenues from domestic and international institutional equity activities
increased, reflecting higher trading volumes and market share gains. Equity
derivatives net revenues increased significantly during the 2005 quarter
reflecting increased customer activity. The 2005 quarter also included principal
gains of approximately $48 million associated with the Company's investment in
the ISE and small gains from certain energy related activities. Partially
offsetting these gains was a decline in net revenues from NYSE specialist
activities reflecting lower market volatility and volume levels.
Fixed income net revenues decreased 6.1% to $808.0 million for the 2005 quarter
from $860.4 million for the comparable prior year quarter. Despite an increase
in short term rates, flattening yield curve and widening of credit spreads,
fixed income market activity remained robust as trading volumes were at record
levels and customer activity across the fixed income area remained high.
Mortgage-backed securities origination revenues declined from the robust levels
of the 2004 quarter due to the shifting market conditions. The Company's agency
CMO volumes declined over 30% when compared to the 2004 quarter. However, the
Company's non-agency CMO volumes increased 12.9% when compared to the 2004
quarter, reflecting the strength of purchase mortgage activity and a significant
increase in adjustable rate mortgage volumes. Secondary mortgage-backed
securities revenues also declined from the 2004 quarter as increased hedging
costs resulting from volatile market conditions offset increased volumes. The
Company's foreign exchange and interest rate derivatives areas delivered solid
results during the 2005 quarter. Net revenues from the credit businesses
achieved record levels as credit derivatives revenues increased during the 2005
quarter on significantly higher customer volumes and increased structured
origination activity. In addition, leveraged finance revenues increased
reflecting increased acquisition finance activity.
Investment banking revenues decreased 0.7% to $231.9 million for the 2005
quarter from $233.6 million for the 2004 quarter. Underwriting revenues
decreased 7.4% to $117.6 million for the 2005 quarter from $127.0 million for
the corresponding prior year quarter, primarily due to lower levels of high
yield underwriting revenues during the quarter resulting from the widening of
credit spreads. Equity underwriting also decreased modestly compared to the 2004
quarter, reflecting the more challenging market conditions offset by the
Company's improved market share of lead managed IPO and follow on offerings.
Advisory and other fees for the 2005 quarter increased 6.0% to $69.2 million
from $65.2 million for the prior year quarter reflecting a significant increase
in the Company's volume of completed M&A assignments during the quarter.
Merchant banking revenues increased 9.3% to $45.2 million for the 2005 quarter,
from $41.3 million for the prior year quarter.
Net revenues for Capital Markets increased 4.5% to $2.83 billion for the six
months ended May 31, 2005 compared to $2.70 billion for the comparable prior
year period. Pre-tax income for Capital Markets decreased 5.1% to $937.5 million
for the 2005 period from $988.1 million for the comparable prior year period.
Pre-tax profit margin was 33.2% for the 2005 period compared with 36.5% for the
2004 period.
39
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Institutional equities net revenues for the 2005 six month period increased
30.5% to $703.4 million from $539.0 million for the comparable prior year
quarter. Net revenues from domestic and international institutional equity
activities increased, reflecting higher trading volumes and market share gains.
Equity derivatives revenue increased significantly during the 2005 period
reflecting increased customer activity. The 2005 period also includes principal
gains of approximately $48 million associated with the Company's investment in
the ISE. Partially offsetting these increases was a decline in net revenues from
convertible arbitrage and NYSE specialist activities reflecting lower market
volatility and volume levels.
Fixed income net revenues decreased 1.5% to $1.67 billion for the 2005 six month
period from $1.70 billion for the comparable prior year period. Mortgage-backed
securities origination revenues declined from the robust levels of the 2004
period due to the shifting market conditions. Secondary mortgage-backed
securities revenues also declined from the 2004 period as hedging costs
increased in volatile market conditions. Net revenues from the credit product
businesses, particularly the distressed debt and credit derivatives areas,
increased during the 2005 period reflecting heavy volumes. In addition,
leveraged finance revenues increased on greater volume. The Company's foreign
exchange and interest rate derivatives areas delivered solid results but were
down from the prior year period.
Investment banking revenues decreased 3.6% to $449.3 million for the six months
ended 2005 from $466.2 million for the 2004 period. Underwriting revenues
decreased 3.2% to $269.8 million for the 2005 period from $278.8 million for the
corresponding prior year period, primarily due to lower levels of high yield and
equity underwriting revenues during the period. These decreases were partially
offset by an increase in municipal underwriting revenues during the 2005 period
compared to the 2004 period. Advisory and other fees for the 2005 period
decreased 13.0% to $124.8 million from $143.4 million for the prior year period
reflecting the industry-wide decline in completed M&A volume. Merchant banking
revenues increased 24.3% to $54.7 million for the 2005 period, from $44.0
million for the comparable prior year period.
Global Clearing Services
------------------------
Three Months Ended Six Months Ended
-----------------------------------------------------------------
May 31, May 31, % May 31, May 31, %
(in thousands) 2005 2004 Increase 2005 2004 Increase
-----------------------------------------------------------------------------------
Net revenues $276,160 $235,196 17.4% $546,552 $460,529 18.7%
Pre-tax income $142,989 $ 98,225 45.6% $280,763 $184,446 52.2%
-----------------------------------------------------------------------------------
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 May 31, 2005 and May 31, 2004, the Company held approximately
$244.0 billion and $224.5 billion, respectively, in equity in Global Clearing
Services client accounts.
Net revenues for Global Clearing Services increased 17.4% to $276.2 million for
the 2005 quarter from $235.2 million in the 2004 quarter. Net interest revenues
increased 34.2% to $196.1 million for the 2005 quarter from $146.1 million for
the prior year quarter primarily reflecting a significant increase in average
customer margin and short sale balances. Commission revenues decreased 18.3% to
$67.5 million for the 2005 quarter from $82.6 million for the comparable prior
year quarter reflecting lower average rates from prime brokerage and fully
disclosed clients and slightly lower trading volumes from prime brokerage
clients. Pre-tax income increased 45.6% to $143.0 million, from $98.2 million
for the 2004 quarter, reflecting higher net revenues and stable expenses.
Pre-tax profit margin was 51.8% for the 2005 quarter compared to 41.8% for the
2004 quarter.
Net revenues for Global Clearing Services increased 18.7% to $546.6 million for
the six months ended May 31, 2005 from $460.5 million in the 2004 period. Net
interest revenues increased 37.4% to $394.2 million for the 2005 period from
$287.0 million for the prior year period primarily reflecting increased average
customer margin and short sale balances. Commission revenues decreased 17.0% to
$134.6 million for the 2005 period from $162.1 million for the comparable prior
year period reflecting lower average rates from prime brokerage and fully
disclosed clients and slightly lower trading volumes from prime brokerage
clients. Pre-tax income increased 52.2% to $280.8
40
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
million, from $184.4 million for the 2004 period, reflecting higher net revenues
and stable expenses. Pre-tax profit margin was 51.4% for the 2005 period
compared to 40.1% for the 2004 period.
The following table presents the Company's interest-bearing balances for the
fiscal periods ended:
---------------------------------------------------------------------------------------------------------------
Three Months Ended Six Months Ended
---------------------------------------------------------------------------------------------------------------
(in billions) May 31, 2005 May 31, 2004 May 31, 2005 May 31, 2004
---------------------------------------------------------------------------------------------------------------
Margin debt balances, average for period $ 58.7 $ 46.7 $ 58.4 $ 46.7
Margin debt balances, at period end $ 53.9 $ 44.4 $ 53.9 $ 44.4
Customer short balances, average for period $ 86.8 $ 77.2 $ 87.6 $ 75.8
Customer short balances, at period end $ 82.5 $ 74.9 $ 82.5 $ 74.9
Securities borrowed, average for period $ 65.1 $ 65.3 $ 67.3 $ 64.0
Securities borrowed, at period end $ 59.7 $ 59.7 $ 59.7 $ 59.7
Free credit balances, average for period $ 30.6 $ 28.1 $ 30.8 $ 27.3
Free credit balances, at period end $ 31.6 $ 28.8 $ 31.6 $ 28.8
Equity held in client accounts $ 244.0 $ 224.5 $ 244.0 $ 224.5
Wealth Management
-----------------
Three Months Ended Six Months Ended
-----------------------------------------------------------------------
May 31, May 31, % May 31, May 31, %
(in thousands) 2005 2004 Decrease 2005 2004 Decrease
-----------------------------------------------------------------------------------------------------
Net revenues
Private Client Services $105,637 $117,272 (9.9)% $219,512 $228,169 (3.8)%
Asset Management 50,148 59,244 (15.4)% 105,463 101,134 4.3%
-----------------------------------------------------------------------------------------------------
Total net revenues $155,785 $176,516 (11.7)% $324,975 $329,303 (1.3)%
Pre-tax income $ 6,054 $ 25,719 (76.5)% $ 21,033 $ 46,586 (54.9)%
-----------------------------------------------------------------------------------------------------
The Wealth Management segment is composed of the private client services ("PCS")
and asset management areas. PCS provides high-net-worth individuals with an
institutional level of investment service, including access to the Company's
resources and professionals. At May 31, 2005, 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 decreased 11.7% to $155.8 million for the
2005 quarter from $176.5 million for the 2004 quarter. PCS revenues decreased
9.9% to $105.6 million for the 2005 quarter from $117.3 million for the 2004
quarter reflecting a reduction in individual investor activity levels during the
quarter. Partially offsetting this decrease was an increase in fee income
resulting from the continued growth in fee-based assets and ongoing development
of the Company's private client advisory services product. Asset management
revenues decreased 15.4% to $50.1 million for the 2005 quarter from $59.2
million for the 2004 quarter. The 2004 quarter included a $21.5 million gain on
the sale of the mutual fund business to Dreyfus. Excluding the gain on the sale,
asset management revenues increased 32.9% reflecting increased management fees
on higher levels of traditional and alternative assets under management.
Performance fees also improved on proprietary hedge fund products. Pre-tax
income for Wealth Management decreased 76.5% to $6.1 million in the 2005 quarter
from $25.7 million for the 2004 quarter, largely reflecting the impact of the
Dreyfus transaction on the year ago quarter.
Net revenues for Wealth Management decreased 1.3% to $325.0 million for the six
months ended May 31, 2005 from $329.3 million for the corresponding prior year
period. PCS revenues decreased 3.8% to $219.5 million for the 2005 period from
$228.2 million for the 2004 period reflecting a reduction in individual activity
levels. Net interest revenues increased due to higher margin balances. In
addition, there were higher levels of fee income during the 2005 period
attributable to the Company's private client advisory services product. Asset
management revenues increased 4.3% to $105.5 million for the 2005 period from
$101.1 million for the 2004 period. The prior year period included a gain on the
sale of the mutual fund business to Dreyfus. Excluding the gain on the sale,
asset
41
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
management revenues have increased 32.5% due to higher levels of assets under
management. Pre-tax income for Wealth Management decreased 54.9% to $21.0
million in the 2005 period from $46.6 million for the 2004 period due to the
impact of the Dreyfus transaction on the year ago quarter.
Assets under management were $36.9 billion at May 31, 2005, reflecting a 35.2%
increase from $27.3 billion in assets under management at May 31, 2004. The
increase in assets under management reflects continued increases in traditional
equity assets attributable to market appreciation and net inflows. In addition,
fixed income assets increased due to the acquisition in the fourth quarter of
2004 of $6.1 billion of fixed income assets of Times Square Capital Management,
Inc. Assets under management at May 31, 2005 include $6.0 billion of assets from
alternative investment products, a slight decrease from $6.2 billion at May 31,
2004.
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 May 31, 2005 increased to $276.8 billion from
$255.9 billion at November 30, 2004. The increase was primarily attributable to
increases in financial instruments owned, receivables from customers,
receivables from brokers, dealers and others, assets of variable interest
entities and mortgage loan special purpose entities and cash and cash
equivalents partially offset by a decrease in securities borrowed and securities
purchased under agreements to resell. The Company's total capital base, which
consists of long-term debt, preferred equity issued by subsidiaries and total
stockholders' equity, increased to $49.3 billion at May 31, 2005 from $45.8
billion at November 30, 2004. This change was primarily due to a net increase in
long-term debt and an increase in equity due to earnings.
The Company's total capital base as of May 31, 2005 and November 30, 2004 was as
follows:
May 31, 2005 November 30, 2004
----------------------------------------------------------------------------
(in millions)
----------------------------------------------------------------------------
Long-Term Borrowings:
Senior debt $ 39,426.1 $ 36,580.8
Subordinated debt (1) 262.5 262.5
----------------------------------------------------------------------------
Total Long-Term Borrowings $ 39,688.6 $ 36,843.3
Stockholders' equity:
Common stockholders' equity $ 9,198.6 $ 8,542.8
Preferred stockholders' equity 442.9 448.1
----------------------------------------------------------------------------
Total Stockholders' Equity $ 9,641.5 $ 8,990.9
----------------------------------------------------------------------------
42
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
----------------------------------------------------------------------------
Total Capital $ 49,330.1 $ 45,834.2
============================================================================
(1) Represents junior subordinated deferrable interest debentures issued by the
Company, held by Bear Stearns Capital Trust III.
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
critical determinants of both total capital and the equity portion thereof, thus
significantly influencing the amount of leverage that the Company can employ.
Given the nature of the Company's market-making and customer-financing activity,
the overall size of the balance sheet fluctuates from time to time. The
Company's total assets at quarter end are lower than would be observed on an
average basis. At the end of each quarter, the Company typically uses excess
cash to finance high-quality, highly liquid securities inventory that otherwise
would be funded via the repurchase agreement market. In addition, the Company
reduces its matched book repurchase and reverse repurchase activities at quarter
end. Finally, the Company may reduce the aggregate level of inventories through
ordinary course, open market activities in the most liquid portions of the
balance sheet, which are principally US government and agency securities and
agency mortgage pass-through securities. At May 31, 2005 and November 30, 2004,
total assets of $276.8 billion and $255.9 billion were approximately 4.6% and
6.4%, respectively, lower than the average of the month-end balances observed
over the trailing 12-month period. Despite reduced total assets at quarter end,
the Company's overall market, credit and liquidity risk profile does not change
materially, since the reduction in asset balances is predominantly in highly
liquid, short-term instruments that are financed on a secured basis. This
periodic reduction verifies the inherently liquid nature of the balance sheet
and provides consistency with respect to creditor constituents' evaluation of
the Company's financial condition.
Leverage Ratios
The following table presents total assets, adjusted assets and net adjusted
assets with the resultant leverage ratios at May 31, 2005 and November 30, 2004.
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.
(in billions, except ratios) May 31, 2005 November 30, 2004
------------------------------------------------------------------------------
Total assets $ 276.8 $ 255.9
Adjusted assets (1) $ 220.0 $ 197.3
Net adjusted assets (2) $ 156.2 $ 127.5
Leverage ratio (3) 27.9 27.7
Adjusted leverage ratio (4) 22.2 21.3
Net adjusted leverage ratio(5) 15.8 13.8
------------------------------------------------------------------------------
(1) Adjusted assets at May 31, 2005 is total assets of $276.8 billion less
securities purchased under agreements to resell of $41.7 billion,
securities received as collateral of $9.3 billion and cash and securities
deposited with clearing organizations or segregated in compliance with
federal regulations of $5.8 billion. Adjusted assets at November 30, 2004
is total assets of $255.9 billion less securities purchased under
agreements to resell of $45.4 billion, securities received as collateral
of $8.8 billion and cash and securities deposited with clearing
organizations or segregated in compliance with federal regulations of $4.4
billion.
(2) Net adjusted assets at May 31, 2005 is adjusted assets of $220.0 billion
less securities borrowed of $63.8 billion. Net adjusted assets at November
30, 2004 is adjusted assets of $197.3 billion less securities borrowed of
$69.8 billion.
(3) Leverage ratio equals total assets divided by stockholders' equity and
junior subordinated debt issued to Bear Stearns Capital Trust III.
(4) Adjusted leverage ratio equals adjusted assets divided by stockholders'
equity and junior subordinated debt issued to Bear Stearns Capital Trust
III.
(5) Net adjusted leverage ratio equals net adjusted assets 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.
43
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 under
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, 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 and mitigates liquidity risk.
Alternative Funding Strategy
The Company maintains an alternative funding strategy focused on the liquidity
and self-funding ability of the underlying assets. The objective is to maintain
sufficient cash capital (i.e., equity plus long-term debt maturing in more than
12 months) and funding sources to enable the Company to refinance short-term,
unsecured borrowings with fully secured borrowings. As such, the Company is not
reliant upon nor does it contemplate forced balance sheet reduction to endure a
period of constrained funding availability. This underlying approach is
supported by maintenance of a formal contingency funding plan, which includes a
detailed delegation of authority and precise action steps for managing an
event-driven liquidity crisis. The plan identifies the crisis management team,
details an effective internal and external communication strategy, and
facilitates the greater information flow required to effect a rapid and
efficient transition to a secured funding environment.
As it relates to the alternative funding strategy discussed above, the Company
prepares an analysis that focuses on a 12-month time period and assumes that the
Company does not liquidate assets and cannot issue any new unsecured debt,
including commercial paper. Given 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 May 31, 2005, the market value of higher quality unencumbered,
unhypothecated financial instruments owned by the Company was approximately
$26.2 billion with a borrowing value of $20.4 billion. The assets are comprised
of primarily mortgage- and asset-backed securities, investment grade municipal
and corporate bonds and US equities. The average advance rate on these different
asset types ranges from 71% 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 203% over
the previous 12 months including unused committed unsecured bank credit, and
189% excluding the unsecured portion of the Company's $3.7 billion
44
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
committed revolving credit facility. The liquidity ratio was 201% as of May 31,
2005 and 190% excluding the unsecured portion of the Company's $3.7 billion
committed revolving credit facility.
The cash capital framework is utilized to evaluate the Company's long-term
funding sources and requirements in their entirety. Cash capital required to
support all of the Company's assets is determined on a regular basis. The two
basic categories of cash capital usage can be characterized broadly as (1)
firmwide haircuts and (2) illiquid assets/long-term investments. The first
category represents the aggregation of the "non-financeable" portion of assets
that can be readily financed on a secured basis. Incorporated in this component
is capital needed to support the vast majority of the Company's assets,
including trading-related assets, inventory, reverse repos, margin loans and
committed funding obligations. The second category consists of items not easily
or readily financed on a secured basis and includes fixed assets, goodwill,
merchant banking investments as well as other items. At May 31, 2005 the
Company's net cash capital position was $305.3 million. Fluctuations in net cash
capital are common and are a function of fluctuations in total assets, balance
sheet composition and total capital. The Company typically maintains in excess
of $1.0 billion of net cash capital. On June 20, 2005, the Company issued $1.0
billion of five-year term debt to restore the aforementioned typical excess.
Over the previous 12 months, the Company's net cash capital position has
averaged $1.1 billion.
In addition to the alternative funding measures above, the Company monitors the
maturity profile of its unsecured debt to minimize refinancing risk, maintains
relationships with a broad global base of debt investors and bank creditors,
establishes and adheres to strict short-term debt investor concentration limits,
and periodically tests its secured and unsecured committed credit facilities. An
important component of the Company's funding and liquidity risk management
efforts involves ongoing dialogues with a large number of creditor constituents.
Strong relationships with a diverse base of creditors and debt investors are
crucial to the Company's liquidity. The Company also maintains available sources
of short-term funding that exceed actual utilization, thus allowing it to endure
changes in investor appetite and credit capacity to hold the Company's debt
obligations.
With respect to the management of refinancing risk, the maturity of the
long-term debt portfolio is monitored on an ongoing basis and structured within
the context of two diversification guidelines. The Company has a general
guideline of approximately no more than 20% of its long-term debt portfolio
maturing in any one year, as well as no more than 10% maturing in any one
quarter over the next five years. The Company continued to meet these guidelines
at the end of the second fiscal quarter of 2005. As of May 31, 2005, the
weighted average maturity of the Company's long-term debt was 4.3 years.
Committed Credit Facilities
The Company has a committed revolving credit facility ("Facility") totaling
$3.70 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 $1.85
billion of the Facility on an unsecured basis. Secured borrowings can be
collateralized by both investment grade and non-investment-grade financial
instruments as the Facility provides for defined advance rates on a wide range
of financial instruments eligible to be pledged. The Facility contains financial
covenants, the most significant of which require maintenance of specified levels
of stockholders' equity of the Company and net capital of BSSC. The facility
terminates in February 2006, with all loans outstanding at that date payable no
later than February 2007. There were no borrowings outstanding under the
Facility at May 31, 2005.
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.
The Company expects to renew the Repo Facility upon its expiration in August
2005. There were no borrowings outstanding under the Repo Facility at May 31,
2005.
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
45
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 2005 with all
loans outstanding at that date payable no later than December 2006. There were
no borrowings outstanding under the Pan Asian Facility at May 31, 2005.
The Company also maintains a series of committed credit facilities to support
liquidity needs for the financing of investment-grade and non-investment-grade
corporate 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 fiscal 2007. All of these
facilities contain a term-out option of one year or more for borrowings
outstanding at expiration. The banks providing these facilities are committed to
provide up to an aggregate of approximately $2.86 billion. At May 31, 2005, the
borrowings outstanding under these committed credit facilities were $269.7
million.
Capital Resources
-----------------
The Company also conducts significant activities through other wholly owned
subsidiaries, including: Bear Stearns Global Lending Limited, Custodial Trust
Company, Bear Stearns Financial Products Inc., Bear Stearns Capital Markets
Inc., Bear Stearns Credit Products Inc., Bear Stearns Forex Inc., EMC Mortgage
Corporation and Bear Stearns Commercial Mortgage, Inc. 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 May
31, 2005, the Parent Company's equity double leverage ratio was approximately
0.68 based on common equity and 0.65 including preferred equity. At November 30,
2004, these measures were 0.70 based on common equity and 0.66 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 having a maturity equal to or greater than the maturity of the
subordinated debt advance. The Company regularly monitors the nature and
significance of assets or activities conducted outside the regulated
subsidiaries and attempts to fund such assets with both capital or borrowings
having a maturity profile and relative mix consistent with the nature and
self-funding ability of the assets being financed.
Long-term debt totaling $30.6 billion and $30.7 billion had remaining maturities
beyond one year at May 31, 2005 and November 30, 2004, 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 May 31, 2005, 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 $1.15 billion in
additional collateral for outstanding over-the-counter derivatives contracts.
At May 31, 2005, 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 A1/P-1
Rating & Investment Information, Inc. A+/NR
Standard & Poor's (1) A/A-1
-----------------------------------------------------------------------------
NR - does not assign a short-term rating
46
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(1) 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 5, 2005, 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 2005 and beyond. During the quarter ended May 31, 2005, the
Company purchased under the current authorization a total of 1,767,843 shares at
a cost of approximately $171.7 million. Approximately $768.7 million was
available to be purchased under the current authorization as of May 31, 2005.
During the quarter ended May 31, 2005, the Company purchased a total of 455,497
shares of its common stock at a total cost of $44.8 million pursuant to a $200
million CAP Plan Earnings Purchase Authorization, which was approved by the
Compensation Committee of the Board of Directors of the Company on November 30,
2004. Approximately $113.2 million was available to be purchased under the
current authorization as of May 31, 2005.
Cash Flows
----------
Cash and cash equivalents during the six month period ended May 31, 2005
increased $3.28 billion to $7.45 billion. Cash used in operating activities was
$7.96 billion, primarily attributable to increases in financial instruments
owned, net receivables from brokers, dealers and others and cash and securities
deposited with clearing organizations or segregated in compliance with federal
regulations, partially offset by a decrease in securities borrowed, net of
securities owned and an increase in financial instruments sold, but not yet
purchased which occurred in the normal course of business as a result of changes
in customer needs, market conditions and trading strategies. Cash used in
investing activities of $0.1 million reflected purchases of property, equipment
and leasehold improvements. Cash provided by financing activities of $11.33
billion reflected net proceeds relating to short-term borrowings and net
proceeds from the issuance of long-term borrowings partially offset by net
payments for the retirement of long-term borrowings and purchases of treasury
stock.
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 May 31, 2005, Bear Stearns, BSSC, BSIL, BSIT and BSB
were in compliance with their respective regulatory capital requirements.
The Company's broker-dealer subsidiaries and other regulated subsidiaries are
subject to minimum capital requirements and may also be subject to certain
restrictions on the payment of dividends, which could limit the Company's
ability to withdraw capital from such regulated subsidiaries, which in turn
could limit the Company's ability to pay dividends. See Note 8, "Regulatory
Requirements," in the Notes to Condensed Consolidated Financial Statements.
In June 2004, the SEC adopted rule amendments relating to "Alternative Net
Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised
Entities" that allow investment banks to voluntarily submit to be regulated by
the SEC on a global consolidated basis. These regulations (referred to as CSE)
were in response to what is known as the "Financial Conglomerates Directive"
(2002/87/EC) of the European Parliament, which served to compel globally active
institutions doing business in Europe to be regulated on a global consolidated
basis. The Company is applying to the SEC during fiscal 2005 to be regulated
under this new CSE regime effective December 1, 2005. The new framework will be
a notable change in the Company's regulation, as activities which are currently
47
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
transacted outside of SEC-regulated entities will come under the scope of SEC
regulation and capital adequacy requirements. On becoming subject to the SEC's
consolidated supervision, the Company will be required to report to the SEC
computations of the Company's consolidated capital adequacy. Although the
application process is not yet complete, the Company believes that it will meet
the requirements of the SEC to be regulated on a consolidated basis.
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 May 31,
2005, the Company held investments with an aggregate recorded value of
approximately $542.0 million, reflected in the Condensed Consolidated Statements
of Financial Condition in "Other Assets." At November 30, 2004, the Company held
investments with an aggregate recorded value of approximately $469.4 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 May 31, 2005 and November 30, 2004, the
Company held high yield positions approximating $11.70 billion and $7.09
billion, respectively, substantially all of which are in "Financial Instruments
Owned" in the Condensed Consolidated Statements of Financial Condition, and
$1.98 billion and $1.09 billion, 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 $1.46 billion at May 31, 2005
and $1.29 billion at November 30, 2004. Also included in the high yield
positions are extensions of credit to highly leveraged companies. At May 31,
2005 and November 30, 2004, the amount outstanding to highly leveraged borrowers
totaled $4.54 billion and $2.14 billion, respectively. The largest industry
concentration was the telecommunications industry, which approximated 27.1% at
May 31, 2005 and 20.4% at November 30, 2004 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 which amounts are not included in the
aggregate high yield positions above. These amounts, net of collateral, were
approximately $221 million and $340 million at May 31, 2005 and November 30,
2004, 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
and concentrations of risk by individual issuer. High yield positions generally
involve greater risk than investment grade debt securities due to credit
considerations, liquidity of secondary trading markets and increased
vulnerability to changes in general economic conditions. The level of the
Company's high yield positions, and the impact of such activities on the
Company's results of operations, can fluctuate from period to period as a result
of customer demand and economic and market considerations.
48
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Contractual Obligations
-----------------------
In connection with its operating activities, the Company enters into contractual
obligations that require future cash payments. At May 31, 2005, the Company's
contractual obligations by maturity, excluding derivative financial instruments,
were as follows:
Payments Due By Period
----------------------------------------------
Remaining Fiscal Fiscal
Fiscal 2006- 2008-
(in millions) 2005 2007 2009 Thereafter Total
-------------------------------------------------------------------------------------------------
Long-term borrowings(1)(2) $ 3,494 $12,523 $11,239 $12,433 $39,689
Future minimum lease payments(3)(4) 34 145 132 250 561
-------------------------------------------------------------------------------------------------
(1) Amounts include fair value adjustments in accordance with Statement of
Financial Accounting Standards (`SFAS") No. 133 as well as $262.5 million
of junior subordinated deferrable interest debentures ("Debentures"). The
Debentures will mature on May 15, 2031; however, the Company, at its
option, may redeem the Debentures beginning May 15, 2006. The Debentures
are reflected in the table at their contractual maturity dates.
(2) Included in fiscal 2005 and fiscal 2006 are approximately $1.3 billion and
$0.8 billion, respectively, of floating-rate medium-term notes that are
redeemable prior to maturity at the option of the noteholder. These notes
contain certain provisions that effectively enable noteholders to put
these notes back to the Company and, therefore, are reflected in the table
at the date such notes first become redeemable. The final maturity date of
these notes is during fiscal 2009 and fiscal 2010.
(3) Includes 383 Madison Avenue in New York City.
(4) See Note 9, "Commitments and Contingencies," in the Notes to Condensed
Consolidated Financial Statements.
Commitments
-----------
The Company has commitments(1) under a variety of commercial arrangements. At
May 31, 2005 the Company's commitments associated with lending and financing,
private equity-related investments and partnerships, outstanding letters of
credit, underwriting and other commercial commitments summarized by period of
expiration were as follows:
Amount of Commitment Expiration Per Period
------------------------------------------
Remaining Fiscal Fiscal
Fiscal 2006- 2008-
(in millions) 2005 2007 2009 Thereafter Total
------------------------------------------------------------------------------------------------------
Lending-Related commitments:
Investment-grade (2) $ 933 $ 338 $ 637 $ 176 $2,084
Non-investment grade 509 717 518 445 2,189
Contingent commitments (3) 1,205 -- -- -- 1,475
Commitments to invest in private equity-related
investments and partnerships (4) 301
Underwriting commitments 1,102 -- -- -- 1,102
Commercial and residential loans 3,948 708 -- -- 4,656
Letters of credit 3,421 78 35 -- 3,534
Other commercial commitments 26 144 -- -- 170
------------------------------------------------------------------------------------------------------
(1) See Note 9, "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 $383.5 million at
May 31, 2005.
(3) Includes $270.0 million in commitments with no stated maturity.
(4) At May 31, 2005, commitments to invest in private equity-related
investments and partnerships aggregated $301.2 million. These commitments
will be funded, if called, through the end of the respective investment
periods, the longest of such periods ending in 2013.
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.
SPEs are corporations, trusts or partnerships that are established for a limited
purpose. SPEs, by their nature, generally are not controlled by their equity
owners, as the establishing documents
49
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
govern all material decisions. The Company's primary involvement with SPEs
relates to securitization transactions in which transferred assets, including
commercial and residential mortgages, consumer receivables, securities and other
financial assets are sold to an SPE and repackaged into securities or similar
beneficial interests. SPEs may also be used to create securities with a unique
risk profile desired by investors and as a means of intermediating financial
risk. The Company, in the normal course of business, may establish SPEs, sell
assets to SPEs, underwrite, distribute, and make a market in securities or other
beneficial interests issued by SPEs, transact derivatives with SPEs, own
securities or other beneficial interests, including residuals, in SPEs, and
provide liquidity or other guarantees for SPEs.
The Company follows SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities--a Replacement of FASB
Statement No. 125," to account for securitizations and other transfers of
financial assets. In accordance with SFAS No. 140, the Company accounts for
transfers of financial assets as sales provided that control has been
relinquished. Control is deemed to be relinquished only when all of the
following conditions have been met: (1) the assets have been isolated from the
transferor, even in bankruptcy or other receivership; (2) the transferee is a
Qualifying Special Purpose Entity ("QSPE") or has the right to pledge or
exchange the assets received; and (3) the transferor has not maintained
effective control over the transferred assets. Therefore, the Company
derecognizes financial assets transferred in securitizations, provided that such
transfer meets all of these criteria. See Note 4, "Transfers of Financial Assets
and Liabilities," in the Notes to Condensed Consolidated Financial Statements
for a more complete discussion of the Company's securitization activities.
The Company regularly creates or transacts with entities that may be VIEs. These
entities are an essential part of its securitization, asset management and
structured finance businesses. In addition, the Company purchases and sells
instruments that may be variable interests. The Company adopted FIN No. 46 (R)
for its variable interests in fiscal 2004. The Company consolidates those VIEs
in which the Company is the primary beneficiary. See Note 5, "Consolidation of
Variable Interest Entities and Mortgage Loan Special Purpose Entities," in the
Notes to Condensed Consolidated Financial Statements for a complete discussion
of the consolidation of VIEs.
The majority of the SPEs that the Company sponsors or transacts with are QSPEs,
which the Company does not consolidate in accordance with this guidance. QSPEs
are entities that have little or no discretionary activities and may only
passively hold assets and distribute cash generated by the assets they hold. The
Company reflects the fair value of its interests in QSPEs on its balance sheet
but does not recognize the assets or liabilities of QSPEs. QSPEs are employed
extensively in the Company's mortgage and asset securitization business.
Certain other SPEs do not meet the requirements of a QSPE, because their
activities are not sufficiently limited or they have entered into certain
non-qualifying transactions. The Company follows the criteria in FIN No. 46 (R)
in determining whether it should consolidate such entities. These SPEs are
commonly employed in collateralized debt obligation transactions where portfolio
managers require the ability to buy and sell assets or in synthetic credit
transactions.
In addition to the above, in the ordinary course of business the Company issues
various guarantees to counterparties in connection with certain derivative,
leasing, securitization and other transactions. See Note 10, "Guarantees," in
the Notes to Condensed Consolidated Financial Statements for a complete
discussion on guarantees.
DERIVATIVE FINANCIAL INSTRUMENTS
Derivative financial instruments are contractual commitments between
counterparties that derive their values from changes in an underlying interest
rate, currency exchange rate, index (e.g., S&P 500), reference rate (e.g.,
LIBOR), or asset value referenced in the related contract. Some derivatives,
such as futures contracts, certain options and index-referenced warrants, can be
traded on an exchange. Other derivatives, such as interest rate and currency
swaps, caps, floors, collars, swaptions, equity swaps and options, structured
notes and forward contracts, are negotiated in the over-the-counter markets.
Derivatives generate both on- and off-balance-sheet risks depending on the
nature of the contract. The Company is engaged as a dealer in over-the-counter
derivatives and, accordingly, enters into transactions involving derivative
instruments as part of its customer-related and proprietary trading activities.
50
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Company's dealer activities require it to make markets and trade a variety
of derivative instruments. In connection with these activities, the Company
attempts to mitigate its exposure to market risk by entering into hedging
transactions that may include over-the-counter derivatives contracts or the
purchase or sale of interest-bearing securities, equity securities, financial
futures and forward contracts. The Company also utilizes derivative instruments
to hedge proprietary market-making and trading activities. In this regard, the
utilization of derivative instruments is designed to reduce or mitigate market
risks associated with holding dealer inventories or in connection with
arbitrage-related trading activities. The Company also utilizes interest rate
and currency swaps, futures contracts and US Treasury positions to hedge its
debt issuances as part of its asset and liability management.
To measure derivative activity, notional or contract amounts are frequently
used. Notional/contract amounts are used to calculate contractual cash flows to
be exchanged and are generally not 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 May 31, 2005 and November 30, 2004, the Company had notional/contract
amounts of approximately $4.68 trillion and $3.50 trillion, respectively, of
derivative financial instruments, of which $1.10 trillion and $692.0 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, modify the interest rate characteristics of its long- and short-term
debt, or are part of its derivative dealer activities, are marked to fair value.
The Company's derivatives had a notional weighted average maturity of
approximately 3.9 years and 4.0 years at May 31, 2005 and November 30, 2004,
respectively. The maturities of notional/contract amounts outstanding for
derivative financial instruments as of May 31, 2005 were as follows:
Less Than One to Three to Greater Than
(in billions) One Year Three Years Five Years Five Years Total
----------------------------------------------------------------------------------------------------------
Swap agreements, including options,
swaptions, caps, collars and floors $ 733.0 $ 876.4 $ 781.2 $ 1,053.2 $ 3,443.8
Futures contracts 363.0 185.1 24.2 -- 572.3
Forward contracts 102.7 -- -- -- 102.7
Options held 323.4 69.1 0.7 0.1 393.3
Options written 160.1 7.8 1.0 0.1 169.0
----------------------------------------------------------------------------------------------------------
Total $ 1,682.2 $ 1,138.4 $ 807.1 $ 1,053.4 $ 4,681.1
===========================================================================================================
Percent of total 35.9% 24.3% 17.3% 22.5% 100.0%
===========================================================================================================
CRITICAL ACCOUNTING POLICIES
The condensed consolidated financial statements of the Company are prepared in
conformity with accounting principles generally accepted in the United States of
America. These principles require management to make certain estimates and
assumptions which could materially affect reported amounts in the financial
statements (see Note 1, "Summary of Significant Accounting Policies," in the
Notes to Condensed Consolidated Financial Statements). Critical accounting
policies are those policies that are the most important to the financial
statements and/or those that require significant management judgment related to
matters that are uncertain.
Valuation of Financial Instruments
The Company has identified the valuation of financial instruments as a critical
accounting policy due to the complex
51
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
nature of certain of its products, the degree of judgment required to
appropriately value these products and the pervasive impact of such valuation on
the financial condition and earnings of the Company.
The Company's financial instruments can be aggregated in three broad categories:
(1) those whose fair value is based on quoted market prices or for which the
Company has independent external valuations, (2) those whose fair value is
determined based on readily observable price levels for similar instruments
and/or models or methodologies that employ data that are observable from
objective sources, and (3) those whose fair value is estimated based on
internally developed models or methodologies utilizing significant assumptions
or other data that are generally less readily observable from objective sources.
(1) Financial Instruments Valued Based on Quoted Market Prices or for Which the
Company Has Independent External Valuations
The Company's valuation policy is to use quoted market prices from securities
and derivatives exchanges where they are available and reliable. Financial
instruments valued based on quoted market prices are primarily exchange-traded
derivatives and listed equities. Financial instruments that are most typically
valued using alternative approaches but for which the Company typically receives
independent external valuation information include US Treasuries, most
mortgage-backed securities and corporate, emerging market, high yield and
municipal bonds. Unlike most equities, which tend to be traded on exchanges, the
vast majority of fixed income trading (including US Treasuries) occurs in
over-the-counter markets, and, accordingly, the Company's valuation policy is
based on its best estimate of the prices at which these financial instruments
trade in those markets. The Company is an active dealer in most of the
over-the-counter markets for these financial instruments, and typically has
considerable insight into the trading level of financial instruments held in
inventory and/or related financial instruments that it uses as a basis for its
valuation.
(2) Financial Instruments Whose Fair Value Is Determined Based on Internally
Developed Models or Methodologies That Employ Data That Are Readily Observable
from Objective Sources
The second broad category consists of financial instruments for which the
Company does not receive quoted prices; therefore, models or other methodologies
are utilized to value these financial instruments. Such models are primarily
industry-standard models that consider various assumptions, including time
value, yield curve, volatility factors, prepayment speeds, default rates, loss
severity, current market and contractual prices for the underlying financial
instruments, as well as other relevant economic measures. Substantially all
these assumptions are observable in the marketplace, can be derived from
observable data or are supported by observable levels at which transactions are
executed in the marketplace. A degree of subjectivity is required to determine
appropriate models or methodologies as well as appropriate underlying
assumptions. This subjectivity makes these valuations inherently less reliable
than quoted market prices. Financial instruments in this category include
non-exchange-traded derivatives such as interest rate swaps, certain
mortgage-backed securities and certain other cash instruments. For an 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
52
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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 May 31, 2005 and November 30, 2004, the total of all positions (primarily
fixed income cash positions) aggregated approximately $5.2 billion and $4.0
billion, respectively, in "Financial Instruments Owned" and $2.3 billion and
$1.6 billion, respectively, in "Financial Instruments Sold, But Not Yet
Purchased" in the Condensed Consolidated Statements of Financial Condition.
Controls Over Valuation of Financial Instruments
In recognition of the importance the Company places on the accuracy of its
valuation of financial instruments as described in the three categories above,
the Company engages in an ongoing internal review of its valuations. Members of
the Controllers and Risk Management Departments perform analysis of internal
valuations, typically on a monthly basis but often on an intra-month basis as
well. These departments are independent of the trading areas responsible for
valuing the positions. Results of the monthly validation process are reported to
the Mark-to-Market ("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 condensed consolidated financial statements at
their initial cost until significant transactions or developments indicate that
a change in the carrying value of the securities is appropriate. Generally, the
carrying values of these securities will be increased only in those instances
where market values are readily ascertainable by reference to substantial
transactions occurring in the marketplace or quoted market prices. If quoted
market prices are not available, or if liquidating the Company's position is
reasonably expected to affect market prices, fair value is determined based on
other relevant factors. Reductions to the carrying value of these securities are
made in the event that the Company's estimate of net realizable value has
declined below the carrying value. See "Merchant Banking and Private Equity
Investments" in Management's Discussion and Analysis for additional details.
ACCOUNTING AND REPORTING DEVELOPMENTS
The American Jobs Creation Act ("the Act"), which was signed into law on October
22, 2004, provides a temporary incentive for US companies to repatriate
accumulated foreign earnings. A corporation that is a US shareholder of
controlled foreign corporations may (subject to various limitations) elect to
deduct 85% of certain cash dividends that it receives from those controlled
foreign corporations during the election year. The election year may be either
the last taxable year beginning before the date of enactment or the first
taxable year beginning during the one-year period starting on the date of
enactment. With respect to the Company, the election year could have been either
the fiscal year ended November 30, 2004 or will be the fiscal year ending
November 30, 2005. Since the Act became
53
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
effective during the fourth quarter of the Company's fiscal year ended November
30, 2004 and the US Treasury Department had not yet issued necessary regulatory
guidance with respect to these statutory provisions, the Company was unable to
evaluate the effects of the repatriation provision with respect to any
unrepatriated foreign earnings as of November 30, 2004 and accordingly did not
elect to remit qualifying cash dividends for the November 30, 2004 fiscal year.
The US Treasury has issued some guidance on this provision recently, but
additional guidance is still expected. For the fiscal year ending November 30,
2005, the Company will complete its evaluation after the US Treasury has issued
the remaining guidance that is expected. However, if the Company decides to
repatriate its current pool of accumulated foreign earnings under these
provisions, it does not expect the income tax on such repatriation, if any, to
be material.
In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 123 (R), "Share-Based Payment." SFAS No. 123 (R) is a revision of SFAS No.
123, "Accounting for Stock-Based Compensation," and supersedes Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees," and amends SFAS No. 95 "Statement of Cash Flows." SFAS No. 123 (R)
eliminates the ability to account for share-based compensation transactions
using APB Opinion No. 25 and requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the financial
statements using a fair value-based method. 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. In April 2005, the Securities and Exchange Commission ("SEC")
amended the effective date of SFAS No. 123 (R) to provide additional time for
companies to comply with the reporting requirements. The Company will adopt SFAS
No. 123 (R) on December 1, 2005, as required and does not expect a material
impact on the consolidated financial statements.
In March 2005, the SEC staff issued Staff Accounting Bulletin No. 107 ("SAB No.
107") to provide guidance on SFAS No. 123 (R). SAB No. 107 provides the staff's
view regarding the valuation of share-based payment arrangements for public
companies. In particular, this SAB provides guidance related to share-based
payment transactions with non-employees, the transition from non public to
public entity status, valuation methods (including assumptions such as expected
volatility and expected term), the accounting for certain redeemable financial
instruments issued under share-based payment arrangements, the classification of
compensation expense, non-GAAP financial measures, first time adoption of SFAS
No. 123 (R), the modification of employee share options prior to the adoption of
SFAS No. 123 (R) and disclosure in Management's Discussion and Analysis
subsequent to adoption of SFAS No. 123 (R). SAB No. 107 is effective March 29,
2005. The Company does not expect the adoption of this guidance to have a
material impact on the consolidated financial statements.
In June 2005, the Emerging Issues Task Force ("EITF") reached a consensus on
EITF Issue No. 04-5, "Determining Whether a General Partner, or the General
Partners as a Group, Controls a Limited Partnership or Similar Entity When the
Limited Partners Have Certain Rights." This consensus applies to voting right
entities not within the scope of FIN No. 46(R) in which the investor is the
general partner(s) in a limited partnership or functional equivalent. The EITF
consensus is that the general partner(s) in a limited partnership is presumed to
control that limited partnership and therefore should include the limited
partnership in its consolidated financial statements. The general partner(s) may
overcome this presumption of control and not consolidate the entity if the
limited partners have: (a) the substantive ability to dissolve (liquidate) the
limited partnership or otherwise remove the general partner through substantive
kick-out rights that can be exercised without having to show cause; or (b)
substantive participating rights in managing the partnership. This guidance
became immediately effective upon ratification by the FASB on June 29, 2005 for
all newly formed limited partnerships and for existing limited partnerships for
which the partnership agreements have been modified. For general partners in all
other limited partnerships, the guidance is effective no later than the
beginning of the first reporting period in fiscal years beginning after December
15, 2005. The Company does not expect the adoption of this guidance to have a
material impact on the consolidated financial statements.
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
54
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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.
55
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, 2004.
Value-at-Risk
An estimation of potential losses that could arise from changes in market
conditions is typically accomplished through the use of statistical models,
known as value-at-risk ("VaR"), that seek to predict risk of loss based on
historical and/or market-implied price and volatility patterns. VaR estimates
the probability of the value of a financial instrument rising above or falling
below a specified amount. The calculation uses the simulated changes in value of
the market risk-sensitive financial instruments to estimate the amount of change
in the current value that could occur at a specified probability level.
The Company has performed an entity-wide VaR analysis of the Company's financial
assets and liabilities, including financial instruments owned and sold,
repurchase and resale agreements and funding assets and liabilities. The Company
regularly evaluates and enhances such VaR models in an effort to more accurately
measure risk of loss. Certain equity-method investments and non-publicly traded
investments are not reflected in the VaR results. The VaR related to certain
non-trading financial instruments has been included in this analysis and is not
reported separately because the amounts are not material. The calculation is
based on a methodology that uses a one-day interval and a 95% confidence level.
The Company uses a historical simulation approach for VaR, which is supplemented
by statistical risk add-ons for risk factors that do not lend themselves readily
to historical simulation. Historical simulation involves the generation of price
movements in a portfolio using price sensitivities, and actual historical
movements of the underlying risk factors to which the securities are sensitive.
Risk factors incorporated via historical simulation include interest rate
movements, yield curve shape, general market credit spreads, equity price
movement, option volatility movement (for certain option types) and foreign
exchange movement, among others. Risk factors incorporated via add-on factors
include the risk of specific bond issuers, among others. The Company believes
that its VaR methodologies are consistent with industry practices for these
calculations.
VaR has inherent limitations, including reliance on historical data, which may
not accurately predict future market risk, and the quantitative risk information
generated is limited by the parameters established in creating the models. There
can be no assurance that actual losses occurring on any one day arising from
changes in market conditions will not exceed the VaR amounts shown below or that
such losses will not occur more than once in 20 trading days. VaR is not likely
to accurately predict exposures in markets that exhibit sudden fundamental
changes or shifts in market conditions or established trading relationships.
Many of the Company's hedging strategies are structured around likely
established trading relationships and, consequently, those hedges may not be
effective and VaR models may not accurately predict actual results. Furthermore,
VaR calculated for a one-day horizon does not fully capture the market risk of
positions that cannot be liquidated in a one-day period. However, the Company
believes VaR models are an established methodology for the quantification of
risk in the financial services industry despite these limitations. VaR is best
used in conjunction with other financial disclosures in order to assess the
Company's risk profile.
56
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The aggregate VaR presented here is less than the sum of the individual
components (i.e., interest rate risk, foreign exchange rate risk, equity risk),
due to the benefit of diversification among the risks. Diversification benefit
equals the difference between aggregate VaR and the sum of the VaRs for the
three risk categories. This benefit arises because the simulated one-day losses
for each of the three primary market risk categories occur on different days and
because of general diversification benefits introduced when risk is measured
across a larger set of specific risk factors than exist in the respective
categories; similar diversification benefits also are taken into account across
risk factors within each category. The following table illustrates the VaR for
each component of market risk as of May 31, 2005, November 30, 2004 and May 31,
2004. Commodity risk has been excluded due to immateriality at May 31, 2005,
November 30, 2004 and May 31, 2004.
May 31, November 30, May 31,
(in millions) 2005 2004 2004
---------------------------------------------------------------
MARKET RISK
Interest rate $ 23.9 $ 15.3 $ 16.3
Currency 3.4 1.4 1.4
Equity 2.5 2.8 2.7
Diversification benefit (6.9) (4.7) (3.8)
---------------------------------------------------------------
Aggregate VaR $22.9022.9 $14.8014.8 $ 16.6
===============================================================
The table below illustrates the high, low and average (calculated on a daily
basis) VaR for each component of market risk and aggregate market risk during
the 2005 second quarter:
(in millions) High Low Average
-----------------------------------------------------------
MARKET RISK
Interest rate $ 27.2 $ 15.5 $ 20.8
Currency 3.4 0.0 1.1
Equity 5.1 1.1 2.8
Aggregate VaR 23.4 12.5 17.8
-----------------------------------------------------------
As previously discussed, the Company utilizes a wide variety of market risk
management methods, including trading limits; marking all positions to market on
a daily basis; daily profit and loss statements; position reports; daily risk
highlight reports; aged inventory position reports; and independent verification
of inventory pricing. Additionally, management of each trading department
reports positions, profits and losses and notable trading strategies to the Risk
Committee on a weekly basis. The Company believes that these procedures, which
stress timely communication between traders, trading department management and
senior management, are the most important elements of the risk management
process.
Stress testing (also referred to as scenario analysis) measures the risk of loss
over a variety of extreme market conditions that are defined in advance. Stress
testing is a key methodology used in the management of market risk as well as
counterparty credit risk (see "Credit Risk"). Stress tests are calculated at the
firmwide level for particular trading books, for particular customer accounts
and for particular individual positions. Stress tests are performed on a regular
basis as well as on an ad hoc basis, as deemed appropriate. The ongoing
evaluation process of trading risks as well as the consideration of new trading
positions commonly incorporates an ad hoc discussion of "what-if" stressed
market conditions and their impact on profitability. This analysis varies in its
degree of formality based on the judgment of trading department management, risk
management and senior managers. While the Company recognizes that no methodology
can perfectly predict future market conditions, it believes that these tools 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 May 31, 2005
and May 31, 2004, respectively. These charts represent a historical summary of
the results generated by the Company's trading activities as opposed to the
probability approach used by the VaR model. The average daily trading profit was
$15.3 million and $14.3 million for the quarter ended May 31, 2005 and May 31,
2004,
57
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
respectively. There were four days with a reported trading loss for the quarter
ended May 31, 2005 and the total trading loss on each of those days never
exceeded the reported aggregate period end VaR amount. During the quarter ended
May 31, 2004, there were two days with a reported trading loss and the total
trading loss on each of those days did not exceed the reported aggregate period
end VaR amount. The frequency distribution of the Company's daily net trading
revenues reflects the Company's historical ability to manage its exposure to
market risk and the diversified nature of its trading activities. Market
conditions were favorable for the Company's trading activity in both quarters
ending May 31, 2005 and May 31, 2004, respectively. Hedging strategies were
generally effective as established trading relationships remained substantially
intact and volatility tended to be lower than historical norms. No guarantee can
be given regarding future net trading revenues or future earnings volatility.
However, the Company believes that these results are indicative of its
commitment to the management of market trading risk.
58
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
DISTRIBUTION OF DAILY NET TRADING REVENUES
Quarter Ended May 31, 2005 and May 31, 2004
|
|
|
|
NUMBER |
OF | [BAR CHART GRAPHIC OMITTED - REPRESENTED BY THE PLOT POINTS BELOW]
TRADING |
DAYS |
|
|
|
|
|
|
-------------------------------------------------------------------
DAILY NET TRADING REVENUES ($ in millions)
May 31, 2005 May 31, 2004
------------------- ----------------
(10)+ - (10)+ -
(10)-(5) 3 (10)-(5) -
(5)-0 1 (5)-0 2
0-5 6 0-5 11
5-10 7 5-10 11
10-15 22 10-15 13
15-20 9 15-20 14
20-25 7 20-25 4
25-30 5 25-30 4
30+ 4 30+ 5
-- --
Total 64 Total 64
59
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Credit Risk
The Company measures its actual credit exposure (the replacement cost of
counterparty contracts) on a daily basis. Master netting agreements, collateral
and credit insurance are used to mitigate counterparty credit risk. The credit
exposures reflect these risk-reducing features to the extent they are legally
enforceable. The Company's net replacement cost of derivatives contracts in a
gain position at May 31, 2005 and November 30, 2004 approximated $4.69 billion
and $4.56 billion, respectively. Exchange-traded financial instruments, which
typically are guaranteed by a highly rated clearing organization, have margin
requirements that substantially mitigate risk of credit loss.
The following table summarizes the counterparty credit quality of the Company's
exposure with respect to over-the-counter derivatives (including foreign
exchange and forward-settling mortgage transactions) as of May 31, 2005:
Over-the-Counter Derivative Credit Exposure (1)
($ in millions)
Percentage of
Exposure, Exposure, Net of
Rating(2) Exposure Collateral(3) Net of Collateral(4) Collateral
-------------------------------------------------------------------------------------------
AAA $1,772 $ 320 $1,493 32%
AA 2,601 1,043 1,591 34%
A 2,119 1,001 1,170 25%
BBB 394 487 214 4%
BB and lower 1,321 3,056 196 4%
Non-rated 26 2 25 1%
-------------------------------------------------------------------------------------------
(1) Excluded are covered transactions structured to ensure that the market
values of collateral will at all times equal or exceed the related
exposures. The net exposure for these transactions will, under all
circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's Credit
Department, converted to rating agency equivalents.
(3) For lower-rated counterparties, the Company generally receives collateral
in excess of the current market value of derivatives contracts.
(4) In calculating exposure net of collateral, collateral amounts are limited
to the amount of current exposure for each counterparty. Excess collateral
is not applied to reduce exposure because such excess in one counterparty
portfolio cannot be applied to deficient collateral in a different
counterparty portfolio.
60
Item 4. CONTROLS AND PROCEDURES
As required by Rule 13a-15(b) of the Exchange Act, the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of its disclosure controls and procedures as of the
end of the period covered by this quarterly report. Based on that evaluation,
the Chief Executive Officer and Chief Financial Officer have concluded that the
Company's disclosure controls and procedures (as defined in Rule 13a-15(e) under
the Exchange Act) were effective as of the end of the period covered by this
quarterly report. As required by Rule 13a-15(d) under the Exchange Act, the
Company's management, including the Company's Chief Executive Officer and Chief
Financial Officer, has evaluated the Company's internal control over financial
reporting to determine whether any changes occurred during the quarter covered
by this quarterly report that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting. Based on
that evaluation, there have been no such changes during the quarter covered by
this quarterly report.
61
Part II - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
In the normal course of business, the Company has been named a defendant in
various legal actions, including arbitrations, class actions and other
litigation. Certain of the legal actions include claims for substantial
compensatory and/or punitive damages or claims for indeterminate amounts of
damages. The Company is also involved in other reviews, investigations and
proceedings by governmental agencies and self-regulatory organizations regarding
the Company's business. Certain of the foregoing could result in adverse
judgments, settlements, fines, penalties or other relief.
Because litigation is inherently unpredictable, particularly in cases where
claimants seek substantial or indeterminate damages or where investigations and
proceedings are in the early stages, the Company cannot predict with certainty
the loss or range of loss related to such matters, how such matters will be
resolved, when they will be ultimately resolved, or what the eventual
settlement, fine, penalty or other relief might be. Consequently, the Company
cannot estimate losses or ranges of losses for matters where there is only a
reasonable possibility that a loss may have been incurred. Although the ultimate
outcome of these matters cannot be ascertained at this time, it is the opinion
of management that the resolution of the foregoing matters will not have a
material adverse effect on the financial condition of the Company, taken as a
whole; such resolution may, however, have a material effect on the operating
results in any future period, depending on the level of income for such period.
The Company has provided reserves for such matters in accordance with Statement
of Financial Accounting Standards No. 5, "Accounting for Contingencies". The
ultimate resolution may differ from the amounts reserved.
Fezzani, et al. v. Bear, Stearns & Co. Inc., et al
--------------------------------------------------
As previously reported in the Company's Form 10-K for the fiscal year ended
November 30, 2004 ("Form 10-K"), Bear, Stearns & Co. Inc. ("Bear Stearns"),
Bear, Stearns Securities Corp. ("BSSC"), and a former officer of BSSC, were
named as defendants in a lawsuit brought by eleven individuals and 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
period ended February 28, 2005, by order dated March 1, 2005, the court granted
in part and denied in part plaintiffs' motion seeking permission to file an
amended complaint. Plaintiffs subsequently filed an amended complaint, which
contains many of the same allegations as the original complaint that was filed
in 1999. The amended complaint alleges claims against the Bear Stearns
defendants for violations of Section 10(b) of the Securities Exchange Act of
1934 and Rule 10b-5 promulgated thereunder, common law fraud, aiding and
abetting fraud, and 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 have filed a motion to dismiss the amended
complaint in its entirety.
McKesson HBOC, Inc.
-------------------
The following matter arises out of a merger between McKesson Corporation
("McKesson") and HBO & Company ("HBOC") resulting in an entity called McKesson
HBOC, Inc. ("McKesson HBOC"). Bear Stearns believes that it has substantial
defenses to the claims asserted in this matter.
In re McKesson HBOC, Inc. Securities Litigation.: As previously reported in the
Company's Form 10-K, beginning on June 29, 1999, 53 purported class actions were
commenced in the United States District Court for the Northern District of
California. These actions were subsequently consolidated, and the plaintiffs
proceeded to file a series of amended complaints. On February 15, 2002,
plaintiffs filed their third amended consolidated complaint, which alleges that
Bear Stearns violated Sections 10(b) and 14(a) of the Exchange Act in connection
with allegedly false and misleading disclosures contained in a joint proxy
statement/prospectus that was issued with respect to the McKesson/HBOC merger.
Plaintiffs purport to represent a class consisting of all persons who either (i)
acquired publicly traded securities of HBOC between January 20, 1997 and January
12, 1999, or (ii) acquired publicly traded securities of McKesson or McKesson
HBOC between October 18, 1998 and April 27, 1999, and who held McKesson
securities on November
62
LEGAL PROCEEDINGS
27, 1998 and January 22, 1999. Named defendants include McKesson HBOC, certain
present and former directors and/or officers of McKesson HBOC, McKesson and/or
HBOC, Bear Stearns and Arthur Andersen LLP. Compensatory damages in an
unspecified amount are sought.
On January 12, 2005, McKesson HBOC announced that it had reached a settlement
with the plaintiff class, which settlement must be approved by the Court. Bear
Stearns's engagement letter with McKesson in connection with the merger of
McKesson and HBOC provides that McKesson cannot settle any litigation without
Bear Stearns's written consent unless McKesson obtains an unconditional written
release for Bear Stearns and, under certain circumstances, is required to
provide indemnification to Bear Stearns. On May 23, 2005, the Court entered an
order denying preliminary approval of the proposed settlement.
Enron Corp.
-----------
The following matters arise out of Bear Stearns's business transactions with
Enron Corp. ("Enron").
(i) Purported Securities Actions: As previously reported in the Company's Form
10-K, Bear Stearns and numerous other defendants were named in certain actions
commenced beginning on October 15, 2002 in the Superior Court of the State of
California, state court in Iowa and the United States District Court for the
Southern District of Texas brought by purchasers of securities issued by Osprey
Trust, Osprey I, Inc., Enron and certain other entities related to Enron. The
complaints generally alleged violations of the disclosure requirements of the
federal securities laws and/or state law and common law claims, including fraud,
and seek compensatory and/or punitive damages in unspecified amounts.
The parties to the actions pending in the Superior Court of the State of
California and state court Iowa, including Bear Stearns, have reached agreements
to settle these actions and have jointly filed stipulations of dismissal for the
settled actions with the respective California and Iowa state courts.
Bear Stearns denies all allegations of wrongdoing asserted against it in the
litigation pending in the United States District Court for the Southern District
of Texas and believes that it has substantial defenses to these claims.
(ii) Enron Corp., et ano. v. Bear, Stearns International Ltd., et ano.: As
previously reported in the Company's Form 10-K, Bear, Stearns International
Limited ("BSIL") and BSSC are named defendants in an adversary proceeding
commenced by Enron and Enron North America Corp. in the United States Bankruptcy
Court for the Southern District of New York on November 25, 2003. Plaintiffs
seek, inter alia, to recover payments, totaling approximately $26 million that
they allegedly made to BSIL and BSSC during August 2001 in connection with an
equity derivative contract between BSIL and Enron.
By Order dated June 3, 2005, the bankruptcy court denied the motion to dismiss
filed by BSIL and BSSC. On July 5, 2005, defendants filed a motion for leave to
take an interlocutory appeal from the bankruptcy court's decision.
Mutual Fund Matters: Inquiries and Investigations
-------------------------------------------------
As previously reported in the Company's Form 10-K, the Company and/or its
subsidiaries have received requests for information and subpoenas from a number
of federal and state agencies seeking information in connection with mutual fund
trading investigations, including the United States Attorney's Office for the
Southern District of New York, the Securities and Exchange Commission (the "SEC"
or "Commission"), the Commodity Futures Trading Commission, the NASD, the NYSE,
the Office of the New York Attorney General and the Office of the New Jersey
Attorney General.
With respect to the investigation by the SEC, the Company has been advised by
the Staff that the Commission has authorized the Staff to bring an enforcement
action against Bear Stearns and BSSC in connection with their role with respect
to mutual fund trading. Such an action could result in, among other things,
disgorgement, civil monetary penalties and/or other remedial sanctions. While
the Company and its subsidiaries believe they have substantial defenses to the
potential claims, the Company has had recent discussions with the Staff
regarding a possible resolution of the matter.
63
LEGAL PROCEEDINGS
Research Investigation Matters
------------------------------
As previously reported in the Company's Form 10-K for the fiscal year ended
November 30, 2003, the State of West Virginia by its Attorney General had
commenced an action in the Circuit Court of Marshall County, West Virginia,
against Bear Stearns and the other securities firms that participated in the
research analyst settlement, alleging violations of the West Virginia Consumer
Credit and Protection Act. The defendant firms filed a motion to dismiss the
action on the basis that the West Virginia Consumer Credit and Protection Act,
as a matter of law, does not apply to a business organization's activities
involving the purchase and sale of securities. The circuit court denied
defendants' motions to dismiss but subsequently granted their motions to certify
this question of law to the Supreme Court of Appeals of West Virginia. By Order
dated July 7, 2005, the Supreme Court of Appeals of West Virginia held that the
Attorney General does not have the authority under the West Virginia Consumer
Credit and Protection Act to bring an action against the defendant firms based
upon their conduct relating to the general business of buying and selling
securities.
Other Investigations/Inquiries
------------------------------
Bear Stearns has been notified by the Staff of the SEC, Southeast Regional
Office, that the Staff intends to recommend that the Commission bring a civil
enforcement action against Bear Stearns in connection with Bear Stearns'
involvement in the pricing, valuation, and analysis related to approximately
$62.9 million of collateralized debt obligations that were purchased by a client
of Bear Stearns. Such an action could result in, among other things,
disgorgement, civil monetary penalties and/or other remedial sanctions.
The Company has also received a subpoena from the Office of the Attorney General
of the State of New York requesting documents related to approximately $16
million of collateralized debt obligations that were purchased by a client of
Bear Stearns.
Bear Stearns is cooperating with each of these investigations or inquiries.
64
Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The table below sets forth the information with respect to purchases made by the
Company of the Company's common stock during the second quarter of fiscal 2005:
Total Number of Shares Approximate Dollar Value of
Purchased as Part of Shares that May Yet Be
Total Number of Average Price Publicly Announced Purchased Under the Plans or
Period Shares Purchased Paid per Share Plans or Programs (1) Programs (1)
------------------------------------------------------------------------------------------------------------------------------
3/1/05 - 3/31/05 506,847 $ 101.44 506,847 $1,046,929,859
4/1/05 - 4/30/05 859,900 96.44 859,900 964,000,263
5/1/05 - 5/31/05 856,593 95.86 856,593 881,891,433
--------- ---------
Total 2,223,340 97.35 2,223,340
========= ---------
(1) On January 5, 2005, the Board of Directors of the Company approved an
amendment to the Repurchase Program to replenish the previous authorization to
allow the Company to purchase up to $1.0 billion of common stock in fiscal 2005
and beyond. The Repurchase Program has no set expiration or termination date. On
November 30, 2004, the Compensation Committee of the Board of Directors approved
a $200 million CAP Plan Earnings Purchase Authorization to allow the Company to
purchase up to $200 million of common stock in fiscal 2005.
65
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of the Company held on April 7, 2005 (the "Annual
Meeting"), the stockholders of the Company approved amendments to the Company's
Performance Compensation Plan that increase to $140 million (in aggregate for
any fiscal year) the maximum amount allocable to any Annual Bonus Pool related
to participants who are not members of the executive committee of Bear, Stearns
& Co. Inc. and to set the maximum proportionate share of any Annual Bonus Pool
for any individual participant at 30%. In addition, at the Annual Meeting the
stockholders of the Company elected twelve directors to serve until the next
Annual Meeting of Stockholders or until successors are duly elected and
qualified and ratified the appointment of Deloitte & Touche LLP as the
independent registered public accounting firm for the fiscal year ending
November 30, 2005.
The affirmative vote of a majority of the shares of common stock represented at
the Annual Meeting and entitled to vote was required for the approval of the
amendments to the Performance Compensation Plan and ratification of the
independent registered public accounting firm, while the affirmative vote of a
plurality of the votes cast by holders of shares of common stock was required to
elect the directors.
With respect to the approval of the amendments to the Performance Compensation
Plan and ratification of the independent registered public accounting firm, set
forth below is information on the results of the votes cast at the Annual
Meeting.
For Against Abstained
----------- ----------- -----------
Amendments to the Performance
Compensation Plan 97,481,299 7,379,292 790,915
Ratification of the independent
registered public accounting firm 100,594,385 4,383,756 673,365
With respect to the election of directors, set forth below is information with
respect to the nominees elected as directors of the Company at the Annual
Meeting and the votes cast for and withheld with respect to each such nominee.
Nominees For Withheld
--------------------------- --------------- -------------
James E. Cayne 100,815,402 4,836,104
Henry S. Bienen 102,162,543 3,488,963
Carl D. Glickman 98,193,586 7,457,920
Alan C. Greenberg 101,687,368 3,964,138
Donald J. Harrington 99,191,862 6,459,644
Frank T. Nickell 99,197,117 6,454,389
Paul A. Novelly 102,031,220 3,620,286
Frederic V. Salerno 98,116,057 7,535,449
Alan D. Schwartz 100,779,866 4,871,640
Warren J. Spector 100,844,571 4,806,935
Vincent Tese 97,567,487 8,084,019
Wesley S. Williams, Jr. 102,162,040 3,489,466
-------------------------------------------------------------
66
Item 6. EXHIBITS
Exhibits
(11) Computation of Per Share Earnings. (The calculation of per share
earnings is in Note 7, "Earnings Per Share," of Notes to Condensed
Consolidated Financial Statements (Earnings Per Share) and is
omitted here in accordance with Section (b) (11) of Item 601 of
Regulation S-K)
(12) Computation of Ratio of Earnings to Fixed Charges 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
67
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
The Bear Stearns Companies Inc.
-------------------------------
(Registrant)
Date: July 11, 2005 By: /s/ Jeffrey M. Farber
Jeffrey M. Farber
Controller
(Principal Accounting Officer)
68
THE BEAR STEARNS COMPANIES INC.
FORM 10-Q
EXHIBIT INDEX
Exhibit
No. Description Page
------- ----------- ----
(12) Computation of Ratio of Earnings to Fixed Charges and to 70
Combined Fixed Charges and Preferred Stock Dividends
(15) Letter re: Unaudited Interim Financial Information 71
(31.1) Certification of Chief Executive Officer Pursuant to Rule 72
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 73
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. 74
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. 75
Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
69