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Bear Stearns (NYSE:BSC)

F3Q07 Earnings Call

September 20, 2007 10:00 am ET

Executives

Elizabeth Ventura – IR

Sam Molinaro – CFO

Analysts

Guy Moszkowski - Merrill Lynch

James Mitchell - Buckingham Research Group

Glen Schorr - UBS

William Tanona - Goldman Sachs

Roger Freeman - Lehman Brothers

Mike Hecht- Banc of America Securities

David Trone - Fox Pitt Kelton

Mike Mayo - Deutsche Bank

TRANSCRIPT SPONSOR
Wall Street Breakfast

Operator

Good morning, ladies and gentlemen, and welcome to the Bear Stearns 2007 third quarter earnings conference call. (Operator Instructions) I'll now turn the conference over to Elizabeth Ventura, Head of Investor Relations and Corporate Communications. Ms. Ventura, please go ahead.

Elizabeth Ventura

Thank you very much, Lou-Anne. Good morning, everybody and welcome to our third quarter 2007 conference call. Before we get started, I'd like to take the moment to remind you that contained in this discussion are forward-looking statements. These statements reflect the firm's belief at this time and are subject to risks and uncertainties which could cause our actual results to differ materially from the statements made during this call. Please keep in mind that there are many factors that affect our business and could potentially affect or change future performance. Some examples include changes in interest rates, market conditions or the current backlog of pending transactions. In addition, our business can be greatly affected by shifts in domestic or global economic conditions.

A fuller discussion of these risks is contained in the disclosure we file with the SEC in our most recent annual report and in our quarterly reports filed on Form 10-Q. In particular, read the sections Management's Discussion and Analysis of Financial Conditions and Results of Operations, and also the Risk Management section. You can also see these documents through our website.

This audiocast is being recorded and is copyright material of the Bear Stearns Companies, Inc. and may not be duplicated, reproduced or rebroadcast without our consent.

Thank you for your attention and I'd like to turn our call over to our Chief Financial Officer, Sam Molinaro.

Sam Molinaro

Thank you, Elizabeth and good morning, everyone. Welcome again to the Bear Stearns Companies, Inc. quarterly earnings conference call for the third quarter ended August 31, 2007.

As you all know, the operating environment during the company's third quarter has been extremely challenging, as the global equity crisis coupled with the repricing of credit risk created extremely difficult markets. A record quarter for our equities and clearing businesses were more than offset by weakness in our fixed income business, which led to disappointing overall results.

Fixed income activity suffered as transaction volumes declined significantly and inventory valuations came under severe pressure. Investor concerns over the sub-prime mortgage market spread to the CDO market, which in turn caused greater concern over all ratings-based structured credit products. Reflecting this concern, asset-backed commercial paper investors grew uneasy with conduit holdings of residential mortgage-backed securities assets, which resulted in commercial paper outstandings declining by over $200 billion and forcing the liquidation of approximately $20 billion of AAA-rated mortgage assets.

In addition, the supply/demand imbalance in the leverage loan market caused investors to demand greater credit protection and improved pricing, which has served to substantially restrict the market's ability to distribute the loans.

As a result of these extraordinary market conditions, our net revenues declined meaningfully to $1.33 billion, a 38% decline from $2.1 billion in the year-earlier period, and a 47% decline from $2.5 billion in the May quarter. Earnings per share for the company's third quarter of fiscal 2007 were $1.16 per share, a decrease of 62% when compared to $3.02 per share in the August 2006 quarter. Sequentially, third quarter earnings declined 54% from $2.52 per share earned in the second quarter of fiscal 2007.

The significant decline in net revenues for the quarter, when compared to both the prior year and sequential quarter, reflects both a substantial decline in fixed income revenues and a significant reduction in revenues from our asset management business. Fixed income revenues declined significantly, as credit risk was repriced and markets became illiquid. U.S. residential mortgage activity suffered as origination and securitization volume shrank and dramatic spread widening across the rating spectrum served to reduce inventory values. The repricing of credit risk by investors in the non-investment grade corporate debt market caused leverage finance pipelines to become frozen and resulted in write-downs of our leverage commitments. As a result, revenues attributable to our U.S. mortgage and leverage finance areas declined sharply, reflecting inventory revaluations and lower activity levels.

Difficult global market conditions and the failure in July of the BSAM-managed high grade structured credit funds caused asset management revenues to turn to a loss of $186 million when compared to $105 million of net revenues in the August 2006 quarter. Included in the quarterly results are approximately $200 million of losses associated with the failure of the high grade funds, representing the write-off of our investment and fees receivable, losses from the liquidation of the $1.6 billion repo facility provided to the high grade fund, and other directly related expenses. In addition, weaker operating performances from our alternative investment products resulted in the reversal of previously accrued performance fees and losses on various hedge fund investments.

While fixed income and asset management results suffered from the extreme market conditions, revenues in our institutional equity and global clearing service areas increased to record levels. Institutional equities achieve record results during the quarter on increased customer volumes and volatility. Global clearing services revenues also reached record net revenues, as average quarterly customer balances increased and transaction volumes rose.

The strong results experienced by our equities and global clearing areas provide further evidence of the success of our strategy of merging these franchises. While still in the early stages, we continue to see significant benefits from this combination in servicing our clients and increasing our share of their activities.

Net revenues from our international activities increased to $537 million, a 98% increase when compared to $271 million earned in the third quarter of 2006. The significant increase in international revenues when compared to the prior year reflects record equity in interest rate derivative revenues and a substantial increase in Asian-based revenues. These increases were partially muted by inventory markdowns in mortgages and leverage finance and reduced arbitrage revenues.

Year to date, international revenues are $1.5 billion, an increase of 70% over the $878 million earned in the nine month period of a year ago. International revenues on a year-to-date basis now account for approximately 25% of consolidated revenues, having exceeded what we earned in all of 2006.

We remain optimistic about the continued prospects for growth outside the U.S. and committed to our plans to continue expanding. In fact, our international headcount increased over 2,000 people, as we added across our equity and fixed income franchises both in Europe and Asia.

Clearly our performance this quarter was adversely impacted by extremely difficult market conditions experienced in the fixed income markets and losses incurred from the failure of the BSAM-managed high grade funds. However, we remain committed to our core strategy of expanding our equity and global clearing franchise, increasing the diversification of our fixed income franchise through growth in credit and interest-rate products and the continued development of our international activities.

In our asset management area, we've moved quickly to restore investor confidence and have added seasoned leadership to the effort. While the failure of the high grade funds have had significant financial cost during the quarter, our counterparty exposures have been dramatically reduced and we've hedged remaining assets.

If I could ask you now to please turn your attention to our segment data contained in our earnings release I'll review each of our three major business segments: capital markets, global clearing services, and wealth management. Capital markets' net revenues, which include institutional equities, fixed income and investment banking were $1.05 billion for the quarter, a decrease of 36% from $1.65 billion in the August 2006 quarter and a 44% decline from $1.86 billion earned in the May 2007 quarter.

Institutional equities net revenues increased 53% to a record $719 million when compared to $471 million earned in the August 2006 quarter. Sequentially, institutional equity net revenues increased 32%, from $543 million earned in the May 2007 quarter. Domestic and international cash equity sales areas achieved strong results associated with increased customer volumes. In particular, international equity revenues increased over 50% on a market share gains and increased volumes.

Structured equity product revenues increased by $225 million when compared to our record performance in the May 2007 quarter, principally reflecting gains in our structured notes portfolio. Let me expand a bit on the gains in the structured note portfolio.

As part of our structured equity products franchise, we issue structured notes to various investors which contain imbedded derivative contracts which enable these investors to express a market view on stocks, baskets or indices around the world. These notes are dynamically hedged as part of our normal trading operations for equity, interest rate and credit exposures. As required by FAS 155, we account for these securities on a mark-to-market basis, with gains and losses reported in revenues.

During the quarter, significant increases in our credit spreads caused the short positions to decline in value and resulted in net portfolio gains. These results were partially offset by lower risk arbitrage revenues, which declined during the quarter as the market was hurt by tightening credit conditions, volatile markets and investor doubts about M&A activity. Energy revenues also declined, reflecting gains recognized in the 2006 period associated with the monetization of certain power assets. However, we continue to make substantial progress in the development of our energy operations and will close on our acquisition of the Williams Power portfolio on October 1, 2007.

Fixed income net revenues for the third quarter were $118 million, down 88% from $945 million earned in the August 2006 quarter. Sequentially, fixed income revenues decreased 88% when compared to the $962 million earned in the May 2007 quarter. Net inventory markdowns of approximately $700 million were recognized during the quarter, primarily related to mark-to-market losses experienced in residential mortgages and leveraged finance activities.

Mortgage revenues were a loss of the quarter, reflecting inventory markdowns in both whole loan collateral and residential and commercial mortgage-backed securities inventories, partially offset by gains on various cash and derivative hedges. Reflecting the exceptionally weak capital market conditions experienced in the residential mortgage markets, origination volumes declined significantly. As a result, MBS revenues suffered from a significant decline in securitization and trading volumes during July and August, which reduced customer-driven revenue levels. Declining revenue levels associated with the inability to securitize and distribute mortgage assets served to exacerbate the impact of inventory markdowns on mortgage revenues.

While market conditions have made normal business activities in the mortgage area difficult, we have moved aggressively to reduce risk and increase liquidity. Net exposure to sub-prime assets remains small and we've continued to reduce inventory of whole loan residential mortgage assets. At the end of August, the company had approximately $50 billion of mortgage and asset-backed inventory. Included in the inventory are sub-prime mortgage loans of $1.4 billion, representing 2007 vintage production, and $700 million of investment-grade sub-prime securities and $313 million of below investment-grade retained interests.

Currently, our mortgage and asset-backed inventory stands at approximately $45 billion, down 10% from quarter end. The above amounts do not include short positions which serve to offset a substantial portion of the risk.

At quarter end, the company held $9.6 billion of retained interest in our own mortgage-backed security securitization. In the month of August, we securitized a substantial portion of our domestic residential whole loans. Accordingly, the portions of those securities that haven't been sold have been mark-to-market and are included in retained interests. The $2.3 billion increase in retained interest when compared to the prior-quarter end largely represent investment-grade securities split between 2007 vintage prime and Alt-A loans. The non-investment grade portion of retained interest is unchanged at $1.5 billion when compared to the May quarter end.

Also adding to the decline in fixed income net revenues were losses experienced in the credit products area, as leverage finance exposures were marked to market. The large supply of pending leverage finance activity, together with investor concerns over debt covenants and terms, serve to dramatically reduce liquidity and price in the leverage finance market. While hedges provide some relief, cash assets significantly under perform CDS, resulting in losses. In addition, the increased investor concern around the higher probability of corporate defaults served to reduce revenues in credit trading.

With respect to our pipeline of leveraged finance commitments, we have provided market value reserve adjustments where the loss on the loans are expected to exceed the fees on the deal and pricing flux. During the quarter we recorded markdowns of approximately $250 million on our pipeline of leveraged finance commitments and loans. Our pipeline of outstanding leveraged finance commitments at August 31, 2007 were $7.6 billion, down from $20.8 billion at May 31, 2007.

Partially offsetting the declines in credit and mortgages were record net revenues from interest rate products as global volatility and higher customer volumes served to increase interest rate product net revenues when compared to the prior year. As a result, interest rate derivatives and foreign exchange revenues increased on higher volumes and volatility.

Investment banking revenue for the company's third quarter, excluding merchant banking revenues were $241 million, a 9% increase when compared to $222 million in the August 2006 quarter and a 29% decrease when compared to $338 million earned in the May 2007 quarter. Underwriting revenues for the third quarter were $92 million, a slight decline from $93 million earned in the August 2006 quarter, primarily reflecting a more difficult fixed income capital markets environment, partially offset by higher equity underwriting revenues. Equity underwriting revenues increased when compared to the August 2006 quarter on higher volumes of equity follow on and convertible new issue activity. Sequentially, underwriting revenues decreased 53% from $196 million earned in the May 2007 quarter, due to a decline in equity and high-yield underwriting activity reflecting the more difficult market conditions.

M&A and advisory revenues were $148 million for the third quarter, a 12% increase when compared to $132 million in the August 2006 quarter. Sequentially, M&A revenues increased 5% when compared to the $141 million earned in the May 2007 quarter.

As a result of the exceptionally difficult market environment for leveraged finance, M&A and leverage buyout activities have declined and equity market volatility has reduced the backlog of equity offerings. Accordingly, our M&A and underwriting assignments at the end of the quarter have decreased from the record levels achieved at the end of the May 2007 quarter. However, our backlog levels remain substantially above those at the beginning of the year, reflecting an increase in our filed equity backlog and increased M&A assignments.

During the quarter, we advised that a number of important announced transactions, including advising Blackstone Real Estate Advisors in their $20 billion acquisition of Hilton, Fidelity National Information Services in their $1.8 billion purchase of eFunds, Southern Air in their sale of their company to Oakhill, and Rural Cellular Corporation in their $733 million sale to Verizon Wireless.

Included in Investment Banking net revenues are revenues generated from our merchant banking activities. For the current quarter merchant banking revenues were a loss of $29 million when compared to a gain of $10 million in the August 2006 quarter and a gain of $19 million in the May 2007 quarter.

Global clearing services net revenues rose 30% to a record $332 million when compared to $255 million in the August 2006 quarter. Net interest revenues were again a record, rising 35% to $259 million from $192 million in last year's quarter, as average prime broker margin debt and customer short balances reached record levels. Clearance commission and other revenues increased 16% to $73 million from $63 million in the year-ago quarter on increased customer activity. Sequentially, Global Clearing Services revenues increased 5% when compared to the $317 million earned in the May 2007 quarter.

During the quarter, average customer margin balances increased 49% to a record $102 billion from $69 billion in the August 2006 period and up 7% from $95 billion in the May 2007 period. Average customer short sale balances were a record $102 billion, up 24% from $82 billion in the August 2006 period and up slightly from the $102 billion in the May period. Average securities borrowed balances were $70 billion, up 27% from $55 billion in the August 2006 period and up 4% from $67 billion in the May quarter.

Growth in average customer margin balances reflects a combination of higher balances from existing prime brokerage clients as well as increased balances from new accounts. Equity and client accounts at August 31, 2007 increased 3% to $284 billion when compared to $274 billion at August 31, 2006. Quarter end customer margin balances were $85 billion, customer short balances were $82 billion, and securities borrowed balances were $60 billion.

The decline in customer margin debt and short balances are attributable to [quant]-based strategies and certain other prime broker clients deleveraging in August due to the challenging market environment, as well as a few clients reallocating positions to other prime brokers in early August. Since the first half of August, customer balances have stabilized and we are continuing to attract new business.

Wealth management net revenues for the quarter were a loss of $38 million when compared to $233 million in the August 2006 quarter. Private client services net revenues rose 15% to $148 million from $128 million earned in the year-ago quarter, primarily reflecting growth in fee-based revenues and commissions. Fee-based assets and PCF customer accounts increased 16% to $10.9 billion at the end of the quarter when compared to $9.4 billion in the year-ago period.

Asset management revenues for the quarter were a loss of $186 million, down from a gain of $105 million earned in the August 2006 quarter. The decrease in asset management revenues when compared to the 2006 quarter is primarily attributable to losses of $200 million associated with the failure of the Bear Stearns high-grade funds. In addition, the crude performance fees turned negative during the quarter, reflecting declines in alternative investment fund performances and proprietary investments given the difficult market environment.

Sequentially, wealth management revenues decreased 111% from the $341 million earned in the May 2007 quarter, reflecting the substantial decline in asset management revenues. While asset management revenues declined the significantly during the quarter, reflecting difficult and volatile market conditions experienced in several of the BSAM funds and losses associated with the high grade funds, total assets under management at August 31, 2007 were $57.8 billion, an increase of 15% when compared to $50.2 billion at August 31, 2006. Sequentially, assets under management are down 3% from the levels at May 2007.

Despite the negative quarterly performance, year-to-date asset management revenues, excluding the impact of the high-grade hedge fund losses, are up 28% to $285 million, reflecting growth in both management and performance fees.

Moving to expenses. Total expenses were $1.16 billion, down 21% from the year-ago quarter and down 41% from the May 2007 quarter. The decline in total expenses is primarily due to lower employee compensation and benefits expenses, which decreased both sequentially and year over year. The sequential decrease in expenses is also impacted by the $227 million writedown for the impairment of goodwill and specialist rights related to our New York Stock Exchange specialist activities, which occurred during the May 2007 quarter.

Employee compensation and benefits for the third quarter were $664 million, a decrease of 35% from $1.02 billion in the third quarter of 2006. Sequentially, employee compensation and benefits decreased 46% from $1.23 billion in the May 2007 quarter. Compensation of net revenues for the third quarter of 2007 was 49.9% when compared to 48.1% in the third quarter of 2006 and 49% in the May 2007 quarter.

Non-compensation expenses were $492.4 million for the quarter, an increase of 13% when compared to $437 million in the August 2006 quarter. The increase in non-compensation-related costs, when compared to the August 2006 quarter, is primarily related to increased transaction-related costs associated with higher business volumes, as well as higher occupancy, communications and technology costs associated with an increase in worldwide employee headcount. Advertising and market development cost and professional fees also rose, reflecting increased business activities as well higher recruiting-related expenses.

Partially offsetting these increases is a decrease in other expenses, which declined on lower cap plan-related costs. Sequentially, non-compensation-related expenses, excluding the write-down for impairment of goodwill and specialist rights during the May quarter decreased 3%.

Cap plan-related expenses were $4 million during the quarter, down from $30 million in the August 2006 quarter, attributable to the decreased level of earnings and lower effective tax rate. Sequentially, cap plan-related expenses decreased from $32 million in the May 2007 quarter.

Our tax rate for the quarter declined to only 2%, reflecting the significant decline in pretax earnings and relatively fixed level of tax preference items. As a result, our year-to-date tax rate declined to 30.5% versus 34.7% for the full fiscal year of 2006.

Book value at August 31, 2007 was $91.82 per share with 144.6 million shares outstanding. Book value declined slightly during the quarter, reflecting the impact of share repurchases and employee stock compensation plans. During the quarter, we repurchased 3.5 million shares of common shock at an aggregate cost of $495 million. Of this amount, approximately $225 million was acquired by the company as a share repurchase.

In addition, the board of directors has just approved an increase in the total share repurchase authorization to $2.5 billion, including $1 billion for corporate share buybacks. The board's decision to enact a corporate share repurchase program at this time reflects the stock's current valuation levels and the company's current capital requirements.

I'd like to make a few additional comments on some other important concerns. There's been a great deal of discussion in the press and in the marketplace regarding the difficulties in determining the fair value of inventory given the lack of market liquidity. At Bear Stearns, we mark our inventory to market levels that we can observe in the marketplace. We've taken the view that the stress markets are the markets and that inventory should be marked at levels that transactions are occurring. Of course we do have inventory that does not actively trade in the market. In those cases, we rely on valuation models that utilized observable market inputs in determining fair value. These valuations can typically be benchmarked against transactions in similar products or assets taking place in the market.

During fiscal 2007, we began disclosing a categorization of the assets and liabilities that are recorded at fair value. FAS 157 provides for a level 1, 2 and 3 hierarchy which ranges from exchange-traded instruments through model-based fair values. At May 31, 2007, approximately 4% of the firm's assets were considered level 3 assets. Given the lack of liquidity in the marketplace for many instruments, it is reasonable that some assets we choose to be level 2 assets will move to level 3, but we haven't completed the review for 10-Q disclosure. It is not expected that the amount of level 3 assets will increase materially.

A brief comment on aggregate market risk statistics. Firm-wide VaR at the end of the quarter increased approximately 20% to $34 million when measured against the May 31, 2007 amount. While the company reduced positions and risks during the quarter, the increase on VaR is primarily the result of the significant increase at market volatility during the quarter.

With respect to our balance sheet capital and liquidity position, our profile has never been stronger. As of August 31, 2007, stockholders equity was $13 billion and total capital was $78.1 billion. During the quarter we moved to enhance our liquidity position by reducing our balance sheet, reducing commercial paper outstanding, and increasing our cash liquidity pool. Our approach to liquidity risk management ensures that we are able to meet all unsecured debt maturities over the next 12 months without issuing additional unsecured debt or liquidating assets.

Over the last several months we have materially reduced reliance on short-term unsecured funding while simultaneously building excess liquidity at the parent company. Commercial paper outstanding currently stands at $3.6 billion compared to $11.4 billion and $20.7 billion at May 31, 2007 and November 30, 2006 respectively. The firm's parent company liquidity pool, which consists of very high-quality money market instruments, stands at a record $19 billion versus $17.6 billion at the end of May. In addition, readily available secured and unsecured committed bank lines are approximately $8 billion.

At the end of August, the balance sheet was approximately $395 billion, which is down from $423 billion at the end of the May quarter and gross leverage has declined to approximately 29.9 times from 31.2 times at the end of the prior quarter. Given the balance sheet and capital trend of the third quarter, the firm has substantial cash capital surplus at August 31st.

Before opening the call to your questions, I'd like to make just a few concluding comments. The significant decline in fixed income revenue this quarter are a direct result of the lack of global liquidity and price declines in mortgage and leverage finance assets, which resulted in inventory mark-to-market losses, not a decline in the revenue capacity of the franchise. Mortgage revenues will likely decline in the short run, as liquidity slowly returns to the market and origination moves towards agency-guaranteed products and away from non-agency Alt-A and sub-prime. As a result, aggregate U.S. mortgage origination volumes will likely decline to approximately $2 trillion in 2008 and agency market share will return to the historical levels of 2001 through 2004. We will adjust the cost structure of our current origination efforts to meet market volumes and we'll reposition our franchise to focus on agency and jumbo prime mortgages.

As a leading underwriter of MBS for the past 17 years, we believe our ability to analyze, structure and distribute credit and prepayment risk will enable us to continue to compete effectively in the future. We are already focusing our Bear Res platform to focus on FHA, Fannie Mae, and federal home loan banks and jumbo prime production and the overhaul of our EMC servicing platform should provide capacity and scalability to take advantage of market opportunities.

Recently we've seen signs of improvement in the mortgage and asset-backed markets, as well as the leverage finance markets, as real money investors have begun to establish market clearing levels. We expect market conditions in the MBS sector will to continue to stabilize as deleveraging and asset-backed commercial paper liquidation subside. High-quality mortgage assets, with little exposure to default and losses, are now trading at historically wide spreads and represent an attractive investment opportunity. We are already seeing large amounts of capital amassing, seeking to exploit the current market environment to acquire mortgage security, structured credit and leverage finance loans.

As for the credit markets, low historical default rates and a growing U.S. economy should provide support to a market coping with an oversupply of leveraged financings. In fact, recent market activity would suggest this process is already under way and longer term, the adjustment of credit terms, leverage and pricing should be healthy for the leveraged finance market.

As a result, we believe the earnings capacity of our fixed income franchises is firmly intact. Highly-rated structured credit securities in residential, commercial, CDOs and CLOs will likely see price improvement as liquidity returns to the market. This should provide trading opportunities as clients look to reposition their portfolios or exploit valuation inefficiencies. The expected reduction in the supply of new non-agency MBS securities in 2008 should also provide support for spreads over the next six to 12 months.

Accordingly, we expect to see a substantial recovery in mortgage and credit trading revenues. We think the worst is largely behind us. We've marked our positions down, reduced risk and freed up balance sheet capacity.

We've made great strides in 2007 to build our franchise through significant investments in our international businesses, the development of our energy platform, and the evolution of our equities and clearing businesses into a cohesive unit. The returns on those investments are evident in the quarter results.

Finally, as we mentioned in the press release, we'll be conducting an investor conference on October 4th. It's impossible in the course of an earnings call to adequately cover the status of our businesses and our strategy going forward. Accordingly, we've planned a half-day session with member of senior management to discuss the firm's businesses.

With that we'll open up the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions)The first question comes from Guy Moszkowski - Merrill Lynch.

Guy Moszkowski - Merrill Lynch

Good morning, Sam. You gave us some numbers on your leveraged loan charges. Would you be able to give us your funded leveraged finance loans as of the end of the period?

Sam Molinaro

I think our funded loans are about $2 billion at period end.

Guy Moszkowski - Merrill Lynch

Did you give us what your commitments were at period end as well?

Sam Molinaro

We did, the commitment balance is $7 billion.

Guy Moszkowski - Merrill Lynch

The $250 million that you talked about as the writedown, was that a net of fees number?

Sam Molinaro

Yes.

Guy Moszkowski - Merrill Lynch

Can you tell us what it was gross of fees?

Sam Molinaro

Guy, I don't have that number. It is imbedded in the forward pipeline so I don't have that number. We can try to get back to you on that.

Guy Moszkowski - Merrill Lynch

That would be real helpful. On the mortgage side, I think I heard you say that your residuals you were up about $2.5 billion versus the end of the second quarter, is that correct?

Sam Molinaro

During the course of the quarter, we securitized substantially all of our whole loan inventories and our retained increased by about $2 billion during the period. That is total retained interest. The vast majority of that are investment grade rated prime and Alt-A retained interest. Our non-investment grade rated retained interests are essentially unchanged from the prior quarter end.

Guy Moszkowski - Merrill Lynch

That was about one and a half, right

Sam Molinaro

That's right.

Guy Moszkowski - Merrill Lynch

The total at the end of the second quarter was $7 billion, so it is correct to think of that number as being something about 9 now?

Sam Molinaro

That's right.

Guy Moszkowski - Merrill Lynch

The share repurchase, I assume based on the price which I think your average price was around 140, that most of that took place before mid to late July?

Sam Molinaro

Yes, that's right.

Guy Moszkowski - Merrill Lynch

Another question on the fixed income and structured product side overall. You alluded to some liability benefit, but I think you alluded to it in the context when you were talking about the equities business, is that correct? In other words, the mark-to-market on the structured product because of the widening of your credit spreads.

Sam Molinaro

Right. In our structured equity products business, we are a substantial issuer -- substantial for us, at any rate – a substantial issuer of structured notes. Structured equity product revenue were up about $225 million quarter to quarter; substantially all of that was a result of the gains recognized in that structured note portfolio.

Guy Moszkowski - Merrill Lynch

You didn't have any similar type gains that helped the fixed income business?

Sam Molinaro

Not material.

Operator

Your next question comes from James Mitchell - Buckingham Research Group.

James Mitchell - Buckingham Research Group

I want to confirm you said $700 million in markdowns; negative marks?

Sam Molinaro

Right.

James Mitchell - Buckingham Research Group

That includes the 250, or is the 250 in addition?

Sam Molinaro

The $700 million is a net number. The 250 is a gross number, but it is inclusive in there.

James Mitchell - Buckingham Research Group

The 250 is gross and it is inclusive, whatever the net is, is in the $700 million.

Sam Molinaro

Yes.

James Mitchell - Buckingham Research Group

All that would be in fixed income?

Sam Molinaro

Yes.

James Mitchell - Buckingham Research Group

Given your discussion about the capacity of the fixed income business still intact, is it fair to say if prices were flat, all else being equal that $700 million goes away and that would be an uptick in fixed income? Is that the way we should think about that?

Sam Molinaro

I think that is fair to say.

James Mitchell - Buckingham Research Group

Volume and things like that, but that is not an incorrect statement?

Sam Molinaro

Right.

James Mitchell - Buckingham Research Group

Obviously we have to think of the offset in the structured products which would go away if your spread is tight.

Sam Molinaro

Exactly. Though I would point out, Jim, on that there is an awful a lot of attention being given to this structured notes issue. If you can indulge me for a minute. The way we look at this structured notes business, we are issuing securities to investors. These are essentially marketable securities that get mark-to-market by them and us. They are trading instruments. They do get traded. Generally the way customers exit those trades is by selling them back to us. The fact is that we had a policy of not hedging the credit exposures imbedded in that portfolio given the fact we have been issuing these over the last several years at what were then very tight credit spreads for not only us but for the industry. That posture may change going forward, but we think that the gains that are recognized there while it is an accounting change, the accounting change was, I believe, granted to allow dealers like us to reflect the true economics of this business.

James Mitchell - Buckingham Research Group

Fair enough, but you wouldn't expect that level of gains going forward?

Sam Molinaro

Right. I was trying to address that; you may not see a reversal of it.

James Mitchell - Buckingham Research Group

Can you talk about the impact of the commodities acquisitions at Williams? It is not insignificant. Should we expect that to be material in the quarter or accretive or neutral? How should we think about that?

Sam Molinaro

That acquisition of the Williams asset has many valuable attributes for us. One is it gives us a much bigger profile in the energy markets which we think will be additive next year and next quarter to our results. But more importantly, we think it is a tremendously attractive acquisition of assets. We think this is really a groundbreaking event in the evolution of our energy business, and we are very excited about it.

James Mitchell - Buckingham Research Group

Is there any timing discussion from your perspective on the buyback that we should look at that $1 billion in corporate buybacks and view that as a net buyback potential, above and beyond neutralizing share origination to employee? Is there a timeframe you are looking at that?

Sam Molinaro

That will begin soon, obviously dictated by market conditions. But that will begin soon.

Operator

Your next question comes from Glen Schorr - UBS.

Glen Schorr - UBS

One last point on the status 159 adjustments. Did you disclose it? I couldn't find the Q, specifically, how large the structured note book outstanding is?

Sam Molinaro

I don't think we do and I don't know that number so we can try to get back to you. I don't have the exact number.

Glen Schorr - UBS

You said a comment just on the last question of you could potentially hedge so you don't necessarily expect a full reversal if let's say hypothetically, spreads start to tighten. How do you do that, and why? In other words, what is beautiful about the FAS 159 is that it is like a beautiful accounting macro hedge against your overall business.

Sam Molinaro

But I don't think it is just an accounting issue. I think that left to their own devices, any derivatives trading desk any place on The Street would look to hedge all of the attributes of the risk of the securities that they are selling. We took a policy decision, as I suspect many other people did in light of the market environment, to not have them hedge that.

The issue is, if spreads were to tighten dramatically, obviously you are giving profit opportunity back. Our view had been it didn't make sense to do that and that may be reconsidered. I am not telling you exactly what we are going to do with that, but I think this is getting a lot of attention. I think the gains are real. It really reflects the change in fair value. There is somebody on the other side of that trade who lost money.

Glen Schorr - UBS

We will take it offline. Theoretically, if everybody owned the structure notes to maturity --

Sam Molinaro

But that is not what happens generally. They trade them and they don't get held to maturity and obviously there are hedging strategies that can be employed without simply selling protection on your own company. So there are a variety of different ways to do that. I am not going to get into all the details of it, but I think it is fair to say that the fair value of that portfolio was impacted by the change. There is somebody on the other side of that trade that was impacted by it.

Glen Schorr - UBS

If you take the 250 out of the 700 -- or am I doing apples and oranges? I want to strip out the leverage lending component of the 700.

Sam Molinaro

It is a little bit apples and oranges, but you are directionally going in the right place.

Glen Schorr - UBS

So directionally, the other 450 it is fair to say it is primarily mortgage asset-backed CDO related to positions that are in your book, and commitments?

Sam Molinaro

Yes. It is primarily related to the mortgage and asset-backed businesses globally reflecting the change in value of mortgage assets across the capital structure and across the prime, Alt-A and sub-prime sectors.

Glen Schorr - UBS

Inside asset management, is there anything you can help us with in terms of a breakdown on what is reversal versus what is charged? It went down a little bit in the quarter but not tremendous. What people want to piece together is what's a normalized world where performance fees don't go up or down and you don't have a charge.

Sam Molinaro

Well, you can pull out the $200 million from the high grade funds. So that gets you started in the right direction. We had probably about $125 million worth of reversals of performance fees and losses; most of our alternative investment strategies we have seed investments in them, so losses across the board in a variety of different strategies from our own investment.

I would say the reason that we gave the asset management numbers on a year-to-date basis stripping out the impact to the high grade funds was to give you a sense of what we think is the quarterly run rate to what that business is capable of generating which I would put somewhere between $75 million and $100 million a quarter. That's made up of management and some normalized level of performance fees.

Glen Schorr - UBS

So then summing it all up after the things we just discussed and you can even leave 159 off on the side. If you take a look at a bunch of these charges and assume to Jim's point the steady state world, is it far to say that you feel you could be back in the mid-teens ROE in the not too distant future? Without making predictions, of course.

Sam Molinaro

Glen I was just going to say, I don't want to start to try to make predictions. Clearly the markets while they are showing some signs of improvement, I don't want to say significant, but signs of improvement and we think the worst is behind us and the Fed rate cut is definitely a positive step in that direction, when we see some normalized level of liquidity in the market again is probably going to be influenced significantly by what is happening in the asset-backed commercial paper markets.

Not until we can see some normalized level of liquidity return to the markets can things get back on track. However, I would say from looking at normal, historically looking at market dislocations that have happened, these phenomena tend to run for a quarter, maybe two quarters at most. So I would say some time in 2008, business activity will get back to normal levels where customers can utilize leverage again to buy securities and in that environment, I would say absolutely we can earn those kind of returns.

We don't see any permanent damage in our fixed income franchise at all. We think that fundamentally the business is very sound. Clearly we ran into an extremely difficult market environment that hit two large business units.

Operator

Your next question comes from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

A quick clarification, I want to make sure I understand. The 225 that you benefited from the widening of your spreads was in the equities line. If I were to exclude that your equities revenues were down 10% sequentially. Is that right?

Sam Molinaro

That's right. That was influenced by declines in risk arbitrage revenues during the quarter. On a sequential basis, May was a very strong quarter. Obviously this was a more difficult quarter in risk arbitrage.

William Tanona - Goldman Sachs

Very similar to Morgan Stanley's results.

Sam Molinaro

Right.

William Tanona - Goldman Sachs

In terms of talking about not having permanent damage in the fixed income business, I wanted to just get your thoughts and assessments on other parts of the business like prime brokerage. I know you mentioned that some customers had switched balances and things had stabilized there. If you could give us an update as to why people were leaving and how you feel about that business as well as the collateral damage you might have suffered on the asset management business and what you might be doing to try to bolster that business once again?

Sam Molinaro

Sure. In the prime brokerage side. Certainly in early August at the height of the crisis if you will in the marketplace, we had a combination of many hedge funds being in money-losing positions, particularly in the quant strategies which suffered so significantly in the early August. So with the stress at many of the funds themselves, together with the market dislocation that was going on, candidly I think the noise around us was more than some could handle from the standpoint of dealing with their own investors. We did see some balance migration going to other prime brokers.

I would point out though, importantly, that was relatively limited and we saw very few situations where clients moved their entire business. What we really saw were clients trying to be more defensive and moving balances in many cases into the hands of the banks where they felt there was a stronger hand, if you will.

So I think as the crisis passed in mid-August, things have returned to normal state. We are in dialogue with many, if not all, of those clients about bringing business back. Most are very receptive to do that. So we think that it was a bit of a crisis mentality, but we think that the worst is behind us there and business is normalizing and returning.

The good news is that the merger of our equities and prime brokerage franchise and the benefits of that were never more pronounced in my view than what we saw during the month of August, because we were able to rally around these clients with the full capabilities of the firm, which I think made a dramatic difference in our ability to retain business.

I think that the outlook for the business is very strong. I think we have been able to do a much better job of providing services in a much more seamless way to our prime broker clients. I think they are receptive to that. We think that both businesses have a very bright future as we leverage the relationship between the two complementary businesses.

As it relates to asset management, obviously the situation with the high grade funds has been not only a major distraction in the management of the BSAM franchise, but also candidly has inflicted some damage on the franchise and reputation of that business which we are dealing with. Certainly the move to hire Jeff Lane was a big step in that direction. Jeff is obviously a seasoned pro and brings a lot of credibility to the business and we are in the process of trying to reassure clients that their money is in good hands here, and that we run a professional operation that is looking out for their interests. We think that, at least as far as we could tell, seems to be successful. Obviously it is very early. We have a lot of work to do there but what I can tell you is we are working hard at trying to do that.

William Tanona - Goldman Sachs

Jeff obviously did a very good job at Neuberger Berman and at Lehman Brothers in terms of building up their franchise. Will the strategy now be more of a focus on long only business as opposed to the prior strategy where you had a greater push on the alternatives business?

Sam Molinaro

There will definitely be greater emphasis on the long-only strategies. I don't want to say that we are leaving the alternative investment business. We will certainly look to possibly retool it a bit. The alternative business is important to us. We have a number of very good managers in there who have done a very good job for their clients and we are going to continue to be committed to that.

William Tanona - Goldman Sachs

Lastly just one housekeeping item. On page 6 of the release, your first footnote is missing as it relates to the private client services. So I wanted to see what line item we are missing in terms of the highlight.

Sam Molinaro

Footnote 1 is actually just breaking down the PCS revenues gross and net.

William Tanona - Goldman Sachs

What was that?

Sam Molinaro

The gross numbers for the quarter were $168 million in revenues. $20 million transferred to capital markets net 147.

Operator

Your next question comes from Roger Freeman - Lehman Brothers.

Roger Freeman - Lehman Brothers

I wanted to just come back to the write-offs for a second. If I start with the $700 million and take out the $250 million, we are left with $450 million. Does that include the $200 million write-down on the high grade hedge fund?

Sam Molinaro

No it does not. That is in addition.

Roger Freeman - Lehman Brothers

Can you talk to the effectiveness of hedging in the fixed income business during the quarter? I know you can't give us a gross amount what the writedowns were, did you see obviously the pattern where August became very difficult? If we looked at that gross versus the net, is it going to be an order of magnitude difference?

Sam Molinaro

August, I would say hedges were generally effective, but August definitely put a tremendous amount of stress on hedging strategies. We saw many instances where cash and derivative markets gapped out cash assets significantly underperforming the indices. Hedging definitely was put to the task, not only, candidly, in the mortgage business and leveraged finance, but really across many other business areas where we saw significant disconnects in hedging strategies.

There were many, many of the desks that were impacted by that. We are focusing on the two biggest but credit we alluded to in the release, saw disconnects in the historical trading patterns even plain vanilla strategies like municipal bond strategies saw fairly significant disconnects in cash and index-oriented hedges.

Roger Freeman - Lehman Brothers

On the $200 million write-down of the high grade funds. Is that effectively a writedown of what was last reported a $1.3 billion balance?

Sam Molinaro

Roger, two big pieces to that. It is almost split evenly. About $100 million of that is the writeoff of our investment in the fund and the writeoff of receivables that we had from the funds predominantly related to management and performance fees that related to 2006. The balance of that was the mark on the inventory when we closed out the repo position.

Roger Freeman - Lehman Brothers

What would that updated balance be now?

Sam Molinaro

The balance at the date we closed out the repo was $1.3 billion. We marked down the inventory by about $100 million so you are directionally, we may have sold a little bit from there.

Roger Freeman - Lehman Brothers

But by and large you haven't sold much of that yet, is that fair to say?

Sam Molinaro

That is fair to say. The vast majority of those assets are AAA-rated CDOs and they are in our inventory.

Roger Freeman - Lehman Brothers

What is your alternative A-1 balance as of the third quarter? I think it was 10.2 or something at the end of last quarter.

Sam Molinaro

I think it is down $2 billion from there which is essentially the high-grade funds. That might be off by a couple hundred million. We will confirm that to you. It is not more than $2 billion.

Roger Freeman - Lehman Brothers

Can you talk to the total performance of alternatives as a category for you in the quarter?

Sam Molinaro

It was negative because as you can see from the reversal of performance fees on balance, the alternative strategies were down during the quarter.

Roger Freeman - Lehman Brothers

I was wondering if you can give us specific performance for the quarter?

Sam Molinaro

You mean blended across all the strategies?

Roger Freeman - Lehman Brothers

Yes.

Sam Molinaro

I don't have that. I will point out Roger that we have one fund in the strategies that is an emerging market strategy that has quite a bit of volatility in it. It was up substantially for the first six months. We have a large amount of performance fees accrued. It was down in the current quarter but still significantly positive year to date, and we had to reverse some of those fees in the third quarter.

Roger Freeman - Lehman Brothers

Lastly, can you give us a walk through from the second quarter to third quarter in terms of your loan commitments? What fell away? You gave the $2 billion number. Can you walk us through from 31 to 7?

Sam Molinaro

Actually from 21 to 7. There are essentially two significant pieces to that. The first piece of that was the completion of the Chrysler transaction. The second piece of that was a commitment that essentially rolled off and was not executed against.

Roger Freeman - Lehman Brothers

How much did you add during the quarter?

Sam Molinaro

I don't believe it was a material number.

Operator

Your next question comes from Mike Hecht- Banc of America Securities.

Mike Hecht- Banc of America Securities

Just to come back to the $7 billion left in the claims. What is your sense of how long you think it will take to work through the remainder of these commitments? Do you think we are talking a quarter or two? Do you think it will take longer?

Sam Molinaro

Our pipeline is relatively small and concentrated. We have a handful of smaller deals that will come to market over the next several months which will be worked off. We have one larger transaction which I don't really want to get into discussing the specific transactions, but one larger one which is probably not going to be until late fourth quarter. So I would say hopefully by the end of the year we have worked through the balance of the pipeline.

Mike Hecht- Banc of America Securities

To come back to the $450 million in marks on the mortgages and other things outside the LBO area, you said that was a net number. Any sense of what the gross mark was and impact the hedges have?

As part of that, you said your mortgage book assets at the end of the quarter were $50 billion and $45 billion currently. What was it at the end of Q2 to get a sense of how much they have come in, if you have that number?

Sam Molinaro

I think at the end of Q2 they were somewhere below $50 billion. They spiked up through July, largely because obviously we had commitments. We were still originating mortgages in our mortgage origination units and we had commitment to acquire loans from other originators and of course we were boarding those loans and with no securitization market takeout, they were somewhat trapped.

So I think our peak assets in the mortgage area probably hit about $55 billion during that period. We brought them down to currently standing at $45 billion. Now the question that you asked about giving you some view. I would say the gross losses that were taken on these books were substantially more than the net; the hedges were effective. There were substantial gains from hedges, but they were certainly not completely effective.

Mike Hecht- Banc of America Securities

Just to come back to the global clearing balance declines. You already have gone through this, it has been partially delevering and partially client attrition. But quarter over quarter you had some pretty sharp declines from $326 billion in equity to $284 quarter to quarter. Is it possible to get any sense more of the delevering story versus the attrition or possible to get a sense? Are we at a comparable level at period end where those balances stand today that suggests things have stabilized there?

Sam Molinaro

Balances are pretty much where they were at the end of the quarter. They might be trending up a little bit. That is pretty heavily influenced by market conditions. I would say in terms of looking at the balance declines it was probably one-third deleveraging and two-thirds customers reallocating balances to other primes.

Mike Hecht- Banc of America Securities

That's helpful. Moving on to the decline in book value this quarter. Was that all repurchase or any marks that you took that went directly to the balance sheet versus through the P&L?

Sam Molinaro

No, there are no marks that go directly through to equity. The main issue there is we buy a lot of stock for our employee share plans and the way we measure that, the impact on book value is, we generally add back what we bought in anticipation of granting to employees. Normally we are buying shares at levels that approximate the levels we will award them to employees. Obviously with the significant decline in the share price, that hasn't been the case in this year so we are taking a hit of about $0.70 in the book value calculation.

Mike Hecht- Banc of America Securities

Can you talk a little bit about headcount trends outside of the mortgage origination areas? As part of that, with year-to-date revenues down 7%, comp expense pulled down 6% year-to-date. What impact do you think it is going to have on morale? Are you seeing any employee attrition issues cropping up as a result?

Sam Molinaro

We have not seen any employee attrition issues. I think morale has been pretty good considering the market environment that we have been in and some of the difficulties that we have been confronting in the asset management unit through most of the summer. I think morale has been very, very good.

I think as far as headcount goes, we are not going to likely see much headcount growth between now and year end because we are past the peak in the season for hiring. I would expect to see, all things being equal, employee headcount trending downward.

Clearly we are going to have to address the mortgage origination efforts. We already had one headcount reduction effort in our sub-prime unit. We will continue to evaluate market conditions and what our staffing needs are as we get better visibility into what the market is going to look like. But my guess is that we will continue to trim headcount there.

I would say as far as the firm generally goes, we are going to evaluate headcount levels. Clearly we have to evaluate our cost structure as we think about what 2008 might look like. To the extent we try to make headcount reduction there I think that will probably happen over the balance of the fiscal year, but certainly by the end of the year.

Mike Hecht- Banc of America Securities

One last question on tax rate. Essentially zero this quarter. Sounds like a true-up to bring you to what you think the full year rate is going to be. Is that how we should model out to the fourth quarter, based on what the year-to-date is?

Sam Molinaro

Exactly. I would say if we had a rebound in revenue levels which we expect to have, we might see that rate tick up a little bit, obviously higher. You can look at what annualized revenues are because that is how the tax rate computed and compare it to where you think revenues might be for the quarter.

Operator

Your next question comes from David Trone - Fox Pitt Kelton.

David Trone - Fox Pitt Kelton

My questions were answered but just to be clear, you didn't have any tax rulings or true one-time events on the tax rate, right?

Sam Molinaro

No, just a true-up on the rate.

David Trone - Fox Pitt Kelton

So the 700 in marks, you said net of gains on hedges and fees. Is it reasonable for us to throw an educated guess that gross was probably $1 billion to $1.5 billion?

Sam Molinaro

I am hesitating only because I am trying to think through where I think that is. I don't really have a great fix on the aggregate number. $1.5 billion is probably too high.

David Trone - Fox Pitt Kelton

You mentioned that the 700 and the 250 wasn't exactly apples to apples and just piecing together your commentary, the 250 sounds like net of fees but not net of hedges.

Sam Molinaro

That's right.

Operator

Your final question comes from Mike Mayo - Deutsche Bank.

Mike Mayo - Deutsche Bank

Just understanding one more time, if we take the $250 million writedown of leveraged loans on a starting base of $21 billion, that would imply only a 1% writedown.

Sam Molinaro

Can't do that math, Mike.

Mike Mayo - Deutsche Bank

But we have to add back the fees and maybe take the midpoint between the $7 billion and $21 billion? I am trying to get what percent you mark down.

Sam Molinaro

You can't take the $21 billion because we had a fairly large transaction in there that did not happen and went away. So of course, that is not to be included. It is very difficult to do that math. I know everybody is trying to do it but every transaction is different and we have to evaluate each of them. Each transaction gets looked at in the context of it and what the price flux is we have in deals, the fees that we are collecting, total fees. So I can't shed a lot of light on that for you.

What I can tell you is we have $7 billion of open pipeline at the end of the quarter and we have a couple of billion dollars in assets on the books at the end of the quarter.

Mike Mayo - Deutsche Bank

But we should probably take something between the $7 billion and the $21 billion as the denominator?

Sam Molinaro

I wouldn't recommend that you do that. I don't think that will give you the right direction you are trying to go in. I think you will get a better picture of looking at where our inventory balances are today and looking at what the pipeline looks like.

Mike Mayo - Deutsche Bank

If you take the $250 million writedown and we try to get the gross number, maybe is closer to $350 million or so? If you add back the fees?

Sam Molinaro

I don't have the number at my disposal but 250 is the number that we took in markdowns.

Mike Mayo - Deutsche Bank

But that was after reducing the charge for the fees you would have gotten?

Sam Molinaro

That is right, so reducing it for fees that were imbedded in the open pipeline.

Mike Mayo - Deutsche Bank

You aren't telling us what those fees are, but can you give us some sense?

Sam Molinaro

I don't have the number and I don't want to guess at it.

Mike Mayo - Deutsche Bank

How much were your gains on cash and derivative hedges?

Sam Molinaro

I don't believe we gave you that. Are you talking about in the $700 million level? I think somebody asked the question directionally what you can look at. What I am willing to share with you is that the gross loss was substantially more than that. Hedges did have a significant positive benefit but they did not offset all the losses. I am going to leave it at that.

Mike Mayo - Deutsche Bank

So you have basically a $1 billion of reductions, the $700 million writedown in LBO mortgages, $200 million in the high grade funds and $125 million of reversal of performance fees. So all else equal, if spreads don't widen any more, should we expect that $1 billion to come back next quarter?

Sam Molinaro

I think that is a reasonable assumption. Obviously we need to see activity levels continue to stay reasonably good. We probably won't have as much spread widening in the credit next quarter, so I would guess that those revenues might not reoccur. I think you are directionally going in the right place.

Mike Mayo - Deutsche Bank

Then with the taxes also?

Sam Molinaro

Right. The tax rate will obviously normalize.

Operator

There are no further questions at this time. Do you have any final comments?

Sam Molinaro

I do not. Thank you everybody. Appreciate your being with us.

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Source: Bear Stearns F3Q07 (Qtr End 8/31/07) Earnings Call Transcript

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