The Bear Stearns Companies FQ407 (Qtr End 11/30/07) Earnings Call Transcript

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The Bear Stearns Companies, Inc. (NYSE:BSC)

FQ407 (Qtr End 11/30/07) Earnings Call

December 20, 2007 10:00 am ET

Executives

Elizabeth Ventura - IR and Corporate Communications

Sam Molinaro - COO and CFO

Analysts

Roger Freeman - Lehman Brothers

Guy Moszkowski - Merrill Lynch

James Mitchell - Buckingham Research

Michael Hecht - Banc of America

Douglas Sipkin - Wachovia Capital

Meredith Whitney - CIBC World Market

Mike Mayo - Deutsche Bank

Jeff Harte - Sandler O'Neill

Glenn Schorr - UBS

Operator

Good morning, ladies and gentlemen, and welcome to the BearStearns 2007 fourth quarter Earnings Call. (Operator Instructions).

I'll now turn the conference over to Elizabeth Ventura, Headof Investor Relations and Corporate Communications. Ms. Ventura, please goahead.

Elizabeth Ventura

Thank you, Dennis. Good morning, everybody, happy holidays.Welcome to our fourth quarter and full year 2007 results conference call.Before we begin the discussion of results I'd like to take a moment to remindyou that contained in this discussion are forward-looking statements. Thesestatements reflect the firm's belief at this time and are subject to risks anduncertainties.

These risks and uncertainties could affect our business andpotentially change our future performance. Some examples include changes ininterest rates, market conditions or the current backlog of pendingtransactions.

In addition, our business can be greatly affected by shiftsin domestic or global market and economic conditions. For fuller discussion ofthese risks, please see our disclosures file with the SEC in our most recentannual report and in our quarterly Form 10-Q filing. In particular, read thesections Management's Discussion and Analysis of Financial Conditions andResults of Operations and Risk Management. You can see these documents throughour website. This audiocast is being recorded and is the copyrighted materialof the Bear Stearns Companies, Inc. and may not be duplicated, reproduced orrebroadcast without our consent.

Thank you. I'd now like to turn the call over to our ChiefFinancial Officer and Chief Operating Officer, Mr. Sam Molinaro.

Sam Molinaro

Thanks, Elizabeth, and good morning, everybody and welcomeagain to the Bear Stearns Companies, Inc. quarterly earnings conference callfor the fourth quarter ended November 30, 2007.

Market conditions during the company's fourth quartercontinue to be very challenging as the global credit prices that begin on Julycontinue to adversely impact global fixed income markets. The combination ofcontinued weakness in the U.S. housing market and increased levels of mortgagedelinquencies, together with investor anxiety over recessionary pressures,rating agencies down rate various structured products and uncertainties withrespective assets, led to significant declines in MBS prices and activity.

November 14, we announced we would take a $ 1.2 billionwrite-down on our mortgage securities inventories, as a result of continuingdeterioration in market conditions through the end of October. During the monthof November, market conditions continue to deteriorate, which resulted inadditional write-down bring total mortgage related losses to $1.9 billion orapproximately $8.21 per share. This write-down, together with difficultconditions across the credit and interest rate markets, resulted in netrevenues turning negative to a loss of $379 million for the quarter and theCompany recording its first ever quarterly loss of $6.90.

The extremely disappointing results we experienced thisquarter are attributable to the number of factors. In fixed income, inadditional to the significant decline in mortgage markets, high-grade andhigh-yield credit spreads increased significantly moving to the widest levelsthat we have seen in several years. As a result, market conditions wereexceptionally challenging and we experienced significant decline in credittrading results.

The deteriorating conditions in the global fixed incomemarket also resulting in customer trading volume declining significantly.Customer is moving to more risk diverse assets and strategies.

Equity market conditions were mixed during the quarter,concern over the impact of the difficulties in the U.S.housing market on a broader U.S.economy and continued tight global credit conditions, caused significantvolatility in equity markets. Our customer volumes rose significantly both inthe U.S. and Europe. The more volatile market conditions resulting insignificantly weaker trading revenues and structured equity products whencompared to the record performance.

Investment Banking activity level also declined as a resultof these [conditions]. M&A volumes declined as the more difficult creditmarket conditions in leveraged finance and high-yield, there were significantlyreduced financial sponsor activity. Equity underwriting activity also declinedreflecting the more difficult environment.

The $6.90 loss per share recognized for the company's fourthquarter of fiscal 2007, compares to net of $4 in the November 2006 quarter.Sequentially, fourth quarter earnings declined from $1.16 per share, earned inthe third quarter of fiscal 2007.

Diluted earnings per share of $1.52 for the full fiscal yearended November 30, 2007, representing a decrease of 89% from the $14.27 per shareearned in fiscal 2006.

Included in the company's second quarter results was acharge of $227 million, or $0.88 per share, related to the write-off ofintangible assets, representing goodwill and specialist rights associated withour New York Stock Exchange specialist activities.

Earnings per share for fiscal 2007 excluding this chargewere $2.41 per share, a decrease of 83% when compared to 2006. Also included infiscal 2007 results are approximately $2.6 billion of net inventory write-downsrelated to market losses and mortgages and leveraged finance recognized inthird and fourth quarters. These losses representing approximately $10.11 pershare, served to materially offset strong results delivered by the balance ofthe franchise.

In particular, we experienced record years in a number ofkey areas, such as Institutional Equities, Global Clearing and Private ClientServices, reflecting successes we have achieved in executing against ourstrategic objectives. Revenues from our international activities also wereadversely impacted by the challenging global fixed income and equity marketingconditions.

Inventory markdowns of mortgage and asset-backed securitypositions held in both Europe and Asia, servedto reduce international net revenue significantly to approximately $84 million,a decline of 84% from the record $536 million earned in the August quarter.However, despite these results, international revenues reached a record $1.6billion for fiscal 2007, a 23% increase from $1.3 billion earned in fiscal2006.

International expansion remains a key priority as we moveinto 2008. In fact, our international headcount increased to over 2,100 people,a 37% increase from 1,500 people a year ago.

During the quarter, we also announced an agreement in principleto establish comprehensive strategic alliance with CITIC Securities. Thisalliance will include the establishment of a joint venture in Hong Kongtogether with the cooperation agreement to assist CITIC in the development oftheir institutional capital markets activities in China. We also announced that wewould issue a $1 billion, 40-year convertible trust preferred securities thatwould convert to approximately 6% of Bear Stearns and that we would acquire asix-year convertible bond and warrants, giving us the right to acquire 7% ofCITIC.

We expect the transaction to close during the first half of2008, we are confident that the combination of our operations in Asia withCITIC Securities will greatly benefit our global client base and generatesignificant opportunities for revenue growth in the years ahead.

During the quarter, we took actions to reduce our overalloperating costs by reducing headcount and rationalizing our businesses in lightof the deteriorating market conditions. Total employee headcount was reduced byapproximately 1,400 employees, or 9%, as we reduced staffing levels across thefirm and, in particular, in the mortgage origination and securitization areas.The headcount reduction resulted in non-recurring severance cost of approximately$100 million been recognized during the fourth quarter. We will continue tomonitor market condition and make additional cost reduction as necessary during2008.

Our performance this quarter, and for the full year, isclearly disappointing, which is not acceptable to us. We are fully committedand confident in our ability to return the franchise to profitability in 2008.To that end, we have taken a number of important steps to reduce risks,maintain a high level of balance sheet liquidity and cut operating costs.

The headcount reductions we made over the course of thefourth quarter, we will reduce operating costs in excess of $250 million andshould meaningfully enhance pre-tax margins in the 2008. We remain committed toour core strategy of expanding our global equity and clearing franchises,increasing the diversification of our fixed income activities by product andregion, and continuing the development of our international activities.

Another area of focus is around wavering commitment to the philosophyof Pay-for-Performance at the Executive Committee level. This means that if thecompany doesn't make money, Executive Committee bonuses are zero. Our [plan todesign] with this goal in mind and, as a result, Executive Committee memberswill not receive any compensation for fiscal 2007. This philosophy is at ourcore and represents our culture of meritocracy and performance.

If I could ask you now to please turn your attention to oursegment data contained in the earnings release, I'll review each of the threemajor business segments, Capital Markets, Global Clearing Services, and WealthManagement.

Capital Market net revenues includes institutional equities,fixed income and investment banking, were a loss of $956 million for thequarter, a decrease from $1.91 billion of net revenues in November 2006quarter, and a decline from a gain of $1.05 billion earned in the August 2007quarter.

Institutional Equity net revenues decreased 11% to $384million when compared to $430 million earned in the November 2006 quarter.Sequentially, Institutional Equity net revenues decreased 47% from a record$719 million earned in the August 2007 quarter.

During the quarter, the domestic and international cashequity sales areas achieved record results associated with increased customervolumes and market share gains. Risk arbitrage revenues rebounded strongly fromthe difficult sequential quarter into more favorable market conditions.

Principal strategies area also experienced record netrevenues and increased trading gains in quantitative strategies. The strongfourth quarter performance for each of these areas, [capped off] record yearsin this area. Offsetting these increases were significantly reduced netrevenues from the structure equity products area, primarily due to volatilemarket conditions and a $190 million reduction in gain and our structured noportfolio when compared to the prior quarter.

Fixed income net revenue for the fourth quarter was a lossof $1.54 billion, down meaningfully from a gain of $1.1 billion earned in theNovember 2006 quarter. Sequentially, fixed income revenue also decreased whencompared to the gain of $118 million earned in the August 2007 quarter. Thequarters results include, net inventory markdowns of $1.9 billion, which includedthe $1.2 billion loss previously disclosed on November 14.

During the quarter, the Company had gross inventorymarkdowns of mortgage assets of approximately $3.2 billion. Partiallyoffsetting these losses were hedging gains of approximately $1.3 billion. Alarge component of these losses were approximately $1 billion of losses,incurred related to CDOs and the unwinding of CDO warehouse facilities, where acustomer loss mitigation arrangement proved to be inadequate.

At November 30, all CDO warehouse positions have been unwindand collateral has been sold or hedged. Remaining net losses were experiencedacross our U.S.and international CDO, Alt-A and subprime mortgage loans and securities andcommercial loan inventories reflecting weakness in global market conditions. Atthe end of November 2007, the Company had approximately $46 billion of mortgageand asset backed loans and securities.

Included in the exposure are subprime mortgage loans of $500million, representing 2007 vintage production, and $1.1 billion ofinvestment-grade subprime securities and $200 million of below investment gradesecurities. ABS CDO exposures are approximately $750 million at the end of thequarter.

Currently, our mortgage and asset backed inventories areapproximately $43.6 billion, down 5% from quarter end. I should point out thatthese balances representing gross asset values and net exposures areconsiderably lower. In particular, net of hedges are ABS CDO and subprimepositions are net short.

At year end, the company held $7.8 billion of retainedinterest in our own MBS securitization, a 19% decline from the $9.6 billionlevel below with August 31. The non-investment grade portion of retainedinterest is $1.3 billion, down slightly from the August 31 levels.

The valuation of our mortgage positions reflects acombination of observable market data, the decline in the ABX indexes and ourexpectations of housing prices, the falls and cumulative losses. Accordinglywhile no assurances can be given as to future performance, we believe ourmortgage positions have been conservatively valued in light of current marketconditions and expected levels of the falls in cumulative loss estimates.

Difficult global credit market conditions also served tocreate challenging in trading environments in both rates and credit productareas, as credit curves inverted, spreads wide ended correlation estimatesproved delusive. Credit product net revenues declined sharply during thequarter, reflected a more challenging environment and net losses wereexperienced in our flow and structured credit areas. In our rates area,increased customer activity was offset by more challenging markets for interestrates and foreign exchange options.

Partially offsetting the losses from our credit trading businesseswere improvement in our leverage finance area, which rebounded from the poorresults during the sequential quarter. Leveraged finance pipeline commitmentsdeclined significantly during the quarter to $600 million from $7.6 billion atAugust 31, 2007 and closed at funded loans outstanding decreased to $2 billionfrom $2.5 billion.

Investment Banking revenues for the company's fourthquarter, excluding merchant banking revenues, were $205 million, a 38% decreasewhen compared to $329 million of November 2006 quarter and a 15% decrease whencompared to $241 million earned in August 2007 quarter.

Underwriting revenues for the fourth quarter were $113million, a decrease of 32% from a $165 million earned in the November 2006 quarter.This decline primarily reflects lower high yield underwriting revenue,resulting from the more difficult fixed income capital markets environment. Equityunderwriting revenues also decreased when compared to the November 2006 quarteron lower volumes of equity follow on and convertible new issue activity.Sequentially, underwriting revenues increased 13% from $100 million earned inthe August 2007 quarter.

M&A and advisory revenues were $150 million for the fourthquarter, a 7% increase when compared to $140 million in the November 2006quarter. Sequentially, M&A revenues increased 2% when compared to the $148million earned in the August 2007 quarter.

The difficult market environment for leveraged finance thatbegan in the third quarter has continued through the end of our fiscal year. Asa result, leverage buyout activities have declined and equity market volatilityhas reduced the backlog of equity offerings. However, M&A discussions withcorporate clients remain active and our backlog of M&A and underwritingassignments at the end of the quarter has decreased slightly from the levelsachieved at the end of the August quarter.

Accordingly, despite the difficult market conditions forleveraged finance related activities, strategic M&A dialogues haveincreased and equity backlogs have remained relatively firm.

Included in investment banking net revenues are revenues generatedfrom our merchant banking activities. For the current quarter, merchant bankingrevenues were flat, compared to a gain of $35 million of November 2006 quarterand a loss of $29 million in the August 2007 quarter.

Global clearing services net revenues increased by 2% to$276 million when compared to $271 million in November 2006 quarter. Netinterest revenues increased 1% to $205 million from $203 million in last year'squarter, as average margin debt balance has increased from the levels reached fromNovember 2006 quarter.

Clearance commission and other revenue increased 3% to $70billion from $68 billion in the year ago quarter due to increased customeractivity. Sequentially, global clearance services revenue decreased 17% whencompared to the record revenues of $332 million earned in the August 2007quarter. Net interest revenue decreased 21% from a record $259 million in thethird quarter, as average margin debt customer short balance decreased.Clearance commission and other revenues decreased 4% from $73 million in theAugust quarter due to reduce customer activity.

During the fourth quarter, average customer margin balancesincreased 14% to $82 billion from $72 billion in the November 2006 period anddown 20% from a record of $102 billion in the August 2007 period. Averagecustomer short balances were $85 billion, down 6% from $90 billion in November2006 period and down 17% from a record $102 billion in the August period.

Average securities borrowed balances were $61 billion, up 6%from $58 billion in November 2006 period, and down 12% from $70 billion in theAugust quarter.

The decline in average customer margin debt and shortbalances when compared to the August quarterly levels reflects clientdeleveraging due to the challenging market environment, as well as prime brokerbalance reallocations experienced during early August. Customer balances haveincreased after lows experienced in the third quarter, and new businessprospects remain strong.

Equity in client accounts at November 30, 2007 increased 2%to $289 billion when compared to the August 2007 quarter. Quarter-end customermargin balances were $86 billion, customer short balances were $88 billion andsecurity borrowed balances were $63 billion.

For the full fiscal year, Global Clearing achieved recordrevenues of $1.2 billion, up 11.5% from fiscal 2006, reflecting significantcustomer balance growth in prime brokerage. We believe the success of thefranchise in 2007 provides clear evidence of the value of merging our cashderivative and clearing franchises and positions us for continued success in2008.

Wealth Management net revenues for the quarter increased 10%to $272 million when compared to $247 million in the November 2006 quarter.

Private Client Services net revenue rose 20% to a record$161 million from a $134 million earned in the year ago quarter, primarilyreflecting growth in fee-based revenues and commissions.

Fee-based assets in PCS customer account is 9%, $11.1billion at the end of the fourth quarter compared to $10.2 billion in the yearago period.

Asset Management revenues for the quarter were a $111million, slightly down from a $113 million earned in the November 2006 quarter.

The strong results were primarily due to growth inmanagement fees on alternative assets and traditional fixed income assets. Inaddition, performance fees increased and growth of fees in proprietary hedgefund products.

Sequentially, Wealth Management revenues increased from theloss of $38 million when compared to the August 2007 quarter, as the businessrebounded in the third quarter which included a $170 million loss in the assetmanagement area.

Full year Asset Management revenues were $228 billion, down32% from fiscal 2006. However, excluding the impact of the losses incurred fromthe failure of the high-grade hedge funds, net revenues are up 14% to $382billion reflecting strong growth in both management and performance fees.

Full year net revenues in the Private Client Services areawere also a record $602, up 15% from fiscal 2006. Total assets under managementat November 30, 2007 were $44.6 billion, a decrease of 15% when compared to$52.5 billion on November 30, 2006.

Sequentially, assets under management were down 23% from thelevels of August 2007. The decline in assets under management primarily relatesto the $8.8 billion transfer of assets related to the spin-off of [Ocean CAsset Management]. Under the terms of our agreement, PCM will maintain acontinuing interest in the results of [Ocean C] and will maintain asub-advisory arrangement of $3.5 billion of AUM.

Alternative assets under management were $8.3 billion inNovember 30, down 7% from $8.9 billion at August 31, but up 6% from $7.8billion in November 2006.

Moving to expenses. Total expenses were $992 million, down35% from the year ago quarter and down 14% from August 2007 quarter. Thedecline in total expenses is primarily due to lower employee compensation andbenefit expenses, which decreased both sequentially and year-over-year due tolower net revenues.

Employee compensation and benefits for the fourth quarterwere $326 million, a decrease of 69% from $1.05 billion in the fourth quarterof 2006. Sequentially, employee compensation and benefits decreased 51% from$664 million in the August 2007 quarter.

Compensation and net revenues for the year ended November2007 was 57.6% as compared to 47.1% fiscal 2006. The increase in compensationratios, when compared to fiscal 2006, reflects the impact of the significantdecline in net revenues experienced during 2007 associated with lossesrecognized in mortgage and asset-backed products.

The compensation ratio increased as other areas of thecompany performed well, and compensation levels needed to be maintained inorder to reflect market levels.

During the year, the company amended the terms of its stockawards for fiscal 2007 in order to align its plans with market practices and toemphasis long-term service and retention objectives. The 2007 Stock Awardsestablished future service requirements to be met in all cases in order tosatisfy vesting requirements.

Accordingly, the awards granted in December 2007 will beexpensed over the vesting period or sooner for participant that is retirementeligible. The net effect of the change in the terms of the stock award was atapproximately $721 million of 2007 Stock Awards will be deferred and amortizedover the applicable vesting period.

Worldwide headcount as of November 30, 2007 is 14,100 up from13,600 in November 30, 2006, were down from the 15,500 level reached in thesequential quarter.

The overall headcount increased we have experienced, ascompared to November 30, 2006 reflects the expansion of our fixed income,wealth management, global clearing and derivative areas, which are attributableto increased business activities and growth initiatives particularlyinternationally. However, during the fourth quarter, headcount was reduced byaction and attrition of approximately 9% in 1400 employees reflecting thedifficult global credit markets.

Non-compensation expenses were $666 million for the quarter,an increase of 42% when compared to $468 million in November 2006 quarter. Theincrease in non-compensation related cost when compared to November 2006quarter is primarily related to increase severance expenses, legal settlements,and professional fees. These increases were partially offset by lower CAP plan relatedexpenses.

Also adding to the increase of non-compensation expenses arehigher transaction related costs associated with higher business volumes, aswell as higher occupancy, communication, and technology cost associated withthe increase in worldwide employee headcount.

Sequentially, non-compensation expenses increased 35% whencompared to $492 million in the August 2007 quarter, associated with severancecost, increased legal related expenses, and minority interest cost. CAP plan-relatedexpenses were a credit of $59 million during the quarter versus $46 million ofexpenses in November 2006 quarter attributable to the decreased level ofearnings. Sequentially CAP plan related expenses were $4 million in the August2007 quarter.

Out tax rate for the quarter, was a benefit of 38%reflecting the net loss before income taxes and relatively fixed level oftax-preference items. Our year-to-date tax rate also moved to a net tax benefitof 21%, as compared to a tax rate of 34.7% for the full fiscal year 2006,reflecting the mix of domestic and international profits.

Book value at November 30, 2007 $84.9 per share with a$136.2 million shares outstanding. Book value declined from August 31, 2007,primarily reflecting the impact of the net loss in the fourth quarter intreasury stock purchases. During the quarter, we repurchased $3.4 millionshares of common shock at an aggregate cost of $373 million. For the fullfiscal year, the company repurchased $12 million shares of common stock in anaggregate cost of $1.7 billion.

At November 30, 2007, approximately 7% of the firm assetswere considered level three assets. Given the lack of liquidity in themarketplace for many instruments, it's reasonable with some assets which is tobe level two assets will move to level three. While we haven't completed thereview for the 10-K disclosure and it is anticipated that the amount of levelthree assets will increase by approximately $7 billion, when compared to theAugust 31, amounts.

Firm-wide VAR at the end of the quarter increasedsignificantly to $69 million when measured against the August 31, 2007 amount.While the company reduced positions and risks during the quarter, the increaseon VAR is primarily the result of the significant increase in market volatilityduring the quarter and the impact of the Williams transaction which closedduring the period.

With respect to our balance sheet capital and liquidityposition, our profile is strong. As of November 30, 2007, total stockholdersequity was $11.8 billion and total capital was $80.3 billion. During thequarter we moved to enhance our liquidity position by reducing the risk on ourbalance sheet, continuing to reduce commercial paper outstandings andincreasing secured term funding and maintaining our strong cash liquidity flow.Our approach to liquidity risk management shows that we are able to meet all ofour unsecured debt maturities over the next 12 months without issuingadditional unsecured debt or liquidating assets.

Over the past several quarters we have materially reducedreliance on short-term unsecured funding or simultaneously building excessliquidity of the parent company. Commercial paper outstanding currently standsat $3.9 billion compared to $4.6 billion and $20.7 billion at August 31 2007and November 30, 2006 respectively.

The firm's parent company liquidity pool, which consists ofvery high quality money market instrument, stands at $17.4 billion. Inaddition, readily available secured and unsecured committed bank lines areapproximately $8 billion.

In closing we make a few remarks about our outlook as wehead into 2008. Our2007 was an incredibly challenging year. We began 2008 as a stronger firm. Ourinternational expansion efforts are on track. The build out of our Europeaneffort continues to go well and in Asia we areexcited about our partnership with CITIC Securities.

In equities, we achieved record levels in 2007. Our energybusinesses have reached a new level with the closing of the Williamstransaction by broadening our national presence as a major player in the fiscalenergy markets. We think there is significantly more to come in the developmentof that business.

Our clients tell us they are extremely pleased with thecomprehensive service they are receiving, because of the successful integrationof our cash and derivatives equities and prime brokerage efforts, both in theU.S. and internationally and we believe there are more benefits to be realizedin this area. In wealth management, our record performance of PCS tells us ourstrategy of hiring experienced brokers with proven books of business is theright one for us and the changes in our strategy for Bear Stearns 1:20 21 areshowing early signs of success. While fixed income conditions are likely toremain challenging for some time, we are moving to reposition ourindustry-leading mortgage area to reflect the current market environment.

In recent weeks we have completed steps to size our mortgageorigination business to more accurately reflect our view of current andpotential market conditions. As part of this effort, we closed our subprimeoriginator Encore credit reducing occupancy costs, headcount and technologiesspend, while retaining our ability to originate all types of mortgages throughBear Residential Mortgage Corp.

In distressed mortgage area, we have devoted significantresources to developing EMC servicing platform, including expanding ourcapabilities and loan modification and workout through EMC's Mod Squad.

In addition, we continue to believe there would beopportunities in the future to purchase and service distressed loan portfolios.Overall, this franchise is strong, smaller and more focused on restructuringand origination going forward, but our top talent is in place and we areconfident in the underlying earnings potential of the mortgage business.

As a management team, we are determined to improve ourperformance, the employees here are motivated and we are very confident in theearnings power of the franchise.

Okay. With that, I am going to open the call up forquestions.

Question-and-AnswerSession

Operator

(Operator Instructions). Your first question comes fromRoger Freeman from Lehman Brothers. Please ask your question.

Roger Freeman -Lehman Brothers

Hi, thank you. I guess Sam, could you comment a bit on thecontour of customer activity levels during the quarter, particularly comparedsort of November to September and October? And maybe give us an early read onwhat you are seeing in December here?

Sam Molinaro

Well, I would say as we came into the quarter, conditionsseem to be relatively improving and certainly didn't end that way. I would say,as we progressed through October/November, market conditions got significantlymore difficult, and as a result, we saw a customer activity in fixed incomedeclining significantly, and moving to a more safe haven if you will. So, theactivity levels that we saw in fixed income during the fourth quarter.(inaudible) Roger can you hear me okay?

Roger Freeman -Lehman Brothers

Barely, but yes.

Sam Molinaro

The activity levels, as I said, were more subdued in most ofthe fixed income markets--certainly in credit and mortgages--during the latterend of the quarter, and the more liquidity products, and rates and foreigncurrency. Obviously, customer volumes continue to be strong.

As we move into the first quarter, conditions have seeminglybeen improving. The effect of the pulse and plan moves of central banks aroundthe world to improve liquidity all have had a favorable impact, and activitylevels have picked up, and conditions have been somewhat better than where weended in November.

Roger Freeman -Lehman Brothers

Okay. The actions you've taken to resize the business, haveyou take any actions you think you need to take at this point pendingadditional slowdowns or is there still more to come in the first quarter?

Sam Molinaro

I think we have taken the actions that we need to take rightnow. As I said, we'll continue to monitor the environment and, to the extentthings change or become more difficult, we'll take additional actionsnecessary. But the key focus that we had has been to get our operating costsdown. Clearly, we needed to address the mortgage origination effort, which hadbeen built up in a different environment, and in light of expected volumes thatneeded to be addressed; so we've done that.

Roger Freeman - LehmanBrothers

Okay. There were actually losses this quarter from markingstructured debt on your balance sheet to market, even though your CDS spreadwide. In the last quarter, you've talked about trying to sort of locking thosegains. Was the reversal have anything to do with hedging activities thisquarter?

Sam Molinaro

No, it's really that the gains were smaller. The gains werelarger in the third quarter than they were in the fourth quarter.

Roger Freeman -Lehman Brothers

Also, it was just a reduction in the amount of gains. That'swhat you are saying?

Sam Molinaro

That's right.

Roger Freeman -Lehman Brothers

Got it. Okay. And structured equities, how much of thedecline in the equities business during the quarter, it was related to slowdownin that piece. And is that just a function of clients sort of sitting back, andas all other markets not doing transactions?

Sam Molinaro

Well, most of the decline in the equity revenues came fromthe decline in structured equity revenues. Now, we had a record quarter in thethird quarter, fourth quarter. Customer volumes were not bad, but the marketwas extremely volatile, and we had lower performance from our SCP area as aresult.

Roger Freeman -Lehman Brothers

Okay. Lastly, how much of the markdowns in fixed income wererelated to CMBS and Alt-A during the quarter?

Sam Molinaro

Well, of the $1.9 billion in write-downs, as I said, about$1 billion of that came from the write-down of CDOs and unwinding of the CDOwarehouse. The balance of those losses $900 million came from the revaluationof our mortgage books, both our Alt-A positions, as well as commercials.

Roger Freeman -Lehman Brothers

Was one bigger, much bigger than the other there, in termsof Alt-a, as well as commercial?

Sam Molinaro

The Alt-A and other mortgages were a larger than thecommercial.

Roger Freeman -Lehman Brothers

Okay. All right, thanks a lot.

Sam Molinaro

Sure.

Operator

The next question comes from Guy Moszkowski from MerrillLynch. Please ask your question.

Guy Moszkowski -Merrill Lynch

Thank you. Good morning Sam.

Sam Molinaro

Good morning, Guy.

Guy Moszkowski -Merrill Lynch

I know you went over this quickly, but I was wondering ifyou could help us reconcile the risk exposures to the chart that you showed uson November 14, that was broken up sort of AAA Super Senior, and then you havesub-prime mortgages exposures--at that time, the net of the two was roughly$830 million, and I am just wondering if there is an update to that, whichwould reconcile sort of to the $700 million greater charge that you took?

Sam Molinaro

Yeah, there – I have that, Guy, I have to -- in my stackedstuff here, I have to try to find that, but I think that, just from memory,while I try to find the right schedule--to walk you through this. We saw or wecame in to this quarter with a subprime position, but I think was flattish andwe closed the quarter with a net short subprime position. We came into thequarter with a CDO position that I think was about $850 million, and we closedit about, what was the number that I just gave you $700 million? I believe thatwas the number.

Guy Moszkowski -Merrill Lynch

Okay. So it's sounds like then most of the differencebetween the hit that you pre-announced on November 14 and the actual $1.9billion that you did was really away from the CDO, and subprime and more just aresult of taking a big write-down to Alt-A and CMBS, is that's fair?

Sam Molinaro

Partially, yes, we had some additional losses in warehousefacilities that we had in Europe and Asia that we’re not included in that $1.2billion, that was part of it additional markdowns on CNBS positions. And then,of course, the continued decline in the indices and decline in the market forresidential mortgages.

Guy Moszkowski -Merrill Lynch

Yeah, okay, including Alt-A which you really didn’t addressNovember 14.

Sam Molinaro

Well we did address Alt-A. Alt-A was included in thatmarkdown, and as market conditions continued to deteriorate we took additionalmarkdowns.

Guy Moszkowski -Merrill Lynch

Got you. Okay, that helps me understand sort of thedifference. Thank you.

Sam Molinaro

Okay.

Guy Moszkowski -Merrill Lynch

And just to clarify on the reduction on equity revenuesbecause of the structured product decline, is most of that decline instructured product revenue that you addressed, the result of the decline in thecredit that you get from the structured product related liabilities that wetalked about, or is it that the actual underline cause of this decline?

Sam Molinaro

I would say it was about 50-50 between lower tradingrevenues in a very difficult trading environment, and structured equities giventhe level of market volatility, and the decline in the structured note gains.

Guy Moszkowski -Merrill Lynch

Okay. That’s also helpful. Thanks.

Sam Molinaro

Okay.

Guy Moszkowski -Merrill Lynch

Let me ask you a question about the capital. There is not alot in your release on the balance sheet. Maybe you can talk to us about yourcapital position at quarter end, not just in absolute terms, but in term of keycapital ratios--how they look at the end of the quarter, given the reduction inbook value, and sort of how that looks when you then layer in the capitalinfusion that is coming from CITIC, and whether we should think that, given themagnitude of the charges, you might be capital constrained, or whether you shouldwhere you probably don't have to raise capital?

Sam Molinaro

Well, the overall level of the balance sheet, quarter-to-quarteris about unchanged. Obviously, capital is down from where we closed the thirdquarter given the losses that we experienced this quarter. We have historicallyhad very strong capital ratios, significant excess capital, obviously thereduction will reduce that somewhat. But our capital ratios, we believe, arestill very strong.

We don't see a particular need to address that. Of course,we do expect that the closing of the converted $1 billion convertible securitythat we sold to CITIC will happen during the first half of the year, and thatwill add to the equity capital base. So with that, capital ratios should moveback to a levels that we have been running at.

Guy Moszkowski -Merrill Lynch

And just to refresh us, what sort of capital ratios do youtarget? What is the benchmark that you want to work toward?

Sam Molinaro

Well, there is a variety of things. Obviously, we arefocused on absolute levels of balance sheet leverage. We are focused onadjusted leverage levels, and probably most importantly, focused on our Tier 1and Tier 2 capital ratios, which is, we don't disclose. But obviously, wemonitor that carefully, and we've had significant excess position now and we'llcontinue to try to maintain that.

Guy Moszkowski -Merrill Lynch

So, just--I don't want to put word to your mouth--but what Ithink I have heard you are saying, is that with the closing of the CITICtransactions, you would expect that by mid-year that you're Tier I and Tier IIwould be back where there were say at mid-year 2007, is that fair?

Sam Molinaro

Yeah, I think that's fair. Obviously, all things beingequal, what's happening with the balance sheet. But I think that I also want topoint out that we are comfortable with where the capital ratios are right now.

Guy Moszkowski -Merrill Lynch

Okay, great. That's very helpful. Thank you.

Sam Molinaro

Okay.

Operator

The next question comes from James Mitchell from BuckinghamResearch. Please ask your question.

James Mitchell -Buckingham Research

Hi, Sam.

Sam Molinaro

Hi, Jim.

James Mitchell -Buckingham Research

Just quick question on the comp. Obviously, it did come downquite a bit this year, but then you mentioned that you had about what $720million in additional stock that didn't flow through, I guess, the expenseline, right now?

Sam Molinaro

Right.

James Mitchell -Buckingham Research

Right. So that helps, I guess, locking some people. I guesswould it be fair to think about adding that to the comp this year to get a sortof a more of a truer comp expense for the year, in terms of what you told outto your employees?

Sam Molinaro

Well, I think you can do that. Thinking now as I think, thatwe've been a little bit off industry standard with the way that we've awardedstock compensation. Because the terms of many of our stock award plans are suchthat the accounting for those were that we expensed them at the year grant,which is not the norm. The norm is to amortize it over the vesting periods.

The changes that we are making kind of block in, in terms ofthe service periods that are necessary to receive the award, which, of course,we've done in order to provide additional retention, and that will have theeffect of requiring those awards to be amortized in the future. But I thinkit's fair to think about as the employees might look at it, from the employeestandpoint, the value of the compensation awards this year by adding that backin.

James Mitchell -Buckingham Research

Okay. And then going forward with the $250 million in costsaves from the severance, I guess, annually. Did you disclose what theamortization period will be if it is a typical three year? I guess you wouldkind of cover the increase cost going forward with the cost saves. Is that kindof how we should think about it?

Sam Molinaro

Yeah. I would think the way to think about these stockawards is, if you assume a relatively level amount of stock awards over thenext three years, and I don't know if that's a good assumption or not, but ifyou make that assumption, the $700 million that we awarded this year--a thirdof our vesting period is, basically, three years—so, sort of, that willamortize in the next year. Whatever next year's award would be, that wouldn'tstart amortizing until the following year.

So, I think we will likely see some headroom in thecompensation numbers, as a result of the period of time it takes to ramp up thedeferrals, and we expect the $250 million reduction in operating costs thatstart to be up in the first quarter.

James Mitchell -Buckingham Research

Okay. And that's mostly in the comp line. So you are sayingthat because of the kind of the switch we might see -- assuming a normalizedkind of level of revenues that the comp ratio could be a little bit lower thanin the past?

Sam Molinaro

That's right.

James Mitchell -Buckingham Research

At least initially.

Sam Molinaro

Yes.

James Mitchell -Buckingham Research

Okay. And did you talk any sense on the legal expense, howmuch of that contribution. I assume those may be some litigation reservebuilding in there. Is there any indication of what size that would be?

Sam Molinaro

I believe the increase in litigation and legal expenses wasabout $60 million.

James Mitchell -Buckingham Research

Okay.

Sam Molinaro

Versus last quarter.

James Mitchell -Buckingham Research

Okay, great Thanks.

Sam Molinaro

Okay, Jim.

Operator

The next question comes from Michael Hecht from Banc ofAmerica. Please ask your question.

Michael Hecht - Bancof America

Hey, Sam, good morning, how you are doing?

Sam Molinaro

Good morning, Mike.

Michael Hecht - Bancof America

Can we maybe talk a little bit about, I guess, the loss ofthis magnitude this quarter? Can you just talk a little bit about, I guess, howit's impacted the Board's relationship with the executive management team? Andwhat the Board is going to be looking for here to really restore confidence?So, I am assuming it's probably pretty shaken. And then maybe as par of that,talk a little about changes you guys have made the bolster risk managementpractices to help ensure you guys are kind of more protective from a loss likethis going forward?

Sam Molinaro

Let me start with that last part first. I think that thereis a lot of discussion about risk management practices and whether these losseswere unexpected, surprising, etcetera. Obviously, they are unexpected andobviously, they are not acceptable the level of losses. But these losses arewon't surprises if you'll. I mean we understood the nature of our risks. Weunderstood the nature of the mortgage positions that we held. Candidly, we madedecisions in hindsight as it related to the hedging of these books that didn'tturn out well.

We also made decisions as it relates to the ramping of theCDO business, the CDO warehouse loans if you'll that in retrospect were verypoorly timed and bad decisions--and they were certainly looked at thattime--the decisions were made to do them, and they didn't turn out well.

So we were operating in unprecedented market conditions, thedeclines that we've seen as a result of the level of defaults that we'reexperiencing in the mortgage market have been very significant and it's beendifficult certainly easy to be able to hedge these exposures, but these weredecisions that were made. So, I think that probably place into what therelationship of the executive management with the Board, which I think is verysolid and very good, but it's a difficult environment, and we're trying tomanage through it.

Michael Hecht - Bancof America

Okay. Can we walk through, I guess, the non-comp expenses? Imean, I know there is lot of noise this quarter with the severance; some of thelegal stuff. Can we talk about, I guess, how we should think about run ratethere going forward, and just to be clear, the $250 million reduction--is thatpretty much all-comp, or is there some non-comp, that's kind of imbedded withinthat?

Sam Molinaro

I would say the bulk of that number is comp. It's directcompensation and benefit cost and some amount of ancillary, communications, bonds, market data, etc. I think that you willwith taking 1400 employees out of census; I think that it’s reasonable toassume that we'll start to see declines in all of the infrastructure lines,occupancy, communication, etcetera.

So, that is not included in that 250 number, and I think youwill see some decline in those numbers going forward. Also included in thisquarter, as I said, were a $100 million severance charges, which arenon-recurring, and we did have an uptake in legal and litigation related costof about $60 million.

Michael Hecht - Bancof America

Okay, that's helpful. Coming back to the equity's business onemore times. Is it possible, last quarter, I guess, structured note gain was,maybe about $225 million, if I remember, is it possible just kind of get what thatamount was? And then, thinking about the results, in structured equity pricing,it just seems like a lot of other folks that have reports so far have actuallyseemed to strength in those areas. I am just trying to understand if theweakness that you guys saw was more, just a lack of customer activity or badpositioning, or what?

Sam Molinaro

More a question of bad positioning. The unfortunatelytrading results were extremely poor. We are not well positioned for thevolatility that we encountered in those books and had weak trading results, asa result coming off of record third quarter performance. Customer volumes werenot materially different. Just did not have a good trading quarter.

Michael Hecht - Bancof America

Okay. There is possibility actually size the otherstructured note gain in Q4?

Sam Molinaro

I think the total amount of structured note gains from thethird quarter to the fourth quarter, total gains were about $400 million in thethird quarter and about $200 million in the fourth quarter. And that's spreadacross equities and fixed income, both rates and credit.

Michael Hecht - Bancof America

Okay. So, so someone in the equities and someone in the(inaudible) of the fixed income?

Sam Molinaro

Right.

Michael Hecht - Bancof America

Okay. And then you mentioned the reduction in the LBO[Credits], I think from $7.6 billion down to $600 million. Can you give alittle bit more color on how you kind of get there, close deals versus dealsthat maybe get pulled?

Sam Molinaro

Yeah. Well, the biggest move in there was, deal that didn'thappen, which was our involvement with the cable vision transaction that was$4.5 billion, I believe. So that deal fell out of the pipeline, the balance ofthe change were transaction that were closed. You can see that, because our fundedbalance are down, we were able to distribute much of that.

Michael Hecht - Bancof America

Right. Okay. And then can we go back to the, I guess, thefixed income business this quarter, just maybe getting a little bit more coloron how some of the sub segments of fixed income performed. Because if I kind ofback out the marks, I get a run rate of, maybe like $350 million in fixedincome, which I guess, if we assume, even some of the structured no gains wentthrough there, maybe even a little bit softer than that,. I am just looking toget a little more color on performance across rates MBS credit and how weshould think about our kind of run rate going forward for that business?

Sam Molinaro

Right. Well, it was a very weak quarter for us across the boardof fixed income, and I certainly not indicative of run rate levels by anystretch. In addition to the large mortgage loss as we took which effectively swampanything else that we were doing in mortgages. The credit markets were verydifficult.

The distressed business was good, but structured credit andflow trading areas were very difficult, with volatile market conditions andgenerally wider credit spreads, so results there were negative; they were alsorelatively weak in the rates business, particularly position taking in theinterest rate derivatives areas and foreign exchange in the options book lot ofvolatility, and that we had weak trading results there. Customer flows is good,strong, but trading results were week across the board in fixed income.

Michael Hecht - Bancof America

Okay. And just last question. I just want to follow up onsome thing you said in your comments. Investment banking revenues, you said$150 million for M&A; I think, $113 million underwriting; flat or zero inmerchant banking--that was like towards $263 million versus the $205 millionyou reported. Am I missing something?

Sam Molinaro

Yeah. We have a process where we do--we allocate--because ofthis leverage finance business and some of the other businesses dominant fixedincome where those revenues largely reside we do an allocation of revenues and costsback and forth between the businesses.

Normally those are revenues, in the fourth quarter therewere losses from the write-downs of loan facilities either leverage finance ormortgage products so we try to strip those out and talking about how thebusiness flows look in the fourth quarter and I think those numbers that wegave for investment banking underwriting revenues are a truer a picture of thevolume of activity. Equity underwriting revenues were pretty good, fixed incomeobviously was soft because high yield was down quite a bit.

Michael Hecht - Bancof America

Okay got it. Thanks a lot Sam happy holidays.

Sam Molinaro

Sure thank you Mike.

Operator

The next question comes from Douglas Sipkin from Wachovia.Please ask your question.

Douglas Sipkin –Wachovia Capital

Yeah, hi. Good morning Sam how are you?

Sam Molinaro

Good how are you doing?

Douglas Sipkin –Wachovia Capital

Just two questions, one I guess more from a longer termsstrategic standpoint given that I – then more probably in the period of highervolatility it does sort of appear like and obviously not just for you but theentire industry the ability to hedge and use derivatives to offset risks hasbecome a lot more challenging. For a firm like you guys are maybe little bitsmaller than the rest. I mean how do you think about that potential structuralchange about your ability to compete in certain businesses? I mean are theregoing to be areas now where you guys make conscious decisions just to say heywe're not going to be able to compete as effectively as maybe we were withoutthat ability to hedge going forward and as a result we're going to pull back incertain areas?

Sam Molinaro

No, not at all. I think there is nothing really new here.Derivatives have been a fact of life for a long time and we had a verysuccessful derivatives franchise that has grown dramatically over the last fiveyears. We've now crossed the board, both rates, equity and credit of allenjoyed very strong performance. We just had a very difficult operatingenvironment this quarter.

When you are running trading positions and customerfacilitation books, it doesn't always go your way and we had a very toughquarter, not the first tough quarter we ever had, I am sure won't be the lastone. But I don't think the results that you saw for the quarter across thosebusinesses are any indications of inability to compete. What's happening in themortgage market, I also don't think has any reflection on that. Candidly, thishas been a very difficult market to call.

A handful of firms have done it reasonably well, mosthaven't. Just by looking at the results, we've clearly been wrong in the waythat we position the books though the course of the year. I don't think thatthat is a risk management failure, if you will. I think it really is, we madejudgments that proved to be inaccurate.

Douglas Sipkin –Wachovia Capital

So I mean I guess you guys still believe in the growth inthe innovation of the derivatives markets especially from a hedging standpointis still valid and that few guys here is really just more of a function ofmisinterpreting markets?

Sam Molinaro

Unfortunately, I think that's the case and we are not happywith the way that we performed, and certainly not happy with the outcome of it.But as it relates to mortgage market, unfortunately that's what happened inthese other markets. When you get into difficult market environments and theenvironment gets quite volatile, sometimes that works out, sometimes thatdoesn't, this is just a tough quarter.

Douglas Sipkin –Wachovia Capital

Okay. I was also shifting gear, I was encouraged to see themargin balances as think far. I know you guys had maybe little bit more challengesin the first half of the year. Could you maybe walk us through, what you guysare doing, just sort of continue to impress upon potential hedge fund clientsto strength in the long-term franchise of your business in the prime brokeragearena going into 2008?

Sam Molinaro

Sure. Well, I think, domestically the franchise is certainlywell known and his capabilities are evident. The difficulties that we had inthe third quarter had nothing to do with the franchise itself, it had mostly todo with the concerns in the markets about the credit, the viability of thebalance sheet given the significant dislocation we saw in August and the lackof visibility really in anybody's balance sheets of that time.

So, I think as we worked our way thorough that and themarkets have calm down. There has been greater visibility into what the natureof the risks are, that people are running. That issue has subsided.

So, I think, domestically it was really all about, somewhatof a panic that was going on in the summer as this market dislocation wasunfolding. I think as we go foreword, the goal is what it always is which ifyou provide strong customer service and you are committed to the business andyou deliver the full capabilities the firm, your clients you will win more thanyour share of the business and I think we will do that.

Internationally, we are very focused on building out theprime brokerage business in Europe. We havehired a very strong team of guys over there that were very pleased with, thenwe think we are off to a good start. And we are very optimistic about thegrowth of the non-U.S.-based business. So that that's really, nothing hasreally changed here other than having a deal with the operating environmentthat we were confronted with.

Douglas Sipkin –Wachovia Capital

Okay. And then just finally and possibly question, but I'llgive it a shot anyway, I don't even expect to have pinpoint answer. But puttingthis year aside, thinking about 2008 and the way businesses are operating.Obviously, the mortgages debt at a much lower level and maybe less in the wayof a non-conforming mortgages. I mean what type of returns do you think arereasonable for you guys? Obviously, not in the November environment but maybesomething that's a little bit better than November, but still a challenging?

So sort of thinking about your potential book value growthfor 2008. And obviously I know I'm not going to hold you too, just given howdicey the markets are. But I am just curious, what you guys think you can do insort of a new normal operating environment, which who know what normal is, butcertainly something that did not exist in 2005 and 2006?

Sam Molinaro

Right. Well, I'm not going to try to estimate what kind ofoperating returns we're going to have. But I think that we don't believe thatcertainly the level of revenues that we saw this is anywhere near indicative ofthe revenue generating capacity, the franchise. So, we would expect the revenuelevels to be considerably higher, obviously not maybe at 2006 levels, becausewe would expect the fixed income businesses to be a bit more challenging.

But as we look at the mix of -- the business mix is alwayschanging and while our mortgages may be somewhat smaller this year relative towhere we were in '06, it's difficult to predict because I think if marketsfirm, the opportunity into distressed side of the business maybe very strong.

Secondary trading activity is certainly going to be theprimary area of activity in 2008 or at least that would look like that at thismoment in the mortgage business. Spreads are very wide and we think it’s kindof an interesting opportunity for people with franchises like ours.

But when you look at the broad mix of the business when youexpect our energy business to make a big contribution this year, we are veryencouraged by that. We think the equity is in global equity and prime brokerageplatforms continue to be poised for significant continued growth. So, I thinkthat revenues will be probably lower than '06 and what that turns into aprofitability will be a function of the mix of the business and our ability tocontrol expenses.

Douglas Sipkin –Wachovia Capital

Okay. And then just finally, obviously the challenging 2007,where you guys obviously over the long-term have done a phenomenal job. Anyupdate on succession planning over the next year, two year success. I felt Ihave seen some headlines not from you guys just from Newswire. So, any updateyou can provide on that process that maybe going on or will be going onsometime in 2008?

Sam Molinaro

No, I don’t have any update to give you on that, Doug.

Douglas Sipkin –Wachovia Capital

Okay. Great, thanks for taking my question, Sam.

Sam Molinaro

Sure, thanks.

Operator

The next question then comes from Meredith Whitney from CIBCWorld Market, please ask your question.

Sam Molinaro

Hi Meredith, are you there.

Meredith Whitney -CIBC World Market

My question has been answered, thank you.

Sam Molinaro

Okay.

Operator

The next question then comes from Mike Mayo from DeutscheBank. Please ask your question.

Mike Mayo - DeutscheBank

Hi. Yeah, you had $3.2 billion of gross write-downs on theinventory, how much was the inventory.

Sam Molinaro

I think we told you the inventory balances were $46 billionat the end of the quarter.

Mike Mayo - DeutscheBank

So in total, how much of those inventories been writtendown. Should we guess it - there are probably more write-downs than just thisquarter, that’s why I asked?

Sam Molinaro

Yeah. I don’t know, Mike, off of the top of my head. I thinkwe disclosed it over the third and fourth quarter’s, we had taken totalwrite-downs of $2.6 billion the bulk of that was in the mortgage area.

As you may recall I think we disclosed approximately $200million of net write-downs and leverage finance in the third quarter so thatgives you a sense of what the total size of the write-downs have been from thesignificant decline in value we’ve seen in the mortgage space.

Mike Mayo - DeutscheBank

How much were the write-downs this quarter on CMBS andwhat’s the assets there?

Sam Molinaro

The bulk of the write-downs that we took during the quarterwhile we broke out a $1 billion of the $1.9 billion of the balance the majorityis from the residential mortgage portfolio. CMBS inventories are currently atabout $15 billion out of that (inaudible) billion that we recorded as currentmortgage inventory balances. When we look at the $15 billion I will point outthat of that the largest majority are relatively short-term floating ratecommercial loans.

Mike Mayo - DeutscheBank

And you said you had write-downs of warehouse facilitiesthis quarter how much do you have left on those facilities and how much ofthose have been written down?

Sam Molinaro

Those are gone we’re out of those facilities the inventorieshave been liquidated.

Mike Mayo - DeutscheBank

And you also said you had write -- going back to thewrite-down from residential mortgages -- so how much have the mortgages beenwritten down may be sub-sector so all day how much of that been written downand prime mortgages how much of those have been written down?

Sam Molinaro

Well, I am not going to get into the detail of all of thewrite-downs Mike, but I think it’s fair to say that when you look at the lossesin the mortgage space, most of the losses are going be in the lower creditquality loans, so all day is going to bear more of it than the prime loans aregoing to.

Mike Mayo - DeutscheBank

Okay. And then one more general question how is themanagement. How is the management transition going with several changes thereand the reason I say that and clearly it’s a tough markets. But, when youcompare Bear's performance to few of the peers, you mentioned weaker equity trading,fixed income when you strip out the charges, was a little bit worst than peer,some of the prime brokerage revenues were down a bit this quarter. So, it justbased on the data itself that looks like some the problems from mortgage couldbe spilling over elsewhere at the firm. I guess, did you agree or disagree withthat and why?

Sam Molinaro

I disagree with that, Mike. I think that I can understandyour observation, but I think the simple facts are, we deal with the verychallenging market environment across the board, and we had very weak tradingresults, unfortunately, across the number of the different business, inaddition to the mortgage write-downs.

And given that the size of our other fee-based businessesare just not big enough to offset that, I mean that, is just--it’s obvious. Soit was a difficult quarter on the trading side from looking at, at least someof the results that I have seen from others. I don't think our performance inequity derivatives or structured-equity products was really that far off thenorm. Credit trading was very tough for everybody in the business. So, I thinkour results are more or less in line with what you are seeing from others. Big-- small asset management and product client businesses, if you will.

Mike Mayo - DeutscheBank

All right. Thank you.

Sam Molinaro

Okay.

Operator

The next question then comes from Jeff Harte from SandlerO'Neill. Please ask your question.

Jeff Harte - SandlerO'Neill

Good morning, Sam.

Sam Molinaro

Hi, Jeff.

Jeff Harte - SandlerO'Neill

Couple of things, one assets under management. You talkedabout the spin off impacting on. Beyond the spin off, can you talk about littlebit of about what kind of flows you have seen or how things are going as far aasset levels go on the wake of the troubles you guys have last quarter?

Sam Molinaro

Yeah, it's a good question. I think that things haveactually gone quite well, obviously a very, very challenging third quarter thatcreated a big challenge to the franchise. We spent really the last three tofour months trying to stabilize the situation changes in the management team,stabilizing the internal situation, employee morale, etcetera, which I thinkwhich has largely, hopefully been done and stabilizing the situation withclients.

We've seen very little spillover impact from the problemsthat we had in the high-grade funds and the other areas in asset management. Wedid see net positive inflows during the quarter, so we are encouraged.

The alternatives business had a good year, a number of theestablished funds that we had there have performed well. It's been challengingbecause really anything, any firm that was focused in the credit markets hashad a very difficult time of it. But the equities in emerging market firms havedone well.

And again on the traditional side, we are continuing to plugaway and building the traditional side of the business. I think we are in goodhands there with the management changes we've made.

Jeff Harte - SandlerO'Neill

Okay. And then the wake of a rating agency finally takingactions against the bond insurer yesterday. Can you talk a little bit about A,your exposure or your dependence upon bond insurers to get to net numbersversus gross numbers? And secondarily, given your merchant banking investmentin ACA, do you still own a portion of that. Can you give us any details onthat?

Sam Molinaro

Yeah. Let's start with ACA, it often gets confused becauseour merchant banking funds is an equity owner of ACA. We often create someconfusion as to what our level of involvement is away from that.

The equity investments, the exposure to the company from ourequity investment through the fund is not material, and as it relates tocounterparty credit exposures to ACA, those exposures are also quite benign andfully reserved and reflected in the earnings. We have no additional exposure tothem.

So I think that is quite well contained and behind uswhatever the exposure was. As it relates to other model lines, we have verylittle wrap to CDO credit exposure, almost none. And whatever exposure we haveto them is typically limited to our credit trading books and to some extentmunicipal inventories.

Jeff Harte - SandlerO'Neill

Is (inaudible) protection something maybe historically beenmore dependent on and kind of seeing the way things were going, you reducedexposure to, or is it typically been some something you don't have a lot ofdependence on?

Sam Molinaro

It has typically been something we've not had a lot ofdependence on.

Jeff Harte - SandlerO'Neill

Okay. Thank you.

Sam Molinaro

Okay.

Operator

The final question comes from Glenn Schorr from UBS. Pleaseask your question.

Glenn Schorr - UBS

Hi, Sam.

Sam Molinaro

Hi, Glenn. Are you there?

Glenn Schorr - UBS

Yeah. I am here. Can you hear me?

Sam Molinaro

Yeah.

Glenn Schorr - UBS

Okay, thanks. Just quickly--clarification on the 700, or so,in stock based comp. Comp on the P&L is down 21% for the year, if youheaded back, you get it down around four or five. Is that might doing apples toapples or mixing thing?

Sam Molinaro

It's a reasonable way to cough it to try to take a look atthe numbers. Obviously, aggregate compensation levels have to reflect theoperating environment that we are going through in all the areas of the firm,not just in the mortgage area. So when you look at the results for the fullyear, we have many areas of the firm that had record years.

We had to obviously compensate the people that did the work.A few areas that had very difficult operating environment so we had to dealwith that. So lot of compensation often becomes an issue of mix. The key focusobviously is making sure that we're paying market competitive compensation andretaining the people which we think we've done and that's the key objective inall of this.

Glenn Schorr - UBS

Don't get me wrong, I am a big fan of the comp and thepeople.

Sam Molinaro

I am sure you are.

Glenn Schorr - UBS

You mentioned balance sheet reduction as one other thingsgoing forward in terms of how you feel about capital adequacy. What exactlydone during the quarter and maybe you can size it in terms of net assetreduction, like what makes it way off? And is that a more of a permanent way ofthinking about Bear, in terms of a little bit more of the risk franchise from abalance sheet perspective going forward, like what kind of net leveragereduction are we looking at?

Sam Molinaro

Well, I think you are actually going to see net leverageprobably uptick a little bit, but that's mostly a mix issues. So when we lookat our gross leverage, when you look at total balance sheet footings, we willprobably be largely unchanged versus the August quarter.

But when we look inside the mix of that balance sheet,clearly mortgage inventories are declining largely because there is very littleintake on the origination side, very low levels of warehousing for either CDOsor CLO activities virtually nothing in CDOs obviously. So the balance sheetdemands of that business are likely to diminish a bit in the near-term.Offsetting that is the mix in the liquid products could be up in any givenperiod, whether those are agencies or treasuries whatever that maybe either aspart of your dealer inventories or hedging your derivatives books.

And then, of course, growth in the customer margin balances,which are good things and we are obviously strongly trying to encourage that.So, I think that we think about capital adequacy. We monitored most intentlyour capital ratios which I said have been very strong, and we think are quitehigh relative to peer comparisons to the extent that that's you are capable of doingthat.

And while they dipped a little bit is a result of the lossthat was taken, we do know that we should have the closing on the convertiblewith CITIC during the first half of the year and our expectation is thatinventory balances will continue to grind down in an environment where we arenot originating a lot of new mortgage product.

Glenn Schorr - UBS

I appreciate that. Just to clear, I mean, the things areabundantly clear that you don't expect any further capital raise from here.It's interesting because you are saying this big capital raises that of some ofyour larger peers. What are you saying then, it's a function of mix and onbalance sheet and overall size as well, because arguably your charge-off isjust as big as anybody else on a percentage basis?

Sam Molinaro

I think I remember all those numbers, but I think eachcompany has its own issues that is dealing with, and it's hard to know what thecapital ratio situation looks like inside of each firm. But I think thosedecisions, typically, are predicated upon that.

Glenn Schorr - UBS

Okay. Thanks very much, Sam.

Sam Molinaro

Okay, Glenn.

Operator

At this time, I will turn the call over to Mr. Molinaro forany closing comments.

Sam Molinaro

Okay. Well, there are no further questions. Thank youeverybody for being with us. Have a very happy holiday, and we will see younext quarter. Thanks.

Operator

This concludes today's call. You may now disconnect.

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