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

The Bear Stearns Companies, Inc. (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

Presentation

Operator

Good morning, ladies and gentlemen, and welcome to the Bear Stearns 2007 fourth quarter Earnings 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, 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 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.

These risks and uncertainties could affect our business and potentially change our 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 market and economic conditions. For fuller discussion of these risks, please see our disclosures file with the SEC in our most recent annual report and in our quarterly Form 10-Q filing. In particular, read the sections Management's Discussion and Analysis of Financial Conditions and Results of Operations and Risk Management. You can see these documents through our website. This audiocast is being recorded and is the copyrighted material of the Bear Stearns Companies, Inc. and may not be duplicated, reproduced or rebroadcast without our consent.

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

Sam Molinaro

Thanks, Elizabeth, and good morning, everybody and welcome again to the Bear Stearns Companies, Inc. quarterly earnings conference call for the fourth quarter ended November 30, 2007.

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

November 14, we announced we would take a $ 1.2 billion write-down on our mortgage securities inventories, as a result of continuing deterioration in market conditions through the end of October. During the month of November, market conditions continue to deteriorate, which resulted in additional write-down bring total mortgage related losses to $1.9 billion or approximately $8.21 per share. This write-down, together with difficult conditions across the credit and interest rate markets, resulted in net revenues turning negative to a loss of $379 million for the quarter and the Company recording its first ever quarterly loss of $6.90.

The extremely disappointing results we experienced this quarter are attributable to the number of factors. In fixed income, in additional to the significant decline in mortgage markets, high-grade and high-yield credit spreads increased significantly moving to the widest levels that we have seen in several years. As a result, market conditions were exceptionally challenging and we experienced significant decline in credit trading results.

The deteriorating conditions in the global fixed income market 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 significant volatility in equity markets. Our customer volumes rose significantly both in the U.S. and Europe. The more volatile market conditions resulting in significantly weaker trading revenues and structured equity products when compared to the record performance.

Investment Banking activity level also declined as a result of these [conditions]. M&A volumes declined as the more difficult credit market conditions in leveraged finance and high-yield, there were significantly reduced financial sponsor activity. Equity underwriting activity also declined reflecting the more difficult environment.

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

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

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

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

In particular, we experienced record years in a number of key areas, such as Institutional Equities, Global Clearing and Private Client Services, reflecting successes we have achieved in executing against our strategic objectives. Revenues from our international activities also were adversely impacted by the challenging global fixed income and equity marketing conditions.

Inventory markdowns of mortgage and asset-backed security positions held in both Europe and Asia, served to 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 $1.6 billion for fiscal 2007, a 23% increase from $1.3 billion earned in fiscal 2006.

International expansion remains a key priority as we move into 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 principle to establish comprehensive strategic alliance with CITIC Securities. This alliance will include the establishment of a joint venture in Hong Kong together with the cooperation agreement to assist CITIC in the development of their institutional capital markets activities in China. We also announced that we would issue a $1 billion, 40-year convertible trust preferred securities that would convert to approximately 6% of Bear Stearns and that we would acquire a six-year convertible bond and warrants, giving us the right to acquire 7% of CITIC.

We expect the transaction to close during the first half of 2008, we are confident that the combination of our operations in Asia with CITIC Securities will greatly benefit our global client base and generate significant opportunities for revenue growth in the years ahead.

During the quarter, we took actions to reduce our overall operating costs by reducing headcount and rationalizing our businesses in light of the deteriorating market conditions. Total employee headcount was reduced by approximately 1,400 employees, or 9%, as we reduced staffing levels across the firm 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 to monitor market condition and make additional cost reduction as necessary during 2008.

Our performance this quarter, and for the full year, is clearly disappointing, which is not acceptable to us. We are fully committed and 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 the fourth quarter, we will reduce operating costs in excess of $250 million and should meaningfully enhance pre-tax margins in the 2008. We remain committed to our core strategy of expanding our global equity and clearing franchises, increasing the diversification of our fixed income activities by product and region, and continuing the development of our international activities.

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

If I could ask you now to please turn your attention to our segment data contained in the earnings release, I'll review each of the three major business segments, Capital Markets, Global Clearing Services, and Wealth Management.

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

Institutional Equity net revenues decreased 11% to $384 million 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 cash equity sales areas achieved record results associated with increased customer volumes and market share gains. Risk arbitrage revenues rebounded strongly from the difficult sequential quarter into more favorable market conditions.

Principal strategies area also experienced record net revenues and increased trading gains in quantitative strategies. The strong fourth quarter performance for each of these areas, [capped off] record years in this area. Offsetting these increases were significantly reduced net revenues from the structure equity products area, primarily due to volatile market conditions and a $190 million reduction in gain and our structured no portfolio when compared to the prior quarter.

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

During the quarter, the Company had gross inventory markdowns of mortgage assets of approximately $3.2 billion. Partially offsetting these losses were hedging gains of approximately $1.3 billion. A large component of these losses were approximately $1 billion of losses, incurred related to CDOs and the unwinding of CDO warehouse facilities, where a customer loss mitigation arrangement proved to be inadequate.

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

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

Currently, our mortgage and asset backed inventories are approximately $43.6 billion, down 5% from quarter end. I should point out that these balances representing gross asset values and net exposures are considerably lower. In particular, net of hedges are ABS CDO and subprime positions are net short.

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

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

Difficult global credit market conditions also served to create challenging in trading environments in both rates and credit product areas, as credit curves inverted, spreads wide ended correlation estimates proved delusive. Credit product net revenues declined sharply during the quarter, reflected a more challenging environment and net losses were experienced in our flow and structured credit areas. In our rates area, increased customer activity was offset by more challenging markets for interest rates and foreign exchange options.

Partially offsetting the losses from our credit trading businesses were improvement in our leverage finance area, which rebounded from the poor results during the sequential quarter. Leveraged finance pipeline commitments declined significantly during the quarter to $600 million from $7.6 billion at August 31, 2007 and closed at funded loans outstanding decreased to $2 billion from $2.5 billion.

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

Underwriting revenues for the fourth quarter were $113 million, 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. Equity underwriting revenues also decreased when compared to the November 2006 quarter on lower volumes of equity follow on and convertible new issue activity. Sequentially, underwriting revenues increased 13% from $100 million earned in the August 2007 quarter.

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

The difficult market environment for leveraged finance that began in the third quarter has continued through the end of our fiscal year. As a result, leverage buyout activities have declined and equity market volatility has reduced the backlog of equity offerings. However, M&A discussions with corporate clients remain active and our backlog of M&A and underwriting assignments at the end of the quarter has decreased slightly from the levels achieved at the end of the August quarter.

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

Included in investment banking net revenues are revenues generated from our merchant banking activities. For the current quarter, merchant banking revenues were flat, compared to a gain of $35 million of November 2006 quarter and 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. Net interest revenues increased 1% to $205 million from $203 million in last year's quarter, as average margin debt balance has increased from the levels reached from November 2006 quarter.

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

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

The decline in average customer margin debt and short balances when compared to the August quarterly levels reflects client deleveraging due to the challenging market environment, as well as prime broker balance reallocations experienced during early August. Customer balances have increased after lows experienced in the third quarter, and new business prospects remain strong.

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

For the full fiscal year, Global Clearing achieved record revenues of $1.2 billion, up 11.5% from fiscal 2006, reflecting significant customer balance growth in prime brokerage. We believe the success of the franchise in 2007 provides clear evidence of the value of merging our cash derivative and clearing franchises and positions us for continued success in 2008.

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, primarily reflecting growth in fee-based revenues and commissions.

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

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

The strong results were primarily due to growth in management fees on alternative assets and traditional fixed income assets. In addition, performance fees increased and growth of fees in proprietary hedge fund products.

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

Full year Asset Management revenues were $228 billion, down 32% from fiscal 2006. However, excluding the impact of the losses incurred from the failure of the high-grade hedge funds, net revenues are up 14% to $382 billion reflecting strong growth in both management and performance fees.

Full year net revenues in the Private Client Services area were also a record $602, up 15% from fiscal 2006. Total assets under management at 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 the levels of August 2007. The decline in assets under management primarily relates to the $8.8 billion transfer of assets related to the spin-off of [Ocean C Asset Management]. Under the terms of our agreement, PCM will maintain a continuing interest in the results of [Ocean C] and will maintain a sub-advisory arrangement of $3.5 billion of AUM.

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

Moving to expenses. Total expenses were $992 million, down 35% from the year ago quarter and down 14% from August 2007 quarter. The decline in total expenses is primarily due to lower employee compensation and benefit expenses, which decreased both sequentially and year-over-year due to lower net revenues.

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

Compensation and net revenues for the year ended November 2007 was 57.6% as compared to 47.1% fiscal 2006. The increase in compensation ratios, when compared to fiscal 2006, reflects the impact of the significant decline in net revenues experienced during 2007 associated with losses recognized in mortgage and asset-backed products.

The compensation ratio increased as other areas of the company performed well, and compensation levels needed to be maintained in order to reflect market levels.

During the year, the company amended the terms of its stock awards for fiscal 2007 in order to align its plans with market practices and to emphasis long-term service and retention objectives. The 2007 Stock Awards established future service requirements to be met in all cases in order to satisfy vesting requirements.

Accordingly, the awards granted in December 2007 will be expensed over the vesting period or sooner for participant that is retirement eligible. The net effect of the change in the terms of the stock award was at approximately $721 million of 2007 Stock Awards will be deferred and amortized over the applicable vesting period.

Worldwide headcount as of November 30, 2007 is 14,100 up from 13,600 in November 30, 2006, were down from the 15,500 level reached in the sequential quarter.

The overall headcount increased we have experienced, as compared to November 30, 2006 reflects the expansion of our fixed income, wealth management, global clearing and derivative areas, which are attributable to increased business activities and growth initiatives particularly internationally. However, during the fourth quarter, headcount was reduced by action and attrition of approximately 9% in 1400 employees reflecting the difficult 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. The increase in non-compensation related cost when compared to November 2006 quarter is primarily related to increase severance expenses, legal settlements, and professional fees. These increases were partially offset by lower CAP plan related expenses.

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

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

Out tax rate for the quarter, was a benefit of 38% reflecting the net loss before income taxes and relatively fixed level of tax-preference items. Our year-to-date tax rate also moved to a net tax benefit of 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 in treasury stock purchases. During the quarter, we repurchased $3.4 million shares of common shock at an aggregate cost of $373 million. For the full fiscal year, the company repurchased $12 million shares of common stock in an aggregate cost of $1.7 billion.

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

Firm-wide VAR at the end of the quarter increased significantly to $69 million when measured against the August 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 in market volatility during the quarter and the impact of the Williams transaction which closed during the period.

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

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

The firm's parent company liquidity pool, which consists of very high quality money market instrument, stands at $17.4 billion. In addition, readily available secured and unsecured committed bank lines are approximately $8 billion.

In closing we make a few remarks about our outlook as we head into 2008. Our 2007 was an incredibly challenging year. We began 2008 as a stronger firm. Our international expansion efforts are on track. The build out of our European effort continues to go well and in Asia we are excited about our partnership with CITIC Securities.

In equities, we achieved record levels in 2007. Our energy businesses have reached a new level with the closing of the Williams transaction by broadening our national presence as a major player in the fiscal energy markets. We think there is significantly more to come in the development of that business.

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

In recent weeks we have completed steps to size our mortgage origination business to more accurately reflect our view of current and potential market conditions. As part of this effort, we closed our subprime originator Encore credit reducing occupancy costs, headcount and technologies spend, while retaining our ability to originate all types of mortgages through Bear Residential Mortgage Corp.

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

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

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

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

Question-and-Answer Session

Operator

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

Roger Freeman - Lehman Brothers

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

Sam Molinaro

Well, I would say as we came into the quarter, conditions seem to be relatively improving and certainly didn't end that way. I would say, as we progressed through October/November, market conditions got significantly more difficult, and as a result, we saw a customer activity in fixed income declining significantly, and moving to a more safe haven if you will. So, the activity 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 of the fixed income markets--certainly in credit and mortgages--during the latter end of the quarter, and the more liquidity products, and rates and foreign currency. Obviously, customer volumes continue to be strong.

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

Roger Freeman - Lehman Brothers

Okay. The actions you've taken to resize the business, have you take any actions you think you need to take at this point pending additional 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 right now. As I said, we'll continue to monitor the environment and, to the extent things change or become more difficult, we'll take additional actions necessary. But the key focus that we had has been to get our operating costs down. Clearly, we needed to address the mortgage origination effort, which had been built up in a different environment, and in light of expected volumes that needed to be addressed; so we've done that.

Roger Freeman - Lehman Brothers

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

Sam Molinaro

No, it's really that the gains were smaller. The gains were larger 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's what you are saying?

Sam Molinaro

That's right.

Roger Freeman - Lehman Brothers

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

Sam Molinaro

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

Roger Freeman - Lehman Brothers

Okay. Lastly, how much of the markdowns in fixed income were related 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 CDO warehouse. The balance of those losses $900 million came from the revaluation of 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 terms of Alt-a, as well as commercial?

Sam Molinaro

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

Roger Freeman - Lehman Brothers

Okay. All right, thanks a lot.

Sam Molinaro

Sure.

Operator

The next question comes from Guy Moszkowski from Merrill Lynch. 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 if you could help us reconcile the risk exposures to the chart that you showed us on November 14, that was broken up sort of AAA Super Senior, and then you have sub-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, which would 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 stacked stuff 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 we came in to this quarter with a subprime position, but I think was flattish and we closed the quarter with a net short subprime position. We came into the quarter with a CDO position that I think was about $850 million, and we closed it about, what was the number that I just gave you $700 million? I believe that was the number.

Guy Moszkowski - Merrill Lynch

Okay. So it's sounds like then most of the difference between the hit that you pre-announced on November 14 and the actual $1.9 billion that you did was really away from the CDO, and subprime and more just a result 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 warehouse facilities that we had in Europe and Asia that we’re not included in that $1.2 billion, 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 for residential mortgages.

Guy Moszkowski - Merrill Lynch

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

Sam Molinaro

Well we did address Alt-A. Alt-A was included in that markdown, and as market conditions continued to deteriorate we took additional markdowns.

Guy Moszkowski - Merrill Lynch

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

Sam Molinaro

Okay.

Guy Moszkowski - Merrill Lynch

And just to clarify on the reduction on equity revenues because of the structured product decline, is most of that decline in structured product revenue that you addressed, the result of the decline in the credit that you get from the structured product related liabilities that we talked about, or is it that the actual underline cause of this decline?

Sam Molinaro

I would say it was about 50-50 between lower trading revenues in a very difficult trading environment, and structured equities given the 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 a lot in your release on the balance sheet. Maybe you can talk to us about your capital position at quarter end, not just in absolute terms, but in term of key capital ratios--how they look at the end of the quarter, given the reduction in book value, and sort of how that looks when you then layer in the capital infusion that is coming from CITIC, and whether we should think that, given the magnitude of the charges, you might be capital constrained, or whether you should where you probably don't have to raise capital?

Sam Molinaro

Well, the overall level of the balance sheet, quarter-to-quarter is about unchanged. Obviously, capital is down from where we closed the third quarter given the losses that we experienced this quarter. We have historically had very strong capital ratios, significant excess capital, obviously the reduction will reduce that somewhat. But our capital ratios, we believe, are still 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 security that we sold to CITIC will happen during the first half of the year, and that will add to the equity capital base. So with that, capital ratios should move back to a levels that we have been running at.

Guy Moszkowski - Merrill Lynch

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

Sam Molinaro

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

Guy Moszkowski - Merrill Lynch

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

Sam Molinaro

Yeah, I think that's fair. Obviously, all things being equal, what's happening with the balance sheet. But I think that I also want to point 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 Buckingham Research. 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 down quite a bit this year, but then you mentioned that you had about what $720 million in additional stock that didn't flow through, I guess, the expense line, right now?

Sam Molinaro

Right.

James Mitchell - Buckingham Research

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

Sam Molinaro

Well, I think you can do that. Thinking now as I think, that we've been a little bit off industry standard with the way that we've awarded stock compensation. Because the terms of many of our stock award plans are such that 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 of the 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 the effect of requiring those awards to be amortized in the future. But I think it's fair to think about as the employees might look at it, from the employee standpoint, the value of the compensation awards this year by adding that back in.

James Mitchell - Buckingham Research

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

Sam Molinaro

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

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

James Mitchell - Buckingham Research

Okay. And that's mostly in the comp line. So you are saying that because of the kind of the switch we might see -- assuming a normalized kind of level of revenues that the comp ratio could be a little bit lower than in 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, how much of that contribution. I assume those may be some litigation reserve building in there. Is there any indication of what size that would be?

Sam Molinaro

I believe the increase in litigation and legal expenses was about $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 of America. Please ask your question.

Michael Hecht - Banc of America

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

Sam Molinaro

Good morning, Mike.

Michael Hecht - Banc of America

Can we maybe talk a little bit about, I guess, the loss of this magnitude this quarter? Can you just talk a little bit about, I guess, how it's impacted the Board's relationship with the executive management team? And what 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 management practices to help ensure you guys are kind of more protective from a loss like this going forward?

Sam Molinaro

Let me start with that last part first. I think that there is a lot of discussion about risk management practices and whether these losses were unexpected, surprising, etcetera. Obviously, they are unexpected and obviously, they are not acceptable the level of losses. But these losses are won't surprises if you'll. I mean we understood the nature of our risks. We understood the nature of the mortgage positions that we held. Candidly, we made decisions in hindsight as it related to the hedging of these books that didn't turn out well.

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

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

Michael Hecht - Banc of America

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

Sam Molinaro

I would say the bulk of that number is comp. It's direct compensation and benefit cost and some amount of ancillary, communications, bonds, market data, etc. I think that you will with taking 1400 employees out of census; I think that it’s reasonable to assume 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 you will see some decline in those numbers going forward. Also included in this quarter, as I said, were a $100 million severance charges, which are non-recurring, and we did have an uptake in legal and litigation related cost of about $60 million.

Michael Hecht - Banc of America

Okay, that's helpful. Coming back to the equity's business one more 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 that amount 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 actually seemed to strength in those areas. I am just trying to understand if the weakness that you guys saw was more, just a lack of customer activity or bad positioning, or what?

Sam Molinaro

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

Michael Hecht - Banc of America

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

Sam Molinaro

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

Michael Hecht - Banc of America

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

Sam Molinaro

Right.

Michael Hecht - Banc of 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 a little bit more color on how you kind of get there, close deals versus deals that maybe get pulled?

Sam Molinaro

Yeah. Well, the biggest move in there was, deal that didn't happen, 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 of the change were transaction that were closed. You can see that, because our funded balance are down, we were able to distribute much of that.

Michael Hecht - Banc of America

Right. Okay. And then can we go back to the, I guess, the fixed income business this quarter, just maybe getting a little bit more color on how some of the sub segments of fixed income performed. Because if I kind of back out the marks, I get a run rate of, maybe like $350 million in fixed income, which I guess, if we assume, even some of the structured no gains went through there, maybe even a little bit softer than that,. I am just looking to get a little more color on performance across rates MBS credit and how we should 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 board of fixed income, and I certainly not indicative of run rate levels by any stretch. In addition to the large mortgage loss as we took which effectively swamp anything else that we were doing in mortgages. The credit markets were very difficult.

The distressed business was good, but structured credit and flow trading areas were very difficult, with volatile market conditions and generally wider credit spreads, so results there were negative; they were also relatively weak in the rates business, particularly position taking in the interest rate derivatives areas and foreign exchange in the options book lot of volatility, 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 - Banc of America

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

Sam Molinaro

Yeah. We have a process where we do--we allocate--because of this leverage finance business and some of the other businesses dominant fixed income where those revenues largely reside we do an allocation of revenues and costs back and forth between the businesses.

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

Michael Hecht - Banc of 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 terms strategic standpoint given that I – then more probably in the period of higher volatility it does sort of appear like and obviously not just for you but the entire industry the ability to hedge and use derivatives to offset risks has become a lot more challenging. For a firm like you guys are maybe little bit smaller than the rest. I mean how do you think about that potential structural change about your ability to compete in certain businesses? I mean are there going to be areas now where you guys make conscious decisions just to say hey we're not going to be able to compete as effectively as maybe we were without that ability to hedge going forward and as a result we're going to pull back in certain 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 very successful derivatives franchise that has grown dramatically over the last five years. We've now crossed the board, both rates, equity and credit of all enjoyed very strong performance. We just had a very difficult operating environment this quarter.

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

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

Douglas Sipkin – Wachovia Capital

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

Sam Molinaro

Unfortunately, I think that's the case and we are not happy with 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 in these other markets. When you get into difficult market environments and the environment gets quite volatile, sometimes that works out, sometimes that doesn't, this is just a tough quarter.

Douglas Sipkin – Wachovia Capital

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

Sam Molinaro

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

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

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

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

Douglas Sipkin – Wachovia Capital

Okay. And then just finally and possibly question, but I'll give it a shot anyway, I don't even expect to have pinpoint answer. But putting this 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 way of a non-conforming mortgages. I mean what type of returns do you think are reasonable for you guys? Obviously, not in the November environment but maybe something that's a little bit better than November, but still a challenging?

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

Sam Molinaro

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

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

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

But when you look at the broad mix of the business when you expect our energy business to make a big contribution this year, we are very encouraged by that. We think the equity is in global equity and prime brokerage platforms continue to be poised for significant continued growth. So, I think that revenues will be probably lower than '06 and what that turns into a profitability will be a function of the mix of the business and our ability to control 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. Any update on succession planning over the next year, two year success. I felt I have seen some headlines not from you guys just from Newswire. So, any update you can provide on that process that maybe going on or will be going on sometime 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 CIBC World 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 Deutsche Bank. Please ask your question.

Mike Mayo - Deutsche Bank

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

Sam Molinaro

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

Mike Mayo - Deutsche Bank

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

Sam Molinaro

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

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

Mike Mayo - Deutsche Bank

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

Sam Molinaro

The bulk of the write-downs that we took during the quarter while we broke out a $1 billion of the $1.9 billion of the balance the majority is from the residential mortgage portfolio. CMBS inventories are currently at about $15 billion out of that (inaudible) billion that we recorded as current mortgage inventory balances. When we look at the $15 billion I will point out that of that the largest majority are relatively short-term floating rate commercial loans.

Mike Mayo - Deutsche Bank

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

Sam Molinaro

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

Mike Mayo - Deutsche Bank

And you also said you had write -- going back to the write-down from residential mortgages -- so how much have the mortgages been written down may be sub-sector so all day how much of that been written down and 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 the write-downs Mike, but I think it’s fair to say that when you look at the losses in the mortgage space, most of the losses are going be in the lower credit quality loans, so all day is going to bear more of it than the prime loans are going to.

Mike Mayo - Deutsche Bank

Okay. And then one more general question how is the management. How is the management transition going with several changes there and the reason I say that and clearly it’s a tough markets. But, when you compare 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 just based on the data itself that looks like some the problems from mortgage could be spilling over elsewhere at the firm. I guess, did you agree or disagree with that and why?

Sam Molinaro

I disagree with that, Mike. I think that I can understand your observation, but I think the simple facts are, we deal with the very challenging market environment across the board, and we had very weak trading results, unfortunately, across the number of the different business, in addition to the mortgage write-downs.

And given that the size of our other fee-based businesses are just not big enough to offset that, I mean that, is just--it’s obvious. So it was a difficult quarter on the trading side from looking at, at least some of the results that I have seen from others. I don't think our performance in equity derivatives or structured-equity products was really that far off the norm. Credit trading was very tough for everybody in the business. So, I think our 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 - Deutsche Bank

All right. Thank you.

Sam Molinaro

Okay.

Operator

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

Jeff Harte - Sandler O'Neill

Good morning, Sam.

Sam Molinaro

Hi, Jeff.

Jeff Harte - Sandler O'Neill

Couple of things, one assets under management. You talked about the spin off impacting on. Beyond the spin off, can you talk about little bit of about what kind of flows you have seen or how things are going as far a asset 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 have actually gone quite well, obviously a very, very challenging third quarter that created a big challenge to the franchise. We spent really the last three to four months trying to stabilize the situation changes in the management team, stabilizing the internal situation, employee morale, etcetera, which I think which has largely, hopefully been done and stabilizing the situation with clients.

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

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

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

Jeff Harte - Sandler O'Neill

Okay. And then the wake of a rating agency finally taking actions 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 numbers versus gross numbers? And secondarily, given your merchant banking investment in ACA, do you still own a portion of that. Can you give us any details on that?

Sam Molinaro

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

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

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

Jeff Harte - Sandler O'Neill

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

Sam Molinaro

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

Jeff Harte - Sandler O'Neill

Okay. Thank you.

Sam Molinaro

Okay.

Operator

The final question comes from Glenn Schorr from UBS. Please ask 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 you headed back, you get it down around four or five. Is that might doing apples to apples or mixing thing?

Sam Molinaro

It's a reasonable way to cough it to try to take a look at the numbers. Obviously, aggregate compensation levels have to reflect the operating 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 full year, 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 deal with that. So lot of compensation often becomes an issue of mix. The key focus obviously is making sure that we're paying market competitive compensation and retaining the people which we think we've done and that's the key objective in all of this.

Glenn Schorr - UBS

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

Sam Molinaro

I am sure you are.

Glenn Schorr - UBS

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

Sam Molinaro

Well, I think you are actually going to see net leverage probably uptick a little bit, but that's mostly a mix issues. So when we look at our gross leverage, when you look at total balance sheet footings, we will probably 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 little intake on the origination side, very low levels of warehousing for either CDOs or CLO activities virtually nothing in CDOs obviously. So the balance sheet demands 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 given period, whether those are agencies or treasuries whatever that maybe either as part 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 intently our capital ratios which I said have been very strong, and we think are quite high relative to peer comparisons to the extent that that's you are capable of doing that.

And while they dipped a little bit is a result of the loss that was taken, we do know that we should have the closing on the convertible with CITIC during the first half of the year and our expectation is that inventory balances will continue to grind down in an environment where we are not originating a lot of new mortgage product.

Glenn Schorr - UBS

I appreciate that. Just to clear, I mean, the things are abundantly 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 of your larger peers. What are you saying then, it's a function of mix and on balance sheet and overall size as well, because arguably your charge-off is just as big as anybody else on a percentage basis?

Sam Molinaro

I think I remember all those numbers, but I think each company has its own issues that is dealing with, and it's hard to know what the capital ratio situation looks like inside of each firm. But I think those decisions, 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 for any closing comments.

Sam Molinaro

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

Operator

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

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