Increases in the credit spreads caused the short positions to decline in value, resulting in net portfolio gains though this was offset by lower risk arbitrage revenues.
- The decline in energy revenues, reflected gains in the 2006 period associated with the monetization of certain power assets. In line with the development of energy operations, the acquisition of the Williams Power portfolio will be concluded on October 1, 2007.
- Fixed income revenues were $118 million, down 88% from $945 million in 2006.
- Net inventory markdowns of $700 million were recognized related to mark-to-market losses experienced in residential mortgages and leveraged finance activities leading to losses in mortgage revenues.
- Declining revenue levels associated with the inability to securitize and distribute mortgage assets served to exacerbate the impact of inventory markdowns on mortgage revenues.
The firm had $50 billion of mortgage and asset-backed inventory, including sub-prime mortgage loans of $1.4 billion, and $700 million of investment-grade sub-prime securities and $313 million of below investment-grade retained interests.
- The large supply of pending leverage finance activity, together with investor concerns over debt covenants and terms, serve to reduce liquidity and price in the leverage finance market.
- The company recorded markdowns of $250 million on the pipeline of leveraged finance commitments and loans concluding the quarter with outstanding leveraged finance commitments of $7.6 billion, from $20.8 billion at May 31, 2007.
Investment banking revenue was $241 million, up 9% increase from $222 million in the prior year.
- Underwriting revenues marginally declined to $92 million, evidence of a difficult fixed income capital markets environment, partially offset by higher equity underwriting revenues.
- M&A and advisory revenues rose 12% to $148 million from $132 million in 2006 quarter despite a decline in M&A and leverage buyout activities and equity market volatility which has reduced the backlog of equity offerings.
- Announced transactions included advising Blackstone Real Estate Advisors in their $20 billion acquisition of Hilton, Fidelity National Information Services in their $1.8 billion purchase of eFunds, Southern Air in their sale of their company to Oakhill, and Rural Cellular Corporation in their $733 million sale to Verizon Wireless.
Global Clearing Services:
- Revenues rose 30% to $332 million from $255 million in 2006, following strong net interest revenues of $259 million, up 35% as average prime broker margin debt and customer short balances reached record levels.
- Average customer margin balances increased 49% to $102 billion, reflecting a combination of higher balances from existing prime brokerage clients as well as increased balances from new accounts.
- Customer margin balances declined to $85 billion attributable to quantitative-based strategies and certain other prime broker clients deleveraging in August, as well as a few clients reallocating positions to other prime brokers.
Wealth Management:
- Revenues were a loss of $38 million from $233 million in 2006, following private client services revenues of $148 million, reflecting growth in fee-based revenues and commissions.
- Fee-based assets and PCF customer accounts increased 16% to $10.9 billion from $9.4 billion in the prior year.
- Asset management revenues were a loss of $186 million, down from a gain of $105 million in 2006 due to losses of $200 million associated with the failure of the Bear Stearns high-grade funds as well as negative crude performance fees.
- Total assets under management were $57.8 billion, an increase of 15% from $50.2 billion in 2006.
- As a result, asset management revenues, excluding the impact of the high-grade hedge fund losses, were up 28% to $285 million, reflecting growth in both management and performance fees.
Fair Value Disclosures
- The firm commenced disclosing a categorization of the assets and liabilities that are recorded at fair value, with 4% of assets considered level 3 assets.
- Given the lack of liquidity in the marketplace for many instruments, management believes some level 2 assets will move to level 3 though the increase will not be material.
Aggregate U.S. mortgage origination volumes are expected to decline to $2 trillion in 2008, thus management is adjusting the cost structure of origination efforts and repositioning the franchise to focus on agency and jumbo prime mortgages.
- Market conditions in the MBS sector are expected to continue to stabilize as deleveraging and asset-backed commercial paper liquidation subside.
- On the credit markets, low historical default rates and a growing U.S. economy should provide support to a market coping with an oversupply of leveraged financings.
Key questions and answers from the third quarter earnings call conducted by Bear Stearns Inc. (BSC) on September 20, 2007.
Guy Moszkowski (Merrill Lynch):
What is your funded leveraged finance loans as of the end of the period?
Sam Molinaro: Our funded loans are $2 billion.
Guy Moszkowski (Merrill Lynch):
On the fixed income and structured product side, you alluded to some liability benefit. Was the mark-to-market on the structured product because of the widening of your credit spreads?
Sam Molinaro: Yes. In our structured equity products business, we are a substantial issuer of structured notes. Structured equity product revenue was up about $225 million quarter to quarter; and all of that was a result of the gains recognized in that structured note portfolio.
James Mitchell (Buckingham Research Group):
Given your discussion about the capacity of the fixed income business still intact, if prices were flat, the $700 million goes away and that would be an uptick in fixed income?
Sam Molinaro: It is fair to say so. We are issuing securities to investors, which are marketable securities that get mark-to-market by them and us. They are trading instruments. Customers exit those trades by selling them back to us.
We had a policy of not hedging the credit exposures imbedded in that portfolio given the fact we have been issuing these over the last several years at what were then tight credit spreads for not only us but for the industry. That posture may change going forward, but we think that the gains that are recognized there while it is an accounting change, granted to allow dealers like us to reflect the true economics of this business.
