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Original Source: FD (FAIR DISCLOSURE) WIRE
JIMMY CAYNE, CHAIRMAN AND CEO, BEAR STEARNS COMPANIES INC.: Welcome, everybody, and thank you for joining us today. I'm Jimmy Cayne, CEO, Chairman of the Company.
Following our third-quarter earnings announcement, which was devoted to discussing the quarter, we thought it would be helpful for you to hear from our senior leadership team in some depth about the firm's outlook, especially in fixed income and in BSAM. In a challenging credit environment we made money in the third quarter and are now seeing most of our businesses beginning to rebound. The question is how we will make money going forward in the new environment. Despite a bad quarter, the fact is that our franchise is strong, our business model is intact and our many talented and terrific people are totally committed to Bear Stearns. We're confident of our future and our business and we see compelling value in our own stock.
In our earnings release, we announced a $2.5 billion share buyback, of which up to $1 million of stock will be purchased above and beyond what we need to fund the compensation of our employees. Together, we're continuing our strategy of diversifying our business mix and positioning the firm to resume growth. We will continue our international expansion and our development of innovative new products to meet the evolving needs of our clients. I'm confident that Bear Stearns will weather the storm and come out stronger, more diversified, and a greater organization that continue to prosper in the months and years ahead.
The team assembled before you today, some of whom you have met before, some of whom you may be seeing for the first time are highly experienced and they work cohesively together to create value for our clients and our shareholders and they've done that over the years successfully.
First you will hear from Alan Schwartz, President of Bear Stearns on the strategic outlook for our businesses. Then, our new CEO of Bear Stearns Asset Management will discuss that, Jeff Lane. We will then have an in-depth review of our fixed income businesses from Jeff Mayer and Craig Overlander, Co-Heads of Global Fixed Income, and from Tom Morano, Global Head of Mortgages, Rates, and Foreign Exchange. And next, you will hear from Sam, our CFO, who will give you some perspective on our financial outlook.
We want you to have plenty of time for questions, so the speakers will do some Q&A following their presentations. Then at the end of the half-day session, Sam, Alan and I will do an overall Q&A on any issues you want to discuss further. We promise to have you out of here before lunch and we're going to start the ball rolling with Alan. Alan Schwartz.
ALAN SCHWARTZ, PRESIDENT, BEAR STEARNS COMPANIES INC.: So I want to talk to you about how we are positioned for the future. Before we get started on how we're looking at the future and how we are positioned, we thought we would just take a quick look at a snapshot of what we thought were the market environment that we've worked through as we came through mid-year of '07, and summarize a little bit what the conditions were about and what the causes of them were.
You know, to start, any credit crisis, which is something that we've been living through, always has the seeds sewn in the underlying market conditions in the cycle that led up to that crisis. So, we would like to talk about that a little bit.
You know, it's our view that a combination of forces, one, a tremendous amount of global liquidity, a lot of liquidity in the market, liquidity in excess of investing demand, essentially had the effect of bringing the natural level of interest rates around the world down to very low levels from a historical perspective.
Two, that that in and of itself helped create a tremendous thirst for yield and a demand for yield. But that was exacerbated, we believe, by demographic trends, where aging populations in most of the developed economies shifted investor focus in many cases from growth to absolute return and yield. So, there was a lot of demand for yield at a time that liquidity was bringing the natural interest rate and the level of yields down.
And three was a disaggregation of the banking system or the financial intermediary system on a global basis, especially here in the United States. What we mean by disaggregation is, we essentially over the years separated underwriting of risk from ownership of risk. We went from a system where the entity that underwrote a credit basically held onto the credit. We went to a system where it was underwritten and then sold off. And so, the owner of the risk was different from the underwriter of the risk. Now, the place where you had the least transparency and underwriting risk and where you had essentially the most distance from the underwriting and the ownership of the risk was in the mortgage business. And so, what we saw as we came into '07 was that the '06 underwriting standards in the sub-prime mortgage business were where we had the biggest problem. And it stemmed as I said from the disaggregation.
So, as that sub-prime '06 vintage came into the marketplace and we came into '07 and it became clear in many people's eyes that the default rates or the default assumptions on the '06 vintage had been too low, that changed risk perceptions about a number of instruments. Sub-prime mortgages are the underlying collateral for a lot of collateralized obligations. One of the ways that the market was meeting in that cycle that I talked about the demand for yield in a low interest rate environment was creating a lot of new instruments that allowed people to expresses a bet, to take more credit risk or to take more interest rate risk in a structured way to get more yield. And so, as those structured instruments -- some of them have sub-prime mortgages attached to them -- created a change in the perception of risk of collateralized obligations across the board. That was the first reaction.
So, while sub-primes were part of the CDO market, it also created questions about other collateralized instruments like CLOs, the collateralized loan obligation market. And what that did was it spasmed a little bit the demand for leveraged loans. CLOs have been a major buyer of leveraged loans. When people wanted to stop investing in CLOs, that level of demand was no longer in the marketplace and that came at a time when there was a lot of supply coming into the marketplace, as everybody knows, from the leveraged finance activity that had led up to that point in time. So, what we had as we came into the summer was a dramatic change in the pricing of credit risk. And we had a large bid [ask] spread and it kind of froze activity in a number of sectors.
But, then the last places we came into the summer, deeper into the summer, was what we're calling AAA contagion. What happened was as sub-prime and CDOs were on people's radar screens earlier in the year for the riskier tranches, it became clear later in the summer that some very highly rated AAA securities contained a significant amount of sub-prime exposure and that caused a lot of problems and there was some talk of downgrades and certainly some major price adjustments. And once people saw that AAA instruments could have a lot of risk, that created the contagion effect of saying, we can no longer rely on the fact that a security of AA or AAA to assume that it is high quality. And then, you get a flight from any of that kind of paper.
Now, as it turns out, as we said when we disaggregated the banking system, we recreated one of the aspects of the old Savings and Loan system as the global economy was borrowing short and lending long. Because the tenor of a lot of these instruments was longer in the vehicles they were in than they were borrowing against or being financed by commercial paper that was very short. So, as the commercial paper -- the asset-backed commercial paper market essentially said we've got to move out of this market until we can see which instruments are really high quality and which ones aren't, that threw all the paper back into the market and created a real liquidity freeze in the economy.
That liquidity freeze essentially had the same impact that a major monetary tightening would have. It dried up credit creation. It stopped credit flow in the economy. Now, as we all know, the Fed responded to that by cutting interest rates, so, they essentially responded by saying policy got too tight, not because we engineered it but, the market engineered a policy tightening and now we're easing policy to offset some of the effects that might have on the economy.
So, as we stand here today, in the fall, conditions have eased somewhat. We're seeing liquidity flow better in the marketplace. We're seeing more activity levels coming back at a slow pace. But we're in the very early stages of seeing how this plays out.
We see it as we look forward as this market plays out, we see tremendous opportunities, because, you see, we can never reaggregate the financial system. That has already occurred. It's too late for that.
So, what we see happening as we go forward is, a lot of this paper, a lot of these credits that have been tranched, securitized, sliced and diced and sold different attributes of paper to different investors, a lot of the investor appetite is going to change. Previous owners of a certain type of risk may not want to own that risk anymore, given what just happened in the cycle. New pools of capital are forming every day to try and take advantage of buying what the kinds of risk and reward that they see available in these types of instruments. So what we're going to go through in our view is a period of time where not only new credit will come into the marketplace, because new mortgages and new loans will be written, but existing assets that have been sitting out there are likely to move in an aggressive way -- be restructured. That will create an environment where analytical capability, structuring capability, client service, execution capability are going to be great attributes and we feel very good about our ability to participate in that kind of environment and benefit from that kind of environment.
Of course, there is always a risk. As I said, we're in the early stages of this recovery as we see it. The clear risk is that the effects with a lag of the previous period of monetary tightness could be more serious on the economy than what is kind of currently expected in the marketplace. If I could handicap that, I would say the current expectation that there will be a definite slowdown in economic activity, at least in the U.S. and probably in some other major economies but not a deep recession. If in fact the risk that there was a deep recession occurred, that could put some pressure on credit performance. So far, we've had mostly a liquidity problem, not as much a credit performance problem, which our guys will talk about. If we had a deep recession concerns about credit performance would -- could have a significant impact on the marketplace. So, our job going forward is to be able to position ourselves to take advantage of all of those opportunities that we see from the restructuring of the paper that's out there and the growth in a number of asset categories while at the same time making sure that we are properly hedged and that we don't have undue exposure to the downside. And we feel very, very comfortable about our ability to navigate through that.
So, now let's talk about going forward and how we intend to execute on the environment that I just outlined for you. First of all, I think that the bottom line is that we're going to stay the course of the strategic initiatives that we've already had in place and that we feel very comfortable with. The reason we're staying the course is for a couple of reasons, actually. One, you've always heard us when we've talked in these kinds of environments about cycle over cycle performance. Whenever we talk about growth in book value, when we talk about returns, we always talk about cycle over cycle. That quite plainly is because we always know that there are going to be interruptions to the trend and there are going to be down cycles. So, we have to plan our business, and we do, around the fact that we know that we can't have uninterrupted growth in the markets that we serve. And therefore, the pace of our expansions have to be measured against the opportunities for these or the potential for these disruptions and, therefore, we have to make sure that we're growing and creating initiatives at a pace that we can sustain, even in difficult environments. So, part of our plan has already taken into account the type of environment that we've been living through, and therefore, we should stay on plan.
The second reason is that we have come into this environment with very strong balance sheet, very strong financially. Our franchises in our key areas are in very good shape. And, therefore, we are excited about the opportunities that we see to actually accelerate some of these growth initiatives in the environment that we see coming ahead.
The growth initiatives that we have talked about and we'll talk about today are outlined on this slide. The last two, the areas in wealth management, especially asset management and our diversification of fixed-income, we're going to spend a fair amount of time on. You're going to hear from Jeff and Jeff and Craig and Tom later on those. So I'm not going to talk about those. But I'm going to briefly touch on the other areas of our strategy.
First, international. International is a tremendous opportunity for Bear Stearns. We are seeing dynamic growth in both Europe and Asia in operations for Bear Stearns. Our revenues year-to-date in '07 have already surpassed our revenues from all of fiscal '06. Importantly, we're seeing profitable growth. We have lived through -- part of the reason we're excited about international is, we had to live through -- in the early stages of our build out of international we were subcritical mass. And being subcritical mass as you are trying to grow, you have to deal with below average profitability while you're trying to put the pieces in place for your operation.
We have now achieved critical mass. We are operating at good levels of profitability. We have solid position in the markets we're in, and therefore, at the margin as we continue to grow, we see it as very profitable growth.
We're very simply expanding the products and our product capabilities to bring more product capabilities into the markets that we deeply serve and we're expanding the geographies for the products that we already have. We have been opening new offices. We've opened I think two new offices we will open this year. We have a brand new Paris office. We have a brand new office in Frankfurt I think opening in about a week or two. And we have expansion across Asia. So, we see a lot of opportunities in sort of the existing markets that we've been serving and the periphery of them.
But, there is also in international another exciting opportunity from our view opening up to us and it's what I'm labeling or we're labeling a wholesale opportunity in the emerging markets. The emerging markets historically financed themselves through borrowing in the dollar markets by the government and allocating capital internally into their economies. What has changed I would say post '98 and has really taken flight in the last several years is that the emerging markets have changed the way they finance themselves. The governments are actually, instead of borrowing dollars, they are building up dollar reserves and they are allowing direct capital to flow into their economies. That creates a very, very, very different dynamic in those economies than has existed in the past. There are a lot of existing institutions in those geographies that have long-standing client relationships but as those clients are now looking to access the global capital markets, a lot of those institutions don't have the capability to access those markets but they want to maintain their client relationships. The perfect counterparty for them to help do that is a firm like Bear Stearns that's got state-of-the-art product capabilities and access to capital flow but is not a direct competitor with brick and mortar next to theirs in their markets. So, there's a tremendous opportunity to marry up their client relationships and our product capabilities and since it is an asset-light model, we believe it's going to have important return implications for us.
We also just want to mention our new international headquarters is opening in 2009 in London's Canary Wharf. It's going to be a significant new presence for us, and frankly, I think it's going to do for our international operations what this building helped do for our overall firm. I think it's a sign of what we have become. I think it's a sign of pride for the people over there and an announcement of our presence and I think it's going to coincide with a period of really robust growth for us overseas.
So, move on to the second piece of our growth initiatives, the Global Equities division. Now we've made a lot of this. You wouldn't -- as many of you know, we put together our cash derivatives in the equities business and our clearance businesses into one business managed by Bruce Lisman and Steve Meyer as one business. It wouldn't jump out at you necessarily that putting three businesses together is a growth initiative. But I can tell you that already what we have seen in terms of the energy and the vitality of what we're able in that business sector now to bring to our client and the impact that that is having on our clients and our revenues, this is one of the most exciting growth opportunities that we are pursuing.
And, this picture kind of says it all. Client first. Client first is not a campaign slogan. Client first is a way of life in the Equities business. And this slide puts the client in the center and all of the products and capabilities we have around that product. The reason that I think, if you get underneath why we put these three businesses together. We had three businesses that we are operating very well and very profitably. We had three businesses that all had a strong client culture. If you measured, if you looked at surveys on sales performance in each of these businesses, or client service, you've got very strong marks. But what was coming back through the people who are close to the clients was that, we could no longer satisfy our clients' needs by bringing them products. We had to bring them solutions. And in order to bring them integrated solutions, we had to put all of the products together. It's our responsibility to figure out which of those products can serve their needs and bring them solutions to their needs. And it's really happening.
So, when we look at the business going forward, you know, I grew up in a traditional equity business here. I started in institutional equities. I ran the research department. And, you know, so, it's a core strength of ours. It's a franchise of ours that is built and has gotten better and stronger, year after year. If you look at the surveys, if you look our position, it's always gotten stronger. But, in the days that I did it, it was very specialized even within just the cash equities business.
We had our analysts service -- the buy-side analysts, we had our sales force service the portfolio manager. But that changed dramatically over the years and it was the portfolio manager became a focal point of where we could see how we were impacting investment performance. Now, we take that base, we take the base of our -- the quality that we have and the orientation that we have and we're making global clearance the center of our integrated equities effort. Global clearance because while good investment ideas are still the cornerstone of investment performance, there's a lot of other things in today's world that really drive the performance of investing organizations. So, at the global clearance level we can get a window into everything they are doing and everything they need and we can go back and focus on how we can help them achieve their goals.
And we've always believed if we help clients do well, we do well. That's the cornerstone of what we do at Bear Stearns across the board. We have built the senior relationship management team, now headed by Mitch Jennings and Mike [Minikus] that are taking all of the product salesmen and all of the relationship salesmen and making them -- pulling together and saying how do we focus on our clients and help them achieve their goals?
As we go forward we see opportunities for growth. International, a subset of what I talked about earlier, is a big opportunity in the equities area, especially in the prime brokerage area. We've hired people, we've hired professionals in each of the geographies in Europe and Asia. We are following our clients -- a lot of our anchor tenants here -- we are following overseas and we're helping them meet their needs. And as we do that, we create capabilities to attract more clients.
Structured equity products -- big opportunity here. Probably even a bigger opportunity overseas because the way investors express their views on equities around the world are oftentimes through structured products instead of directly into the cash markets. And risk arbitrage -- we just want to emphasize that. It's a great opportunity for us. It was not a great risk arbitrage market last quarter as spreads really widened out. But it is a core competency of ours. It is something that we not only do well with our own capital but is a very big client business for us and a virtuous cycle of how you can use your capital and your research and your client service and create one really strong business.
A subset of what is in the equity business, I want to put a focus on, which is our Bear Energy business. Bear Energy is something that we have been building for a number of years, actually, beneath the surface. We have wanted to find a way into the commodities business because commodities are an opportunity for firms like ours or with the skill sets -- firms that have the skill sets that we do. We started a number of years ago through the merchant banking side, through principal investing, to get to know the markets, to get to be in the markets, to transact, gain a reputation, to understand the economics of the business and the energy business. We've probably bought and sold at this point something like over 5,000 natural gas wells. And you know, we have a real depth of expertise.
But as we looked at the energy markets, what we saw was a very large market, very fragmented and with changing regulatory environments and different regulatory environments in each market which creates opportunities to exploit inefficiencies.
So, what we did is, we decided to go into the physical side of the business. We started with a joint venture with Calpine. Calpine was the largest merchant power company in the country at the time. And we wanted to go into the physical side of the business in a way that we thought we had an edge. Because we were servicing an existing participant in the markets, who had to buy gas and sell power, it allowed us to get into the physical trading side of things around customer flow. And that meets our type of business, as most of you know.
The Calpine joint venture, we ended up taking 100% control of. It is now Bar Energy. It is a significant player in the physical markets. We're building out our counterparties. We're building out our trading and sales. We're putting in the risk management, the operational systems that we need. The Williams transaction, which will close shortly, is a big step forward and highlights the benefits of the strategy to me. We're able to do better, be a better buyer of those assets from the merchant banking side of the equation because we have the operational capability to service the assets through the physical side of our plant. And the physical sales and trading business will be enhanced by the fact that we're going to own those assets and be able to service them and have more customer flow to trade around. And we see -- we're just beginning to lay the foundation to enter the power business in Europe and it will basically mirror what we're doing here in the United States. And we think Bear Energy is going to be a significant business for us as we go forward.
Investment banking -- the strategy remains the same. I think -- I don't know how many of you were here on our investor day back in March but I actually gave a presentation about our investment banking strategy. And at that time, where we had tremendous activity in the LBO arena, we talked about how Jeff and David's strategy was to benefit from that environment but that they were really stressing to all of our bankers that we couldn't allow our coverage to tilt too much over to the financial buyer's side of the equation. And so that we had to keep a focus on our core clients and our core industry expertise. That is what they did and that is serving us well as the markets always shift back and we see real opportunities by continuing with our focus group of clients. A lot of you have heard us talk about how we run our business around maximizing returns as a client service business. It is focused and it is bringing them also the very customer centric operation of bringing solutions instead of products. And you use custom-tailored solutions to drive share of wallet to your existing clients and then you use those solutions and find that there are other people who could use high intellectually value-added solutions to add to your core group of customers over time.
We're also expanding internationally. What we have found is that our industry expertise are strong industry presences that we have in the United States are in demand by European clients. But the way to service those clients is, instead of duplicating industry expertise over there, we are hiring bankers with strong local knowledge, local clients in each of the major countries and having them bring our industry expertise into clients in those markets. And the whole time is very important we aggressively manage costs in that business and productivity, and as we talked about at that meeting, expand our producer base.
So, those are our growth initiatives. And I started out when I said to you that we -- it's important that we continue on our growth path, but it's very important that we manage risks in a volatile environment and risk management is an important part of our culture. As I think many of you know, our business is driven more about using our capital around flow businesses around what our customers are trying to do and the opportunities to both help them and profit from inefficiencies that we see. So, we tend to avoid big directional bets and we tend to hedge our exposures.
Now, that was a challenge in the environment that we just went through. Because unlike a lot of credit crises, as I said, the etymology of this credit crisis was a liquidity crisis. And that environment, customer flow in a …