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The Bear Stearns Companies Inc. (NYSE:BSC) was a leading investment bank and provider of broker-dealer trading services. Through its three principal Capital Markets, Global Clearing Services, and Wealth Management divisions, Bear Stearns advises institutional clients on mergers and acquisitions (M&A), facilitates client equity and fixed-income trading, manages assets for institutional and individual investors, and engages in both long-term (private equity) and short-term investing (proprietary trading). Although it's a prominent figure in the financial services industry, Bear Stearns is the smallest of the pure-play investment banks.

Bear Stearns has grown significantly since the early 2000s, earning revenues of $16.1 billion in 2007. The company has consistently ranked among the top ten firms in terms of the number of mortgage-backed securities, asset-backed securities, and commercial mortgage-backed securities originated each year. Despite its rapid growth, Bear still lags behind many of its competitors in terms of both geographical and operational diversity. Of Bear's 2007 revenue, 24% was earned by the Capital Markets division, 17% of which came from fixed-income trading, down significantly from 2006. As such, Bear Stearns is highly leveraged to conditions in both the fixed-income markets and general economic conditions. Additionally, Bear earned 87% of its 2006 revenue from within the U.S., more than twice as much as Merrill Lynch (MER), the investment bank with the second-smallest exposure to international markets.

Though fixed-income was a major source of growth for Bear Stearns through the mid-2000s, the firm's performance has been suffering recently as a result of its exposure to the ailing subprime and mortgage industries. Contracting credit markets led to decreased liquidity and large write-offs on many of Bear's holdings, leading Bear's customers and lenders to question whether the firm had enough cash to continue funding its operations. On March 14, 2008, Bear Stearns got U.S. Treasury-backed financing from commercial banking giant J P Morgan Chase (JPM) after a flood of customer withdrawals depleted its cash reserves. Two days later, on March 16, J P Morgan announced that it had acquired Bear Stearns in a stock-only deal that valued the company at just $2 per share, or $236 million. Additionally, the U.S. Federal Reserve is providing up to $30 billion in financing for the takeover, which is thought to be the largest advance ever made to a single firm.[1]

As on March 24th 2008, JPM increased their bid to 10$ a share, upping the bid to about $1.6 Billion.

History

The Bear Stearns Companies Inc. was founded in 1923 by Joseph Bear and Robert Stearns (with $500,000 in equity) to serve primarily as an equity trading house. Now, Bear Stearns serves the financial needs of high-net-worth individuals, government entities, and institutional clients like corporations, by providing brokerage, investment, and capital-raising services, corporate finance, research, credit and interest derivatives, and various other services. On March 16, 2008, Bear announced that it would be acquired by commercial bank J P Morgan Chase (JPM) and become part of J P Morgan's investment banking operations.


Annual income data, in millions FY2003 FY2004 FY2005 FY2006 FY2007
Total Revenue $7,395 $8,422 $11,552 $16,551$16,151
Cost of Revenue $4,462 $5,094 $7,916 $11,895 $13,910
Net Revenue $2,933 $3,328 $3,636 $4,656$2,241
Other Operating Expenses $1,161 $1,306 $1,429 $1,510 $2,048
Operating Income $1,772 $2,022 $2,207 $3,147 $193
Net Income $1,156 $1,345 $1,462 $2,054 $233

Business Segments

Bear Stearns operates globally as a supply and demand facilitator for various equity, bond, and derivative securities. With a significant focus on fixed-income securities, 66% of Bear Stearns’ 2007 revenues were generated by the Capital Markets segment. Global Clearing Services accounted for 20% of net revenues in 2007, and Wealth Management brought in 14%.

2007 segment results, millions USD Net revenue % total revenue Pre-tax income
Capital Markets $3,919 66% -$232
Institutional Equities $2,158 36% -
Fixed Income $685 12% -
Investment Banking $1,076 27% -
Global Clearing Services $1,200 20% $566
Wealth Management $830 14% -$45
Private Client Services $602 10% -
Asset Management $228 4% -

Capital Markets (66% of Revenue)

Capital Markets is further divided into three subdivisions: Institutional Equities, Fixed-Income, and Investment Banking.

  • Institutional Equities provides cross-selling opportunities for the firm between prime brokerage services and in-house trading activities. Bear offers clients a wide range of research, sales, and trading services, many of which complement its other products and services. In this way, Bear tries to earn more revenue from each client by providing services in several different areas.
  • Fixed-Income: This division facilitates the sale, trade, and research of a wide scope of debt products including mortgage-backed securities, government and municipal bonds, corporate bonds, foreign exchange and interest rate and credit derivatives.

Domestically, Bear Stearns has the largest market share in mortgage backed securities, which amounts to $102.2 billion or a 10.3% market share. Also, Bear Stearns consistently ranks in the top ten firms for underwriting asset backed and commercial mortgage backed securities by market share. Taking advantage of the rise in demand for adjustable rate mortgages between 2002 and 2004, Bear Stearns increased its dependence on these securities from 8% to 21% of mortgage banking revenue, and currently remains at this level.

  • Investment Banking: Bear Stearns’ Investment Banking segment provides clients services such as mergers and acquisitions, capital raising (underwriting of equity, investment grade, municipal, and high yield products), strategic advice, and merchant banking. Growing at a compound rate of 14% since 2002, the Investment Banking sub-segment caters to the needs of each individual client, creating solutions rather than just offering products. Over the past six years, Bear Stearns underwriting market share in global, high yield, and investment grade debt has been steadily falling. In addition to this, Bear Stearns global merger and acquisition market share has been extremely volatile.

Global Clearing (20%)

The Global Clearing segment provides services as market clearing, execution, margin lending, and security borrowing to assist customer short sales. Also, Global Clearing facilitates the broker-dealer relationship between other segments within the Bear Stearns companies. Main clients of this segment include hedge funds, money managers, short sellers, professional investors, and arbitrageurs.

One of the leading prime brokerage firms globally, Bear Stearns has consistently ranked in the top three firms for total US and non-US funds assets, with 30.6% and 17.9% market share respectively in 2005. In addition, total equity in client accounts have been growing on average at rate of 15% annually since 2001. Correspondingly, net revenue has been increasing steadily and currently commands a 49.3% pre-tax profit margin.

Wealth Management (14%)

Bear Stearns is the 102nd largest wealth manager in the world and its assets are only 1/10th the size of its major competitors’. The Wealth Management segment is divided into two sub-segments: Asset Management and Private Client Services.

  • Asset Management: The Asset Management sub-segment provides equity, fixed-income, and alternative assets management for corporate pension plans, public systems, endowments, foundations, multi-employer plans, insurance companies, corporations, families, and high net worth individuals globally. Asset Management provides about one third of the total revenue produced by the Wealth Management segment. Services offered to hedge funds provide the majority of Asset Management’s net revenue.
  • Private Client Services: Accounting for roughly two-thirds of Wealth Management’s total revenue, Private Client Services provides high net worth individuals with institutional level investment services, giving these clients exclusive access to Bear Stearns resources and professionals.

Business Drivers

BSC's 9bn+ revenues in 2006 came from a mix which included 4+bn from Fixed Income, 2+ bn from Equities trading & research, 1+bn investment banking underwriting and advisory, 1+ bn from Global clearing services/Prime brokerage and another 0.5bn each from Private Client services & asset management. The most seriously affected portion of the business is obviously the Fixed income division, which is heavily exposed to residential MBS (including a good component of securitized ARMs). Most of its securities and fund loans to hedge fund providers would probably be significanly impaired in terms of liquidity. It has over USD 350+bn in assets/liabilities riding on a shareholder capital of just over USD 12bn...this leverage of over 32:1 with about 15+bn of its debt maturing in the next 4 quarters exacerbates the short-to-medium term liquidity position. However, its prime brokerage infrastructure, equities trading & research depth and private client advisory business would still command good value despite current market conditions. Considering that the Friday EOD stock price of 30/share is just about 1/3rd of its 85/share+ book value, there's probably still enough value in this stock considering that there's still good potential in divisions that account for over 50% of its revenue stream. However, with its over-leveraged balance sheet, true value depends a lot on mark-to-market valuation of its huge MBS and CDO portfolios.

Exposure to business cycles

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Investment banks are highly dependent on both global and U.S. economic cycles. When the economy is growing rapidly, companies typically borrow more and IPOs are more common, leading to greater demand for investment banking services. The stock markets typically move in the same direction as the overall economy. If the market is up, then demand for trading and other capital markets services increases. Conversely, if the economy is depressed, demand for banking services decreases substantially.

Interest rates sensitivity

Interest rates can be thought of as the cost of borrowing money. Businesses and subprime lenders are particularly sensitive to fluctuations in interest rates. As interest rates increase, businesses such as Bear Stearns are less likely to issue debt or equity given that the price of borrowing has increased. Interest rates have been near historic lows since 2004. This has played a significant role in driving business activities. Bear Stearns has benefited from high levels of M&A, underwriting, and IPO activities over the last three years. The rate cuts in late 2007 and 2008 by the U.S. Federal Reserve were designed to further stimulate business activity in the U.S., which should benefit Bear Stearns.

Subprime lending risks

Subprime lending refers to the practice of extending credit or loans to borrowers to who fail qualify for prime or market rates due to their less-than-optimal credit scores. The interest rates associated with subprime loans are typically much higher than those associated with prime loans; the rationale is that borrowers with lower credit scores present a higher risk of default and must therefore pay a considerable risk premium. Subprime borrowers can be extremely sensitive to interest rates. As rates rise these borrowers, many of whom have adjustable-rate mortgages, find themselves unable to meet their debt obligations.

Investment banks such as Bear Stearns generate profit by bundling subprime mortgages and reselling them to other investors in the form of asset-backed securities. As the number of defaults among subprime borrowers has risen, the overall demand for these securitized mortgages has fallen significantly. This, in turn, has caused the value of many of these mortgage-backed securities to decline considerably, which has left Bear holding large numbers of devalued securities that few are willing to buy. Bear has been forced to write-down, or lower the estimated market value of, these securities, which has taken a big chunk out of its earnings, especially in the third quarter of 2007. Moreover, Bear Stearns has additional exposure to the subprime mortgage industry through its hedge funds, three of which collapsed after the subprime fallout caused the value of their holdings to plunge. By mid-July of 2007, the firm had lost an estimated $3.4 billion, and Bear's third-quarter earnings statement showed drops in net revenue and net income of 38% and 61%, respectively.

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Percentage of Fixed-Income Market in Each Country in Bank Loans and Corporate Bonds

European bonds growth

Recently, the European market has seen large growth in the amount of debt underwriting. Unlike a decade ago, European investors, governments, corporations, and institutions are looking to finance through debt issuance rather than by obtaining bank loans. Currently, underwritten debt only constitutes 14% of the debt market, with 86% of the debt market being dominated by loans from the bank. In contrast, the United States debt market is composed of 82% underwritten debt and 18% bank loans. The introduction of the euro in 1999 was the catalyst for moving away from bank loans. By creating a commonly denominated currency, thereby increasing the liquidity of currency across national boundaries and integrating numerous financial markets, the euro made issuing corporate debt more attractive and accessible to European corporations. In addition to opportunities for growth in Europe, Japan's fixed-income market has shown significant potential for expansion.


These newly accessible, growing markets could provide the demand needed for Bear Stearns to expand its supply of financial products and services on an international level. By utilizing the strength of its domestic Capital Markets segment to expand its offerings in Europe and other regions, Bear Stearns will be able to tap into new revenue sources and mitigate its exposure to potential downturns in the U.S. economy.

Industry Analysis

Small-size disadvantage

Bear Stearns is both the smallest and least geographically diverse of the pure play investment banks. Only 13% of its total revenues were generated outside of the US, compared to its next closest competitor, Merrill Lynch which generated 33%. More over a disproportionate amount of its revenues are derived from fixed-income and mortgage related activities. The former accounted for 12% of the company's revenues in 2007 when compared to 5% for most of its competitions. Additionally, Bear Stearns Investment Banking segment lags behind nearly all of its peers in market share. Bear Stearns' main industry competitors include Morgan Stanley (MS), Goldman Sachs Group (GS), Merrill Lynch (MER), and Lehman Brothers Fin SA (LEH).

2007 metrics Goldman Sachs Group (GS) Morgan Stanley Merrill Lynch Lehman Brothers Bear Stearns
Gross earnings ($B) 45.6 23.1 -6.119.32.2
Pre-tax income ($M) 17,604 3,441 -12,831 6,013 193
1-yr revenue growth (%) 23 -9.7 N/A9.5-52
Equity origination revenue ($B) 1,382 1,570 1,6291,015N/A
M&A advisory revenue ($B) 4,222 2,541 1,740 1,337 828
Debt underwriting revenue ($B) 1,951 1,427 1,550 1,551 N/A
Note: Bear Stearns reported $529 million in revenue for all its underwriting activities but did not provide a breakdown of debt vs. equity underwriting in its Form 10-K.

References

  1. J.P. Morgan Buys Bear in Fire Sale, As Fed Widens Credit to Avoid Crisis - WSJ.com
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