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Lehman Brothers Holdings Inc. Plan Trust · 10-K · For 11/30/07

Filed On 1/29/08, 4:44pm ET   ·   Accession Number 1104659-8-5476   ·   SEC File 1-09466

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  As Of                Filer                Filing    For/On/As Docs:Size              Issuer               Agent

 1/29/08  Lehman Brothers Holdings Inc...Tr 10-K       11/30/07   20:7.1M                                   Merrill Corp-MD/FA
Subsequent Filing That References This Filing:
 2/05/08  Lehman Brothers Holdings Inc...Tr 8-K:8,9     1/29/08    6:3.7M                                   RR Donnelley/FA

Annual Report   —   Form 10-K
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report                                       HTML   3.94M 
 2: EX-10.11    Material Contract                                   HTML     98K 
 3: EX-10.14    Material Contract                                   HTML    122K 
 4: EX-10.15    Material Contract                                   HTML     64K 
 5: EX-10.16    Material Contract                                   HTML     38K 
 6: EX-10.17    Material Contract                                   HTML     31K 
 7: EX-10.19    Material Contract                                   HTML     59K 
 8: EX-10.20    Material Contract                                   HTML     22K 
 9: EX-10.21    Material Contract                                   HTML     27K 
10: EX-10.28    Material Contract                                   HTML     21K 
11: EX-10.29    Material Contract                                   HTML     25K 
12: EX-10.30    Material Contract                                   HTML     16K 
13: EX-12.01    Statement re: Computation of Ratios                 HTML     36K 
14: EX-21.01    Subsidiaries of the Registrant                      HTML    158K 
15: EX-23.01    Consent of Experts or Counsel                       HTML     32K 
16: EX-24.01    Power of Attorney                                   HTML     32K 
17: EX-31.01    Certification per Sarbanes-Oxley Act (Section 302)  HTML     17K 
18: EX-31.02    Certification per Sarbanes-Oxley Act (Section 302)  HTML     18K 
19: EX-32.01    Certification per Sarbanes-Oxley Act (Section 906)  HTML     12K 
20: EX-32.02    Certification per Sarbanes-Oxley Act (Section 906)  HTML     12K 


10-K   —   Annual Report
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
"Available Information
"Item 1
"Business
"Item 1A
"Risk Factors
"Item 1B
"Unresolved Staff Comments
"Item 2
"Properties
"Item 3
"Legal Proceedings
"Item 4
"Submission of Matters to a Vote of Security Holders
"Item 5
"Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
"Item 6
"Selected Financial Data
"Item 7
"Management's Discussion and Analysis of Financial Condition and Results of Operations
"Introduction
"Forward-Looking Statements
"Executive Overview
"Certain Factors Affecting Results of Operations
"Critical Accounting Policies and Estimates
"Consolidated Results of Operations
"Business Segments
"Geographic Revenues
"Liquidity, Funding and Capital Resources
"Contractual Obligations and Lending-Related Commitments
"Off-Balance-Sheet Arrangements
"Risk Management
"2-for-1 Stock Split
"Accounting and Regulatory Developments
"Effects of Inflation
"Item 7A
"Quantitative and Qualitative Disclosures About Market Risk
"Item 8
"Financial Statements and Supplementary Data
"Management's Assessment of Internal Control over Financial Reporting
"Report of Independent Registered Public Accounting Firm
"On Internal Control over Financial Reporting
"Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
"Consolidated Statement of Income
"Years Ended November 30, 2007, 2006 and 2005
"Consolidated Statement of Income- Years Ended November 30, 2007, 2006 and 2005
"Consolidated Statement of Financial Condition
"November 30, 2007 and 2006
"Consolidated Statement of Financial Condition- November 30, 2007 and 2006
"Consolidated Statement of Changes in Stockholders' Equity
"Consolidated Statement of Changes in Stockholders' Equity- Years Ended November 30, 2007, 2006 and 2005
"Consolidated Statement of Cash Flows
"Consolidated Statement of Cash Flows- Years Ended November 30, 2007, 2006 and 2005
"Notes to Consolidated Financial Statements
"Note 1
"Summary of Significant Accounting Policies
"Note 2
"Business Segments and Geographic Information
"Note 3
"Financial Instruments and Other Inventory Positions
"Note 4
"Fair Value of Financial Instruments
"Note 5
"Securities Received and Pledged as Collateral
"Note 6
"Securitizations and Special Purpose Entities
"Note 7
"Identifiable Intangible Assets and Goodwill
"Note 8
"Borrowings and Deposit Liabilities
"Note 9
"Commitments, Contingencies and Guarantees
"Note 10
"Stockholders' Equity
"Note 11
"Earnings per Common Share
"Note 12
"Shared-Based Employee Incentive Plans
"Note 13
"Employee Benefit Plans
"Note 14
"Income Taxes
"Note 15
"Regulatory Requirements
"Note 16
"Quarterly Information (unaudited)
"Item 9
"Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
"Item 9A
"Controls and Procedures
"Item 9B
"Other Information
"Item 10
"Directors, Executive Officers and Corporate Governance
"Item 11
"Executive Compensation
"Item 12
"Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
"Item 13
"Certain Relationships and Related Transactions, and Director Independence
"Item 14
"Principal Accountant Fees and Services
"Item 15
"Exhibits, Financial Statement Schedules
"Signatures
"Index to Consolidated Financial Statements and Schedule
"Schedule I-Condensed Financial Information of Registrant

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K

(Mark One)

x

 

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended November 30, 2007

 

 

 

OR

 

 

 

¨

 

Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from               to               

 

Commission File Number 1-9466

 


 

Lehman Brothers Holdings Inc.

(Exact Name of Registrant as Specified in its Charter)

 

Delaware

 

13-3216325

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

745 Seventh Avenue
New York, New York

 

10019

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (212) 526-7000

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

 

Name of each exchange
on which registered

Common Stock, $.10 par value

 

New York Stock Exchange

Depositary Shares representing 5.94% Cumulative Preferred Stock, Series C

 

New York Stock Exchange

Depositary Shares representing 5.67% Cumulative Preferred Stock, Series D

 

New York Stock Exchange

Depositary Shares representing 6.50% Cumulative Preferred Stock, Series F

 

New York Stock Exchange

Depositary Shares representing Floating Rate Cumulative Preferred Stock, Series G

 

New York Stock Exchange

5.857% Mandatory Capital Advantaged Preferred Securities of Subsidiary Trust (and Registrant’s guarantee thereof)

 

New York Stock Exchange

Floating Rate Mandatory Capital Advantaged Preferred Securities of Subsidiary Trust (and Registrant’s guarantee thereof)

 

New York Stock Exchange

6.375% Trust Preferred Securities, Series K, of Subsidiary Trust (and Registrant’s guarantee thereof)

 

New York Stock Exchange

6.375% Trust Preferred Securities, Series L, of Subsidiary Trust (and Registrant’s guarantee thereof)

 

New York Stock Exchange

6.00% Trust Preferred Securities, Series M, of Subsidiary Trust (and Registrant’s guarantee thereof)

 

New York Stock Exchange

6.24% Trust Preferred Securities, Series N, of Subsidiary Trust (and Registrant’s guarantee thereof)

 

New York Stock Exchange

2.00% Medium Term Notes, Series H, Due March 3, 2009 Performance Linked to the Common Stock of Morgan Stanley (MS)

 

American Stock Exchange

0.25% Medium Term Notes, Series I, Due February 16, 2012 Performance Linked to a Basket of Two Stocks

 

American Stock Exchange

0.00% Medium Term Notes, Series I, Due May 15, 2010 Performance Linked to the Common Stock of General Electric Company (GE)

 

American Stock Exchange

Absolute Buffer Notes Due July 29, 2008, Linked to the Dow Jones EURO STOXX 50® Index (SX5E)

 

American Stock Exchange

Absolute Buffer Notes Due July 7, 2008, Linked to the Dow Jones EURO STOXX 50® Index (SX5E)

 

American Stock Exchange

Currency Basket Warrants Expiring February 13, 2008

 

American Stock Exchange

Dow Jones Global Titans 50 Index SM SUNS® Stock Upside Note Securities Due February 9, 2010

 

American Stock Exchange

Dow Jones Industrial Average SUNS® Stock Upside Note Securities Due April 29, 2010

 

American Stock Exchange

Index-Plus Notes Due December 23, 2009, Performance Linked to the Russell 2000® INDEX (RTY)

 

American Stock Exchange

Index-Plus Notes Due March 3, 2010, Linked to the S&P 500® Index (SPX)

 

American Stock Exchange

Index-Plus Notes Due November 15, 2009, Linked to the Dow Jones STOXX 50® Index (SX5P)

 

American Stock Exchange

Index-Plus Notes Due September 28, 2009, Performance Linked to S&P 500® Index (SPX)

 

American Stock Exchange

Japanese Yen Linked Warrants Expiring June 20, 2008

 

American Stock Exchange

Nasdaq-100® Index RANGERSSM Rebound Risk AdjustiNG Equity Range Securities Notes Due June 7, 2008

 

American Stock Exchange

Nikkei 225SM Index SUNS® Stock Upside Note Securities Due June 10, 2010

 

American Stock Exchange

S&P 500® Index Callable SUNS® Stock Upside Note Securities Due November 6, 2009

 

American Stock Exchange

S&P 500® Index SUNS® Stock Upside Note Securities Due August 5, 2008

 

American Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x  No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x

 

Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of ‘accelerated filer and large accelerated filer’ in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer  x  Accelerated filer  o  Non-accelerated filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

The aggregate market value of the voting and nonvoting common equity held by non-affiliates of the Registrant at May 31, 2007 (the last business day of the Registrant’s most recently completed second fiscal quarter) was approximately $37,489,482,000. As of that date, 510,895,095 shares of the Registrant’s common stock, $0.10 par value per share, were held by non-affiliates. For purposes of this information, the outstanding shares of common stock that were and that may be deemed to have been beneficially owned by directors and executive officers of the Registrant were deemed to be shares of common stock held by affiliates at that date.

 

As of December 31, 2007, 530,588,207 shares of the Registrant’s common stock, $.10 par value per share, were issued and outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE:

 

Portions of Lehman Brothers Holdings Inc.’s Definitive Proxy Statement for its 2008 Annual Meeting of Stockholders (the “Proxy Statement”) are incorporated in Part III.

 

 

 


 

LEHMAN BROTHERS HOLDINGS INC.

 

TABLE OF CONTENTS

 

Available Information

 

2

 

 

 

 

 

Part I

 

 

 

 

 

 

 

 

 

Item 1.

 

Business

 

3

Item 1A.

 

Risk Factors

 

14

Item 1B.

 

Unresolved Staff Comments

 

22

Item 2.

 

Properties

 

22

Item 3.

 

Legal Proceedings

 

23

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

26

 

 

 

 

 

Part II

 

 

 

 

 

 

 

 

 

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

27

Item 6.

 

Selected Financial Data

 

29

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

32

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

80

Item 8.

 

Financial Statements and Supplementary Data

 

81

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

137

Item 9A.

 

Controls and Procedures

 

137

Item 9B.

 

Other Information

 

137

 

 

 

 

 

Part III

 

 

 

 

 

 

 

 

 

Item 10.

 

Directors, Executive Officers and Corporate Governance

 

138

Item 11.

 

Executive Compensation

 

138

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

138

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

 

138

Item 14.

 

Principal Accountant Fees and Services

 

138

 

 

 

 

 

Part IV

 

 

 

 

 

 

 

 

 

Item 15.

 

Exhibits, Financial Statement Schedules

 

139

 

 

 

 

 

Signatures

 

142

 

 

 

 

 

Index to Consolidated Financial Statements and Schedule

 

F-1

 

 

 

 

 

Schedule I—Condensed Financial Information of Registrant

 

F-2

 

 

 

 

 

Exhibit Index

 

 

 

 

 

 

 

Exhibits

 

 

 



 

LEHMAN BROTHERS HOLDINGS INC.

 

AVAILABLE INFORMATION

 

Lehman Brothers Holdings Inc. (“Holdings”) files annual, quarterly and current reports, proxy statements and other information with the United States Securities and Exchange Commission (“SEC”). You may read and copy any document Holdings files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, U.S.A. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330 (or 1-202-551-8090). The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Holdings’ electronic SEC filings are available to the public at http://www.sec.gov.

 

Holdings’ public internet site is http://www.lehman.com. Holdings makes available free of charge through its internet site, via a link to the SEC’s internet site at http://www.sec.gov, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the SEC. Holdings also makes available through its internet site, via a link to the SEC’s internet site, statements of beneficial ownership of Holdings’ equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

 

In addition, Holdings currently makes available on http://www.lehman.com its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q for the current fiscal year, its most recent proxy statement and its most recent annual report to stockholders, although in some cases these documents are not available on that site as soon as they are available on the SEC’s site.

 

Holdings also makes available on http://www.lehman.com (i) its Corporate Governance Guidelines, (ii) its Code of Ethics (including any waivers therefrom granted to executive officers or directors) and (iii) the charters of the Audit, Compensation and Benefits, and Nominating and Corporate Governance Committees of its Board of Directors. These documents are also available in print without charge to any person who requests them by writing or telephoning:

 

Lehman Brothers Holdings Inc.
Office of the Corporate Secretary
1271 Avenue of the Americas
42nd Floor
New York, New York 10019, U.S.A.
1-212-526-0858

 

In order to view and print the documents referred to above (which are in the .PDF format) on Holdings’ internet site, you will need to have installed on your computer the Adobe® Acrobat® Reader® software. If you do not have Adobe Acrobat, a link to Adobe Systems Incorporated’s internet site, from which you can download the software, is provided.

 

“ECAPS”, “LehmanLive”, “RANGERS” and “SUNS” are registered trademarks or service marks of Lehman Brothers Holdings Inc. in the United States and/or other countries. All other marks are the property of their respective owners.

 

-2-



 

LEHMAN BROTHERS HOLDINGS INC.

 

PART I

 

ITEM 1. BUSINESS

 

As used herein, “Holdings” or the “Registrant” means Lehman Brothers Holdings Inc., a Delaware corporation, incorporated on December 29, 1983. Holdings and its subsidiaries are collectively referred to as the “Company,” “Lehman Brothers,” the “Firm,” “we,” “us” or “our.” Our executive offices are located at 745 Seventh Avenue, New York, New York 10019, U.S.A., and our telephone number is 1-212-526-7000.

 

Forward-Looking Statements
 

Some of the statements contained or incorporated by reference in this Report, including those relating to the Company’s strategy and other statements that are predictive in nature, that depend upon or refer to future events or conditions or that include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates” and similar expressions, are forward-looking statements within the meaning of Section 21E of the Exchange Act. These statements are not historical facts but instead represent only management’s expectations, estimates and projections regarding future events. Similarly, these statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict, which may include, but are not limited to, the risk factors discussed in Item 1A below and the factors listed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Certain Factors Affecting Results of Operations” in Part II, Item 7, of this Report.

 

As a global investment bank, the nature of our business makes predicting future performance difficult. Revenues and earnings may vary from quarter to quarter and from year to year. Caution should be used when extrapolating historical results to future periods. Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, accordingly, readers are cautioned not to place undue reliance on such statements, which speak only as of the date on which they are made. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Lehman Brothers

 

Lehman Brothers, an innovator in global finance, serves the financial needs of corporations, governments and municipalities, institutional clients and high-net-worth individuals worldwide. We provide a full array of services in equity and fixed income sales, trading and research, investment banking, asset management, private investment management and private equity. Our worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by a network of offices in North America, Europe, the Middle East, Latin America and the Asia Pacific region. The Firm, through predecessor entities, was founded in 1850.

 

Through our subsidiaries, we are a global market-maker in all major equity and fixed income products. To facilitate our market-making activities, we are a member of all principal securities and commodities exchanges in the United States, as well as FINRA (the Financial Industry Regulatory Authority, formed in 2007 by the consolidation of NASD, Inc. and the member regulation, enforcement and arbitration functions of the New York Stock Exchange, Inc. (“NYSE”)), and we hold memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan, Singapore and Australian stock exchanges.

 

Through our investment banking, trading, research, structuring and distribution capabilities in equity and fixed income products, we continue to build on our client-flow business model, which is based on our principal focus of facilitating client transactions in all major global capital markets products and services. We generate client-flow revenues from institutional, corporate, government and high-net-worth clients by (i) advising on and structuring transactions specifically suited to meet client needs; (ii) serving as a market maker and/or intermediary in the global marketplace, including having securities and other financial instrument products available to allow clients to adjust their portfolios and risks across different market cycles; (iii) originating loans for distribution to clients in the securitization or principals market; (iv) providing investment management and advisory services; and (v) acting as an underwriter to clients. As part of our client-flow activities, we maintain inventory positions of varying amounts across a broad range of financial instruments. In addition, we also take proprietary trading and principal investment positions. The financial services industry is significantly influenced by worldwide economic conditions as well as other factors inherent in the global financial markets. As a result, revenues and earnings may vary from quarter to quarter and from year to year. We believe our client-flow orientation and the diversity of our business helps to mitigate overall revenue volatility. See Part I, Item 1A, “Risk Factors,” in this Report for a discussion of certain material risks to our business, financial condition and results of operations.

 

We operate in three business segments (each of which is described below): Capital Markets, Investment Banking and Investment Management. Financial information concerning the Company for the fiscal years ended November 30, 2007,

 

-3-



 

LEHMAN BROTHERS HOLDINGS INC.

 

2006 and 2005, including the amount of net revenues contributed by each segment in such periods, is set forth in the Consolidated Financial Statements and Notes thereto in Part II, Item 8, of this Report. Information with respect to our operations by business segment and net revenues by geographic area is set forth under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Segments” and “—Geographic Revenues” in Part II, Item 7, of this Report, and in Note 2 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

 

Capital Markets

 

Capital Markets primarily represents institutional client-flow activities, including secondary trading, financing, mortgage origination and securitization, prime brokerage and research activities in fixed income and equity products. These products include a wide range of cash, derivative, secured financing and structured instruments and investments. We are a leading global market-maker in numerous equity and fixed income products, including U.S., European and Asian equities, government and agency securities, money market products, corporate high-grade, high-yield and emerging market securities, mortgage- and asset-backed securities, preferred stock, municipal securities, commodities and energy products, bank loans, foreign exchange, financing and derivative products. We are one of the largest investment banks in terms of U.S. and pan-European listed equities trading volume and maintain a major presence in over-the-counter U.S. stocks, major Asian large capitalization stocks, warrants, convertible debentures and preferred issues. In addition, the secured financing business manages our equity and fixed income matched book activities, supplies secured financing to institutional clients and provides secured funding for our inventory of equity and fixed income products.

 

We facilitate client transactions by serving as an agent, market-maker and/or intermediary in the global marketplace, including making available securities and other financial instruments and products to clients to adjust their portfolios and risks across different market cycles, enabling clients to sell large positions of securities through block trades and originating loans for distribution to clients through securitizations and/or syndications.

 

The Capital Markets segment also includes principal investing and proprietary trading activities including investments in real estate, private equity and other long-term investments.

 

Lehman Brothers combines the skills from the sales, trading and research areas of our Equities and Fixed Income Capital Markets businesses to serve the financial needs of our clients. This integrated approach enables us to structure and execute global transactions for clients and to provide worldwide liquidity in marketable securities.

 

Equities Capital Markets. The Equities Capital Markets business is responsible for our equities and equity-related operations and products worldwide. These products include listed and over-the-counter securities, American Depositary Receipts and convertibles, as well as equity options, futures, warrants and other derivatives. We make markets in equity and equity-related securities as well as take positions for our own account. We participate in global equity markets through our worldwide presence and membership in major stock and option exchanges. During 2007, we acquired the institutional equities business, including the institutional research group, of Brics Securities Limited, a brokerage firm in India. Equities Capital Markets is composed of Liquid Markets, Leveraged Businesses and Private Equity.
 

Liquid Markets. Liquid Markets consists of our Cash Trading, Flow Derivatives and Program Trading businesses, which also includes connectivity services. Cash trades are executed for clients in both conventional (calls to a sales person) or electronic fashion through external systems as well as our own execution management platform. These trades can be executed manually or via algorithmic trading strategies based on client needs. Our Flow Derivatives business facilitates client orders in listed options markets and vanilla over-the-counter options and derivatives. Program Trading specializes in execution of trades on baskets of stocks, which can be executed on an agency or principal basis. We deliver global electronic connectivity services to our clients, offering seamless electronic access to our trading desks and sources of liquidity around the world.

 

Leveraged Businesses. Leveraged Businesses include Structured Derivatives and Convertibles. Our Structured Derivatives business offers customized equity derivative products across a wide spectrum of equity-related assets globally, leveraging sales, trading and research into a global solution for the customer. We have experienced significant growth in a number of products, including Exchange Traded Funds (ETFs), options and warrants, spread-trading, agency/risk baskets, index rebalancing and other structured products. We are a leading participant in the development and trading of new equity derivative instruments. Our product development capabilities enable investors to take risk positions tailored to their specific needs or undertake sophisticated hedging and monetization strategies. The Convertibles business trades and makes markets in conventional and structured convertible securities.

 

Private Equity. The Equities Capital Markets segment also includes realized and unrealized gains and losses related to private equity principal investments. See “Investment Management—Asset Management—Private Equity” below.

 

-4-



 

LEHMAN BROTHERS HOLDINGS INC.

 

Specialist Business. In December 2007, we acquired certain assets related to Van der Moolen Specialists, including its NYSE portfolio of listed company specialist’s assignments and certain technology. As a result, Lehman Brothers Market Makers, a division of Lehman Brothers Inc., our U.S. registered broker dealer, acts as specialist for approximately 400 NYSE-listed issues and is the fourth-largest specialist firm on the NYSE.

 

Fixed Income Capital Markets. Lehman Brothers actively participates in key fixed income markets worldwide and maintains a 24-hour trading presence in global fixed income securities. We are a market-maker and participant in the new issue and secondary markets for, and take positions for our own account in, a broad variety of fixed income securities. During 2007, we acquired Grange Securities Limited, a full service Australian broker-dealer specializing in fixed income products. Fixed Income businesses include the following:
 

Government and Agency Obligations. Lehman Brothers is one of the leading primary dealers in U.S. government securities, participating in the underwriting of and market-making in U.S. Treasury bills, notes and bonds, and securities of federal agencies. We are also a market-maker in the government securities of all G-7 countries, and participate in other major European and Asian government bond markets.

 

Corporate Debt Securities and Loans. We make markets in fixed and floating rate investment grade debt worldwide. We are also a major participant in preferred stock and hybrid capital securities, including long-term and perpetual preferred stock and preferred securities, and auction rate securities.

 

Global Family of Indices. Lehman Brothers’ Global Family of Indices provides comprehensive performance and risk measurements for the major bond markets. The Index Group produces some of the most widely followed benchmarks in the global debt markets.

 

High Yield Securities and Leveraged Bank Loans. We also make markets in non-investment grade debt securities. Through our high grade and high yield sales, trading and underwriting activities, we make commitments to extend credit in loan syndication transactions. We also provide contingent commitments to high-grade and high-yield counterparties related to acquisition financings.

 

Money Market Products. We hold leading market positions in the origination and distribution of medium-term notes and commercial paper. We are a dealer or agent for numerous active commercial paper and medium-term note programs on behalf of companies and government agencies worldwide.

 

Mortgage and Loan Origination and Mortgage- and Asset-Backed Securities. Lehman Brothers Bank, FSB (“LB Bank”), offers traditional and online mortgage banking services to individuals and institutions. Lehman Brothers Bankhaus AG (“Bankhaus”), a German bank, offers lending and real estate financing to corporate and institutional borrowers worldwide. We originate commercial and residential mortgage loans through LB Bank, Bankhaus and other subsidiaries in the U.S., Europe and Asia. We are a leading underwriter of and market-maker in residential and commercial mortgage- and asset-backed securities and are active in all areas of secured lending, structured finance and securitized products. We underwrite and make markets in the full range of U.S. agency-backed mortgage products, mortgage-backed securities, asset-backed securities and whole loan products. We are also a leader in the global market for residential and commercial mortgages (including multi-family financing) and leases and have an established private student loan origination platform. During the third and fourth quarters of 2007, we restructured our global residential mortgage origination business, including rescaling operations in the U.S. and U.K. due to market conditions and product revisions and closing BNC Mortgage LLC, our U.S. subprime origination platform, as well as our Korean mortgage business. In addition, in January 2008, we suspended our wholesale and correspondent lending activities at our Aurora Loan Services subsidiary (“Aurora”). We will continue to originate loans through Aurora’s direct lending channel and will maintain Aurora’s servicing business. For additional information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Acquisitions, Business Dispositions and Strategic Investments—Business Dispositions,” in Part II, Item 7, of this Report.

 

Lehman Brothers Commercial Bank (“LB Commercial Bank”), a Utah-chartered industrial loan company, issues certificates of deposit to institutions and conducts certain lending activities. During 2007, we acquired Capital Crossing Bank, a state-chartered, FDIC-insured commercial bank that originates small business loans.

 

Real Estate. In addition to our origination and securitization of commercial mortgages, we also invest in commercial real estate in the form of debt, joint venture equity investments and direct ownership interests. We have interests in properties throughout the world.

 

Municipal and Tax-Exempt Securities. Lehman Brothers is a major dealer in municipal and tax-exempt securities, including general obligation and revenue bonds, notes issued by states, counties, cities and state and local governmental agencies, municipal leases, tax-exempt commercial paper and put bonds.

 

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Fixed Income Derivatives. We offer a broad range of interest rate- and credit-based derivative products and related services. Derivatives’ professionals are integrated into all of our Fixed Income areas in response to the worldwide convergence of the cash and derivative markets.

 

Foreign Exchange. Our global foreign exchange operations provide market access and liquidity in all currencies for spot, forward and over-the-counter options markets around the clock. We offer our clients execution, analysis and hedging capabilities, utilizing foreign exchange as well as foreign exchange options and other foreign exchange derivatives. We also provide advisory services to central banks, corporations and investors worldwide, structuring innovative products to fit their specific needs. We make extensive use of our global macroeconomics research to advise clients on the appropriate strategies to manage their interest rate and currency risk.

 

Insurance. We continue to build out our ability to provide financing, securitization and capital markets execution services for clients with insurance-related portfolios. During 2007, we acquired Congress Life Insurance Company, a life insurance company with licenses in 43 U.S. states, and a minority interest in Wilton Re Holdings Limited, a U.S. re-insurer that focuses on the reinsurance of mortality risk on life insurance policies.

 

Commodities. In 2005, Lehman Brothers established an energy trading business with global capability in power, natural gas and oil. The business includes futures, swaps, options and other structured products, as well as physical trading. We deliver energy and commodity risk solutions to customers around the globe, complementing the Firm’s investment banking franchise in power and natural resources, as well as its global sales and distribution platform and capabilities in global trading, derivatives, research, finance and risk management. We are active in the markets for crude oil and refined products, electricity, natural gas, coal, emissions and precious and base metals, trading all major financial commodity products, including futures, swaps, options and structured products. We offer innovative commodity index solutions for investors seeking alternative ways to gain exposure to this asset class.

 

During 2007, we acquired Eagle Energy Partners I, L.P., a Texas-based energy marketing and services company that manages and optimizes supply, transportation, transmission, load and storage portfolios on behalf of wholesale natural gas and power clients. We also acquired a 56.5% controlling interest in SkyPower Corp., a Toronto-based early stage wind and solar power generation development company.

 

Global Principal Strategies and Global Trading Strategies. Global Principal Strategies is a proprietary trading business that employs multiple strategies across global markets, including capital and credit arbitrage and aviation finance and private equity investment opportunities. Global Trading Strategies is a global proprietary multi-strategy value-oriented business whose investment strategies include merger arbitrage, distressed debt, special situations and private equity.

 

Capital Markets Prime Services. The Capital Markets Prime Services group services clients in both Fixed Income and Equities Capital Markets and includes our Secured Financing, Prime Broker, Futures and Clearing and Execution businesses.
 

The Secured Financing business within Capital Markets engages in three primary functions: managing our equity and fixed income matched book activities, supplying secured financing to institutional clients and obtaining secured funding for our inventory of equity and fixed income products. Matched book funding involves borrowing and lending cash on a short-term basis to institutional clients and counterparties collateralized by marketable securities, typically government or government agency securities. We enter into these agreements in various currencies and seek to generate profits from the difference between interest earned and interest paid. Secured Financing works with our institutional sales force to identify clients that have cash to invest and/or securities to pledge to meet our financing and investment objectives and those of our clients. Secured Financing also coordinates with our Treasury group to provide collateralized financing for a large portion of our securities and other financial instruments owned. In addition to our activities on behalf of our U.S. clients, we are a major participant in the European and Asian repurchase agreement markets, providing secured financing for our clients in those regions. Secured Financing provides margin loans in all markets for client purchases of securities, as well as securities lending and short-selling facilitation.

 

The Prime Broker business engages in full operations, clearing and processing services for its hedge fund and other clients. Along with Secured Financing, it offers a full suite of prime brokerage products and services, including margin financing and yield enhancement through synthetic and traditional products, global securities lending (including eBorrow, our online securities lending tool), full-service global execution platforms and research teams, customized risk management solutions, introduction of clients to suitable institutional investors, portfolio accounting and reporting solutions and personalized client service.

 

Our Futures business executes and clears futures transactions for clients on an agency basis. The Clearing and Execution business provides these services to broker-dealers and other clients that do not have the capacity themselves.

 

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Capital Markets Global Distribution. Our institutional sales organizations encompass distinct global sales forces that have been integrated into the Capital Markets businesses to provide investors with the full array of products offered by Lehman Brothers.
 

Equities Sales. Our Equities Capital Markets sales force provides an extensive range of services to institutional investors, focusing on developing long-term relationships through a comprehensive understanding of clients’ investment objectives, while providing proficient execution and consistent liquidity in a wide range of global equity securities and derivatives.

 

Fixed Income Sales. Our Fixed Income Capital Markets sales force is one of the most productive in the industry, serving the investing and liquidity needs of major institutional investors by employing a relationship management approach that provides superior information flow and product opportunities for our clients.

 

Research. Research at Lehman Brothers encompasses the full range of research disciplines, including fundamental, quantitative, economic, strategic, credit, relative value and market-specific analysis. To ensure in-depth expertise within various markets, Equity Research has established regional teams on a worldwide basis that are staffed with industry and strategy specialists. Fixed Income Research provides expertise in U.S., European and Asian government and agency securities, derivatives, sovereign issues, corporate securities, high yield, asset- and mortgage-backed securities, indices, emerging market debt and municipal securities.
 

Investment Banking

 

Investment Banking provides advice to corporate, institutional and government clients throughout the world on mergers, acquisitions and other financial matters. Investment Banking also raises capital for clients by underwriting public and private offerings of debt and equity instruments. Our Investment Banking professionals are responsible for developing and maintaining relationships with these clients to gain a thorough understanding of their specific needs and for bringing together the full resources of Lehman Brothers to accomplish their financial and strategic objectives.

 

Investment Banking is comprised of Corporate Finance, Mergers & Acquisitions (“M&A”) and Global Finance units that serve our corporate, institutional and government clients. The Corporate Finance unit is organized into global industry groups—Communications, Consumer/Retail, Financial Institutions, Financial Sponsors, Healthcare, Industrial, Media, Middle Markets, Natural Resources, Power, Real Estate and Technology—that include bankers who deliver industry knowledge and expertise to meet clients’ objectives. M&A is comprised of Advisory and Restructuring groups. Global Finance serves our clients’ capital-raising needs through specialized product groups in Equity Capital Markets, Debt Capital Markets, Leveraged Finance, Private Capital Markets and Risk Solutions. Bankers in these specialized product groups partner with industry coverage bankers in the global industry groups to provide comprehensive financial solutions for clients.

 

Lehman Brothers maintains investment banking offices in North America, Europe, the Middle East, Latin America and the Asia Pacific region.

 

The high degree of integration among our industry, product and geographic groups has allowed us to become a leading source of “one-stop”  financial solutions for our global clients.

 

M&A Advisory. Lehman Brothers’ global M&A Advisory group delivers strategic advisory services to companies worldwide. Our capabilities cover the entire spectrum of strategic alternatives available to clients, including acquisitions, divestitures, restructurings, leveraged buyouts, takeover defenses, special committee assignments and exclusive sales. Lehman Brothers’ global team of M&A professionals works in partnership with industry coverage bankers, to provide strategic insight, tactical advice and execution capabilities in approaching clients’ most challenging issues.

 

Restructuring. Our Restructuring group provides full-service restructuring expertise on a global basis, including financing capabilities and traditional restructuring advice. The group provides advisory services to distressed companies, their creditors and potential purchasers, including providing out-of-court options for companies seeking to avoid bankruptcy, helping companies and creditors move efficiently through the bankruptcy process and advising strategic and financial buyers on the unique challenges of buying distressed and bankrupt companies. The Restructuring group has significant cross-border transaction expertise.

 

Equity Capital Markets. Lehman Brothers is a leading underwriter in the global equity capital markets. Our capabilities include initial public offerings, follow-on offerings, monetizations, preferred stock, convertible securities, equity-linked securities, equity derivatives and share repurchases. We have a global team of equity product specialists who work closely with industry coverage bankers globally to develop solutions that meet our clients’ needs.

 

Debt Capital Markets. Lehman Brothers is also a leading underwriter in the global fixed income markets. The Firm takes a comprehensive approach, working closely with clients to develop and implement tailored solutions to specific

 

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issues and problems. Our capabilities span the spectrum of fixed income products, including high grade and high yield debt, commercial paper, hybrid capital, government and agency securities, mortgage- and asset-backed securities and collateralized debt obligations, together with risk management and structured finance solutions. Our debt product specialists work closely with industry coverage bankers globally to originate, structure and market fixed income securities to investors.

 

Leveraged Finance. Our global Leveraged Finance group provides comprehensive financing solutions for below-investment grade clients across many industries through our leveraged loan, high yield bond, bridge financing and mezzanine debt products. Lehman Brothers provides “one-stop” leveraged financing solutions for corporate and financial acquirers and high yield issuers, including multi-tranche, multi-product acquisition financing. We have a leading leveraged loan and bond franchise.

 

Private Capital Markets. We have a dedicated Private Capital Markets group focused on raising capital in the private equity and debt markets. The Firm’s Private Capital Markets professionals work closely with our industry coverage bankers to assist clients in establishing optimal capital structures. Clients range from pre-initial public offering companies to well-established corporations that span many industries. The Private Capital Markets group has experience in identifying sources, establishing structures and placing common stock, convertible preferred stock, preferred stock, subordinated and/or mezzanine debt and senior debt, as well as utilizing a variety of financing techniques, including private investments in public equity (PIPEs), securitizations, project financings and sale-leasebacks.

 

Risk Solutions Group. Our Risk Solutions group works with clients to identify and manage their interest rate, inflation, commodities and currency and commodity risks, among other risks. The group’s solutions typically draw upon a range of swap and derivative products.

 

Investment Management

 

Investment Management provides strategic investment advice and services to institutional and high-net-worth clients on a global basis.

 

Information with respect to changes in and composition of assets under management is set forth under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Segments—Investment Management” in Part II, Item 7, of this Report. Investment Management consists of our Asset Management and Private Investment Management businesses.

 

During 2007, we acquired H.A. Schupf, a high net worth boutique asset manager with approximately $2.3 billion in assets under management; LightPoint Capital Management LLC, a leveraged loan investment manager based in Chicago, Illinois, with approximately $3.2 billion in assets under management; Dartmouth Capital, a U.K.-based investment advisory firm with approximately $340 million in assets under advisory; and MNG Securities, an equity securities brokerage firm in Turkey. We also purchased an initial 20% interest and a subsequent 5% interest in both Spinnaker Asset Management Limited and Spinnaker Financial Services, part of Spinnaker Capital, an emerging markets investment management firm, and a 20% interest in the D.E. Shaw group, a global investment management firm.

 

Asset Management. Asset Management provides proprietary asset management products across traditional and alternative asset classes, through a variety of distribution channels, to individuals and institutions. It includes both the Neuberger Berman and Lehman Brothers Asset Management brands as well as our Private Equity business.
 

Neuberger Berman. Neuberger Berman has provided money management products and services to individuals and families since 1939. We acquired Neuberger Berman in October 2003.

 

Neuberger Berman’s Private Asset Management business provides discretionary, customized portfolio management across equity and fixed income asset classes for high-net-worth clients. Experienced money managers, each with a distinct investment style and discipline, tailor investment strategies to fit clients’ individual goals, financial needs and tolerance for risk.

 

The Neuberger Berman family of funds spans asset classes, investment styles and capitalization ranges. Its open-end mutual funds are available directly to investors or through distributors, and its closed-end funds trade on major stock exchanges. Neuberger Berman is also a leading sub-advisor of funds for institutional clients, including insurance companies, banks and other financial services firms. We serve as the investment advisor or sub-advisor for numerous defined contribution plans, and for insurance companies offering variable annuity and variable life insurance products, and we provide portfolio management through both mutual fund and separate account wrap programs.

 

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Lehman Brothers Asset Management. Lehman Brothers Asset Management specializes in investment strategies for institutional and qualified individual investors. While our strategies are numerous and diverse, our managers share a dedication to investment discipline that includes quantitative screening, fundamental analysis and risk management.

 

Lehman Brothers Institutional Asset Management provides a full range of asset management products for pensions, foundations, endowments and other institutions. It offers strategies across the risk/return spectrum, in cash, fixed income, equity and hybrid asset classes. Our money market funds include cash, prime and government funds, as well as customized short-duration fixed income strategies and enhanced cash capabilities. Our longer-maturity fixed income products are available across a continuum of strategies, from indexed to actively managed portfolios, with varying levels of risk parameters geared toward our clients’ particular requirements. Our equities strategies are based on fundamental research and quantitative analysis, with risk management incorporated throughout the investment process, using quantitative tools and adherence to sell-disciplines.

 

Lehman Brothers’ Absolute Return Strategies platform provides a wide range of hedge fund products to institutions and qualified individual clients. It offers proprietary single-manager funds, proprietary multiple-manager funds of funds and third-party single-manager funds. Our proprietary single-manager funds cover a wide array of investment strategies across long/short equity, relative value, event-driven and directional trading styles. As a sponsor of commingled multiple-manager funds of unaffiliated hedge funds and customized accounts, Lehman Brothers offers access to a select universe of fund managers.

 

Private Equity. Private Equity provides opportunities in privately negotiated transactions across a variety of asset classes for institutional and high-net-worth individual investors. Our investment partnerships manage a number of private equity portfolios, with the Company’s capital invested alongside that of our clients. Lehman Brothers creates funds, and through our Capital Markets business segment invests in asset classes in which we have strong capabilities, proprietary deal flow and an excellent reputation. Areas of specialty include Merchant Banking, Venture Capital, Real Estate, Credit-Related Investments, Infrastructure Investments and Private Fund Investments. We generally co-invest on a principal basis through our Capital Markets business segment in the investments made by the funds. The Private Fund Marketing Group focuses on raising capital for a limited number of high-quality private equity sponsors, providing them access to a well-diversified institutional global limited partner base.

 

Private Investment Management. Private Investment Management provides traditional brokerage services and comprehensive investment, wealth advisory, trust and capital markets execution services to both high-net-worth individuals and small and medium size institutional clients, leveraging all the resources of Lehman Brothers.

 

High Net Worth Clients. For individuals needing such services, our investment professionals and strategists work together to provide asset allocation, portfolio strategy and manager selection, and integrate that advice with tax, trust and estate planning. Driven by our clients’ goals for preserving and enhancing wealth across generations, we offer a wide range of investment opportunities including traditional and alternative investments. We are selective in creating our investment platform and look beyond proprietary products for opportunities. As needed, our tax and estate strategists integrate our clients’ investment strategies with their overall tax and estate picture, recommending vehicles to minimize taxes and provide for future generations. Additionally, the Lehman Brothers Trust Company provides private clients with comprehensive trustee and executor services. We address the specific needs of corporate executives and business owners through diversification and liquidity strategies. Additionally, where appropriate we partner with professionals across the Firm to deliver corporate finance and real estate solutions to our clients.

 

Institutional Clients. For institutions, we leverage the Lehman Brothers Capital Markets franchise to provide brokerage and market-making services to small and mid-sized institutional clients in the fixed income and equities capital markets.

 

Technology

 

Our businesses and operations rely on the secure processing, storage and transmission of confidential and other information, and on the utilization of the internet. We have made substantial investments in our technology, and Lehman Brothers is committed to the continued development and use of technology throughout the Firm. Our technology initiatives are designed to enhance client service through increased connectivity and the provision of value-added, tailored products and services, improve our trading, execution and clearing capabilities, enhance risk management and increase our overall efficiency, productivity and control.

 

We have enhanced client service by providing clients with electronic access to our products and services through our LehmanLive® web site and other channels. In particular, we provide global electronic trading, analytics and information distribution capabilities covering many of our fixed income, currency, commodity, equity and other products around the world.

 

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Electronic commerce and technology have changed and will continue to change the ways that securities and other financial products are traded, distributed and settled. This creates both opportunities and challenges for our businesses. We remain committed to being at the forefront of technological innovation in the global capital markets. See Part I, Item 1A, “Risk Factors—Operational Risk,” for a discussion of technology risks to which we are exposed.

 

Corporate

 

Our Corporate division provides support to our businesses through the processing of certain securities and commodities transactions, receipt, identification and delivery of funds and securities, safeguarding of clients’ securities, risk management, and compliance with regulatory and legal requirements. In addition, the Corporate division is responsible for technology infrastructure and systems development, information security, business continuity planning, treasury operations, financial reporting and business unit financial support, tax planning and compliance, internal audit, expense management, career development and recruiting and other support functions.

 

Risk Management

 

A description of our Risk Management infrastructure and procedures is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management” in Part II, Item 7, of this Report. Information regarding our use of derivative financial instruments to hedge interest rate, currency, security and commodity price and other market risks is contained in Notes 1, 3, 4, 6, 8 and 9 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

 

Competition

 

All aspects of our business are highly competitive. Lehman Brothers competes in U.S. and international markets directly with numerous other firms in the areas of securities underwriting and placement, corporate finance and strategic advisory services, securities sales and trading, prime brokerage, research, foreign exchange and derivative products, asset management and private equity, including investment banking firms, traditional and online securities brokerage firms, mutual fund companies and other asset managers, investment advisers, venture capital firms, certain commercial banks, insurance companies and others. Our competitive ability depends on many factors, including our reputation, the quality of our services and advice, product innovation, execution ability, pricing, advertising and sales efforts and the talent of our personnel. See Part I, Item 1A, “Risk Factors – Competitive Environment,” for a further discussion of the competitive risks to which we are exposed.

 

Regulation

 

The financial services industry is subject to extensive regulation in the various jurisdictions in which we do business. Violation of applicable regulations can result in legal and/or administrative proceedings, which may impose censures, fines, cease-and-desist orders, prohibitions from engaging in, or limitations or conditions on, some of our business activities, which could result in significant losses or reputational damage. We believe that we are in material compliance with applicable regulations.

 

Currently, U.S. and other international regulators are considering adopting a “mutual recognition” regulatory scheme to lower the barriers for financial institutions and markets seeking to conduct business in other jurisdictions. The objective is to provide investors with greater access to foreign investment opportunities while preserving important investor protection safeguards. Under “mutual recognition,” non-U.S. financial intermediaries might be able to provide services to U.S. investors without registering in the U.S. so long as those intermediaries are supervised in an approved jurisdiction that offers comparable regulatory oversight and reciprocity to U.S. firms. U.S. regulators are also considering eliminating or loosening some of the restrictive requirements under Rule 15a-6, which sets forth a process by which a non-U.S. broker can access certain U.S. customers without full registration with the SEC. Both mutual recognition and Rule 15a-6 reform could prompt changes to the status of U.S. and non-U.S. entities through which the Firm conducts its business, how and by whom the Firm is regulated internationally, and how certain cross-border transactions are structured.

 

U.S. Regulation. Holdings and its subsidiaries are subject to group-wide supervision and examination by the SEC as a Consolidated Supervised Entity (“CSE”). See “Capital Requirements” below and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Accounting and Regulatory Developments—Basel II” in Part II, Item 7, of this Report.

 

Lehman Brothers Inc. (“LBI”), Neuberger Berman, LLC (“NB LLC”) and Neuberger Berman Management Inc. (“NBMI”) are registered with the SEC as broker-dealers; Lehman Brothers OTC Derivatives Inc. (“LB OTC”) is registered with the SEC as an OTC derivatives dealer; and LBI, NB LLC, NBMI, Lehman Brothers Asset Management LLC (“LBAM”), and certain other of our subsidiaries are registered with the SEC as investment advisers. As such, these entities are subject to regulation by the SEC and by self-regulatory organizations, principally FINRA (which has been designated by the SEC as

 

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LBI’s, NB LLC’s and NBMI’s primary regulator), national securities exchanges such as the NYSE and the Municipal Securities Rulemaking Board, among others. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. Various subsidiaries are registered as broker-dealers in all 50 states, the District of Columbia and the Commonwealth of Puerto Rico.

 

Broker-dealers are subject to regulations, including those contained in the Securities Act of 1933 and the Securities Exchange Act of 1934, and rules promulgated thereunder, that cover all aspects of the securities business, including sales practices, market making and trading among broker-dealers, publication of research, margin lending, use and safekeeping of clients’ funds and securities, capital structure, recordkeeping and the conduct of directors, officers and employees.

 

Registered investment advisers are subject to regulations under the Investment Advisers Act of 1940. Such requirements relate to, among other things, recordkeeping and reporting requirements, disclosure requirements, limitations on agency cross and principal transactions between an adviser and advisory clients, as well as general anti-fraud prohibitions.

 

Certain investment funds that we manage are registered investment companies under the Investment Company Act of 1940. Those funds and the Lehman Brothers entities that serve as the funds’ investment advisers are subject to that act and the rules thereunder, which, among other things, regulate the relationship between a registered investment company and its investment adviser and prohibit or severely restrict principal transactions and joint transactions.

 

LBI and NB LLC are also registered with the Commodity Futures Trading Commission (the “CFTC”) as futures commission merchants, and NB LLC, LBAM and other subsidiaries are registered as commodity pool operators and/or commodity trading advisers. These entities are subject to regulation by the CFTC and various domestic boards of trade and other commodity exchanges. Our U.S. commodity futures and options business is also regulated by the National Futures Association, a not-for-profit membership corporation that has been designated as a registered futures association by the CFTC.

 

LB Bank, a federally chartered savings bank incorporated under the laws of the United States of America, is regulated by the Office of Thrift Supervision and the Federal Deposit Insurance Corporation (“FDIC”). LB Commercial Bank is subject to regulation by the FDIC and the Utah Commissioner of Financial Institutions. Lehman Brothers Trust Company N.A., which holds a national bank charter, is regulated by the Office of the Comptroller of the Currency of the United States. Lehman Brothers Trust Company of Delaware, a non-depository limited purpose Delaware trust company, is subject to oversight by the State Bank Commissioner of the State of Delaware. These bodies regulate such matters as policies and procedures on conflicts of interest, account administration and overall governance and supervisory procedures.

 

Lehman Brothers Commodity Services Inc. (“LBCS”) is authorized by the Federal Energy Regulatory Commission (“FERC”) to sell wholesale physical power at market-based rates. As a FERC-authorized power marketer, LBCS is subject to regulation under the Federal Power Act and FERC regulations.

 

Our U.S. insurance subsidiaries are subject to state insurance regulation in the states in which they are domiciled and in the other states in which they are licensed.

 

Non-U.S. Regulation. We do business in the international fixed income and equity markets and undertake international investment banking and investment management activities, principally through our regional headquarters in London and Tokyo. Lehman Brothers International (Europe) (“LB Europe”) is an authorized investment firm in the United Kingdom and is a member of the London, Frankfurt, Paris and Milan exchanges, among others. The U.K. Financial Services and Markets Act 2000 (the “FSMA”) and rules promulgated thereunder govern all aspects of the United Kingdom investment business, including regulatory capital, sales, research and trading practices, use and safekeeping of client funds and securities, record keeping, margin practices and procedures, approval standards for individuals, periodic reporting and settlement procedures. Pursuant to the FSMA, certain of our subsidiaries are subject to regulations promulgated and administered by the U.K.’s Financial Services Authority (“FSA”).

 

The investment services that are subject to oversight by the FSA and other European regulators are regulated in accordance with European Union (“EU”) directives requiring, among other things, customer protection requirements and conduct of business rules. These standards, requirements and rules are similarly implemented, under the same directives, throughout the EU and are broadly comparable in scope and purpose to the customer protection requirements imposed under the SEC and CFTC rules. Some EU directives also permit local regulation in each jurisdiction, including those in which we operate, to be more restrictive than the requirements of such directives.

 

The EU Markets in Financial Instruments Directive (“MiFID”), a major piece of legislation that updates and expands the current framework for regulating exchanges, multilateral trading facilities and investment firms on a pan-European basis, was implemented in the U.K. and most other EU member states on November 1, 2007. MiFID facilitates cross-border

 

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business by investment firms by generally establishing the regulatory regime of the member state in which an investment firm has its registered or head office as controlling the investment business of that firm. Once a firm has been authorized by its home member state, it will be able to use the MiFID passport to provide services to customers in other EU member states, which will be regulated by the home member state (whereas previously a service was regulated by the EU member state in which the service was provided). MiFID imposes a new set of organizational and conduct of business requirements on investment firms. Ongoing efforts by EU member countries to adopt national laws and regulations under MiFID could subject the Firm to new regulatory requirements in 2008.

 

Various Lehman Brothers subsidiaries are regulated by the banking and regulatory authorities of the other European countries in which we operate, including the German Federal Supervisory Authority for the Financial Service Industry (BaFin), the Commission Bancaire and other agencies in France, the Banca d’Italia and the Commissione Nazionale per le Società e la Borsa (CONSOB) in Italy, the Commission de Surveillance du Secteur Financier in Luxembourg and the Swiss Federal Banking Commission, as well as by the European securities, derivatives and commodities exchanges of which they are members. The rules and requirements of these European regulators and exchanges are broadly comparable to the rules and the requirements of the U.S. regulators and exchanges.

 

Lehman Brothers Japan Inc. (“LB Japan”) is a registered securities company in Japan and a member of the Tokyo Stock Exchange Inc., the Osaka Securities Exchange Co., Ltd., the Jasdaq Securities Exchange Inc., the Tokyo Financial  Exchange Inc. and the Tokyo Commodity Exchange and, as such, is regulated by the Financial Services Agency, the Securities Exchange Surveillance Commission, the Japan Securities Dealers Association, the Financial Futures Association of Japan, the Tokyo Metropolitan Government and those exchanges.

 

Other Lehman Brothers subsidiaries in Asia are regulated by the Securities and Futures Commission in Hong Kong, the Monetary Authority of Singapore, the China Securities Regulatory Commission, the Korean Financial Supervisory Service, the Australian Securities and Investments Commission, the Securities and Exchange Board of India and the Reserve Bank of India, as well as by the Asian securities, derivatives and commodities exchanges of which they are members. The rules and requirements of these Asian regulators and exchanges are broadly comparable to the rules and the requirements of the U.S. regulators and exchanges.

 

In the Americas, LBI and certain other subsidiaries are regulated by the Ontario Securities Commission in Canada, and certain of our Bermuda-based insurance subsidiaries are regulated by the Bermuda Monetary Authority.

 

LBI, LB Europe, LB Japan and many of our other subsidiaries are also subject to regulation by securities, banking and finance regulatory authorities, securities, derivatives and commodities exchanges and other self-regulatory organizations in numerous other countries in which we do business.

 

Research. The research areas of investment banks have been and remain the subject of regulatory scrutiny. The SEC, NYSE and NASD (now FINRA) have adopted rules imposing restrictions on the interaction between equity research analysts and investment banking personnel at member securities firms. Various non—U.S. jurisdictions have imposed both substantive and disclosure-based requirements with respect to research, and continue to consider additional regulation. In addition, we are a party to a settlement with certain federal and state securities regulators and self-regulatory organizations that imposes restrictions on the interaction between research and investment banking departments and requires us to fund the provision of independent research to our clients.

 

Mortgage Lending. We originate, purchase and securitize commercial and residential mortgage loans through LB Bank, Bankhaus and other subsidiaries in the U.S., Europe and Asia, and we are subject to an extensive body of U.S. federal and state mortgage laws and regulations, as well as laws and regulations in other countries, including the U.K., the Netherlands, Japan and South Korea. In recent years, individual cities and counties in the U.S. have begun to enact laws that restrict non-prime loan origination activities. The U.S. federal government is also considering legislative and regulatory proposals in this regard. In 2006, U.S. federal bank regulators issued interagency guidance applicable to federally chartered lenders such as LB Bank covering certain residential mortgage loan products, and are considering further proposals that cover topics related to loan terms and underwriting standards, risk management practices and consumer protection issues. It remains unclear how all these initiatives will be interpreted, what effect it will have on our business and whether it will change the overall competitive landscape in the mortgage industry.

 

In addition, the SEC and banking regulators are examining the disruption in the subprime mortgage market that began in the summer of 2007. Their efforts have focused on a wide range of issues, including the origination and securitization of mortgages, the sale of collateralized debt obligations and other securities backed by those mortgages, and valuation and pricing of those securities internally and for customers. In addition to reviewing the sales of subprime-backed securities to customers, regulators have expressed interest in reviewing the proprietary positions taken by firms who have underwritten them, including broker-dealer exposure to subprime-backed securities, and capital treatment and

 

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financial reporting, including off-balance sheet vehicles with subprime mortgage exposure. As the regulatory efforts are in their early stages, it is unclear what, if any, action will be taken.

 

Hedge Fund Activities. In recent years, high-profile hedge fund failures and concerns about hedge fund transparency and systemic risk have brought increased regulatory attention to hedge funds as well as to their counterparties and other entities that service them. In addition to Lehman Brothers’ proprietary funds, the Firm provides services and is a counterparty to unaffiliated hedge funds and is subject to regulation concerning all of these activities. We also have investments in a number of hedge fund managers. Because most hedge funds are not directly regulated, financial regulators in the U.S. and abroad are increasingly focused on counterparty credit risk management practices of other financial institutions as the optimal way to control hedge fund leverage and limit systemic vulnerabilities.

 

The U.S. Congress has been examining the adequacy of the existing regulatory structure and is considering whether to introduce legislation to require hedge funds to register with the SEC. The President’s Working Group and central bankers abroad are working on a set of best practices for hedge funds. In addition to proposing new regulations extending anti-fraud protection to hedge fund investors and raising the eligibility threshold for investing in hedge funds, the SEC has created several “working groups” that focus specifically on hedge fund practices, including identifying and managing conflicts of interest, preventing and detecting insider trading, and valuation of hedge fund assets.

 

Protection of Client Information. Many aspects of our business are subject to increasingly comprehensive legal and regulatory requirements concerning the use, safeguarding and disposal of certain client information, including those adopted pursuant to the Gramm-Leach-Bliley Act of 1999, the Fair and Accurate Credit Transactions Act of 2003 and a number of state data protection laws in the U.S., the EU Data Protection and Telecommunications Privacy Directives and member state implementations, and various laws in Asia, including the Japanese Personal Information Protection Law and the Hong Kong Personal Data (Privacy) Ordinance. We monitor these matters closely and adopt policies and procedures designed to comply with such requirements.

 

Anti-Money Laundering. The USA PATRIOT Act of 2001 and various laws and regulations in the U.K, EU, Japan and other jurisdictions contain anti-money laundering and anti-terrorism requirements that mandate the implementation of various regulations applicable to financial services companies, including requirements for verifying client identity at account opening, conducting enhanced due diligence, monitoring client transactions and reporting suspicious activities, staff training and awareness, record keeping and making use of international findings. These laws and regulations seek to promote cooperation among financial institutions, regulators and law enforcement in identifying parties that may be involved in terrorism or money laundering. We have established policies, procedures and internal controls that are designed to comply with these laws and regulations.

 

Judicial, Regulatory and Arbitration Proceedings. We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our business. See Part I, Item 3, “Legal Proceedings,” in this Report for information about certain pending proceedings.

 

Capital Requirements

 

LBI, LB OTC, NB LLC, NBMI, LB Europe, LB Japan, LB Bank, LB Commercial Bank, Bankhaus and other regulated subsidiaries of Holdings are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate. In addition, our “AAA” rated derivatives subsidiaries (Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc.) are subject to capital targets established by various ratings agencies. The regulatory rules referred to above, and certain covenants contained in various debt agreements, may restrict Holdings’ ability to withdraw capital from certain subsidiaries, which in turn could limit its ability to commit capital to other businesses, meet obligations or pay dividends to shareholders. Further information about these requirements and restrictions is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources” in Part II, Item 7, of this Report and in Note 15 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

 

The SEC has granted us permission to operate under its CSE rule, a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies. The rule allows LBI to use an alternative method, based on internal models, to calculate net capital charges for market and derivative-related credit risk. Under this rule, Lehman Brothers is subject to group-wide supervision and examination by the SEC and is subject to minimum capital requirements on a consolidated basis consistent with the Basel II Accord published by the Basel Committee on Banking Supervision. The CSE Rules are designed to minimize the duplicative regulatory requirements on U.S. securities firms resulting from the EU Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. This Directive permits non-EU financial groups that conduct business through regulated financial entities in the EU to demonstrate that they are subject to equivalent

 

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consolidated supervision at the ultimate holding company level; the FSA has determined that the SEC undertakes equivalent consolidated supervision for Lehman Brothers. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Accounting and Regulatory Developments—Basel II” in Part II, Item 7, of this Report for more information.

 

Client Protection

 

LBI and NB LLC are members of the Securities Investor Protection Corporation (“SIPC”). Clients of LBI and NB LLC are protected by SIPC against some losses. SIPC provides protection against lost, stolen or missing securities (except loss in value due to a rise or fall in market prices) for clients in the event of the failure of the broker-dealer. Accounts are protected up to $500,000 per client with a limit of $100,000 for cash balances. In addition to being members of SIPC, LBI and NB LLC carry excess SIPC protection, which increases each client’s protection up to the net equity of the account, subject to terms and conditions similar to SIPC. Like SIPC, the excess coverage does not apply to loss in value due to a rise or fall in market prices. Certain of our non-U.S. broker-dealer subsidiaries participate in programs similar to SIPC in certain jurisdictions.

 

Deposits in LB Bank and LB Commercial Bank are insured by the FDIC, subject to applicable limits per depositor. Bankhaus participates in the German Depositors Protection Fund, which insures deposits from non-bank clients, with applicable limits per depositor.

 

Insurance

 

We maintain insurance coverage in types and amounts and with deductibles that management believes are customary for companies of similar size and engaged in similar businesses. However, the insurance market is volatile, and there can be no assurance that any particular coverage will be available in the future on terms acceptable to us.

 

Employees

 

As of November 30, 2007, Lehman Brothers employed approximately 28,600 persons. We consider our relationship with our employees to be good.

 

ITEM 1A. RISK FACTORS

 

You should carefully consider the following risks and all of the other information set forth in this Report, including the Consolidated Financial Statements and the Notes thereto. If any of the events or developments described below were actually to occur, our business, financial condition, results of operations or cash flows could be materially adversely affected.

 

Market Risk

 

As a global investment bank, risk is an inherent part of our business. Our businesses are materially affected by conditions in the financial markets and economic conditions generally around the world. A favorable business environment is generally characterized by, among other factors, high global gross domestic product growth, stable geopolitical conditions, transparent and efficient capital markets, liquid markets with active investors, low inflation, high business and consumer confidence and strong business earnings. Slowing growth, contraction of credit, increasing energy prices, declines in business or investor confidence or risk tolerance, increases in inflation, higher unemployment, outbreaks of hostilities or other geopolitical instability, corporate, political or other scandals that reduce investor confidence in capital markets and natural disasters, among other things, can affect the global financial markets. In addition, economic or political pressures in a country or region may cause local market disruptions and currency devaluations, which may also affect markets generally. In the event of changes in market conditions, such as interest or foreign exchange rates, equity, fixed income, commodity or real estate valuations, liquidity, availability of credit or volatility, our businesses could be adversely affected in many ways, including those described below. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Market Risk” for a further discussion of the market risks to which we are exposed.

 

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Our Client-Flow Revenues May Decline in Adverse Market Conditions. Recently, the residential real estate market in the U.S. has experienced a significant downturn due to declining real estate values, substantially reducing mortgage loan originations and securitizations, and precipitating more generalized credit market dislocations and a significant contraction in available liquidity globally, which negatively impacted our revenues. These factors have continued into the beginning of fiscal 2008 and, combined with rising oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown and fears of a possible recession. Further declines in real estate values in the U.S. or elsewhere and continuing credit and liquidity concerns could further reduce our level of mortgage loan originations and securitizations and increase our mortgage inventory while adversely affecting its value. In addition, continued or further credit market dislocations or sustained market downturns may reduce client flow revenues and adversely affect the value of our inventory in other businesses.

 

Changes in interest rates, and in particular long-term rates, especially if such changes are rapid, may create a less favorable environment for certain of our businesses. Rising interest rates may cause a decline in our mortgage origination and securitization businesses in particular, as the volume of our origination and securitization activity may decline.

 

Our Investment Banking revenues, in the form of financial advisory and debt and equity underwriting fees, are directly related to the number and size of the transactions in which we participate and therefore were adversely affected in the latter half of 2007 by the mortgage and credit market dislocations, and may be further impacted by continued or further credit market dislocations or sustained market downturns.

 

Sustained market downturns or continued or further credit market dislocations and liquidity issues would also likely lead to a decline in the volume of capital market transactions that we execute for our clients and, therefore, to a decline in the revenues we receive from commissions and spreads earned from the trades we execute for our clients. In addition, because the fees that we charge for managing our clients’ portfolios are in many cases based on the value of those portfolios, a market downturn that reduces the value of our clients’ portfolios would reduce the revenues we receive from our asset management business. Heightened risk aversion among investors may cause them to shift their trading activity to higher quality and more liquid products, which are generally somewhat less profitable for us.

 

Even in the absence of a market downturn, below-market investment performance by our fund and portfolio managers could reduce Investment Management revenues and assets under management and result in reputational damage that might make it more difficult to attract new investors.

 

We May Incur Losses Due to Fluctuations in Market Rates, Prices and Volatility. Market risk is inherent in our client-driven market-making transactions and proprietary trading and principal investment activities in equity and fixed income securities, commodities, currencies and derivatives and our mortgage and loan origination and syndication activities. Fluctuations in market rates, prices and volatility, especially if the changes are rapid and without warning, can adversely affect the market value of our long or short inventory and proprietary and principal positions and, to the extent that such positions are not adequately hedged, cause the Firm to incur losses. To the extent that we hold long inventory positions, a downturn in the market could result in losses from a decline in the value of those positions. On the other hand, to the extent that we have sold inventory short, an upturn in those markets could expose us to losses as we attempt to cover our short positions by acquiring assets in a rising market. The adverse conditions in the U.S. housing market, dislocations in the credit markets and corrections in certain asset-backed security market segments resulted in substantial valuation reductions in the past fiscal year, most significantly on mortgage- and real estate-related positions and lending obligations. Market credit spreads have recently gone from historically tight to historically wide levels, and a further widening of credit spreads or worsening of credit market dislocations or sustained market downturns could have additional negative effects on the value of our inventory.

 

In our market-making and specialist transactions, we maintain substantial inventory positions from time to time, acting as a financial intermediary for our clients, and we hold inventory positions in the normal course of business to allow clients to rebalance their portfolios and diversify risks across market cycles. Current NYSE rules generally require our specialist business to maintain orderly markets in the securities for which it is a specialist. Specialists are obligated to take positions in their issues counter to the direction of the market in order to minimize short-term imbalances in the market, involving risk of loss during periods of market fluctuation and volatility.

 

In our mortgage and loan origination and securitization businesses, we are also subject to risks from decreasing interest rates. Most residential mortgages and consumer loans provide that the borrower may repay them early. Borrowers often exercise this right when interest rates decline. As prepayments increase, the value of mortgages and other loans with prepayment features held in inventory prior to securitization generally will decrease, and to the extent that prepayment risk has not been hedged, prepayments may result in a loss.

 

We also maintain long and short positions through our other proprietary trading activities and make principal

 

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investments (such as in real estate and real estate-related products and private equity), which are also subject to market risks. The value of these positions can be adversely affected by changes in market rates, prices and volatility. We have increased our proprietary trading and principal investing activities and expect to continue to do so, which increases our exposure to market risk.

 

On the other hand our client-flow and proprietary trading businesses generally depend on market volatility to provide trading and arbitrage opportunities, and a decline in volatility may reduce these opportunities and adversely affect the results of these businesses.

 

Holding Large and Concentrated Positions May Expose Us to Losses. Concentration of risk may reduce revenues or result in losses in our market-making, specialist, block trading, underwriting, proprietary trading, principal investment and lending businesses in the event of unfavorable market movements even when economic and market conditions are generally favorable for others in the industry. We have committed substantial amounts of capital to these businesses, which often require us to take large positions in the securities of, or make large loans to, a particular issuer or issuers in a particular industry, country or region. Moreover, the trend in all major capital markets is towards larger and more frequent commitments of capital in many of these activities, and we expect this trend to continue. For example, large positions of securities are increasingly being sold in block trades rather than on a marketed basis, which could increase the risk that we may be unable to resell the securities at favorable prices. While our activities expose us to many different counterparties, we routinely execute a high volume of transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment funds and other institutional clients, resulting in significant credit concentration with respect to this industry. In the ordinary course of business, we may also be subject to a concentration of credit risk to a particular counterparty, borrower or issuer. Concentration of risk will increase as we expand our proprietary trading and principal investing activities or commit additional capital to facilitate client-driven business.

 

Market Risk May Increase the Other Risks That We Face. In addition to the potentially adverse effects on our businesses described above, market risk could exacerbate other risks that we face. For example, if we were to incur substantial market risk losses, our need for liquidity could rise significantly, while our access to liquidity could be impaired. In addition, in conjunction with a market downturn, our clients and counterparties could incur substantial losses of their own, thereby weakening their financial condition and increasing our credit risk exposure to them.

 

Credit Risk

 

We May Incur Losses Associated with Our Credit Exposures. Credit risk represents the possibility a counterparty or an issuer of securities or other financial instruments we hold or a borrower of funds from us will be unable to honor its contractual obligations to us. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Default risk may also arise from events or circumstances that are difficult to foresee or detect, such as fraud. Credit risk may arise, for example, from holding securities of third parties; entering into swap or other derivative contracts under which counterparties have obligations to make payments to us; executing securities, futures, currency or commodity trades that fail to settle at the required time due to non-delivery by the counterparty or systems failure by clearing agents, exchanges, clearing houses or other financial intermediaries; and extending credit to our clients through bridge or margin loans or other arrangements. As a clearing member firm, we finance our client positions, and we could be held responsible for the defaults or misconduct of our clients. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk” for a further discussion of the credit risks to which we are exposed. Our principal focus has been acting as an intermediary of credit. In recent years, we have expanded our activities associated with providing our clients access to credit and liquidity and have also expanded our swaps and derivatives businesses. The amount and duration of our credit exposures have been increasing, as has the diversity of the entities to which we have credit exposures. The extension and pricing of credit is subject to competitive pressure. In addition, corporate clients sometimes seek to require credit commitments from us in connection with investment banking and other assignments. Further, the recent widening of credit spreads and dislocations in the credit markets have in some cases made it more difficult to syndicate credit commitments to investors, and further widening of credit spreads or worsening of these dislocations could increase these difficulties, resulting in increased credit exposures.

 

Defaults by Another Large Financial Institution Could Adversely Affect Financial Markets Generally. The commercial soundness of many financial institutions may be closely interrelated as a result of credit, trading, clearing or other relationships between the institutions. As a result, concerns about, or a default by, one institution could lead to significant market-wide liquidity problems, losses or defaults by other institutions. This is sometimes referred to as “systemic risk” and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which we interact on a daily basis, and therefore could adversely affect Lehman Brothers.

 

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Liquidity Risk

 

Liquidity, that is ready access to funds, is essential to our businesses. Financial institutions rely on external borrowings for the vast majority of their funding, and failures in our industry are typically the result of insufficient liquidity.

 

An Inability to Access the Debt Markets Could Impair Our Liquidity. We maintain a liquidity pool available to Holdings that is intended to cover all expected cash outflows for one year in a stressed liquidity environment, which assumes, among other things, that during that year we cannot issue unsecured debt. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources—Liquidity” for a discussion of our liquidity needs and liquidity management.

 

To the extent that a liquidity event lasts for more than one year, or our expectations concerning the market conditions that exist during a liquidity event, or our access to funds, prove to be inaccurate (e.g., the level of secured financing “haircuts” (the difference between the market and pledge value of the assets) required to fund our assets in a stressed market event is greater than expected, or the amount of drawdowns under our commitments to extend credit in a stressed market environment exceeds our expectations), our ability to repay maturing indebtedness and fund operations could be significantly impaired. Even within the one-year time frame contemplated by our liquidity pool, we depend on continuous access to secured financing in the repurchase and securities lending markets, which could be impaired by factors that are not specific to Lehman Brothers, such as a severe disruption of the financial markets.

 

Structured Instruments May Have Limited Liquidity. The financial instruments that we hold and the contracts to which we are a party are increasingly complex, as we employ structured products to benefit our clients and ourselves, and these complex structured products often do not have readily available markets to access in times of liquidity stress. The growth of our proprietary investing activities may lead to situations where the holdings of structured instruments represent a significant portion of specific markets, which could restrict liquidity for our positions. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time.

 

We Are a Holding Company and Are Dependent on Our Subsidiaries for Funds. Since Holdings is primarily a holding company, our cash flow and consequent ability to pay dividends and satisfy our obligations under securities we issue are dependent upon the earnings of our subsidiaries and the distribution of those earnings as dividends or loans or other payments by those subsidiaries to Holdings. Several of our principal subsidiaries are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate and/or to capital targets established by various ratings agencies. These regulatory rules, and certain covenants contained in various debt agreements, may restrict our ability to withdraw capital from our subsidiaries by dividends, loans or other payments. Further information about these requirements and restrictions is set forth in Note 15 to the Consolidated Financial Statements in Part II, Item 8, of this Report. Additionally, our ability to participate as an equity holder in any distribution of assets of any subsidiary upon liquidation is generally subordinate to the claims of creditors of the subsidiary.

 

Credit Ratings

 

Our borrowing costs and our access to the debt capital markets depend significantly on our credit ratings. A reduction in our long- or short-term credit ratings could increase our borrowing costs, limit our access to the capital markets and trigger additional collateral requirements in derivative contracts and other secured funding arrangements. Credit ratings are also important to us when competing in certain markets, such as longer-term over-the-counter derivatives. Therefore, a substantial reduction in our credit ratings would reduce our earnings and adversely affect our liquidity and competitive position. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources—Liquidity” and “—Credit Ratings” for additional information concerning our credit ratings.

 

Risks Relating to Use of Estimates and Valuations

 

We make various estimates that affect reported amounts and disclosures. Broadly, those estimates are used in measuring fair value of certain financial instruments, accounting for identifiable intangible assets and goodwill, establishing provisions for potential losses that may arise from litigation, regulatory proceedings and tax examinations, assessing our ability to realize deferred taxes and valuing equity-based compensation awards. Estimates are based on available information and judgment. Therefore, actual results could differ from our estimates and that difference could have a material effect on our consolidated financial statements.

 

Financial instruments and other inventory positions owned (including commitments and guarantees, but excluding real estate held for sale), and financial instruments and other inventory positions sold but not yet purchased, are presented at fair value, with realized and unrealized gains or losses reflected in Principal transactions in our Consolidated Statement of

 

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Income. We account for real estate held for sale at the lower of its carrying amount or fair value less cost to sell. In addition, certain long and short-term borrowing obligations, principally hybrid financial instruments, and certain deposits at U.S. banks, are reflected at fair value. Fair value is defined as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity. In particular, certain mortgage and asset-backed securities, certain corporate debt, certain private equity investments, certain commitments and guarantees and certain derivatives have no direct observable levels, and their valuations require significant estimation and judgment and therefore are subject to significant subjectivity. Reliance on estimation and judgment increases in adverse market conditions with decreased liquidity, such as those experienced recently.

 

See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates” and Notes 1 and 3 through 10 to the Consolidated Financial Statements in Part II, Item 8, of this Report for additional information concerning our use of estimates and valuation methodologies.

 

Risks Relating to Off-Balance Sheet Entities

 

In the normal course of our business, we enter into various transactions with special purpose entities (“SPEs”). We do not consolidate certain SPEs in which we do not have a controlling financial interest as defined under applicable accounting standards. When we do not consolidate an entity, we either present our investment in the entity at fair value or apply the equity method of accounting. The assessment of whether the accounting criteria for consolidation are met requires management to exercise significant judgment. A determination of whether we have a controlling financial interest in an entity, and therefore our assessment of consolidation of that entity, is initially made at the time we become involved with the entity. If certain events occur that require us to re-assess our initial determination of non-consolidation or if our judgment of non-consolidation is in error, we could be required to consolidate the assets and liabilities of an SPE onto our consolidated balance sheet and recognize its future gains or losses in our consolidated statement of income. Further, existing accounting standards may be changed, or interpretations of those standards may change, in the future in a manner that requires or increases the risk of consolidation of some SPEs. Consolidation could affect the size of our consolidated balance sheet and related funding requirements, our financial and regulatory capital ratios and, if the SPE’s assets include unrealized losses, could require us to recognize those losses.

 

In addition, we have various commitments to and obligations associated with SPEs, including liquidity commitments and funded loans to certain conduits and other SPEs, limited downside protection guarantees to investors in certain SPEs, obligations as a general partner and investment advisor to private equity and other investment partnerships, indemnification obligations to investors in certain securitization vehicles we sponsor with respect to customary representations and warranties we make about the assets of SPEs, proprietary investments and retained interests in various SPEs and others. For additional information about our consolidation accounting policies and transactions with SPEs, and events that may require us to re-assess our determination of non-consolidation, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies and Estimates—Consolidation Policies” and “—Off-Balance-Sheet Arrangements—Special Purpose Entities” in Part II, Item 7, and Notes 1, 6 and 9 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

 

Operational Risk

 

Operational Risks May Disrupt Our Businesses, Result in Losses or Reputational Damage or Limit Our Growth. We face operational risk arising from errors made in the execution, confirmation or settlement of transactions or from transactions not being properly recorded, evaluated or accounted for. Derivative contracts are not always confirmed by the counterparties on a timely basis; while the transaction remains unconfirmed, we are subject to heightened credit and operational risk and in the event of a default may find it more difficult to enforce the contract. Our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies and the transactions we process have become increasingly complex. Consequently, we rely heavily on our financial, accounting and other data processing systems. If any of these systems do not operate properly or are disabled, we could suffer financial loss, a disruption of our businesses, liability to clients, regulatory intervention or reputational damage. The inability of our systems to accommodate an increasing volume of complex transactions could also constrain our ability to expand our businesses. In recent years, we have substantially upgraded and expanded the capabilities of our data processing systems and other operating technology, and we expect that we will need to continue to upgrade and expand in the future to avoid disruption of, or constraints on, our operations.

 

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Our businesses and operations rely on the secure processing, storage and transmission of confidential and other information, and, increasingly, on the internet. We routinely transmit and receive personal, confidential and proprietary information by email and other electronic means. We have made available to clients and counterparties certain secure transmission capabilities; however, our clients and counterparties do not always choose to avail themselves of these capabilities. We take extensive protective measures for our computer systems, internet sites, software and networks to protect against vulnerabilities to unauthorized access, computer viruses, denial of service attacks or other events that could have a security or business impact. If, nevertheless, such events should occur, they could result in significant losses or reputational damage. We are exposed to similar risks arising from the interception of personal, confidential or proprietary information sent to or received from, or the misuse or mishandling thereof by, vendors, service providers and other third parties who may receive such information from us, and our ongoing efforts to improve security over email and encrypted file transfers and to ensure that these third parties have appropriate controls in place may not be successful.

 

We also face the risk of operational or business failure of any of the clearing agents or other financial intermediaries or data providers we use, and as our interconnectivity with our clients grows, we face higher levels of operational risk that could adversely affect our ability to effect transactions, service our clients and manage our exposure to risk.

 

When we originate or purchase residential mortgage loans, we rely heavily upon information supplied by third parties, including the information contained in the loan application, property appraisal, title information and employment and income documentation. If any of this information is intentionally or negligently misrepresented, whether by the loan applicant, the mortgage broker, another third party or one of our employees, and such misrepresentation is not detected prior to loan funding, the value of the loan may be significantly lower than expected and/or be unsaleable or subject to repurchase if it is sold prior to detection of the misrepresentation. While relevant laws may not explicitly hold the originating lenders responsible for the legal violations of mortgage brokers, increasingly federal and state agencies have sought to impose such assignee liability.

 

In addition, despite the contingency plans we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located. This may include a disruption involving electrical systems, communications, transportation or other services used by Lehman Brothers or third parties with which we conduct business, terrorist activities or disease pandemics. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management” in Part II, Item 7, of this Report for a description of our Risk Management infrastructure and procedures.

 

Acquisitions or Joint Ventures Could Present Unforeseen Integration Obstacles or Costs. Acquisitions and joint ventures involve a number of risks and present financial, managerial and operational challenges, including difficulty with integrating personnel and financial and other systems, hiring additional management and other critical personnel and increasing the scope, geographic diversity and complexity of our operations. In addition, we may not realize the anticipated benefits from an acquisition, and we may be exposed to additional liabilities of any acquired business.

 

Legal, Regulatory and Reputational Risk

 

We face the risk of litigation and intervention by regulatory authorities in all jurisdictions in which we conduct our businesses. Among other things, we could be subjected to judgments or fines, be prohibited from engaging in some of our business activities or be subjected to limitations or conditions on our business activities, all of which could result in significant losses or reputational damage.

 

We Face Significant Litigation Risks in Our Businesses. The volume of litigation against financial services firms and the amount of damages claimed have increased over the past several years. We are exposed to potential liability as an underwriter under securities or other laws for materially false or misleading statements made in connection with securities and other transactions, potential liability for the “fairness opinions” and other advice we provide to participants in corporate transactions and disputes over the terms, conditions and risks of trading arrangements. We also face the possibility that counterparties will claim that we improperly failed to tell them of the risks or that they were not authorized or permitted to enter into these transactions with us and that their obligations to Lehman Brothers are not enforceable. In our Investment Management segment, we are exposed to claims against us for recommending investments that are not consistent with a client’s investment objectives or engaging in unauthorized or excessive trading. The downturn in the mortgage and mortgage-backed securities markets may result in increased claims of this type, and during a prolonged market downturn, we would expect these claims to further increase. We are also subject to claims arising from disputes with employees for alleged discrimination or harassment, among other things. These risks often may be difficult to assess or quantify, and their existence and magnitude often remain unknown for substantial periods of time. We incur significant legal expenses every year in defending against litigation, and we expect to continue to do so in the future. See Part I, Item 3, “Legal Proceedings” for a discussion of some of the legal and regulatory

 

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matters in which we are currently involved.

 

Extensive Regulation of Our Businesses Limits Our Activities and May Subject Us to Significant Penalties. Lehman Brothers, as a participant in the financial services industry, is subject to extensive regulation under both federal and state laws in the U.S. and under the laws of the many global jurisdictions in which we do business. We are also regulated by a number of self-regulatory organizations. The industry has experienced increased scrutiny from a variety of regulators, including the SEC, FINRA and state attorneys general. Over the last several years, penalties and fines sought by regulatory authorities in our industry have increased substantially, and certain regulators have been more likely to commence enforcement actions.

 

The requirements imposed by our regulators are designed to ensure the integrity of the financial markets and to protect customers and other third parties who deal with Lehman Brothers. Consequently, these regulations often serve to limit our activities, including through net capital, customer protection and market conduct requirements. If we were found to have breached certain of these rules or regulations, we could face the risk of significant intervention by regulatory authorities in all jurisdictions in which we conduct our businesses, including extended investigation and surveillance activity, adoption of costly or restrictive new regulations and judicial or administrative proceedings that may result in substantial penalties. Among other things, we could be fined or prohibited from engaging in some of our business activities.

 

Additional legislation and regulations, changes in rules imposed by regulatory authorities, self-regulatory organizations and exchanges or changes in the interpretation or enforcement of existing laws and rules may adversely affect our business and profitability. Our business may be materially affected not only by regulations applicable to us as an investment bank, but also by regulations of general application, including existing and proposed tax legislation and other governmental regulations and policies (including the interest rate and monetary policies of the Federal Reserve Board and other central banks) and changes in the interpretation or enforcement of existing laws and rules that affect the business and financial communities.

 

In emerging markets in particular, we may be subject to risks of possible nationalization, expropriation, price controls, capital controls, currency exchange controls and other restrictive governmental actions. In many countries, the laws and regulations applicable to the securities and financial services industries are uncertain and evolving, and it may be difficult for us to determine the exact requirements of local laws in every market. We are also subject to greater risk in these jurisdictions that transactions we structure might not be legally enforceable in all cases. In addition, in conducting business in these jurisdictions, we are often faced with the challenge of ensuring that our activities are also consistent with U.S. or other laws with extra-territorial application, such as the USA PATRIOT Act and the U.S. Foreign Corrupt Practices Act. Our failure to comply with such laws could result in significant losses or reputational damage.

 

In the past several years, intensified scrutiny of the energy market by federal, state and local authorities and the public has resulted in increased regulatory and legal proceedings involving electricity, natural gas and other energy commodities merchants. Our business and reputation may be adversely affected by legal and regulatory proceedings arising out of our energy commodities activities.

 

We are subject to the income tax laws of the jurisdictions in which we have business operations. These tax laws are complex and may be subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. We must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes. We are subject to contingent tax risk that could adversely affect our results of operations, to the extent that our interpretations of tax laws are disputed upon examination or audit, and are settled in amounts in excess of established reserves for such contingencies. See Part I, Item 1, “Business—Regulation” for a further discussion of the regulatory environment in which we conduct our businesses.

 

Our Mortgage Origination Business is Subject to Special Litigation and Regulatory Risks. The laws and regulations of the various jurisdictions in which we conduct our mortgage lending business are complex, frequently changing and, in some cases, in direct conflict with each other. In particular, this business is subject to various laws, regulations and guidance that restrict non-prime loan origination or purchase activities. Some of these laws and regulations provide for assignee liability for warehouse lenders, whole loan buyers and securitization trusts. In addition, the downturn in the U.S. residential real estate market has resulted in increased regulatory scrutiny, and may result in increased complaints and claims, relating to non-prime mortgage origination practices, and further difficulties in the mortgage markets could result in increased exposure to liability, including possible civil and criminal liability, demands for indemnification or loan repurchases from purchasers of our loans (including securitization trusts), class action lawsuits or administrative enforcement actions. Moreover, our customer base and counterparties in this business are substantially different from the high-net-worth and institutional customers and counterparties of most of our other businesses, which presents a different litigation risk profile.

 

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LEHMAN BROTHERS HOLDINGS INC.

 

Exposure to Reputational Risks Could Impact the Value of Our Brand. Our reputation is critical in maintaining our relationships with clients, investors, regulators and the general public, and is a key focus in our risk management efforts. In recent years, there have been a number of highly publicized cases involving fraud, conflicts of interest or other misconduct by employees in the financial services industry, and we run the risk that misconduct by our employees could occur. Misconduct by employees could include binding Lehman Brothers to transactions that exceed authorized limits or present unacceptable risks, or hiding from Lehman Brothers unauthorized or unsuccessful activities, which, in either case, may result in unknown and unmanaged risks or losses. Employee misconduct could also involve the improper use or disclosure of confidential information, which could result in regulatory sanctions and serious reputational or financial harm. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. In addition, in certain circumstances our reputation could be damaged by activities of our clients in which we participate, or of hedge funds or other entities in which we invest, over which we have little or no control.

 

Potential Conflicts of Interest Are Increasing. As we have expanded the scope of our businesses and our client base, we increasingly have to address potential conflicts of interest, including those relating to our proprietary activities. For example, conflicts may arise between our position as a financial advisor in a merger transaction and a principal investment we hold in one of the parties to the transaction. In addition, hedge funds and private equity funds are an increasingly important portion of our client base, and also compete with us in a number of our businesses. In addition, the SEC, FINRA, other federal and state regulators and regulators outside the U.S., including in the U.K. and Japan, have increased their scrutiny of potential conflicts of interest. We have extensive procedures and controls that are intended to ensure that any potential conflicts of interest are appropriately addressed. However, properly dealing with conflicts of interest is complex and difficult, and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with conflicts of interest and, it is possible that potential or perceived conflicts could give rise to litigation or enforcement actions.

 

Competitive Environment

 

All aspects of our business are highly competitive. Our competitive success depends on many factors, including our reputation, the quality of our services and advice, intellectual capital, product innovation, execution ability, pricing, sales efforts, and the talent of our personnel. Many of our competitors have greater capital resources and greater geographic reach than we do, which enhances their competitive positions.

 

We Face Increased Competition Due to a Trend Toward Consolidation. In recent years, there has been substantial consolidation and convergence among companies in the financial services industry. In particular, a number of large commercial banks, insurance companies and other broad-based financial services firms have established or acquired broker-dealers or have merged with other financial institutions. Many of these firms have the ability to offer a wide range of products, from loans, deposit-taking and insurance to brokerage, asset management and investment banking services, which may enhance their competitive position. They also have the ability to support investment banking and securities products with commercial banking, insurance and other financial services revenues in an effort to gain market share. These abilities have resulted in pricing pressure in our businesses. We have experienced intense price competition in some of our businesses in recent years. For example, equity and debt underwriting and trading spreads and fees for lending and other activities have been under competitive pressure for a number of years.

 

Our Revenues May Decline Due to Competition from Alternative Trading Systems. Securities and futures transactions are now being conducted through the internet and other alternative, non-traditional trading systems, and it appears that the trend toward alternative trading systems will continue and probably accelerate. A dramatic increase in computer-based or other electronic trading may adversely affect our commission and trading revenues, including in our specialist business. The NYSE’s adoption of its hybrid market for trading securities may increase pressure on our Equities business as customers execute more of their NYSE-related trades electronically. We have invested significant resources into the development of electronic trading systems and expect to continue to do so, but there is no assurance that the revenues generated by these systems will yield an adequate return on our investment, particularly given the relatively lower commissions arising from electronic trades.

 

Our Ability to Retain Our Key Employees is Critical to the Success of Our Business. Our people are our most important resource. Our ability to continue to compete effectively in our businesses will depend upon our ability to attract top talent and retain and motivate our existing employees while managing compensation costs.

 

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LEHMAN BROTHERS HOLDINGS INC.

 

Risk Management

 

We have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future. Although we deploy various risk mitigation and risk monitoring techniques, they are subject to judgments as to the timing and duration of their application. Additionally, no risk management procedure can anticipate every market event, and our hedging strategies and other risk management techniques may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk, including risks that are unidentified or unanticipated. Some of our methods of managing risk are based upon our use of observed historical market behavior. As a result, these methods may not predict future risk exposures, which could be significantly greater than the historical measures indicate. The models that we use to assess and control our risk exposures reflect historical correlations among prices of various asset classes or other market indicators, and in times of market stress or other unforeseen circumstances there may be material changes in correlations between asset classes. In the past, including during the recent mortgage and credit market downturn, these types of market movements have at times limited the effectiveness of our hedging strategies and have caused us to incur significant losses, and they may do so in the future. An increase in volatility would increase our measured risk, which might cause us to reduce certain of our business activities. In such circumstances, we may not be able to reduce our positions or our exposure in a timely, cost-effective way or in a manner sufficient to offset the increase in measured risk. Management of operational, legal and regulatory risk requires, among other things, policies and procedures to record properly and verify a large number of transactions and events, and these policies and procedures may not be fully effective. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management” for a discussion of the policies and procedures we use to identify, monitor and manage the risks we assume in conducting our businesses.

 

Risks Relating To New Business Initiatives and New Markets

 

A number of our recent and planned business initiatives and expansions of existing businesses may bring us into contact, directly or indirectly, with new markets and new asset classes and with entities and individuals that are not within our traditional client base. For example, we have expanded our businesses and investments in emerging markets such as Russia, the Middle East, India, Turkey and China, have increased our activities in the markets for derivatives, commodities and foreign exchange and have begun providing loans to small and mid-sized businesses and students. In addition, we are increasingly offering complex structured products and alternative investments to a wider investor base, both directly and through third-party distribution channels. These business activities expose us to new and enhanced risks, including increased credit-related and operational risks, regulatory risks and reputational concerns. As our business expands into new markets and new geographical regions, we will face competitors with more experience and more established relationships with clients, regulators and industry participants in the relevant market, which could adversely affect our ability to expand.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2. PROPERTIES

 

Our world headquarters is a 1,050,000 square-foot owned office tower at 745 Seventh Avenue in New York City. We also lease approximately 2,370,000 square feet of office space in the New York metropolitan area. In addition to our offices in the New York area, we have offices in approximately 31 principal locations in the Americas.

 

Our European headquarters is an 820,000 square-foot leased facility in the Canary Wharf development, east of the City of London. In addition to our European headquarters, we have an additional 16 principal locations in Europe and the Middle East.

 

Our Asian headquarters is located in approximately 275,000 square feet of leased office space in the Roppongi Hills area of central Tokyo, Japan. We lease office space in ten other principal locations in the Asia Pacific region.

 

In addition to our principal locations listed above, we occupy space in various other facilities. Including the locations noted above, we lease approximately 5,570,000 square feet in the Americas, 1,375,000 square feet in Europe and the Middle East and 1,165,000 square feet in Asia Pacific.

 

All three of our business segments (as described herein) use the occupied facilities described above. We believe that the facilities we occupy are adequate for the purposes for which they are used, and the occupied facilities are well maintained.

 

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LEHMAN BROTHERS HOLDINGS INC.

 

Additional information with respect to facilities and lease commitments is set forth under the caption “Lease Commitments” in Note 9 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

 

ITEM 3. LEGAL PROCEEDINGS

 

We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our business. Such proceedings include actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms, including us.

 

Although there can be no assurance as to the ultimate outcome, we generally have denied, or believe we have a meritorious defense and will deny, liability in all significant cases pending against us, including the matters described below, and we intend to defend vigorously each such case. Based on information currently available, we believe the amount, or range, of reasonably possible losses in connection with the actions against us, including the matters described below, in excess of established reserves, in the aggregate, not to be material to the Company’s consolidated financial condition or cash flows. However, losses may be material to our operating results for any particular future period, depending on the level of our income for such period.

 

City of Cleveland v. Deutsche Bank Trust Company, et al.

 

On January 10, 2008, the City of Cleveland, Ohio filed a lawsuit in Cuyahoga County Common Pleas Court, captioned City of Cleveland v. Deutsche Bank Trust Company, et al., against twenty-one financial services entities, including Holdings, seeking damages the City of Cleveland allegedly incurred relating to property foreclosures. The damages are claimed to be the result of the defendants’ creation of a public nuisance in the City of Cleveland through their involvement as lenders and/or securitizers of sub-prime mortgages in the City of Cleveland. On January 16, 2008, the case was removed to the United States District Court for the Northern District of Ohio, and on January 17, 2008, the City of Cleveland filed a motion seeking an order remanding the case back to Common Pleas Court.

 

First Alliance Mortgage Company Matters

 

During 1999 and the first quarter of 2000, LCPI provided a warehouse line of credit to First Alliance Mortgage Company (“FAMCO”), a subprime mortgage lender, and LBI underwrote the securitizations of mortgages originated by FAMCO. In March 2000, FAMCO filed for bankruptcy protection in the United States Bankruptcy Court for the Central District of California (the “California Bankruptcy Court”). In August 2001, a class action (the “Class Action”) was filed in the California Bankruptcy Court, on behalf of a class of FAMCO borrowers seeking equitable subordination of LCPI’s (among other creditors’) liens and claims. In October 2001, the complaint was amended to add LBI as a defendant and to add claims for aiding and abetting fraudulent lending activities by FAMCO and for unfair competition under the California Business and Professions Code. In August 2002, a Second Amended Complaint was filed which added a claim for punitive damages and extended the class period from May 1, 1996 until FAMCO’s bankruptcy filing. The complaint sought actual and punitive damages, the imposition of a constructive trust on all proceeds paid by FAMCO to LCPI and LBI, disgorgement of profits and attorneys’ fees and costs.

 

The United States District Court for the Central District of California (the “California District Court”) withdrew the reference to the California Bankruptcy Court. A class was certified in November 2002, and subsequently amended, to certify the Class Action as being brought on behalf of a class of all persons who acquired mortgage loans from FAMCO from 1999 through March 31, 2000, which were used as collateral for FAMCO’s warehouse credit line with LCPI or were securitized in transactions underwritten by LBI. The trial began in February 2003.

 

In June 2003, the California District Court dismissed plaintiffs’ claim for punitive damages. Also in June 2003, the jury rendered its verdict, finding LBI and LCPI liable for aiding and abetting FAMCO’s fraud. The jury found damages of $50.9 million and held the Lehman defendants responsible for 10% of those damages. In July 2003, the California District Court entered findings of fact and conclusions of law relating to all claims still pending and holding that any transfers to LCPI were not fraudulent and its liens were not avoidable, nor was equitable subordination of amounts owed by FAMCO to LCPI at the time of the Chapter 11 filing warranted. Judgment was entered in November 2003 on the jury verdict. On December 8, 2006, the United States Court of Appeals for the Ninth Circuit issued a decision on the appeals of all parties, affirming the jury verdict on liability, rejecting all plaintiffs’ claims for further relief, vacating the damages verdict and remanding the matter for further proceedings on the proper calculation of “out of pocket” damages rather than the higher benefit of the bargain damages upon which the jury based its verdict. The parties to the Class Action have entered into a settlement agreement, which was presented to the California District Court for preliminary approval on January 28, 2008.

 

IPO Allocation Cases

 

Securities Action. LBI was named as a defendant in numerous purported securities class actions that were filed between March and December 2001 in the United States District Court for the Southern District of New York (the “New York District Court”). The actions, which allege improper initial public offering (“IPO”) allocation practices, were brought by persons who, either directly or in the aftermarket, purchased IPO securities during the period between March 1997 and December 2000. The plaintiffs allege that LBI and other IPO underwriters required persons receiving allocations of IPO shares to pay excessive commissions on unrelated trades and to purchase shares in the aftermarket at specified escalating prices. The plaintiffs, who seek unspecified compensatory damages, claim that these alleged practices violated various

 

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LEHMAN BROTHERS HOLDINGS INC.

 

provisions of the federal securities laws, specifically Sections 11, 12(a)(2) and 15 of the Securities Act and Sections 10(b) and 20(a) of the Exchange Act.

 

Plaintiffs filed 310 actions, each relating to a distinct offering, which actions were consolidated for pretrial purposes before a single judge. LBI is named as a defendant in 83 of those cases. For pretrial coordination purposes, the parties also designated certain focus cases, which were to be used as guidance for decisions in all cases. On October 13, 2004, the New York District Court granted plaintiffs’ motion for certification of a class of investors in each of six focus cases. On appeal to the United States Court of Appeals for the Second Circuit  (the “Second Circuit”), the court, on December 5, 2006, overturned the decision below, set forth the standards for class certification and concluded that classes could not be certified based on the facts alleged by plaintiffs. On June 6, 2007, the Second Circuit denied plaintiffs’ petition for rehearing and rehearing en banc of that decision. Upon remand to the New York District Court, on August 14, 2007, the plaintiffs filed amended complaints.

 

Issuer Action. In April 2002, a suit was filed in Delaware Chancery Court by Breakaway Solutions Inc. (“Breakaway”), which names LBI and two other underwriters as defendants (the “Delaware Action”). The complaint purported to be brought on behalf of a class of issuers who issued securities in IPOs through at least one of the defendants during the period January 1998 through October 2000 and whose securities increased in value 15% or more above the original price within 30 days after the IPO. It alleged that defendants under-priced IPO securities and allocated those under-priced securities to certain favored customers in return for alleged arrangements with the customers for increased commissions on other transactions and alleged tie-in arrangements. The complaint asserted claims for breaches of contract, of the implied covenant of good faith and fair dealing and of fiduciary duty, and for indemnification or contribution and unjust enrichment or restitution. Relief sought included class certification, injunctive relief, an accounting and declarations requiring defendants to indemnify Breakaway in the pending consolidated IPO securities class actions, and compensatory damages. In August 2004, the court denied defendants’ motion to dismiss. On motion by defendants, the court reconsidered its prior decision and, by order dated December 8, 2005, dismissed all but Breakaway’s claim for breach of fiduciary duty.

 

In September 2005, Breakaway commenced an individual action in the New York State Supreme Court, New York County, naming the same defendants (the “New York Action”). This action alleges that LBI, as a co-manager of Breakaway’s initial public offering and in conjunction with the other underwriter defendants, breached a fiduciary duty to Breakaway and breached the covenant of good faith and fair dealing implied in the underwriting agreement among Breakaway and the underwriters by allegedly under-pricing Breakaway’s shares in the IPO.

 

On January 11, 2008, the parties settled both the Delaware Action and the New York Action and filed stipulations of dismissal in both actions.

 

IPO Fee Litigation

 

Harold Gillet, et al. v. Goldman Sachs & Co., et al.; Yakov Prager, et al. v. Goldman, Sachs & Co., et al.; David Holzman, et al. v. Goldman, Sachs & Co., et al. Beginning in November 1998, four purported class actions were filed in the New York District Court against in excess of 25 underwriters of IPO securities, including LBI. The cases were subsequently consolidated into In re Public Offering Antitrust Litigation. Plaintiffs, alleged purchasers of securities issued in certain IPOs, seek compensatory and injunctive relief for alleged violations of the antitrust laws based on the theory that the defendants fixed and maintained fees for underwriting certain IPO securities at supra-competitive levels. In February 2001, the New York District Court granted defendants’ motion to dismiss the consolidated amended complaint, concluding that the purchaser plaintiffs lacked standing under the antitrust laws to assert the claims. On appeal, the Second Circuit reversed and remanded the case to the New York District Court for further proceedings, including potential dismissal of the claims based on additional arguments raised in the motion to dismiss. The New York District Court, in an order dated February 24, 2004, dismissed plaintiffs’ claims for monetary damages allowing only their claims for injunctive relief to proceed. Further activity in this case is stayed pending resolution of class certification issues in the following case.

 

In re Issuer Plaintiff Initial Public Offering Fee Antitrust Litigation. In April 2001, the New York District Court consolidated four actions pending before the court brought by bankrupt issuers of IPO securities against more than 20 underwriter defendants (including LBI). In July 2001, the plaintiffs filed a consolidated class action complaint seeking unspecified compensatory damages and injunctive relief for alleged violations of the antitrust laws based on the theory that the defendant underwriters fixed and maintained fees for underwriting certain IPO securities at supra-competitive levels. Two of the four original plaintiffs subsequently withdrew their claims. The remaining plaintiffs filed a motion for class certification, which the New York District Court denied in an order, dated April 19, 2006. On September 11, 2007, the Second Circuit reversed the New York District Court’s denial of class certification and remanded the case to the New York District Court for further proceedings to determine if the case may proceed as a class action.

 

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LEHMAN BROTHERS HOLDINGS INC.

 

Mirant Corporation Securities Litigation

 

In November 2002, an amended complaint was filed in the United States District Court for the Northern District of Georgia, Atlanta Division, and captioned In re Mirant Corporation Securities Litigation. The action is brought on behalf of a purported class of investors who purchased the securities of Mirant Corporation (“Mirant”) during the period from September 26, 2000 and September 5, 2002. Plaintiffs name Mirant, various officers and directors, Mirant’s former parent, The Southern Company, along with its officers and directors, LBI, as a member of the underwriting syndicate, and eleven other underwriters of Mirant’s IPO of common stock in September 2000. The underwriters are contractually entitled to customary indemnification from Mirant, but Mirant filed for bankruptcy protection in July 2003. The IPO raised approximately $1.467 billion, of which Lehman Brothers’ underwriting share was 9%. Against the underwriters, plaintiffs allege violations of Section 11 of the Securities Act. The complaint alleges that the prospectus and registration statement for the offering contained false and misleading statements or failed to disclose material facts concerning, among other things, Mirant’s alleged misconduct in energy markets in the State of California, the accounting for Mirant’s interest in a United Kingdom-based company, Western Power Distribution, and other accounting issues. The complaint seeks class action certification, unspecified damages and costs. Partially dispositive motions are pending.

 

Research Analyst Independence Litigations

 

Since the announcement of the global regulatory settlement regarding alleged research analyst conflicts of interest at various investment banking firms in the United States, including LBI, in April 2003 (the “Global Settlement”), a number of purported class actions were filed relating to such alleged conflicts. Three consolidated actions had been filed against LBI in federal court, two of which have since been dismissed, which are specific to LBI’s research of particular companies. The actions allege conflicts of interest between LBI’s investment banking business and research activities and seek to assert claims pursuant to Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 thereunder. In the remaining pending action, relating to RSL Communications, plaintiffs have filed an amended consolidated complaint, containing essentially the same allegations as the original complaints, but adding two other investment banks as defendants (Fogarazzo, et al. v. Lehman Brothers Inc., et al.). On July 27, 2005, the New York District Court granted plaintiffs’ motion for class certification. On January 26, 2007, the Second Circuit accepted the defendants’ appeal, vacated the decision below and remanded the case to the New York District Court in light of the decision in the IPO Allocation Securities Action case discussed above. On June 29, 2007, the New York District Court stayed all proceedings in the case pending the Second Circuit’s decision in In re Salomon Analyst Metromedia, which raises similar legal issues.

 

In June 2003, a purported derivative action, Bader and Yakaitis P.S.P. and Trust, et al. v. Michael L. Ainslie, et al., relating to the Global Settlement was filed in New York State Supreme Court, New York County. The suit names Holdings and its then sitting Board of Directors (the “Board”) as defendants and contends that the Board should have been aware of and prevented the alleged misconduct that resulted in the Global Settlement. In December 2003, plaintiffs filed an amended complaint, reiterating the allegations concerning the alleged failure to detect and prevent conduct resulting in the Global Settlement, and adding allegations concerning the alleged failure to detect and prevent conduct relating to purportedly improper IPO allocation practices, discussed more fully above under the heading “IPO Allocation Cases.”

 

Short Sales Related Litigation

 

In re Short Sale Antitrust Litigation. Commencing in April 2006, LBI was named as a defendant in putative class actions relating to short selling filed in the New York District Court. In December 2006, the court ordered that the actions be consolidated and renamed the In re Short Sale Antitrust Litigation. By January 2007, only one plaintiff, Electronic Trading Group, remained in the case (after earlier-named plaintiffs dropped out). A second amended complaint was filed, purportedly on behalf of those who had paid certain fees to broker dealers in connection with borrowing securities against 17 broker-dealers and other unnamed defendants, including LBI. The complaint asserted four causes of action: violations of Section 1 of the Sherman Act, breach of fiduciary duty, aiding and abetting breaches of fiduciary duty, and unjust enrichment. Plaintiff sought injunctive relief and unspecified trebled compensatory and punitive damages. On December 20, 2007, the New York District Court granted defendants’ motion to dismiss the second amended complaint. On January 18, 2008, plaintiffs filed a notice of appeal of the New York District Court decision with the United States Court of Appeals for the Second Circuit.

 

Avenius, et al. v. Banc of America Securities LLC, et al. In June 2006, LBI was named as a defendant in an action filed by 40 shareholders of Novastar Financial, Inc. (“NFI”) against 11 broker-dealers and other unnamed defendants in the Superior Court of California for San Francisco County (“California Superior Court”). The action alleges that the broker-dealers participated in an illegal stock market manipulation scheme that involved accepting orders for purchases, sales and short sales of NFI stock with no intention of covering such orders with borrowed stock or stock issued by NFI. Plaintiffs claim that this scheme caused distortions with regard to the nature and amount of active trading in NFI stock, thereby causing its share price to decline. The complaints assert causes of action under California Corporations Code

 

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LEHMAN BROTHERS HOLDINGS INC.

 

Sections 25400, et seq. and California Business and Professions Code Sections 17200, et seq. and 17500, et seq. The actions seek unspecified damages. On September 14, 2007, plaintiffs filed an amended complaint to, among other things, assert claims for conversion and trespass to chattels, in addition to the causes of action previously asserted.

 

Overstock.com, Inc., et al. v. Morgan Stanley & Co., Inc., et al. On September 14, 2007, LBI was named as a defendant in an amended complaint filed by Overstock.com, Inc. (“Overstock”) and seven of its shareholders against 11 broker-dealers and other unnamed defendants in the California Superior Court. The allegations are similar to those in the Avenius action described above. Plaintiffs claim that this scheme caused distortions with regard to the nature and amount of active trading in Overstock stock, thereby causing its share price to decline. The complaints assert the same causes of action as the Avenius complaint.

 

Wright et al. v. Lehman Brothers Holdings Inc. et al.

 

In August 2005, A. Vernon Wright and Dynoil Refining LLC sued Holdings (who was subsequently dropped as a defendant), LBI and two current and one former LBI employee, in Los Angeles Superior Court (the “Wright action”). Plaintiffs claimed negligence, breach of contract, breach of duties of good faith and fair dealing and of fiduciary duty, interference with prospective business advantage and misappropriation of trade secrets. Plaintiffs alleged that Wright provided Lehman Brothers with confidential information that Wright, along with certain Chinese interests, intended to buy Unocal, which Lehman Brothers allegedly did not keep confidential, preventing Wright from executing his plan. In his complaint, plaintiffs sought $9.2 billion, the alleged value of the U.S. assets plaintiffs say they would have acquired. On January 10, 2008 the parties entered into a confidential settlement, and the Court dismissed the action.

 

In March 2006, Carlton Energy Group, Muskeg Oil Co and Newco filed a similar suit against Holdings (again, later dropped), LBI and three LBI employees in state court in Harris County, Texas. The three plaintiff entities are owned or controlled by Thomas O’Dell and Daniel Chiang, erstwhile business partners of Vernon Wright. The claims and allegations asserted in this action are similar to those asserted in the Wright action. Plaintiffs sought unspecified damages. Pursuant to a confidential settlement agreement, on October 18, 2007, the plaintiffs filed a stipulation of voluntary dismissal.

 

In re Lehman Brothers Holdings, Inc. Derivative Litigation

 

Beginning in mid-April 2007, three purported shareholder derivative actions were filed against Holdings (as a nominal defendant) and certain of its current and former officers and directors in the New York District Court, all relating to Holdings’ historical stock option granting processes. The cases were captioned,  Garber v. Fuld, et al.; Staehr v. Fuld, et al.; and Locals 302 & 612 of the International Union of Operating Engineers-Employers Construction Industry Retirement Trust v. Fuld, et al. An additional plaintiff, Saginaw Police & Fire Pension Board, intervened in the Garber action. On October 3, 2007, the court consolidated the above actions, appointed Plaintiffs Garber and the Saginaw Police & Fire Pension Board as lead plaintiffs, and re-captioned the action  In re Lehman Brothers Holdings, Inc. Derivative Litigation.

 

On or about January 3, 2008, lead plaintiffs filed a Consolidated Complaint and a motion to join the International Brotherhood of Electrical Workers Local No. 38 Pension Fund as an additional plaintiff. The Consolidated Complaint, purportedly brought on behalf of Holdings, alleges state law claims for breach of fiduciary duty, gross mismanagement, misappropriation and/or waste of corporate assets, unjust enrichment, misrepresentation and fraudulent concealment, and invalidation of certain stock options and restricted stock units.

 

The Consolidated Complaint alleges that stock options and restricted stock units granted by Holdings between 1997 and 2002 were backdated and issued in violation of Holdings’ stock option plans. The Consolidated Complaint further alleges that Holdings’ financial statements for the years 1997 through the present misstated Holdings’ financial results by failing to properly report compensation expense and tax liabilities attributable to stock options and restricted stock units granted between 1997 and 2002. The Consolidated Complaint seeks damages from the individual defendants and various types of equitable and injunctive relief, including rescission of all unexercised stock options and restricted stock units granted in the time frame, return of certain incentive-based or equity-based compensation, and imposition of a constructive trust and attachment of assets.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 

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LEHMAN BROTHERS HOLDINGS INC.

 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Holdings’ common stock, par value $0.10 per share, is listed on the New York Stock Exchange. As of December 31, 2007, there were 530,588,207 shares of our common stock outstanding and approximately 23,200 holders of record. On January 28, 2008, the last reported sales price of our common stock was $60.63. The table below shows the high and low sale prices for the common stock for each fiscal quarter within the two most recent fiscal years:

 

Price Range of Common Stock

 

 

 

Low Sale Price

 

High Sale Price

 

Dividends

 

 

 

 

 

 

 

 

 

Fiscal 2007:

 

 

 

 

 

 

 

Fourth Quarter

 

$

51.59

 

$

67.73

 

$

0.15

 

 

 

 

 

 

 

 

 

Third Quarter

 

$

49.06

 

$

82.05

 

$

0.15

 

 

 

 

 

 

 

 

 

Second Quarter

 

$

68.07

 

$

79.21

 

$

0.15

 

 

 

 

 

 

 

 

 

First Quarter

 

$

72.26

 

$

86.18

 

$

0.15

 

 

 

 

 

 

 

 

 

Fiscal 2006:

 

 

 

 

 

 

 

Fourth Quarter

 

$

63.04

 

$

78.89

 

$

0.12

 

 

 

 

 

 

 

 

 

Third Quarter

 

$

58.37

 

$

69.48

 

$

0.12

 

 

 

 

 

 

 

 

 

Second Quarter

 

$

62.82

 

$

78.85

 

$

0.12

 

 

 

 

 

 

 

 

 

First Quarter

 

$

62.14

 

$

74.79

 

$

0.12

 

 

In January 2008, our Board of Directors increased the fiscal 2008 annual common stock dividend rate to $0.68 per share from an annual dividend rate of $0.60 per share in fiscal 2007 and $0.48 per share in fiscal 2006. Dividends on the common stock are generally payable, following declaration by the Board of Directors, in February, May, August and November. The above table and common stock dividend per share rates have been adjusted to reflect the April 28, 2006 2-for-1 stock split.

 

-27-



 

LEHMAN BROTHERS HOLDINGS INC.

 

The table below sets forth information with respect to purchases made by or on behalf of Holdings or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended), of our common stock during the quarter ended November 30, 2007.

 

Issuer Purchases of Equity Securities

 

 

 

 

 

 

 

Total Number of

 

Maximum Number

 

 

 

Total

 

 

 

Shares Purchased

 

of Shares that May

 

 

 

Number of

 

 

 

as Part of Publicly

 

Yet Be Purchased

 

 

 

Shares

 

Average Price

 

Announced Plans

 

Under the Plans

 

 

 

Purchased

 

Paid per Share

 

or Programs

 

or Programs

 

Month 1 (September 1, 2007September 30, 2007)

 

 

 

 

 

 

 

Common stock repurchases(1)

 

223

 

 

 

223

 

 

 

Employee transactions(2)

 

41,292

 

 

 

41,292

 

 

 

Total

 

41,515

 

$

55.64

 

41,515

 

62,208,454

 

Month 2 (October 1, 2007October 31, 2007)

 

 

 

 

 

 

 

Common stock repurchases(1)

 

14,900

 

 

 

14,900

 

 

 

Employee transactions(2)

 

355,501

 

 

 

355,501

 

 

 

Total

 

370,401

 

$

62.70

 

370,401

 

61,838,053

 

Month 3 (November 1, 2007November 30, 2007)

 

 

 

 

 

 

 

Common stock repurchases(1)

 

83,800

 

 

 

83,800

 

 

 

Employee transactions(2)

 

4,791,483

 

 

 

4,791,483

 

 

 

Total

 

4,875,283

 

$

62.46

 

4,875,283

 

56,962,770

 

Total (September 1, 2007November 30, 2007)

 

 

 

 

 

 

 

Common stock repurchases(1)

 

98,923

 

 

 

98,923

 

 

 

Employee transactions(2)

 

5,188,276

 

 

 

5,188,276

 

 

 

Total

 

5,287,199

 

$

62.43

 

5,287,199

 

56,962,770

 

(1)     We have an ongoing common stock repurchase program, pursuant to which we repurchase shares in the open market. As previously announced, in January 2007 our Board of Directors authorized the repurchase, subject to market conditions, of up to 100 million shares of Holdings’ common stock, for the management of the Firm’s equity capital, including offsetting dilution due to employee stock awards. This authorization superseded the stock repurchase program authorized in January 2006. The number of shares authorized to be repurchased in the open market is reduced by the actual number of Employee Offset Shares (as defined below) received.

(2)     Represents shares of common stock withheld in satisfaction of the exercise price of stock options and tax withholding obligations upon option exercises and conversion of restricted stock units (collectively, “Employee Offset Shares”).

In January 2008, our Board of Directors authorized the repurchase, subject to market conditions, of up to 100 million shares of Holdings’ common stock for the management of the Firm’s equity capital, including consideration of dilution due to employee stock awards. This resolution supersedes the stock purchase program authorized in 2007.  For more information about the repurchase program and employee stock plans, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources—Equity Management” in Part II, Item 7, and Note 11 to the Consolidated Financial Statements in Part II, Item 8, in this Form 10-K, and Notes 10 and 12 to the Consolidated Financial Statements in Part II, Item 8, and “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” in Part III, Item 12, of this Form 10-K.

 

-28-



 

LEHMAN BROTHERS HOLDINGS INC.

 

ITEM 6. SELECTED FINANCIAL DATA

 

 

 

As of or for the Year Ended November 30,

 

 

 

2007

 

2006

 

2005

 

2004

 

2003

 

Consolidated Statement of Income (in millions)

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

$

59,003

 

$

46,709

 

$

32,420

 

$

21,250

 

$

17,287

 

Interest expense

 

39,746

 

29,126

 

17,790

 

9,674

 

8,640

 

Net revenues

 

19,257

 

17,583

 

14,630

 

11,576

 

8,647

 

Non-interest expenses:

 

 

 

 

 

 

 

 

 

 

 

Compensation and benefits

 

9,494

 

8,669

 

7,213

 

5,730

 

4,318

 

Non-personnel expenses(1)

 

3,750

 

3,009

 

2,588

 

2,309

 

1,716

 

Real estate reconfiguration charge

 

 

 

 

19

 

77

 

Total non-interest expenses

 

13,244

 

11,678

 

9,801

 

8,058

 

6,111

 

Income before taxes and cumulative effect of accounting change

 

6,013

 

5,905

 

4,829

 

3,518

 

2,536

 

Provision for income taxes

 

1,821

 

1,945

 

1,569

 

1,125

 

765

 

Dividends on trust preferred securities(2)

 

 

 

 

24

 

72

 

Income before cumulative effect of accounting change

 

4,192

 

3,960

 

3,260

 

2,369

 

1,699

 

Cumulative effect of accounting change

 

 

47

 

 

 

 

Net income

 

$

4,192

 

$

4,007

 

$

3,260

 

$

2,369

 

$

1,699

 

Net income applicable to common stock

 

$

4,125

 

$

3,941

 

$

3,191

 

$

2,297

 

$

1,649

 

Consolidated Statement of Financial Condition (in millions)

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

691,063

 

$

503,545

 

$

410,063

 

$

357,168

 

$

312,061

 

Net assets(3) (10)

 

372,959

 

268,936

 

211,424

 

175,221

 

163,182

 

Long-term borrowings(2) (4)

 

123,150

 

81,178

 

53,899

 

49,365

 

35,885

 

Preferred securities subject to mandatory redemption(2)

 

 

 

 

 

1,310

 

Total stockholders’ equity

 

22,490

 

19,191

 

16,794

 

14,920

 

13,174

 

Tangible equity capital(5) (10)

 

23,103

 

18,567

 

15,564

 

12,636

 

10,681

 

Total long-term capital(6)

 

145,640

 

100,369

 

70,693

 

64,285

 

50,369

 

Per Common Share Data (in millions, except per share amounts)(7)

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

7.63

 

$

7.26

 

$

5.74

 

$

4.18

 

$

3.36

 

Diluted

 

$

7.26

 

$

6.81

 

$

5.43

 

$

3.95

 

$

3.17

 

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

540.6

 

543.0

 

556.3

 

549.4

 

491.3

 

Diluted

 

568.3

 

578.4

 

587.2

 

581.5

 

519.7

 

Dividends declared and paid per common share

 

$

0.60

 

$

0.48

 

$

0.40

 

$

0.32

 

$

0.24

 

Book value per common share(8)

 

$

39.44

 

$

33.87

 

$

28.75

 

$

24.66

 

$

22.09

 

Selected Data

 

 

 

 

 

 

 

 

 

 

 

Leverage ratio(9)

 

30.7

x

26.2

x

24.4

x

23.9

x

23.7

x

Net leverage ratio(10)

 

16.1

x

14.5

x

13.6

x

13.9

x

15.3

x

Employees

 

28,556

 

25,936

 

22,919

 

19,579

 

16,188

 

Assets under management (in billions)

 

$

282

 

$

225

 

$

175

 

$

137

 

$

120

 

Financial Ratios

 

 

 

 

 

 

 

 

 

 

 

Compensation and benefits/net revenues

 

49.3

%

49.3

%

49.3

%

49.5

%

49.9

%

Pre-tax margin

 

31.2

%

33.6

%

33.0

%

30.4

%

29.3

%

Return on average common stockholders’ equity(11)

 

20.8

%

23.4

%

21.6

%

17.9

%

18.2

%

Return on average tangible common stockholders’
equity
(11)

 

25.7

%

29.1

%

27.8

%

24.7

%

19.2

%

 

-29-



 

LEHMAN BROTHERS HOLDINGS INC.

 

Notes to Selected Financial Data:

(1)                Non-personnel expenses exclude real estate reconfiguration charges of $19 million and $77 million for the years ended November 30, 2004 and 2003, respectively.

(2)                We adopted FIN 46(R) effective February 29, 2004, which required us to deconsolidate the trusts that issued the preferred securities. Accordingly, at and subsequent to February 29, 2004, preferred securities subject to mandatory redemption were reclassified to junior subordinated notes, a component of long-term borrowings. Dividends on preferred securities subject to mandatory redemption, which were presented as Dividends on trust preferred securities in the Consolidated Statement of Income through February 29, 2004, are included in Interest expense in periods subsequent to February 29, 2004.

(3)                We calculate net assets by excluding from total assets: (i) cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements; and (iii) identifiable intangible assets and goodwill. We believe net assets to be a more useful measure of our assets than total assets because it excludes certain low-risk, non-inventory assets. Net assets as presented are not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation.

 

 

At November 30,

 

In millions

 

2007

 

2006

 

2005

 

2004

 

2003

 

Total assets

 

$

691,063

 

$

503,545

 

$

410,063

 

$

357,168

 

$

312,061

 

Cash and securities segregated and on deposit for regulatory and other purposes

 

(12,743

)

(6,091

)

(5,744

)

(4,085

)

(3,100

)

Collateralized lending agreements

 

(301,234

)

(225,156

)

(189,639

)

(174,578

)

(142,218

)

Identifiable intangible assets and goodwill

 

(4,127

)

(3,362

)

(3,256

)

(3,284

)

(3,561

)

Net assets

 

$

372,959

 

$

268,936

 

$

211,424

 

$

175,221

 

$

163,182

 

(4)                Long-term borrowings exclude borrowings with remaining contractual maturities within twelve months of the financial statement date.

(5)                We calculate tangible equity capital by including stockholders’ equity and junior subordinated notes (at November 30, 2003, preferred securities subject to mandatory redemption), and excluding identifiable intangible assets and goodwill. See “MD&A—Liquidity, Funding and Capital Resources—Balance Sheet and Financial Leverage” for additional information about tangible equity capital. We believe tangible equity capital to be a more meaningful measure of our equity base as it includes instruments we consider to be equity-like due to their subordinated nature, long-term maturity and interest deferral features and excludes assets we do not consider available to support our remaining net assets (see note 3 above). These measures may not be comparable to other, similarly titled calculations by other companies as a result of different calculation methodologies.

 

 

At November 30,

 

In millions

 

2007

 

2006

 

2005

 

2004

 

2003

 

Total stockholders’ equity

 

$

22,490

 

$

19,191

 

$

16,794

 

$

14,920

 

$

13,174

 

Junior subordinated notes (subject to limitation) (a) (b)

 

4,740

 

2,738

 

2,026

 

1,000

 

1,068

 

Identifiable intangible assets and goodwill

 

(4,127

)

(3,362

)

(3,256

)

(3,284

)

(3,561

)

Tangible equity capital

 

$

23,103

 

$

18,567

 

$

15,564

 

$

12,636

 

$

10,681

 

 


(a)                 Preferred securities subject to mandatory redemption at November 30, 2003.

(b)                Our definition for tangible equity capital limits the amount of junior subordinated notes and preferred stock included in the calculation to 25% of tangible equity capital. The amount excluded was approximately $237 million at November 30, 2007. No amounts were excluded in prior periods.

(6)                Total long-term capital includes long-term borrowings (excluding any borrowings with remaining contractual maturities within twelve months of the financial statement date) and total stockholders’ equity and, at November 30, 2003, preferred securities subject to mandatory redemption. We believe total long-term capital is useful to investors as a measure of our financial strength.

(7)                Common share and per share amounts have been retrospectively adjusted to give effect for the 2-for-1 common stock split, effected in the form of a 100% stock dividend, which became effective April 28, 2006.

(8)                The book value per common share calculation includes amortized restricted stock units granted under employee stock award programs, which have been included in total stockholders’ equity.

(9)                 Leverage ratio is defined as total assets divided by total stockholders’ equity.

(10)             Net leverage ratio is defined as net assets (see note 3 above) divided by tangible equity capital (see note 5 above). We believe net leverage based on net assets and tangible equity capital to be a more meaningful measure of leverage as net assets excludes certain low-risk, non-inventory assets and we believe tangible equity capital to be a more meaningful measure of our equity base. Net leverage as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation.

 

-30-



 

LEHMAN BROTHERS HOLDINGS INC.

 

(11)             Return on average common stockholders’ equity is computed by dividing net income applicable to common stock for the period by average common stockholders’ equity. Return on average tangible common stockholders’ equity is computed by dividing net income applicable to common stock for the period by average tangible common stockholders’ equity. Average tangible common stockholders’ equity equals average total common stockholders’ equity less average identifiable intangible assets and goodwill. We believe tangible common stockholders’ equity is a meaningful measure because it reflects the common stockholders’ equity deployed in our businesses. Average common stockholders’ equity, Average identifiable intangible assets and goodwill and Average tangible common stockholders’ equity are calculated as:

 

 

 

As of or for the Year Ended November 30,

 

In millions

 

2007

 

2006

 

2005

 

2004

 

2003

 

Net income applicable to common stock

 

$

4,125

 

$

3,941

 

$

3,191

 

$

2,297

 

$

1,649

 

 

 

 

 

 

 

 

 

 

 

 

 

Average stockholders’ equity

 

$

20,910

 

$

17,971

 

$

15,936

 

$

14,059

 

$

9,899

 

Less: average preferred stock

 

(1,095

)

(1,095

)

(1,195

)

(1,217

)

(838

)

Average common stockholders’ equity

 

$

19,815

 

$

16,876

 

$

14,741

 

$

12,842

 

$

9,061

 

Less: average identifiable intangible assets and goodwill

 

(3,756

)

(3,312

)

(3,272

)

(3,547

)

(471

)

Average tangible common stockholders’ equity

 

$

16,059

 

$

13,564

 

$

11,469

 

$

9,295

 

$

8,590

 

Return on average common stockholders’ equity

 

20.8

%

23.4

%

21.6

%

17.9

%

18.2

%

Return on average tangible common stockholders’ equity

 

25.7

%

29.1

%

27.8

%

24.7

%

19.2

%

 

-31-



 

LEHMAN BROTHERS HOLDINGS INC.

 

ITEM 7.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Contents

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

 

Introduction

 

33

 

 

 

Forward-Looking Statements

 

33

 

 

 

Executive Overview

 

33

 

 

 

Certain Factors Affecting Results of Operations

 

36

 

 

 

Critical Accounting Policies and Estimates

 

38

 

 

 

Consolidated Results of Operations

 

42

 

 

 

Business Segments

 

46

 

 

 

Geographic Revenues

 

54

 

 

 

Liquidity, Funding and Capital Resources

 

56

 

 

 

Contractual Obligations and Lending-Related Commitments

 

65

 

 

 

Off-Balance-Sheet Arrangements

 

66

 

 

 

Risk Management

 

69

 

 

 

2-for-1 Stock Split

 

76

 

 

 

Accounting and Regulatory Developments

 

76

 

 

 

Effects of Inflation

 

80

 

-32-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Introduction

 

Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company,” the “Firm,” “Lehman Brothers,” “we,” “us” or “our”) serves the financial needs of corporations, governments and municipalities, institutional clients and high net worth individuals worldwide with business activities organized in three segments, Capital Markets, Investment Banking and Investment Management. Founded in 1850, Lehman Brothers maintains market presence in equity and fixed income sales, trading and research, investment banking, asset management, private investment management and private equity. The Firm is headquartered in New York, with regional headquarters in London and Tokyo, and operates in a network of offices in North America, Europe, the Middle East, Latin America and the Asia-Pacific region. We are a member of all principal securities and commodities exchanges in the U.S., and we hold memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Australian stock exchanges.

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read together with the Consolidated Financial Statements and the accompanying Notes contained in this Annual Report on Form 10-K for the fiscal year ended November 30, 2007 (the “Form 10-K”). Unless specifically stated otherwise, all references to the years 2007, 2006 and 2005 in this MD&A refer to our fiscal years ended November 30, 2007, 2006 and 2005, or the last day of such fiscal years, as the context requires. All share and per share amounts have been retrospectively adjusted for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective April 28, 2006. For additional information, see “2-for-1 Stock Split” in this MD&A and Note 10, “Stockholders’ Equity,” to the Consolidated Financial Statements.

 

Forward-Looking Statements

 

Some of the statements contained in this MD&A, including those relating to our strategy and other statements that are predictive in nature, that depend on or refer to future events or conditions or that include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates” and similar expressions, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These statements are not historical facts but instead represent only management’s expectations, estimates and projections regarding future events. Similarly, these statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict, which may include, but are not limited to, market risk, investor sentiment, liquidity risk, credit ratings changes, credit exposure and operational, legal, regulatory and reputational risks. For further discussion of these risks, see Certain Risk Factors Affecting Results of Operations” below as well as “Risk Factors” in Part I, Item 1A in this Form 10-K.

 

As a global investment bank, the nature of our business makes predicting future performance difficult. Revenues and earnings may vary from quarter to quarter and from year to year. Caution should be used when extrapolating historical results to future periods. Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, accordingly, readers are cautioned not to place undue reliance on such statements, which speak only as of the date on which they are made. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Executive Overview1

 

Summary of Results

 

On the basis of a record first half and a reasonably successful navigation of difficult market conditions in the second half, we achieved our fourth consecutive year of record net revenues, net income and diluted earnings per common share in 2007. Net income totaled $4.2 billion, $4.0 billion and $3.3 billion in 2007, 2006 and 2005, respectively, increasing 5% in 2007 and 23% in 2006 from the corresponding 2006 and 2005 periods, respectively. Diluted earnings per common share were $7.26, $6.81 and $5.43 in 2007, 2006 and 2005, respectively, up 7% in 2007 and 25% in 2006 from the corresponding prior periods, respectively.2

 


1

 

Market share, volume and ranking statistics in this MD&A were obtained from Thomson Financial, an operating unit of The Thomson Corporation.

2

 

The 2006 results included an after-tax gain of $47 million ($0.08 per diluted common share) from the cumulative effect of an accounting change for equity-based compensation resulting from the Company’s adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised), Share-Based Payment (“SFAS 123(R)”). For additional information, see Note 12, “Share-Based Employee Incentive Plans,” to the Consolidated Financial Statements.

 

-33-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

2007 net revenues were $19.3 billion, which exceeded the prior year record level by 10% and represents the fifth consecutive year of record net revenues. The second half of the 2007 fiscal year presented some of the most challenging mortgage and credit markets experienced in almost a decade, particularly in the U.S. Record net revenues were reported in each of our three business segments and in both the Europe and the Middle East and Asia-Pacific geographic segments. Pre-tax margin for the 2007 fiscal year was 31.2%, compared to 33.6% and 33.0% reported in 2006 and 2005, respectively. Full year return on average common stockholders’ equity1 was 20.8%, 23.4% and 21.6% for 2007, 2006 and 2005, respectively. Return on average tangible common stockholders’ equity was 25.7%, 29.1% and 27.8% in full years 2007, 2006 and 2005, respectively.

 

2007 vs. 2006. In 2007, Capital Markets segment net revenues increased 2% to a record $12.3 billion from $12.0 billion in 2006. Capital Markets—Equities, operating in a favorable environment of strong customer-driven activity and favorable global equities markets, reported net revenues of $6.3 billion in 2007, a 76% increase from $3.6 billion in 2006. These record results in the Equities component of our Capital Markets business segment were offset by a decrease in Capital Markets—Fixed Income’s net revenues which declined 29% to $6.0 billion in 2007 from $8.4 billion in 2006. This decline corresponds to the deterioration throughout the fiscal year in the U.S. residential mortgage sector and the follow-on dislocation in the broader credit markets that occurred later in the fiscal year. Investment Banking segment net revenues increased 24% to $3.9 billion in 2007 from $3.2 billion in 2006, representing record Debt and Equity underwriting-related activities as well as record Advisory Services revenues. These results reflect the significant progress made in building market share in the areas of mergers and acquisitions (“M&A”) and high yield offerings as well as the development of a broader range of geographic and client bases. Investment Management segment net revenues increased 28% to $3.1 billion in 2007 from $2.4 billion in 2006, reflecting record net revenues in both Asset Management and Private Investment Management and our continued expansion of this business segment globally. For the fiscal year, assets under management (“AUM”) of $282 billion increased 25% from 2006 from both net inflows and asset appreciation. Non—U.S. net revenues increased 49% to $9.6 billion in 2007 from $6.5 billion in 2006, representing 50% and 37% of total net revenues in the 2007 and 2006 periods, respectively.

 

2006 vs. 2005. Net revenues increased 20% in 2006 from 2005. Capital Markets segment net revenues increased 22% to $12.0 billion in 2006 from $9.8 billion in 2005. Capital Markets—Equities net revenues rose 44% to $3.6 billion in 2006 from $2.5 billion in 2005, driven by solid client–flow activity in the cash and prime services businesses. Capital Markets—Fixed Income net revenues increased 15% to $8.4 billion in 2006 from $7.3 billion in 2005 due to broad-based strength across products and regions. Investment Banking segment net revenues increased 9% to $3.2 billion in 2006 from $2.9 billion in 2005, reflecting strength in each business. Investment Management segment net revenues increased 25% to $2.4 billion in 2006 from $1.9 billion in 2005, reflecting growth in alternative investment offerings and an increase in equity-related activity. In 2006, AUM increased 29% to $225 billion from $175 billion in 2005. Non–U.S. net revenues increased 21% to $6.5 billion in 2006 from $5.4 billion in 2005, representing 37% of total net revenues for both the 2006 and 2005 periods.

 

While we generated record operating results in 2007, our business, by its nature, does not produce predictable earnings. Our results in any given period can be materially affected by conditions in global financial markets and economic conditions generally. For a further discussion of factors that may affect our future operating results, see “Certain Factors Affecting Results of Operations” below as well as “Risk Factors” in Part I, Item 1A in this Form 10-K. For a detailed

 


1

 

Return on average common stockholders’ equity and return on average tangible common stockholders’ equity are computed by dividing net income applicable to common stock for the period by average common stockholders’ equity and average tangible common stockholders’ equity, respectively. We believe average tangible common stockholders’ equity is a meaningful measure because it reflects the common stockholders’ equity deployed in our businesses. Average tangible common stockholders’ equity equals average common stockholders’ equity less average identifiable intangible assets and goodwill and is computed as follows:

 

 

 

Year Ended November 30,

 

In millions

 

2007

 

2006

 

2005

 

Net income applicable to common stock

 

$

4,125

 

$

3,941

 

$

3,191

 

Average stockholders’ equity

 

$

20,910

 

$

17,971

 

$

15,936

 

Less: average preferred stock

 

(1,095

)

(1,095

)

(1,195

)

Average common stockholders’ equity

 

$

19,815

 

$

16,876

 

$

14,741

 

Less: average identifiable intangible assets and goodwill

 

(3,756

)

(3,312

)

(3,272

)

Average tangible common stockholders’ equity

 

$

16,059

 

$

13,564

 

$

11,469

 

Return on average common stockholders’ equity

 

20.8

%

23.4

%

21.6

%

Return on average tangible common stockholders’ equity

 

25.7

%

29.1

%

27.8

%

 

-34-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

discussion of results of operations by business segments and geographic regions, see “Business Segments” and “Geographic Revenues.”

 

Business Environment

 

As an investment banking, securities and investment management firm, our businesses are materially affected by conditions in the global financial markets and worldwide economic conditions. A favorable business environment is generally characterized by, among other factors, high global gross domestic product growth, stable geopolitical conditions, transparent and efficient capital markets, liquid markets with active investors, low inflation, high business and consumer confidence and strong business earnings. These factors provide a positive climate for our investment banking activities, for many of our capital markets trading businesses and for wealth creation, which contributes to growth in our asset management business. For a further discussion of how market conditions can affect our business, see “Certain Factors Affecting Results of Operations” below as well as “Risk Factors” in Part I, Item 1A in this Form 10-K. A further discussion of the business environment in 2007 and economic outlook for 2008 is set forth below.

 

The global market environment was generally favorable for our businesses for the first half of the 2007 fiscal year. These favorable conditions resulted from a number of factors: strong equity markets, continued strong gross domestic product in most major economies, tightening credit spreads, minimal interest rate actions by major central banks, active trading volumes, and strong M&A and underwriting activities driven by favorable interest rate and credit spread environments. During the second half of the 2007 fiscal year, the global economy was impacted by the deterioration within the U.S. subprime residential mortgage asset category, the weakening of the U.S. housing sector became worse than most observers expected and dislocations began to occur beyond the residential mortgage component of credit markets. Also during the latter part of the 2007 fiscal year, risk aversion escalated following rating agency downgrades of certain structured assets which, in part, led to many market participants re-pricing assets and taking large write-downs. Central banks sought to prevent a more serious downturn by central bank interest rate and liquidity actions. Our fiscal year ended with dislocated inter-bank markets, constrained bank balance sheets and credit uncertainty regarding monoline issuers and structured investment vehicles.

 

The global fixed income environment was characterized by spreads tightening in the first half of the year and, conversely, unprecedented spread widening in the second half of the year. Global high yield and high grade spread indices ended our fiscal year up 209 and 86 basis points, respectively, compared to the end of our 2006 fiscal year. Global equity markets rose over the fiscal year; however, many equity markets experienced high volatility in the second half of the year. Globally, corporate activity levels in completed and announced M&A transactions were up compared to our last fiscal year. In addition, equity underwriting activity remained solid, particularly in convertibles; but debt underwriting activity declined, particularly in leveraged finance during the second half of the 2007 fiscal year.

 

Global economic growth was approximately 3.4% for calendar year 2007 and is forecasted to be lower for calendar year 2008. Our forecast differs by geographies: our growth assumptions for the Americas and Eurozone are lower than those for Asia and other territories. Our growth outlook is dependent on how extended and severe the credit dislocation may be, results from fiscal and monetary policy actions, accessibility of new sources of liquidity and oil prices leveling or continuing to increase. The underpinnings of these growth assumptions also form our view on prospective Investment Banking activity. We expect M&A volumes to decline in 2008 by approximately 20% as compared to 2007 and believe that (i) strategic buyers will continue to account for a larger proportion of overall deal volume, (ii) stock will become prominent in transactions and (iii) cross-border and international activity will continue to increase. If the anticipated higher volatility in global equity markets is realized in calendar 2008, we expect equity issuance will be down compared to 2007. Equity capital markets experienced a 17% return in 2007 in local currency terms, and we expect lower returns in 2008. We expect global fixed income origination to decline in 2008 as a result of lower volumes of securitizations and M&A financings. Fixed income capital markets are expected to continue to face uncertainties in the 2008 calendar year.

 

In the U.S., economic growth showed signs of strength at the beginning of our fiscal year, driven by higher net exports and consumption levels, among other indicators, but the pace of growth slowed in the latter half. Over the twelve-month period, the U.S. housing market weakened, business confidence declined, and, in the last six months of the year, consumer confidence dropped. The labor market followed the same trajectory, showing signs of deterioration in the second half of the period as unemployment levels increased modestly and payroll data showed some signs of weakness. Responding to concerns over liquidity in the financial markets and inflationary pressures, the U.S. Federal Reserve reduced rates three times during the calendar year and made an additional inter-meeting rate cut in January 2008, and most observers anticipate additional reductions will occur in the early part of our 2008 fiscal year. Long-term bond yields declined, with the 10-year Treasury note yield ending our fiscal year down 52 basis points at 3.94%. The S&P 500 Index, Dow Jones Industrial Average and NASDAQ composites were up 5.7%, 9.4%, and 9.4%, respectively, from November 2006 levels. The current high levels of U.S. home inventories suggest that an extended period of construction declines and housing price cuts will

 

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LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

combine with tighter credit conditions and increasing oil prices to slow down consumer spending. We believe those conditions will continue to strain the capital markets, particularly the securitized products and residential housing components. We also believe that those conditions will stress other components of the capital markets, such as commercial real estate. We believe these impediments will decrease the U.S. growth rate in 2008.

 

In Eurozone countries and the U.K., economic growth continued in the second half of the 2007 fiscal year, although it was modest compared to the first half. Business activity reflected a slight tapering at the end of the fiscal year. Unemployment levels declined over the fiscal year, and inflationary pressures appeared contained. The European Central Bank increased rates twice during our fiscal year and is forecasted to hold those levels through the early part of our 2008 fiscal year. The Bank of England (the “BOE”) increased rates three times during our fiscal year, and in December 2007 the BOE began to ease with a rate reduction. Further rate reductions are anticipated in the early part of the 2008 calendar year. The Bund and Gilts 10-year yields were 4.13% and 4.64%, respectively, at the end of our 2007 fiscal year compared to 3.70% and 4.51%, respectively, at the end of our 2006 fiscal year. Equity indices and volatility for continental Europe and the U.K. were up compared to levels at the end of our 2006 fiscal year. At the end of our 2007 fiscal year, stresses in the banking system, particularly in the U.K, were causing bank credit conditions to tighten. We believe that those tighter conditions, lower anticipated world growth and a stronger Euro will combine to slow regional growth for our upcoming 2008 fiscal year.

 

In Japan, real gross domestic product growth decelerated, unemployment levels modestly decreased and deflation eased during our 2007 fiscal year. The Bank of Japan increased its rates in early 2007 and held those rates for the remainder of our fiscal year, and is anticipated to continue to do so into our 2008 fiscal year. The yield on the 10-year Japanese government bond fell 18 basis points to 1.48% at the end of our 2007 fiscal year. The Nikkei 225 equity index was 3.6% lower at the end of our fiscal year than its level at the end of our 2006 fiscal year. Residential and non-residential construction spending is decreasing, and the recovery in the corporate sector during the period has yet to have an effect on wages and consumption, thus increasing the risk of a possible recession. Elsewhere in Asia, however, equity markets broadly ended our fiscal year higher compared to the prior period. We expect three trends to emerge in China’s economy in 2008: (i) GDP growth to fall on an annual basis for the first time in six years; (ii) inflation to increase over the long-term; and (iii) overcapacity concerns to shape central bank actions. During 2008, we expect India to exhibit many of the same characteristics that Japan, South Korea and China did during their economic takeoffs: GDP accelerating, investment and savings rates surging and the economy rapidly opening up. Effects from the region’s dependency on exports and severe overcapacity may exacerbate the regional growth slowdown predicted for 2008.

 

Certain Factors Affecting Results of Operations

 

We are exposed to a variety of risks in the course of conducting our business operations. These risks, which are substantial and inherent in our businesses, include market, liquidity, credit, operational, legal and regulatory risks. A summary of some of the significant risks that could affect our financial condition and results of operations includes, but is not limited to the items below. For a discussion of how management seeks to manage these risks, see “Risk Management” in this MD&A. For a further discussion of these and other important factors that could affect our business, see “Risk Factors” in Part I, Item 1A in this Form 10-K.

 

Market Conditions and Market Risk

 

Global financial markets and economic conditions materially affect our businesses. Market conditions may change rapidly and without forewarning. We believe a favorable business environment for our businesses is generally characterized by, among other factors, high global gross domestic product growth, stable geopolitical conditions, transparent and efficient capital markets, liquid markets with active investors, low inflation, high business and consumer confidence and strong business earnings. The converses of these factors, individually or in their aggregate, have resulted in or may result in unfavorable or uncertain market and economic conditions for our businesses. The effects on our businesses may include the following:

 

·                We are exposed to potential changes in the value of financial instruments caused by fluctuations in interest rates, exchange rates, equity and fixed income securities and commodities and real estate prices, credit spreads, liquidity volatility, overall market activity or other conditions. We may incur losses as a result of changes in market conditions, especially if the changes are rapid and without warning, as these fluctuations may adversely impact the valuation of our trading and inventory positions and principal investments.

 

·                Market fluctuations and volatility may reduce our or our customers’ willingness to enter into new transactions. Conversely, certain of our trading businesses depend on market volatility to provide trading and arbitrage opportunities, and decreases in volatility may reduce these opportunities and adversely affect these businesses.

 

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LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Any change in volume of executed transactions impacts both our costs incurred and revenues received from those trades.

 

·                  Although we deploy various risk mitigation and risk monitoring techniques, they are subject to judgments as to the timing and duration of their application. Additionally, no risk management procedure can anticipate every market event and the existence of risk management in our businesses does not provide complete assurance against incurring losses. Increased market volatility directly impacts our measurement of risks. Increases to our measured risk may cause us to decrease our proprietary positions or certain business activities. In such circumstances, we may not be able to reduce our positions or our exposure in a timely, cost-effective way or in a manner sufficient to offset the increase in measured risk. For additional discussion on risk mitigation and risk monitoring techniques, see “Risk Management” in this MD&A.

 

·                  Declines in the size and number of underwritings and M&A transactions may have an adverse impact on our results of operations and, if we are unable to reduce expenses, our profit margins. An overall decrease in global markets’ appetites for transactions may also impact our ability to syndicate various loan or equity commitments we have made. Additionally, pricing and other competitive pressures may adversely affect revenues for our Investment Banking segment.

 

·                  Asset valuations of our clients’ portfolios are impacted by changes in equity market conditions or interest rates. In turn, our fees for managing those portfolios are also affected. Changing market conditions may cause investors to change their allocations of investments in our funds or other products. Our asset management business operates in a highly competitive environment. Changes in our asset management business’ performance could result in a decline in AUM and in incentive and management fees.

 

Credit Risk

 

We are exposed to the potential for credit-related losses that can occur as a result of an individual, counterparty or issuer who owes us money, securities or other assets being unable or unwilling to honor its contractual obligations. We are also at risk that our rights against any individual, counterparty or issuer may not be enforceable in all circumstances. Additionally, deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses or adversely affect our ability to otherwise use those securities or obligations for liquidity purposes. The amount and duration of our credit exposures have been increasing over the past several years, as have the number and range of the entities to which we have credit exposures. Although we regularly review credit exposures to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, new business initiatives may cause us to transact with a broader array of clients, with new asset classes and in new markets. In addition, the recent widening of credit spreads and dislocations in the credit markets have in some cases made it more difficult to syndicate credit commitments to investors, and further widening of credit spreads or worsening of these dislocations could increase these difficulties, resulting in increased credit exposures.

 

Liquidity Risk

 

While our liquidity strategy seeks to ensure that we maintain sufficient liquidity to meet all of our funding obligations in all markets, our liquidity could be impaired by an inability to access secured and/or unsecured debt markets, an inability to access funds from our subsidiaries, an inability to sell assets or unforeseen outflows of cash or collateral. This situation may arise due to circumstances that we are unable to control, such as a general market disruption or an operational problem that affects third parties or us. As we continue to employ structured products to benefit our clients and ourselves, the financial instruments that we hold and the contracts to which we are a party are becoming increasingly complex and these complex structured products often do not have readily available markets to access in times of liquidity stress. Growth of our principal investing activities could further restrict liquidity for these positions. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time.

 

Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger provisions under certain bilateral provisions in some of our trading and collateralized financing contracts that could permit counterparties to terminate contracts or require us to post additional collateral. Termination of our trading and collateralized financing contracts could cause us to sustain losses and impair our liquidity by requiring us to find other sources of financing or to make significant cash payments or securities movements.

 

-37-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Operational Risk

 

Operational risk is the risk of loss resulting from inadequate or failed internal or outsourced processes, people, infrastructure and technology, or from external events. Our businesses are dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets. These transactions have become increasingly complex and often must adhere to requirements unique to each transaction, as well as legal and regulatory standards. Although contingency plans exist, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our business.

 

Legal, Regulatory and Reputational Risk

 

The securities and financial services industries are subject to extensive regulation under both federal and state laws in the U.S. as well as under the laws of all of the other jurisdictions in which we do business. We are subject to regulation in the U.S. by governmental agencies including the SEC and Commodity Futures Trading Commission, and outside the U.S. by various international agencies including the Financial Services Authority in the United Kingdom and the Financial Services Agency in Japan. We also are regulated by a number of self-regulatory organizations such as the Financial Industry Regulatory Authority (“FINRA”) (formed in 2007 by the consolidation of NASD, Inc., and the member regulation, enforcement and arbitration functions of the New York Stock Exchange, Inc. (“NYSE”)), the Municipal Securities Rulemaking Board and the National Futures Association, and by national securities and commodities exchanges. Violation of applicable regulations could result in legal and/or administrative proceedings, which may impose censures, fines, cease-and-desist orders or suspension of a firm, its officers or employees.

 

The scrutiny of the financial services industry has increased over the past several years, which has led to increased regulatory investigations and litigation against financial services firms. Legislation and rules adopted both in the U.S. and around the world have imposed substantial new or more stringent regulations, internal practices, capital requirements, procedures and controls and disclosure requirements in such areas as financial reporting, corporate governance, auditor independence, equity compensation plans, restrictions on the interaction between equity research analysts and investment banking employees and money laundering. The trend and scope of increased regulatory compliance requirements have increased costs.

 

Our reputation is critical in maintaining our relationships with clients, investors, regulators and the general public, and is a key focus in our risk management efforts. In recent years, there have been a number of highly publicized cases involving fraud, conflicts of interest or other misconduct by employees in the financial services industry, and we run the risk that misconduct by our employees could occur, resulting in unknown and unmanaged risks or losses. Employee misconduct could also involve the improper use or disclosure of confidential information, which could result in regulatory sanctions and serious reputational or financial harm. In addition, in certain circumstances our reputation could be damaged by activities of our clients in which we participate, or of hedge funds or other entities in which we invest, over which we have little or no control.

 

We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our business, including actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and actions brought on behalf of various classes of claimants against many securities firms and lending institutions, including us. See Part I, Item 1A, “Business—Regulation” and Part I, Item 3, “Legal Proceedings” in this Form 10-K for more information about legal and regulatory matters.

 

Critical Accounting Policies and Estimates

 

The following is a summary of our critical accounting policies that may involve a higher degree of management judgment and in some instances complexity in application. For a further discussion of these and other accounting policies, see Note 1 “Summary of Significant Accounting Policies,” to our Consolidated Financial Statements.

 

Use of Estimates

 

In preparing our Consolidated Financial Statements and accompanying notes, management makes various estimates that affect reported amounts and disclosures. Broadly, those estimates are used in:

 

·                  measuring fair value of certain financial instruments;

 

·                  accounting for identifiable intangible assets and goodwill;

 

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LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

·                  establishing provisions for potential losses that may arise from litigation, regulatory proceedings and tax examinations;

 

·                  assessing our ability to realize deferred taxes; and

 

·                  valuing equity-based compensation awards.

 

Estimates are based on available information and judgment. Therefore, actual results could differ from our estimates and that difference could have a material effect on our Consolidated Financial Statements and notes thereto.

 

Consolidation Policies

 

The assessment of whether accounting criteria for consolidation of an entity is met requires management to exercise judgment. We consolidate the entities in which the Company has a controlling financial interest. We determine whether we have a controlling financial interest in an entity by first determining whether the entity is a voting interest entity (sometimes referred to as a non-VIE), a variable interest entity (“VIE”) or a qualified special purpose entity (“QSPE”).

 

Voting Interest Entity. Voting interest entities are entities that have (i) total equity investment at risk sufficient to fund expected future operations independently and (ii) equity holders who have the obligation to absorb losses or receive residual returns and the right to make decisions about the entity’s activities. In accordance with Accounting Research Bulletin (“ARB”) No. 51, Consolidated Financial Statements, and Statement of Financial Accounting Standards (“SFAS”) No. 94, Consolidation of All Majority-Owned Subsidiaries, voting interest entities are consolidated when the Company has a controlling financial interest, typically more than 50 percent of an entity’s voting interests.

 

Variable Interest Entity. VIEs are entities that lack one or more voting interest entity characteristics. The Company consolidates VIEs in which it is the primary beneficiary. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46-R, Consolidation of Variable Interest Entities (revised December 2003)—an interpretation of ARB No. 51 (“FIN 46(R)”), we are the primary beneficiary if we have a variable interest, or a combination of variable interests, that will either (i) absorb a majority of the VIEs expected losses, (ii) receive a majority of the VIEs expected residual returns, or (iii) both. To determine if we are the primary beneficiary of a VIE, we review, among other factors, the VIE’s design, capital structure, contractual terms, which interests create or absorb variability and related party relationships, if any. Additionally, we may calculate our share of the VIE’s expected losses and expected residual returns based upon the VIE’s contractual arrangements and/or our position in the VIE’s capital structure. This type of analysis is typically performed using expected cash flows allocated to the expected losses and expected residual returns under various probability-weighted scenarios.

 

Qualified Special Purpose Entity. QSPEs are passive entities with limited permitted activities. SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125 (“SFAS 140”), establishes the criteria an entity must satisfy to be a QSPE, including types of assets held, limits on asset sales, use of derivatives and financial guarantees, and discretion exercised in servicing activities. In accordance with SFAS 140 and FIN 46(R), we do not consolidate QSPEs.

 

For a further discussion of our involvement with VIEs, QSPEs and other entities see Note 6, “Securitizations and Special Purpose Entities,” to the Consolidated Financial Statements.

 

Equity-Method Investments. Entities in which we do not have a controlling financial interest (and therefore do not consolidate) but in which we exert significant influence (generally defined as owning a voting interest of 20 percent to 50 percent, or a partnership interest greater than 3 percent) are accounted for either under Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock or SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). For further discussion of our adoption of SFAS 159, see “Accounting and Regulatory Developments—SFAS 159” below.

 

Other. When we do not consolidate an entity or apply the equity method of accounting, we present our investment in the entity at fair value. We have formed various non-consolidated private equity or other alternative investment funds with third-party investors that are typically organized as limited partnerships. We typically act as general partner for these funds, and when third-party investors have (i) rights to either remove the general partner without cause or to liquidate the partnership; or (ii) substantive participation rights, we do not consolidate these partnerships in accordance with Emerging Issue Task Force (“EITF”) No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (“EITF 04-5”).

 

A determination of whether we have a controlling financial interest in an entity and therefore our assessment of consolidation of that entity is initially made at the time we become involved with the entity. Certain events may occur which

 

-39-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

cause us to re-assess our initial determination of whether an entity is a VIE or non-VIE or whether we are the primary beneficiary if the entity is a VIE and therefore our assessment of consolidation of that entity. Those events generally are:

 

·                  The entity’s governance structure is changed such that either (i) the characteristics or adequacy of equity at risk are changed, or (ii) expected returns or losses are reallocated among the participating parties within the entity.

 

·                  The equity investment (or some part thereof) is returned to the equity investors and other interests become exposed to expected returns or losses.

 

·                  Additional activities are undertaken or assets acquired by the entity that were beyond those anticipated previously.

 

·                  Participants in the entity acquire or sell interests in the entity.

 

·                  The entity receives additional equity at risk or curtails its activities in a way that changes the expected returns or losses.

 

Valuation of Financial Instruments

 

We measure Financial instruments and other inventory positions owned, excluding Real estate held for sale, and Financial instruments and other inventory positions sold but not yet purchased at fair value. We account for Real estate held for sale at the lower of its carrying amount or fair value less cost to sell. Both realized and unrealized gains or losses from Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased are reflected in Principal transactions in the Consolidated Statement of Income.

 

We adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”), in the first quarter of 2007. SFAS 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the inputs used to measure fair value and enhances disclosure requirements for fair value measurements. Additionally and also in the first quarter of 2007, we adopted SFAS 159, and applied this option to certain hybrid financial instruments not previously accounted for at fair value under SFAS No. 155, Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140, as well as certain deposit liabilities at our U.S. banking subsidiaries.

 

SFAS 157 defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, or an exit price. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices in active markets generally have more pricing observability and less judgment utilized in measuring fair value. Conversely, financial instruments rarely traded or not quoted have less observability and are measured at fair value using valuation models that require more judgment. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions generally.

 

The overall valuation process for financial instruments may include adjustments to valuations derived from pricing models. These adjustments may be made when, in management’s judgment, either the size of the position in the financial instrument or other features of the financial instrument such as its complexity, or the market in which the financial instrument is traded (such as counterparty, credit, concentration or liquidity) require that an adjustment be made to the value derived from the pricing models. An adjustment may be made if a trade of a financial instrument is subject to sales restrictions that would result in a price less than the computed fair value measurement from a quoted market price. Additionally, an adjustment from the price derived from a model typically reflects management’s judgment that other participants in the market for the financial instrument being measured at fair value would also consider such an adjustment in pricing that same financial instrument.

 

We have categorized our financial instruments measured at fair value into a three-level classification in accordance with SFAS 157. Fair value measurements of financial instruments that use quoted prices in active markets for identical assets or liabilities are generally categorized as Level I, and fair value measurements of financial instruments that have no direct observable levels are generally categorized as Level III. The lowest level input that is significant to the fair value measurement of a financial instrument is used to categorize the instrument and reflects the judgment of management. Financial assets and liabilities presented at fair value in Holdings’ Condensed Consolidated Statement of Financial Condition generally are categorized as follows:

 

Level I – Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

 

-40-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The types of assets and liabilities carried at Level I fair value generally are G-7 government and agency securities, equities listed in active markets, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

 

Level II – Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

 

Fair valued assets and liabilities that are generally included in this category are non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments and certain derivatives.

 

Level III – Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

 

Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset-backed securities, certain corporate debt, certain private equity investments, certain commitments and guarantees and certain derivatives.

 

Financial assets and liabilities presented at fair value and categorized as Level III are generally those that are marked to model using relevant empirical data to extrapolate an estimated fair value. The models’ inputs reflect assumptions that market participants would use in pricing the instrument in a current period transaction and outcomes from the models represent an exit price and expected future cash flows. Our valuation models are calibrated to the market on a frequent basis. The parameters and inputs are adjusted for assumptions about risk and current market conditions. Changes to inputs in valuation models are not changes to valuation methodologies; rather, the inputs are modified to reflect direct or indirect impacts on asset classes from changes in market conditions. Accordingly, results from valuation models in one period may not be indicative of future period measurements. Valuations are independently reviewed by employees outside the business unit and, where applicable, valuations are back tested comparing instruments sold to where they were marked.

 

During the 2007 fiscal year, our Level III assets increased, ending the year at 13% of Financial instruments and other inventory positions owned, measured at fair value and with our derivatives on a net basis. The increase in Level III assets resulted largely from the reclassification of approximately $11.4 billion of mortgage and asset-backed securities, including approximately $5.3 billion in U.S. subprime residential mortgage-related assets, previously categorized as Level II assets into the Level III category. This reclassification generally occurred in the second half of 2007, reflecting the reduction of liquidity in the capital markets that resulted in a decrease in the observability of market prices. Approximately half of the residential mortgage-related assets that were classified as Level III at the end of the 2007 fiscal year were whole loan mortgages. In particular, the decline in global trading activity impacted our ability to directly correlate assumptions in valuation models used in pricing mortgage-related assets, including those for cumulative loss rates and changes in underlying collateral values to current market activity. Additionally and during the fiscal year, the increase of assets characterized as Level III was also attributable to the acquisition of private equity and other principal investment assets, funded lending commitments that had not been fully syndicated at the end of the fiscal year as well as certain commercial mortgage-backed security positions.

 

For a further discussion regarding the measure of Financial instruments and other inventory positions owned, excluding Real estate held for sale, and Financial instruments and other inventory positions sold but not yet purchased at fair value, see Note 4, “Fair Value of Financial Instruments,” to the Consolidated Financial Statements.

 

Identifiable Intangible Assets and Goodwill

 

Determining the carrying values and useful lives of certain assets acquired and liabilities assumed associated with business acquisitions— intangible assets in particular— requires significant judgment. At least annually, we are required to assess whether goodwill and other intangible assets have been impaired by comparing the estimated fair value, calculated based on price-earnings multiples, of each business segment with its estimated net book value, by estimating the amount of stockholders’ equity required to support each business segment. Periodically estimating the fair value of a reporting unit and carrying values of intangible assets with indefinite lives involves significant judgment and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant effect on whether or not an impairment charge is recognized and the magnitude of such a charge. We completed our last impairment test on goodwill and other intangible assets as of August 31, 2007, and no impairment was identified.

 

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LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Legal, Regulatory and Tax Proceedings

 

In the normal course of business, we have been named as a defendant in a number of lawsuits and other legal and regulatory proceedings. Such proceedings include actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities firms, including us. In addition, our business activities are reviewed by various taxing authorities around the world with regard to corporate income tax rules and regulations. We provide for potential losses that may arise out of legal, regulatory and tax proceedings to the extent such losses are probable and can be estimated. Those determinations require significant judgment. For a further discussion, see Note 9, “Commitments, Contingencies and Guarantees,” to the Consolidated Financial Statements.

 

Consolidated Results of Operations

 

Overview

 

The following table sets forth an overview of our results of operations in 2007:

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Net revenues

 

$

19,257

 

$

17,583

 

$

14,630

 

10

%

20

%

Income before taxes

 

$

6,013

 

$

5,905

 

$

4,829

 

2

 

22

 

Net income(1)

 

$

4,192

 

$

4,007

 

$

3,260

 

5

 

23

 

Earnings per diluted common share

 

$

7.26

 

$

6.81

 

$

5.43

 

7

%

25

%

Annualized return on average common stockholders’ equity

 

20.8

%

23.4

%

21.6

%

 

 

 

 

Annualized return on average tangible common stockholders’ equity

 

25.7

%

29.1

%

27.8

%

 

 

 

 

 

(1)

 

Net income in 2006 included an after-tax gain of $47 million, or $0.08 per diluted common share, as a cumulative effect of an accounting change associated with our adoption of SFAS 123(R), on December 1, 2005.

 

Net Revenues

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Principal transactions

 

$

9,197

 

$

9,802

 

$

7,811

 

(6

)%

25

%

Investment banking

 

3,903

 

3,160

 

2,894

 

24

 

9

 

Commissions

 

2,471

 

2,050

 

1,728

 

21

 

19

 

Interest and dividends

 

41,693

 

30,284

 

19,043

 

38

 

59

 

Asset management and other

 

1,739

 

1,413

 

944

 

23

 

50

 

Gross revenues

 

$

59,003

 

$

46,709

 

$

32,420

 

26

%

44

%

Interest expense

 

39,746

 

29,126

 

17,790

 

36

 

64

 

Net revenues

 

$

19,257

 

$

17,583

 

$

14,630

 

10

%

20

%

Net interest revenues

 

$

1,947

 

$

1,158

 

$

1,253

 

68

%

(8

)%

Principal transactions, commissions and net interest revenues

 

$

13,615

 

$

13,010

 

$

10,792

 

5

%

21

%

 

Principal Transactions, Commissions and Net Interest Revenue. In both the Capital Markets segment and the Private Investment Management business within the Investment Management segment, we evaluate net revenue performance based on the aggregate of Principal transactions, Commissions and Net interest revenue (Interest and dividends revenue net of Interest expense). These revenue categories include realized and unrealized gains and losses, commissions associated with client transactions and the interest and dividend revenue and interest expense associated

 

-42-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

with financing or hedging positions. Interest and dividends revenue and Interest expense are a function of the level and mix of total assets and liabilities (primarily financial instruments owned and sold but not yet purchased, and collateralized borrowing and lending activities), prevailing interest rates and the term structure of our financings. Caution should be used when analyzing these revenue categories individually because they may not be indicative of the overall performance of the Capital Markets and Investment Management business segments. Principal transactions, Commissions and Net interest revenue in the aggregate rose 5% in 2007 from 2006 and 21% in 2006 from 2005.

 

2007 vs. 2006. Principal transactions revenue decreased 6% in 2007 from 2006, primarily as a result of negative valuation adjustments made on certain components of our Fixed Income inventory during the second half of the 2007 fiscal year. Although we employ risk mitigation strategies for certain inventory positions, correlations broke down, particularly in the latter parts of the fiscal year, resulting in a higher degree of risk incurred. With respect to Capital Markets—Fixed Income customer flow revenues, heightened risk aversion among investors caused many to shift their trading activity to higher quality and more liquid products, which are generally less profitable for the Firm. The negative adjustments and the effects of this shift on our margin were partially offset by record revenues within Capital Markets—Equities. The comparative increase in Equities’ Principal transactions revenue was a result of higher customer activities, increase in market volatility and higher revenues from principal and proprietary trading strategies, especially in the international markets. Commission revenues rose 21% in 2007 from 2006. The increase in 2007 reflected growth in institutional commissions on higher global trading volumes. Net interest revenue increased 68% in 2007 from 2006 reflecting changes in both financing rates and yield curves between the periods. Interest and dividends revenue and Interest expense rose 38% and 36%, respectively, in 2007 from 2006. The comparative increase in Interest and dividend revenues and Interest expense was attributable to the steepening of the yield curve and the growth of certain assets and liabilities on our balance sheet.

 

2006 vs. 2005. Principal transactions revenue improved 25% in 2006 from 2005, driven by broad based strength across fixed income and equity products. Within Capital Markets, the notable increases in 2006 were in credit products and commercial mortgages and real estate. The 2006 increase in net revenues from Equities Capital Markets reflected higher client trading volumes, increases in financing and derivative activities and higher revenues from proprietary trading strategies. Principal transactions revenue in 2006 also benefited from increased revenues associated with certain structured products meeting the required market observability standard for revenue recognition. Commission revenues rose 19% in 2006 from 2005, reflecting growth in institutional commissions on higher global trading volumes, partially offset by lower commissions in our Investment Management business segment, as certain clients transitioned from transaction-based commissions to a traditional fee-based schedule. Net interest revenue declined 8% in 2006 from 2005 as a result of a change in the mix of asset composition, an increase in short-term U.S. financing rates, and a flattened yield curve. Interest and dividends revenue and Interest expense rose 59% and 64%, respectively, in 2006 from 2005. The increase in Interest and dividend revenues and Interest expense was attributable to higher short-term interest rates coupled with higher levels of certain interest- and dividend-earning assets and interest-bearing liabilities.

 

Investment Banking. Investment banking revenues represent fees and commissions received for underwriting public and private offerings of fixed income and equity securities, fees and other revenues associated with advising clients on M&A activities, as well as other corporate financing activities.

 

2007 vs. 2006. Investment banking revenues rose to record levels in 2007, increasing 24% from 2006. Record Global Finance—Debt revenues increased 9% from 2006. Leveraged finance revenues were at all time highs, resulting from a very strong first half of the year, which was partially offset by a decline in the second half of the year. Global Finance—Equity net revenues increased 25% compared to 2006 led by exceptional derivative activity as well as strong initial public offering (“IPO”) revenue in the first half of the fiscal year. Record Advisory Services revenues increased 45% from 2006, as our completed transaction volume increased 124% for the same period. Included in Investment banking revenue are client-driven derivative and other capital markets-related transactions with Investment Banking clients, which totaled approximately $541 million for 2007, compared to approximately $304 million for 2006.

 

2006 vs. 2005. Investment banking revenues rose in 2006, increasing 9% from 2005. Global Finance—Debt 2006 net revenues increased 9% from 2005, reflecting significant growth in global origination market volumes. Global Finance—Equity net revenues decreased 1% compared to 2005, despite increased global origination market volumes. Advisory Services net revenues increased 20% from 2005, reflecting higher completed global M&A transaction volumes. Client-driven derivative and other capital markets-related transactions with Investment Banking clients totaled approximately $304 million for 2006, compared to approximately $308 million for 2005.

 

Asset Management and Other. Asset management and other revenues primarily result from asset management activities in the Investment Management business segment.

 

-43-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

2007 vs. 2006. Asset management and other revenues rose 23% in 2007 from 2006. The growth in 2007 primarily reflected higher asset management fees attributable to the growth in AUM and management and incentive fees.

 

2006 vs. 2005. Asset management and other revenues rose 50% in 2006 from 2005. The growth in 2006 primarily reflected higher asset management fees attributable to the growth in AUM, a transition to fee-based rather than commission-based pricing for certain clients, as well as higher private equity management and incentive fees.

 

Non-Interest Expenses

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Compensation and benefits

 

$

9,494

 

$

8,669

 

$

7,213

 

10

%

20

%

Non-personnel expenses:

 

 

 

 

 

 

 

 

 

 

 

Technology and communications

 

1,145

 

974

 

834

 

18

 

17

 

Brokerage, clearance and distribution fees

 

859

 

629

 

548

 

37

 

15

 

Occupancy

 

641

 

539

 

490

 

19

 

10

 

Professional fees

 

466

 

364

 

282

 

28

 

29

 

Business development

 

378

 

301

 

234

 

26

 

29

 

Other

 

261

 

202

 

200

 

29

 

1

 

Total non-personnel expenses

 

$

3,750

 

$

3,009

 

$

2,588

 

25

%

16

%

Total non-interest expenses

 

$

13,244

 

$

11,678

 

$

9,801

 

13

%

19

%

Compensation and benefits/Net revenues

 

49.3

%

49.3

%

49.3

%

 

 

 

 

Non-personnel expenses/Net revenues

 

19.5

%

17.1

%

17.7

%

 

 

 

 

 

Non-interest expenses were $13.2 billion, $11.7 billion and $9.8 billion in 2007, 2006 and 2005, respectively. A substantial portion of our non-interest expenses is compensation-related, and a significant portion of our compensation expense represents discretionary bonuses which are impacted by levels of business activity and the structure of our share-based compensation programs. Remaining non-interest expense categories are largely variable, and are expected to change over time with revenue levels, business activity mix and employee headcount levels.

 

Compensation and benefits. Compensation and benefits totaled $9.5 billion, $8.7 billion and $7.2 billion in 2007, 2006, and 2005, respectively. Compensation and benefits expense includes both fixed and variable components. Fixed compensation consists primarily of salaries, benefits and amortization of previous years’ deferred equity awards. Variable compensation consists primarily of incentive compensation and commissions. Compensation and benefits expense as a percentage of net revenues was 49.3% for 2007, 2006 and 2005. Employees totaled approximately 28,600, 25,900 and 22,900 at November 30, 2007, 2006 and 2005, respectively.

 

2007 vs. 2006. Headcount increased 10% in 2007 from 2006, reflecting the increased levels of business activity across the Firm as well as our continued investments in the growth of the franchise, particularly in non–U.S. regions. In connection with the announced restructuring of the Firm’s global residential mortgage origination business, employee levels were reduced by approximately 1,900 in the 2007 fiscal year. Fixed compensation in 2007 was 20% greater than 2006 as result of the overall increase in employees. Fixed compensation was approximately $4.6 billion and $3.9 billion in 2007 and 2006, respectively. The 2007 fixed compensation amount of approximately $4.6 billion includes approximately $1.3 billion of amortization expense for stock awards granted in prior periods. Variable compensation was 1% greater in 2007 than 2006.

 

2006 vs. 2005. Headcount increased 13% in 2006 from 2005, reflecting the increased levels of business activity across the Firm as well as our continued investments to grow the franchise, particularly in non–U.S. regions. Correlated to the increase in employees, fixed compensation in 2006 was 21% greater than 2005. Fixed compensation was approximately $3.9 billion and $3.2 billion in 2006 and 2005, respectively. The 2006 fixed compensation amount of approximately $3.9 billion includes approximately $1.0 billion of amortization expense for stock awards granted in prior periods. The increased level of revenue from 2005 to 2006 resulted in comparatively higher incentive compensation expense. Variable compensation was 20% greater in 2006 than 2005.

 

Non-personnel expenses. Non-personnel expenses totaled $3.8 billion, $3.0 billion and $2.6 billion in 2007, 2006 and 2005, respectively. Non-personnel expenses as a percentage of net revenues were 19.5%, 17.1%, and 17.7% in 2007, 2006, and 2005, respectively.

 

2007 vs. 2006. Technology and communications expenses rose 18% in 2007 from 2006, reflecting increased costs from the continued expansion and development of our Investment Management platforms and infrastructure. Brokerage, clearance and distribution fees rose 37% in 2007 from 2006, primarily due to higher transaction volumes in Equities Capital Markets

 

-44-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

and Investment Management products. Occupancy expenses increased 19% in 2007 from 2006, primarily due to increased space requirements from the increased number of employees. Professional fees and business development expenses increased 27% in 2007 on higher levels of business activity and increased costs associated with recruiting, consulting and legal fees. In 2007, Other non-personnel expenses included approximately $62 million associated with the restructuring of the Firm’s global residential mortgage origination business.

 

2006 vs. 2005. Technology and communications expenses rose 17% in 2006 from 2005, reflecting increased costs from the continued expansion and development of our Capital Markets platforms and infrastructure. Brokerage, clearance and distribution fees rose 15% in 2006 from 2005, primarily due to higher transaction volumes in certain Capital Markets and Investment Management products. Occupancy expenses increased 10% in 2006 from 2005, primarily due to increased space requirements from the increased number of employees. Professional fees and business development expenses increased 29% in 2006 on higher levels of business activity and increased costs associated with recruiting, consulting and legal fees.

 

Income Taxes

 

The provision for income taxes totaled $1.8 billion, $1.9 billion and $1.6 billion in 2007, 2006 and 2005, respectively. The provision for income taxes resulted in effective tax rates of 30.3%, 32.9% and 32.5% for 2007, 2006 and 2005, respectively. The decrease in the effective tax rate in 2007 compared to 2006 was primarily due to a more favorable mix of earnings, which resulted in lower tax expense from foreign operations as compared to the U.S. statutory rate. The increases in the effective tax rates in 2006 and 2005 compared with the prior years were primarily due to an increase in the level of pretax earnings, which minimizes the impact of certain tax benefit items, and in 2006 a net reduction in certain benefits from foreign operations, partially offset by a reduction in state and local taxes due to favorable audit settlements in 2006 and 2005.

 

Business Acquisitions, Business Dispositions and Strategic Investments

 

Business Acquisitions. During the fiscal year, we completed the business acquisitions listed below. As a result of these acquisitions, the additions to goodwill and intangible assets were approximately $860 million.

 

·                  Eagle Energy Partners I, L.P., a Texas-based energy marketing and services company that manages and optimizes supply, transportation, transmission, load and storage portfolios on behalf of wholesale natural gas and power clients.

 

·                  Capital Crossing Bank, a state-chartered, FDIC-insured commercial bank that originates small business loans.

 

·                  A controlling interest in SkyPower Corp., a Toronto-based early stage wind and solar power generation development company. SkyPower Corp. is consolidated in our results of operations.

 

·                  The final contingent payment under a 2004 deferred transaction agreement was made for the remaining 50% of Lehman Brothers Alternative Investment Management (“LBAIM”), which manages fund of hedge fund portfolios and investment products for institutional and high-net-worth private clients. LBAIM was previously consolidated in Holdings’ results of operations.

 

·                  Grange Securities Limited, a full service Australian broker-dealer specializing in fixed income products.

 

·                  LightPoint Capital Management LLC, a leveraged loan investment manager based in Chicago, Illinois, with approximately $3.2 billion in AUM.

 

·                  The institutional equities business, including the institutional research group, of Brics Securities Limited, located in India.

 

·                  H.A. Schupf, a high net worth asset manager with approximately $2.3 billion in AUM.

 

·                  Congress Life Insurance Company, a life insurance company with licenses in 43 U.S. states.

 

·                  Dartmouth Capital, a U.K.-based investment advisory firm with approximately $340 million in assets under advisory.

 

·                  MNG Securities, an equity securities brokerage firm in Turkey.

 

A portion of the consideration paid to shareholders of certain entities described above consisted of shares of Holdings’ common stock. For more information, see Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds” in the Quarterly Reports on Form 10-Q for the quarters ended August 31, 2007 and May 31, 2007.

 

-45-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Business Dispositions. During the fiscal year, we completed the business dispositions listed below.

 

·                  Within Capital Markets we disposed of Neuberger Berman’s correspondent clearing business, which decreased our goodwill and intangible assets by approximately $26 million. The gain on sale was not material.

 

·                  We incurred non-personnel costs of approximately $62 million, including a goodwill write-down of approximately $27 million, and approximately $30 million of severance expense (reported in Compensation and benefits), in connection with the announced restructuring of the Firm’s global residential mortgage origination business, including the closure of BNC Mortgage LLC, our U.S. subprime residential mortgage origination platform, the rescaling of operations in the U.S. and U.K. due to market conditions and product revisions and the closure of our Korean mortgage business. The non-personnel costs were approximately $22 million after-tax and were generally associated with terminated leases.

 

·                  Lehman Brothers Bank disposed of a leasing subsidiary, Dolphin Capital Corp., acquired in the acquisition of Capital Crossing. The transaction was an asset sale and amounts were transferred at approximately book value.

 

Strategic Investments. During the fiscal year, we made the following strategic investments.

 

·                  Acquired a 20% interest in the D.E. Shaw group, a global investment management firm.

 

·                  Purchased an initial 20% interest and a subsequent 5% interest in both Spinnaker Asset Management Limited and Spinnaker Financial Services, part of Spinnaker Capital, an emerging markets investment management firm.

 

·                  Purchased a minority interest in Wilton Re Holdings, a U.S. re-insurer that focuses on the reinsurance of mortality risk on life insurance policies.

 

Subsequent to the fiscal year ended November 30, 2007, we acquired certain assets of Van der Moolen Specialists, including its book of NYSE-listed securities, staff and certain technology. We and certain other broker-dealers entered into a joint-venture and invested in TradeWeb Markets LLC, an electronic securities trading platform owned by Thomson Financial. In addition, in January 2008, we sold our 20% interest in Marble Bar Asset Management LLP, an investment management firm.

 

In January 2008, we announced the suspension of our wholesale and correspondent mortgage lending activities at our Aurora Loan Services subsidiary. We will continue to originate loans through Aurora’s direct lending channel and will maintain Aurora’s servicing business. As a result of these suspension activities, we estimate that we will incur one-time expenses, after tax, of approximately $40 million for severance and facilities exit costs.

 

Business Segments

 

Our operations are organized into three business segments:

 

·                  Capital Markets;

 

·                  Investment Banking; and

 

·                  Investment Management.

 

These business segments generate revenues from institutional, corporate, government and high net worth individual clients across each of the revenue categories in the Consolidated Statement of Income. Net revenues and expenses contain certain internal allocations, such as funding costs, that are centrally managed.

 

-46-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Segment Operating Results

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Capital Markets

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

12,257

 

$

12,006

 

$

9,807

 

2

%

22

%

Non-interest expense

 

8,058

 

7,286

 

6,235

 

11

 

17

 

Income before taxes

 

$

4,199

 

$

4,720

 

$

3,572

 

(11

)%

32

%

Investment Banking

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

3,903

 

$

3,160

 

$

2,894

 

24

%

9

%

Non-interest expense

 

2,880

 

2,500

 

2,039

 

15

 

23

 

Income before taxes

 

$

1,023

 

$

660

 

$

855

 

55

%

(23

)%

Investment Management

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

3,097

 

$

2,417

 

$

1,929

 

28

%

25

%

Non-interest expense

 

2,306

 

1,892

 

1,527

 

22

 

24

 

Income before taxes

 

$

791

 

$

525

 

$

402

 

51

%

31

%

Total

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

19,257

 

$

17,583

 

$

14,630

 

10

%

20

%

Non-interest expense

 

13,244

 

11,678

 

9,801

 

13

 

19

 

Income before taxes

 

$

6,013

 

$

5,905

 

$

4,829

 

2

%

22

%

 

The below charts illustrate the percentage contribution of each business segment to our total net revenues.

 

 

Capital Markets

 

Our Capital Markets segment is divided into two components:

 

Fixed Income – We make markets in and trade municipal and public sector instruments, interest rate and credit products, mortgage-related securities and loan products, currencies and commodities. We also originate mortgages and we structure and enter into a variety of derivative transactions. We also provide research covering economic, quantitative, strategic, credit, relative value, index and portfolio analyses. Additionally, we provide financing, advice and servicing activities to the hedge fund community, known as prime brokerage services. We engage in certain proprietary trading activities and in principal investing in real estate that are managed within this component.

 

Equities – We make markets in and trade equities and equity-related products and enter into a variety of derivative transactions. We also provide equity-related research coverage as well as execution and clearing activities for clients. Through our capital markets prime services, we provide prime brokerage services to the hedge fund community. We also engage in proprietary trading activities and private equity and other related investments.

 

-47-


 


 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following table sets forth the operating results of our Capital Markets business segment.

 

Capital Markets Results of Operations

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Principal transactions

 

$

8,400

 

$

9,285

 

$

7,393

 

(10

)%

26

%

Commissions

 

1,752

 

1,420

 

1,132

 

23

 

25

 

Interest and dividends

 

41,648

 

30,264

 

18,987

 

38

 

59

 

Other

 

97

 

105

 

33

 

(8

)

218

 

Total revenues

 

51,897

 

41,074

 

27,545

 

26

 

49

 

Interest expense

 

39,640

 

29,068

 

17,738

 

36

 

64

 

Net revenues

 

12,257

 

12,006

 

9,807

 

2

 

22

 

Non-interest expenses

 

8,058

 

7,286

 

6,235

 

11

 

17

 

Income before taxes

 

$

4,199

 

$

4,720

 

$

3,572

 

(11

)%

32

%

 

The following table sets forth net revenues for the two components of our Capital Markets business segment.

 

Capital Markets Net Revenues

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Fixed Income

 

$

5,977

 

$

8,447

 

$

7,334

 

(29

)%

15

%

Equities

 

6,280

 

3,559

 

2,473

 

76

 

44

 

 

 

$

12,257

 

$

12,006

 

$

9,807

 

2

%

22

%

 

2007 vs. 2006. Net revenues totaled $12.3 billion and $12.0 billion in 2007 and 2006, respectively. Overall growth in 2007 Capital Markets’ net revenues was driven by net revenues from the Equities component of Capital Markets and a higher contribution from non-U.S. regions, partially offset by declines in net revenues for the Fixed Income component of Capital Markets. Capital Markets net revenues in 2007 include approximately $1.3 billion of gains on debt liabilities which we elected to fair value under SFAS 157 and SFAS 159.

 

Net revenues in Capital Markets—Fixed Income of $6.0 billion for 2007, decreased 29% compared with $8.4 billion in 2006. Capital Markets—Fixed Income sales credit volumes were $4.8 billion, increasing 40% compared with $3.4 billion in 2006.

 

The businesses within the Fixed Income component of Capital Markets were the most affected by the market dislocations, risk repricing and de-levering that took place during the second half of the fiscal year. The adverse conditions in the U.S. housing market, changes in the credit markets and continued correction in leveraged loan pricing and certain asset-backed security market segments were generally responsible for the negative variance in Capital Markets—Fixed Income revenues between the benchmark periods. The negative valuation adjustments resulting from the impact of adverse market conditions were partially mitigated by the economic risk management strategies we employed as well as valuation changes on certain debt liabilities and realized gains from the sale of certain leveraged lending positions in the fourth quarter.

 

The table below presents certain components that generally contributed to the decline of Capital Markets—Fixed Income revenues in 2007 from 2006. These components are presented on a gross basis, as well as a net basis. The net impact represents the revenue impact from the components after adjusting for the impact of certain economic risk management strategies. Caution should be utilized when evaluating the amounts in the following table as they represent only certain components of revenue associated with the general business activities described.

 

-48-



 

LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Gain/(Loss)

 

Year Ended November 30, 2007

 

In billions

 

Gross

 

Net(1)

 

Residential mortgage-related positions

 

$

(4.7

)

$

(1.3

)

Commercial mortgage-related positions

 

(1.2

)

(0.9

)

Collateralized debt and lending obligation positions(2)

 

(0.6

)

(0.2

)

Municipal positions

 

(0.2

)

 

High-yield contingent acquisition loans and facilities(3)

 

(1.0

)

(0.4

)

Valuation of debt liabilities(4)

 

0.9

 

0.9

 

 

 

$

(6.8

)

$

(1.9

)

(1)              The net impact represents the remaining impact from the components after deducting the impact of certain economic risk management strategies. The gross impact excludes any effect of economic risk management strategies.

(2)              These valuation adjustments substantially relate to asset-backed collateralized debt obligations including warehoused positions.

(3)              Includes approximately $0.3 billion of realized gains from the sale of certain leveraged lending positions that were recognized in our fiscal fourth quarter. The net amount includes certain transaction fees earned, in addition to the impact of certain economic risk management strategies.

(4)              Represents the amount of gains on debt liabilities allocated to Capital Markets—Fixed Income and for which we elected to fair value under SFAS 157 and SFAS 159. These gains represent the effect of changes in our credit spread and exclude any Interest income or expense as well as any gain or loss from the embedded derivative components of these instruments. Changes in valuations are allocated to the businesses within Capital Markets—Fixed Income in relation to the cash generated by, or funding requirements of, the underlying positions.

Capital Markets—Equities net revenues of $6.3 billion for 2007, increased 76% compared with $3.6 billion in 2006. These results reflected the higher revenue levels reflecting the broader customer franchise developed globally. Capital Markets—Equities sales credit volumes were $3.7 billion, increasing 53% compared with $2.4 billion in 2006. Global market trading volumes rose 29% in 2007 compared to 2006.

 

The increase in Capital Markets—Equities net revenues reflected increased performance during the fiscal year across all products, with the exception of convertibles, driven by record customer activity and profitable principal trading and investing strategies. Global equity markets advanced year over year. In the latter half of our 2007 fiscal year, volatility was at higher levels relative to the comparable 2006 period. The volatility in the global equity markets led investors to employ risk mitigation strategies, driving global market demand for and strong customer activity in cash and derivative products. 2007 revenues in convertibles declined compared to 2006, mainly due to unprofitable proprietary trading strategies in certain sectors. Capital Markets—Equities prime services’ net revenues increased compared to those in the 2006 fiscal year. At the end of the 2007 fiscal year, the number of our prime brokerage services clients increased 20% to 630 from the end of the 2006 fiscal year. Correspondingly, overall client balances were 30% higher at the end of the 2007 fiscal year also compared to balances at the end of the 2006 fiscal year. Capital Markets—Equities revenues in the 2007 fiscal year include gains of approximately $700 million from private equity and other principal investments, including our investment in GLG Partners LP, as well as approximately $400 million in allocated gains from valuation changes in certain of our debt liabilities carried at fair value pursuant to SFAS 157 and SFAS 159.

 

Net interest revenues for the Capital Markets segment in 2007 increased 68% compared to 2006, primarily attributable to higher short-term U.S. financing rates and a change in the mix of asset composition. Interest and dividends revenue rose 38% in 2007 compared to 2006, and interest expense rose 36% in 2007 compared to the corresponding 2006 period. Non-interest expenses for 2007 increased 11%. Technology and communications expenses increased due to the continued expansion and development of our business platforms and infrastructure. Brokerage, clearance and distribution fees rose primarily due to higher transaction volumes across most Capital Markets products. Professional fees and business development expenses increased due to global growth of the business segment. For the Capital Markets segment, Income before taxes for 2007 decreased 11% compared with 2006 and, correspondingly, pre-tax margins in 2007 were 34% compared to 39% in 2006. During 2007, we announced steps to restructure our residential mortgage origination business, which is a component of our securitized products business within Capital Markets—Fixed Income. See “Business Acquisitions and Dispositions—Business Dispositions” above. The costs associated with these steps are included in the above non interest expenses.

 

2006 vs. 2005. Capital Markets net revenues increased to $12.0 billion in 2006 from $9.8 billion in 2005, reflecting record performances in both Fixed Income and Equities. On strong performances across most products, Capital Markets—Fixed Income net revenues increased 15% in 2006 from 2005 and Capital Markets—Equities net revenues increased 44% over the same period. Income before taxes totaled $4.7 billion and $3.6 billion in 2006 and 2005, respectively, up 32%. Pre-tax margin was 39% and 36% in 2006 and 2005, respectively.

 

Our Capital Markets—Fixed Income net revenues grew to a record $8.4 billion in 2006, an increase of 15% from 2005. This growth was attributable to strong client-flow activity and profitable trading strategies, leading to record revenues in

 

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LEHMAN BROTHERS HOLDINGS INC.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

most products. The products that contributed most to the increase in revenues year over year included credit, commercial mortgages and real estate and prime brokerage, partially offset by strong, but lower revenues in both interest rate products and residential mortgages.

 

Capital Markets—Equities net revenues increased 44% to a record level in 2006 on strong client-flow and robust global trading volumes. Global equity indices were up 14% in local currency terms for 2006, helped by strong earnings reports, lower energy prices and the end to the interest rate tightening cycle by central banks. Substantially all equity products in 2006 surpassed their 2005 performance, including gains in cash products, prime brokerage, equity derivatives, convertibles and proprietary and principal activities.

 

Net interest revenues decreased 4% in 2006 from 2005, primarily due to higher short-term U.S. interest rates, a flattened yield curve and a change in mix of asset composition. Interest and dividends revenue and Interest expense increased 59% and 64%, respectively, in 2006 from 2005 as a result of higher short-term interest rates coupled with higher levels of interest- and dividend-earning assets and interest-bearing liabilities. Non-interest expenses increased to $7.3 billion in 2006 from $6.2 billion in 2005. The growth in Non-interest expenses reflected higher compensation and benefits expense related to improved performance as well as increased technology, occupancy and communications expenses attributable to continued investments in trading platforms, integration of business acquisitions, and higher brokerage and clearance costs and professional fees from increased business activities.

 

Investment Banking

 

We take an integrated approach to client coverage, organizing bankers into industry, product and geographic groups within our Investment Banking segment. Business services provided to corporations and governments worldwide can be separated into:

 

Global Finance – We serve our clients’ capital raising needs through underwriting, private placements, leveraged finance and other activities associated with debt and equity products.

 

Advisory Services – We provide business advisory services with respect to mergers and acquisitions, divestitures, restructurings and other corporate activities.

 

The following table sets forth the operating results of our Investment Banking segment.

 

Investment Banking Results of Operations1

 

 

 

 

 

 

 

 

 

Percent Change

 

 

 

Year Ended November 30,

 

2007/

 

2006/

 

In millions

 

2007

 

2006

 

2005

 

2006

 

2005

 

Global Finance—Debt

 

$

1,551

 

$

1,424

 

$

1,304

 

9

%

9

%

Global Finance—Equity

 

1,015

 

815

 

824

 

25

 

(1

)

Advisory Services

 

1,337

 

921

 

76