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Lehman Brothers Holdings Inc. Plan Trust – ‘10-Q’ for 8/31/07

On:  Wednesday, 10/10/07, at 2:59pm ET   ·   For:  8/31/07   ·   Accession #:  1104659-7-74207   ·   File #:  1-09466

Previous ‘10-Q’:  ‘10-Q’ on 7/10/07 for 5/31/07   ·   Next:  ‘10-Q’ on 4/9/08 for 2/29/08   ·   Latest:  ‘10-Q’ on 7/10/08 for 5/31/08   ·   Referenced via Accession #:  By:  Lehman Brothers Holdings Inc. Plan Trust – ‘8-K’ on 10/15/07 for 10/10/07

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

10/10/07  Lehman Brothers Holdings Inc … Tr 10-Q        8/31/07    7:3.2M                                   Merrill Corp-MD/FA

Quarterly Report   —   Form 10-Q
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: 10-Q        Quarterly Report                                    HTML   2.03M 
 2: EX-12.01    Ex-12.1                                             HTML     38K 
 3: EX-15.01    Letter re: Unaudited Interim Financial Information  HTML     17K 
 4: EX-31.01    Certification per Sarbanes-Oxley Act (Section 302)  HTML     15K 
 5: EX-31.02    Certification per Sarbanes-Oxley Act (Section 302)  HTML     15K 
 6: EX-32.01    Certification per Sarbanes-Oxley Act (Section 906)  HTML     11K 
 7: EX-32.02    Certification per Sarbanes-Oxley Act (Section 906)  HTML     11K 


10-Q   —   Quarterly Report
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
"Available Information
"Part I. FINANCIAL INFORMATION
"Item 1. Financial Statements-(unaudited)
"Consolidated Statement of Income- Three and Nine months ended August 31, 2007 and 2006
"Consolidated Statement of Financial Condition- August 31, 2007 and November 30, 2006
"Consolidated Statement of Cash Flows- Nine months ended August 31, 2007 and 2006
"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
"Borrowings and Deposit Liabilities
"Note 8
"Commitments, Contingencies and Guarantees
"Note 9
"Earnings per Common Share and Stockholders' Equity
"Note 10
"Share-Based Employee Incentive Plans
"Note 11
"Employee Benefit Plans
"Note 12
"Regulatory Requirements
"Note 13
"Condensed Consolidating Financial Statements
"Report of Independent Registered Public Accounting Firm
"Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
"Introduction
"Forward-Looking Statements
"Executive Overview
"Consolidated Results of Operations
"Business Segments
"Geographic Revenues
"Critical Accounting Policies and Estimates
"Liquidity, Funding and Capital Resources
"Lending-Related Commitments
"Off-Balance-Sheet Arrangements
"Risk Management
"Accounting and Regulatory Developments
"Effects of Inflation
"Item 3. Quantitative and Qualitative Disclosures About Market Risk
"Item 4. Controls and Procedures
"Part II. OTHER INFORMATION
"Item 1 Legal Proceedings
"Item 1A. Risk Factors
"Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
"Item 6. Exhibits
"Signature
"Exhibit Index

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

(Mark one)

 

x                  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended August 31, 2007

 

OR

 

o                   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

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

745 Seventh Avenue, New York, New York

 

10019

(Address of principal executive offices)

 

(Zip Code)

 

(212) 526-7000

(Registrant’s telephone number, including area code)

 

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 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. 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

 

As of September 30, 2007, 530,039,222 shares of the Registrant’s Common Stock, par value $0.10 per share, were outstanding.

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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LEHMAN BROTHERS HOLDINGS INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED AUGUST 31, 2007

 

Contents

 

 

Page

 

Number

 

 

 

Available Information

2

 

 

 

 

Part I. FINANCIAL INFORMATION

 

 

 

 

 

Item 1. Financial Statements—(unaudited)

 

 

 

 

 

Consolidated Statement of Income—
Three and Nine months ended August 31, 2007 and 2006

3

 

 

 

 

Consolidated Statement of Financial Condition—
August 31, 2007 and November 30, 2006

4

 

 

 

 

Consolidated Statement of Cash Flows—
Nine months ended August 31, 2007 and 2006

6

 

 

 

 

Notes to Consolidated Financial Statements

7

 

 

 

 

Report of Independent Registered Public Accounting Firm

44

 

 

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

45

 

 

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

84

 

 

 

 

Item 4. Controls and Procedures

84

 

 

 

 

Part II. OTHER INFORMATION

 

 

 

 

 

Item 1 Legal Proceedings

85

 

 

 

 

Item 1A. Risk Factors

87

 

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

88

 

 

 

 

Item 6. Exhibits

90

 

 

 

 

Signature

91

 

 

 

 

Exhibit Index

92

 

 



 

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

1301 Avenue of the Americas

5th 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® Reader® software. If you do not have Adobe Reader, a link to Adobe Systems Incorporated’s internet site, from which you can download the software, is provided.

 

 

 

 

 

 

“ECAPS” is a registered trademark of Lehman Brothers Holdings Inc.

 

- 2 -



 

LEHMAN BROTHERS HOLDINGS INC.

PART 1—FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

 

LEHMAN BROTHERS HOLDINGS INC.

CONSOLIDATED STATEMENT of INCOME

(Unaudited)

 

 

 

Three Months

 

Nine Months

 

 

 

Ended August 31,

 

Ended August 31,

 

In millions, except per share data

 

2007

 

2006

 

2007

 

2006

 

Revenues

 

 

 

 

 

 

 

 

 

Principal transactions

 

$

1,612

 

$

2,247

 

$

7,421

 

$

7,298

 

Investment banking

 

1,071

 

726

 

3,071

 

2,302

 

Commissions

 

674

 

529

 

1,783

 

1,529

 

Interest and dividends

 

10,910

 

7,867

 

30,557

 

21,386

 

Asset management and other

 

472

 

358

 

1,281

 

1,034

 

Total revenues

 

14,739

 

11,727

 

44,113

 

33,549

 

Interest expense

 

10,431

 

7,549

 

29,246

 

20,499

 

Net revenues

 

4,308

 

4,178

 

14,867

 

13,050

 

Non-Interest Expenses

 

 

 

 

 

 

 

 

 

Compensation and benefits

 

2,124

 

2,060

 

7,330

 

6,434

 

Technology and communications

 

282

 

247

 

834

 

713

 

Brokerage, clearance and distribution fees

 

224

 

164

 

620

 

463

 

Occupancy

 

170

 

128

 

468

 

408

 

Professional fees

 

128

 

90

 

346

 

245

 

Business development

 

91

 

77

 

275

 

211

 

Other

 

84

 

45

 

211

 

160

 

Total non-personnel expenses

 

979

 

751

 

2,754

 

2,200

 

Total non-interest expenses

 

3,103

 

2,811

 

10,084

 

8,634

 

Income before taxes and cumulative effect of accounting change

 

1,205

 

1,367

 

4,783

 

4,416

 

Provision for income taxes

 

318

 

451

 

1,477

 

1,460

 

Income before cumulative effect of accounting change

 

887

 

916

 

3,306

 

2,956

 

Cumulative effect of accounting change

 

 

 

 

47

 

Net income

 

$

887

 

$

916

 

$

3,306

 

$

3,003

 

Net income applicable to common stock

 

$

870

 

$

899

 

$

3,255

 

$

2,954

 

 

 

 

 

 

 

 

 

 

 

Earnings per basic common share:

 

 

 

 

 

 

 

 

 

Before cumulative effect of accounting change

 

$

1.61

 

$

1.66

 

$

6.03

 

$

5.34

 

Cumulative effect of accounting change

 

 

 

 

0.09

 

Earnings per basic common share

 

$

1.61

 

$

1.66

 

$

6.03

 

$

5.43

 

 

 

 

 

 

 

 

 

 

 

Earnings per diluted common share:

 

 

 

 

 

 

 

 

 

Before cumulative effect of accounting change

 

$

1.54

 

$

1.57

 

$

5.71

 

$

5.01

 

Cumulative effect of accounting change

 

 

 

 

0.08

 

Earnings per diluted common share

 

$

1.54

 

$

1.57

 

$

5.71

 

$

5.09

 

 

 

 

 

 

 

 

 

 

 

Dividends paid per common share

 

$

0.15

 

$

0.12

 

$

0.45

 

$

0.36

 

 

See Notes to Consolidated Financial Statements.

 

- 3 -



 

LEHMAN BROTHERS HOLDINGS INC.

CONSOLIDATED STATEMENT of FINANCIAL CONDITION

(Unaudited)

 

 

 

August 31,

 

November 30,

 

In millions

 

2007

 

2006

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

7,048

 

$

5,987

 

 

 

 

 

 

 

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

 

10,579

 

6,091

 

 

 

 

 

 

 

Financial instruments and other inventory positions owned:
(includes $64,747 in 2007 and $42,600 in 2006 pledged as collateral)

 

302,297

 

226,596

 

 

 

 

 

 

 

Collateralized agreements:

 

 

 

 

 

 

 

 

 

 

 

Securities purchased under agreements to resell

 

144,774

 

117,490

 

 

 

 

 

 

 

Securities borrowed

 

142,653

 

107,666

 

 

 

 

 

 

 

Receivables:

 

 

 

 

 

 

 

 

 

 

 

Brokers, dealers and clearing organizations

 

10,518

 

7,449

 

 

 

 

 

 

 

Customers

 

25,229

 

18,470

 

 

 

 

 

 

 

Other

 

2,644

 

2,052

 

 

 

 

 

 

 

Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization of $2,322 in 2007 and $1,925 in 2006)

 

3,677

 

3,269

 

 

 

 

 

 

 

Other assets

 

5,689

 

5,113

 

 

 

 

 

 

 

Identifiable intangible assets and goodwill
(net of accumulated amortization of $330 in 2007 and $293 in 2006)

 

4,108

 

3,362

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

659,216

 

$

503,545

 

 

 

 

 

 

 

 

See Notes to Consolidated Financial Statements.

 

- 4 -



 

LEHMAN BROTHERS HOLDINGS INC.

CONSOLIDATED STATEMENT of FINANCIAL CONDITION—(Continued)

(Unaudited)

 

 

 

August 31,

 

November 30,

 

In millions, except share data

 

2007

 

2006

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Short-term borrowings and current portion of long-term borrowings
(including $5,528 in 2007 and $3,783 in 2006 at fair value)

 

$

26,314

 

$

20,638

 

Financial instruments and other inventory positions sold but not yet purchased

 

140,840

 

125,960

 

Collateralized financings:

 

 

 

 

 

Securities sold under agreements to repurchase

 

169,302

 

133,547

 

Securities loaned

 

60,491

 

23,982

 

Other secured borrowings

 

26,284

 

19,028

 

Payables:

 

 

 

 

 

Brokers, dealers and clearing organizations

 

2,750

 

2,217

 

Customers

 

49,079

 

41,695

 

Accrued liabilities and other payables

 

17,157

 

14,697

 

Deposits at banks
(including $13,709 in 2007 and $14,708 in 2006 at fair value)

 

24,935

 

21,412

 

Long-term borrowings
(including $22,956 in 2007 and $11,025 in 2006 at fair value)

 

120,331

 

81,178

 

Total liabilities

 

637,483

 

484,354

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

Preferred stock

 

1,095

 

1,095

 

Common stock, $0.10 par value:

 

 

 

 

 

Shares authorized: 1,200,000,000 in 2007 and 2006;

 

 

 

 

 

Shares issued: 611,930,630 in 2007 and 609,832,302 in 2006;

 

 

 

 

 

Shares outstanding: 529,445,153 in 2007 and 533,368,195 in 2006

 

61

 

61

 

Additional paid-in capital

 

9,802

 

8,727

 

Accumulated other comprehensive income/(loss), net of tax

 

(37

)

(15

)

Retained earnings

 

18,915

 

15,857

 

Other stockholders’ equity, net

 

(2,445

)

(1,712

)

Common stock in treasury, at cost: 82,485,477 shares in 2007 and 76,464,107 shares in 2006

 

(5,658

)

(4,822

)

Total common stockholders’ equity

 

20,638

 

18,096

 

Total stockholders’ equity

 

21,733

 

19,191

 

Total liabilities and stockholders’ equity

 

$

659,216

 

$

503,545

 

 

See Notes to Consolidated Financial Statements.

 

- 5 -



 

LEHMAN BROTHERS HOLDINGS INC.

CONSOLIDATED STATEMENT of CASH FLOWS

(Unaudited)

 

 

 

Nine Months Ended August 31

,

In millions

 

2007

 

2006

 

Cash Flows From Operating Activities

 

 

 

 

 

Net income

 

$

3,306

 

$

3,003

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

427

 

380

 

Non-cash compensation

 

948

 

747

 

Cumulative effect of accounting change

 

 

(47

)

Other adjustments

 

(116

)

15

 

Net change in:

 

 

 

 

 

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

 

(4,488

)

8

 

Financial instruments and other inventory positions owned

 

(73,489

)

(24,885

)

Resale agreements, net of repurchase agreements

 

8,470

 

3,903

 

Securities borrowed, net of securities loaned

 

1,522

 

(21,807

)

Other secured borrowings

 

7,256

 

(5,307

)

Receivables from brokers, dealers and clearing organizations

 

(3,069

)

2,373

 

Receivables from customers

 

(6,759

)

(3,339

)

Financial instruments and other inventory positions sold but not yet purchased

 

14,531

 

10,094

 

Payables to brokers, dealers and clearing organizations

 

533

 

1,407

 

Payables to customers

 

7,384

 

4,006

 

Accrued liabilities and other payables

 

2,926

 

620

 

Other receivables and assets

 

(1,774

)

(448

)

Net cash used in operating activities

 

(42,392

)

(29,277

)

Cash Flows From Investing Activities

 

 

 

 

 

Purchase of property, equipment and leasehold improvements, net

 

(697

)

(404

)

Business acquisitions, net of cash acquired

 

(958

)

(206

)

Proceeds from sale of business

 

65

 

 

Net cash used in investing activities

 

(1,590

)

(610

)

Cash Flows From Financing Activities

 

 

 

 

 

Derivative contracts with a financing element

 

349

 

200

 

Tax benefit from the issuance of stock-based awards

 

284

 

376

 

Issuance of short-term borrowings, net

 

4,433

 

2,472

 

Deposits at banks

 

2,640

 

6,096

 

Issuance of long-term borrowings

 

69,540

 

37,614

 

Principal payments of long-term borrowings, including the current portion of long term borrowings

 

(29,641

)

(15,533

)

Issuance of common stock

 

60

 

111

 

Issuance of treasury stock

 

292

 

358

 

Purchase of treasury stock

 

(2,600

)

(2,282

)

Dividends paid

 

(314

)

(258

)

Net cash provided by financing activities

 

45,043

 

29,154

 

Net change in cash and cash equivalents

 

1,061

 

(733

)

Cash and cash equivalents, beginning of period

 

5,987

 

4,900

 

Cash and cash equivalents, end of period

 

$

7,048

 

$

4,167

 

Supplemental Disclosure of Cash Flow Information (in millions):

 

 

 

 

 

Interest paid totaled $29,428 and $20,209 in 2007 and 2006, respectively.

 

 

 

 

 

Income taxes paid totaled $939 and $585 in 2007 and 2006, respectively.

 

 

 

 

 

See Notes to Consolidated Financial Statements.

 

- 6 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Contents

 

 

 

Page

 

 

Number

 

 

 

Note 1

Summary of Significant Accounting Policies

8

 

 

 

 

 

Note 2

Business Segments and Geographic Information

14

 

 

 

 

 

Note 3

Financial Instruments and Other Inventory Positions

17

 

 

 

 

 

Note 4

Fair Value of Financial Instruments

19

 

 

 

 

 

Note 5

Securities Received and Pledged as Collateral

22

 

 

 

 

 

Note 6

Securitizations and Special Purpose Entities

22

 

 

 

 

 

Note 7

Borrowings and Deposit Liabilities

26

 

 

 

 

 

Note 8

Commitments, Contingencies and Guarantees

27

 

 

 

 

 

Note 9

Earnings per Common Share and Stockholders’ Equity

32

 

 

 

 

 

Note 10

Share-Based Employee Incentive Plans

32

 

 

 

 

 

Note 11

Employee Benefit Plans

36

 

 

 

 

 

Note 12

Regulatory Requirements

37

 

 

 

 

 

Note 13

Condensed Consolidating Financial Statements

38

 

 

- 7 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 1 Summary of Significant Accounting Policies

 

Basis of Presentation

 

The Consolidated Financial Statements include the accounts of Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company,” “Lehman Brothers,” “we,” “us” or “our”). The principal U.S., European, and Asian subsidiaries of Holdings are Lehman Brothers Inc. (“LBI”), a U.S. registered broker-dealer, Lehman Brothers International (Europe) (“LBIE”) and Lehman Brothers Europe Limited, authorized investment firms in the United Kingdom, and Lehman Brothers Japan (“LBJ”), a registered securities company in Japan.

 

These Consolidated Financial Statements are prepared in conformity with U.S. generally accepted accounting principles and in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”) with respect to Form 10-Q. Material inter-company balances and transactions have been eliminated in consolidation. Normal recurring adjustments are reflected when in the opinion of management they are necessary for a fair presentation of the results for the interim periods presented. Certain prior-period amounts reflect reclassifications to conform to the presentation in current periods.

 

These Consolidated Financial Statements and notes should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto (the “2006 Consolidated Financial Statements”) included in Holdings’ Annual Report on Form 10-K for the fiscal year ended November 30, 2006 (the “Form 10-K”). The Consolidated Statement of Financial Condition at November 30, 2006 included in this Form 10-Q for the quarter ended August 31, 2007 was derived from the 2006 Consolidated Financial Statements.

 

The nature of our business is such that the results of any interim period may vary significantly from quarter to quarter and may not be predictive of the results for the fiscal year.

 

Consolidation Accounting Policies

 

The Consolidated Financial Statements include the accounts of Holdings and 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 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 (“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, amongst 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 (“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.

 

- 8 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

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 (“APB”) 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 an entity at fair value. We have formed various non-consolidated 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 rights to terminate the funds or to remove us as the general partner, we do not consolidate these partnerships.

 

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;

 

                  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.

 

Currency Translation

 

Assets and liabilities of subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the applicable Consolidated Statement of Financial Condition date. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating non-U.S. dollar functional currency into U.S. dollars, net of hedging gains or losses, are included in Accumulated other comprehensive income/(loss), net of tax, a component of Stockholders’ equity. Gains or losses resulting from non-U.S. dollar currency transactions are included in the Consolidated Statement of Income.

 

Revenue Recognition Policies

 

Principal transactions. Gains or losses from Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased, as well as the gains or losses from certain short- and long-term borrowing obligations, principally structured notes, and certain deposits at banks that we measure at fair value are reflected in Principal transactions in the Consolidated Statement of Income as incurred.

 

Investment banking. Underwriting revenues, net of related underwriting expenses, and revenues for merger and acquisition advisory and other investment banking-related services are recognized when services for the transactions are completed. In instances where our Investment Banking segment provides structuring services and/or advice in a capital markets-related transaction, we record a portion of the transaction-related revenue as Investment Banking fees.

 

Commissions. Commissions primarily include fees from executing and clearing client transactions on stocks, options and futures markets worldwide. These fees are recognized on a trade-date basis.

 

Interest and dividends revenue and interest expense. We recognize contractual interest on Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased, excluding derivatives, on an accrual basis as a component of Interest and dividends revenue and Interest expense, respectively. We account for our secured financing activities and certain short- and long-term borrowings

 

- 9 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

on an accrual basis with related interest recorded as interest revenue or interest expense, as applicable. Contractual interest expense on all deposit liabilities and structured notes are recorded as a component of Interest expense.

 

Asset management and other. Investment advisory fees are recorded as earned. In certain circumstances, we receive asset management incentive fees when the return on assets under management exceeds specified benchmarks. Incentive fees are generally based on investment performance over a twelve-month period and are not subject to adjustment after the measurement period ends. Accordingly, we recognize incentive fees when the measurement period ends.

 

We also receive private equity incentive fees when the returns on certain private equity funds’ investments exceed specified threshold returns. Private equity incentive fees typically are based on investment results over a period greater than one year, and future investment underperformance could require amounts previously distributed to us to be returned to the funds. Accordingly, we recognize these incentive fees when all material contingencies have been substantially resolved.

 

Income Taxes

 

We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). We recognize the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. Deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carry-forwards. We record a valuation allowance to reduce deferred tax assets to an amount that more likely than not will be realized. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in future years. Contingent liabilities related to income taxes are recorded when probable and reasonably estimable in accordance with SFAS No. 5, Accounting for Contingencies.

 

For a discussion of the impact of FIN 48, Accounting for Uncertainty in Income Taxesan interpretation of FASB Statement No. 109 (“FIN 48”) on SFAS 109, see “Accounting and Regulatory Developments—FIN 48” below.

 

Earnings per Share

 

We compute earnings per share (“EPS”) in accordance with SFAS No. 128, Earnings per Share. Basic EPS is computed by dividing net income applicable to common stock by the weighted-average number of common shares outstanding, which includes restricted stock units (“RSUs”) for which service has been provided. Diluted EPS includes the components of basic EPS and also includes the dilutive effects of RSUs for which service has not yet been provided and employee stock options.

 

Financial Instruments and Other Inventory Positions

 

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 are carried at fair value. Real estate held for sale is accounted for at the lower of its carrying amount or fair value less cost to sell. For further discussion of our financial instruments and other inventory positions, see Note 3, “Financial Instruments and Other Inventory Positions,” to the Consolidated Financial Statements.

 

Firm-owned securities pledged to counterparties who have the right, by contract or custom, to sell or repledge the securities are classified as Financial instruments and other inventory positions owned and are disclosed as pledged as collateral. For further discussion of our securities received and pledged as collateral, see Note 5, “Securities Received and Pledged as Collateral,” to the Consolidated Financial Statements.

 

We adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”) effective December 1, 2006. 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. When observable prices are not available, we either use implied pricing from similar instruments or valuation models based on net present value of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors.

 

Prior to December 1, 2006, we followed the American Institute of Certified Public Accountants (“AICPA”) Audit and Accounting Guide, Brokers and Dealers in Securities when determining fair value for financial instruments, which permitted the recognition of a discount to the quoted price when determining the fair value for a substantial block of a particular security, when the quoted price was not considered to be readily realizable (i.e., a block discount).

 

- 10 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

For further discussion of our adoption of SFAS 157, see “Accounting and Regulatory Developments—SFAS 157” below.

 

Derivative financial instruments. Derivatives are financial instruments whose value is based on an underlying asset (e.g., Treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR), and include futures, forwards, swaps, option contracts, or other financial instruments with similar characteristics. A derivative contract generally represents a future commitment to exchange interest payment streams or currencies based on the contract or notional amount or to purchase or sell other financial instruments or physical assets at specified terms on a specified date. Over-the-counter (“OTC”) derivative products are privately-negotiated contractual agreements that can be tailored to meet individual client needs and include forwards, swaps and certain options including caps, collars and floors. Exchange-traded derivative products are standardized contracts transacted through regulated exchanges and include futures and certain option contracts listed on an exchange.

 

Derivatives are recorded at fair value and included in either Financial instruments and other inventory positions owned or Financial instruments and other inventory positions sold but not yet purchased in the Consolidated Statement of Financial Condition. Derivatives are presented net-by-counterparty when a legal right of offset exists; net across different products or positions when applicable provisions are stated in a master netting agreement; and/or net of cash collateral received or paid on a counterparty basis, provided legal right of offset exists.

 

We enter into derivative transactions both in a trading capacity and as an end-user. Acting in a trading capacity, we enter into derivative transactions to satisfy the needs of our clients and to manage our own exposure to market and credit risks resulting from our trading activities (collectively, “Trading-Related Derivatives”). For Trading-Related Derivatives, margins on futures contracts are included in receivables and payables from/to brokers, dealers and clearing organizations, as applicable.

 

As an end-user, we primarily use derivatives to hedge our exposure to market risk (including foreign currency exchange and interest rate risks) and credit risks (collectively, “End-User Derivatives”). When End-User Derivatives are interest rate swaps they are measured at fair value through earnings and the carrying value of the related hedged item is adjusted through earnings for the effect of changes in the risk being hedged. The hedge ineffectiveness in these relationships is recorded in Interest expense in the Consolidated Statement of Income. When End-User Derivatives are used in hedges of net investments in non-U.S. dollar functional currency subsidiaries, the gains or losses are reported within Accumulated other comprehensive income/(loss), net of tax, in Stockholders’ equity.

 

Prior to December 1, 2006, we followed Emerging Issues Task Force (“EITF”) Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF 02-3”). Under EITF 02-3, recognition of a trading profit at inception of a derivative transaction was prohibited unless the fair value of that derivative was obtained from a quoted market price supported by comparison to other observable inputs or based on a valuation technique incorporating observable inputs. Subsequent to the inception date (“Day 1”), we recognized trading profits deferred at Day 1 in the period in which the valuation of the instrument became observable. The adoption of SFAS 157 nullified the guidance in EITF 02-3 that precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative was obtained from a quoted market price or other valuation technique incorporating observable inputs. For further discussion of our adoption of SFAS 157, see “Accounting and Regulatory Developments—SFAS 157” below.

 

Securitization activities. In accordance with SFAS 140, we recognize transfers of financial assets as sales, if control has been surrendered. We determine control has been surrendered when the following three criteria have been met:

 

                  The transferred assets have been isolated from the transferor – put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (i.e., a true sale opinion has been obtained);

 

                  Each transferee (or, if the transferee is a QSPE, each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor; and

 

- 11 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

                  The transferor does not maintain effective control over the transferred assets through either (i) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (ii) the ability to unilaterally cause the holder to return specific assets.

 

Collateralized Lending Agreements and Financings

 

Treated as collateralized agreements and financings for financial reporting purposes are the following:

 

                  Repurchase and resale agreements. Securities purchased under agreements to resell and securities sold under agreements to repurchase are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities subsequently will be resold or repurchased plus accrued interest. We take possession of securities purchased under agreements to resell. The fair value of the underlying positions is compared daily with the related receivable or payable balances, including accrued interest. We require counterparties to deposit additional collateral or return collateral pledged, as necessary, to ensure the fair value of the underlying collateral remains sufficient.

 

                  Securities borrowed and securities loaned. Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. We value the securities borrowed and loaned daily and obtain additional cash as necessary to ensure these transactions are adequately collateralized. When we act as the lender of securities in a securities-lending agreement and we receive securities that can be pledged or sold as collateral, we recognize an asset, representing the securities received and a liability, representing the obligation to return those securities.

 

                  Other secured borrowings. Other secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140. Additionally, Other secured borrowings includes non-recourse financings of entities that we have consolidated because we are the primary beneficiaries of such entities.

 

Long-Lived Assets

 

Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets. Buildings are depreciated up to a maximum of 40 years. Leasehold improvements are amortized over the lesser of their useful lives or the terms of the underlying leases, which range up to 30 years. Equipment, furniture and fixtures are depreciated over periods of up to 10 years. Internal-use software that qualifies for capitalization under AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, is capitalized and subsequently amortized over the estimated useful life of the software, generally three years, with a maximum of seven years. We review long-lived assets for impairment periodically and whenever events or changes in circumstances indicate the carrying amounts of the assets may be impaired. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized to the extent the carrying value of the asset exceeds its fair value.

 

Identifiable Intangible Assets and Goodwill

 

Identifiable intangible assets with finite lives are amortized over their expected useful lives, which range up to 15 years. Identifiable intangible assets with indefinite lives and goodwill are not amortized. Instead, these assets are evaluated at least annually for impairment. Goodwill is reduced upon the recognition of certain acquired net operating loss carryforward benefits.

 

Cash Equivalents

 

Cash equivalents include highly liquid investments not held for resale with maturities of three months or less when we acquire them.

 

Accounting and Regulatory Developments

 

SFAS 159. In February 2007, the FASB issued SFAS 159, which permits certain financial assets and financial liabilities to be measured at fair value, using an instrument-by-instrument election. The initial effect of adopting SFAS 159 must be accounted for as a cumulative-effect adjustment to opening retained earnings for the fiscal year

 

- 12 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

in which we apply SFAS 159. Retrospective application of SFAS 159 to fiscal years preceding the effective date was not permitted.

 

We elected to early adopt SFAS 159 beginning in our 2007 fiscal year and to measure at fair value substantially all structured notes not previously accounted for at fair value under SFAS No. 155, Accounting for Certain Hybrid Financial Instruments (“SFAS 155”), as well as certain deposits at our U.S. banking subsidiaries. We elected to adopt SFAS 159 for these instruments to reduce the complexity of accounting for these instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. As a result of adopting SFAS 159, we recognized a $22 million after-tax increase ($35 million pre-tax) to opening retained earnings as of December 1, 2006, representing the effect of changing the measurement basis of these financial instruments from an adjusted amortized cost basis at November 30, 2006 to fair value.

 

SFAS 158. In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Retirement Plans (“SFAS 158”) which requires an employer to recognize the over- or under-funded status of its defined benefit postretirement plans as an asset or liability in its Consolidated Statement of Financial Condition, measured as the difference between the fair value of the plan assets and the benefit obligation. For pension plans, the benefit obligation is the projected benefit obligation; while for other postretirement plans the benefit obligation is the accumulated postretirement obligation. Upon adoption, SFAS 158 requires an employer to recognize previously unrecognized actuarial gains and losses and prior service costs within Accumulated other comprehensive income/(loss), net of tax, a component of Stockholders’ equity.

 

SFAS 158 is effective for our fiscal year ending November 30, 2007. Had we adopted SFAS 158 at November 30, 2006, we would have recognized a pension asset of approximately $60 million for our funded pension plans and a liability of approximately $160 million for our unfunded pension and postretirement plans. Additionally, we would have reduced Accumulated other comprehensive income/(loss), net of tax, by approximately $380 million. At August 31, 2007, due to changes in interest rates and projected asset returns, the reduction to Accumulated other comprehensive income/(loss), net of tax, would be approximately $250 million. The actual impact of adopting SFAS 158 will depend on the fair value of plan assets and the amount of the benefit obligation measured as of November 30, 2007.

 

SFAS 157. In September 2006, the FASB issued SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value, outlines a fair value hierarchy based on inputs used to measure fair value and enhances disclosure requirements for fair value measurements. SFAS 157 does not change existing guidance as to whether or not an instrument is carried at fair value.

 

SFAS 157 also (i) nullifies the guidance in EITF 02-3 that precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative was obtained from a quoted market price or other valuation technique incorporating observable inputs; (ii) clarifies that an issuer’s credit standing should be considered when measuring liabilities at fair value; (iii) precludes the use of a liquidity or block discount when measuring instruments traded in an active market at fair value; and (iv) requires costs related to acquiring financial instruments carried at fair value to be included in earnings as incurred.

 

We elected to early adopt SFAS 157 beginning in our 2007 fiscal year and we recorded the difference between the carrying amounts and fair values of (i) stand-alone derivatives and/or structured notes measured using the guidance in EITF 02-3 on recognition of a trading profit at the inception of a derivative, and (ii) financial instruments that are traded in active markets that were measured at fair value using block discounts, as a cumulative-effect adjustment to opening retained earnings. As a result of adopting SFAS 157, we recognized a $45 million after-tax ($78 million pre-tax) increase to opening retained earnings.

 

The effect of adopting SFAS 157 was not material to our Consolidated Financial Statements. For additional information regarding our adoption of SFAS 157, see Note 4, “Fair Value of Financial Instruments,” to the Consolidated Financial Statements.

 

- 13 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

EITF Issue No. 04-5. In June 2005, the FASB ratified the consensus reached in EITF Issue 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”), which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with substantive rights to remove the general partner or to terminate the partnership. As the general partner of numerous private equity and asset management partnerships, we adopted EITF 04-5 effective June 30, 2005 for partnerships formed or modified after June 29, 2005. For partnerships formed on or before June 29, 2005 that had not been modified, we adopted EITF 04-5 as of the beginning of our 2007 fiscal year. The adoption of EITF 04-5 did not have a material effect on our Consolidated Financial Statements.

 

FIN 48. In June 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, which sets out a framework for management to use to determine the appropriate level of tax reserves to maintain for uncertain tax positions. This interpretation of SFAS 109 uses a two-step approach wherein a tax benefit is recognized if a position is more likely than not to be sustained, and the amount of benefit is then measured on a probabilistic approach, as defined in FIN 48. FIN 48 also sets out disclosure requirements to enhance transparency of an entity’s tax reserves. We must adopt FIN 48 as of the beginning of our 2008 fiscal year. We are evaluating the effect of adopting FIN 48 on our Consolidated Financial Statements.

 

FSP FIN 48-1. In May 2007, the FASB directed the FASB Staff to issue FASB Staff Position No. FIN 48-1, Definition of “Settlement” In FASB Interpretation No.  48 (“FSP FIN 48-1”). Under FSP FIN 48-1, a previously unrecognized tax benefit may be subsequently recognized if the tax position is effectively settled and other specified criteria are met. We are evaluating the effect of adopting FSP FIN 48-1 on our Consolidated Financial Statements as part of our evaluation of the effect of adopting FIN 48.

 

SOP 07-1. In June 2007, the AICPA issued Statement of Position (“SOP”) No. 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”). SOP 07-1 addresses when the accounting principles of the AICPA Audit and Accounting Guide Investment Companies must be applied by an entity and whether those accounting principles must be retained by a parent company in consolidation or by an investor in the application of the equity method of accounting. SOP 07-1 is effective for our fiscal year beginning December 1, 2008, with earlier application permitted as of December 1, 2007. We are evaluating the effect of adopting SOP 07-1 on our Consolidated Financial Statements.

 

FSP FIN 46(R)-7. In May 2007, the FASB directed the FASB Staff to issue FASB Staff Position No. FIN 46(R)-7, Application of FASB Interpretation No. 46(R) to Investment Companies (“FSP FIN 46(R)-7”). FSP FIN 46(R)-7 makes permanent the temporary deferral of the application of the provisions of FIN 46(R) to unregistered investment companies, and extends the scope exception from applying FIN 46(R) to include registered investment companies. FSP FIN 46(R)-7 is effective upon adoption of SOP 07-1. We are evaluating the effect of adopting FSP FIN 46(R)-7 on our Consolidated Financial Statements.

 

FSP FIN 39-1. In April 2007, the FASB directed the FASB Staff to issue FSP No. FIN 39-1, Amendment of FASB Interpretation No. 39 (“FSP FIN 39-1”). FSP FIN 39-1 modifies FIN No. 39, Offsetting of Amounts Related to Certain Contracts, and permits companies to offset cash collateral receivables or payables with net derivative positions under certain circumstances. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. FSP FIN 39-1 does not affect our Consolidated Financial Statements because it clarified the acceptability of existing market practice, which we use, of netting cash collateral against net derivative assets and liabilities.

 

Note 2 Business Segments and Geographic Information

 

Business Segments

 

We organize our business operations into three business segments: Capital Markets, Investment Banking and Investment Management.

 

Our business segment information for the periods ended August 31, 2007 and 2006 is prepared using the following methodologies and generally represents the information that is relied upon by management in its decision-making processes:

 

- 14 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

                  Revenues and expenses directly associated with each business segment are included in determining income before taxes.

 

                 Revenues and expenses not directly associated with specific business segments are allocated based on the most relevant measures applicable, including each segment’s revenues, headcount and other factors.

 

                  Net revenues include allocations of interest revenue, interest expense and revaluation of certain long-term and short-term debt measured at fair value to securities and other positions in relation to the cash generated by, or funding requirements of, the underlying positions.

 

                 Business segment assets include an allocation of indirect corporate assets that have been fully allocated to our segments, generally based on each segment’s respective headcount figures.

 

Capital Markets. Our Capital Markets segment is divided into two components:

 

Fixed Income – We make markets in and trade interest rate and credit products, mortgage-related securities, loan products, municipal and public sector instruments, currencies and commodities. We also originate mortgages and we structure and enter into a variety of derivative transactions. We 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.

 

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 financing, advice and servicing activities to the hedge fund community (prime brokerage) as well as provide execution and clearing activities for clients. We also engage in proprietary trading activities as well as principal investing in real estate and private equity.

 

Investment Banking. We take an integrated approach to client coverage, organizing bankers into industry, product and geographic groups within our Investment Banking segment. Business activities 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 assignments with respect to mergers and acquisitions, divestitures, restructurings, and other corporate activities.

 

Investment Management. The Investment Management business segment consists of:

 

Asset Management – We provide customized investment management services for high net worth clients, mutual funds and other small and middle market institutional investors. Asset Management also serves as general partner for private equity and other alternative investment partnerships and has minority stake investments in certain alternative investment managers.

 

Private Investment Management – We provide investment, wealth advisory and capital markets execution services to high net worth and middle market institutional clients.

 

- 15 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Business Segments

 

 

 

Capital

 

Investment

 

Investment

 

 

 

In millions

 

Markets

 

Banking

 

Management

 

Total   

 

Three months ended August 31, 2007

 

 

 

 

 

 

 

 

 

Gross revenues

 

$

12,811

 

$

1,071

 

$

857

 

$

14,739

 

Interest expense

 

10,376

 

 

55

 

10,431

 

Net revenues

 

2,435

 

1,071

 

802

 

4,308

 

Depreciation and amortization expense

 

107

 

12

 

24

 

143

 

Other expenses

 

1,613

 

771

 

576

 

2,960

 

Income before taxes

 

$

715

 

$

288

 

$

202

 

$

1,205

 

Segment assets (in billions)

 

$

648.2

 

$

1.7

 

$

9.3

 

$

659.2

 

Three months ended August 31, 2006

 

 

 

 

 

 

 

 

 

Gross revenues

 

$

10,378

 

$

726

 

$

623

 

$

11,727

 

Interest expense

 

7,531

 

 

18

 

7,549

 

Net revenues

 

2,847

 

726

 

605

 

4,178

 

Depreciation and amortization expense

 

98

 

11

 

21

 

130

 

Other expenses

 

1,635

 

584

 

462

 

2,681

 

Income before taxes

 

$

1,114

 

$

131

 

$

122

 

$

1,367

 

Segment assets (in billions)

 

$

464.9

 

$

1.1

 

$

7.7

 

$

473.7

 

 

 

 

Capital

 

Investment

 

Investment

 

 

 

In millions

 

Markets

 

Banking

 

Management

 

Total   

 

Nine months ended August 31, 2007

 

 

 

 

 

 

 

 

 

Gross revenues

 

$

38,648

 

$

3,071

 

$

2,394

 

$

44,113

 

Interest expense

 

29,118

 

 

128

 

29,246

 

Net revenues

 

9,530

 

3,071

 

2,266

 

 

14,867

 

Depreciation and amortization expense

 

318

 

34

 

75

 

427

 

Other expenses

 

5,774

 

2,222

 

1,661

 

9,657

 

Income before taxes

 

$

3,438

 

$

815

 

$

530

 

$

4,783

 

Segment assets (in billions)

 

$

648.2

 

$

1.7

 

$

9.3

 

$

659.2

 

Nine months ended August 31, 2006

 

 

 

 

 

 

 

 

 

Gross revenues

 

$

29,432

 

$

2,302

 

$

1,815

 

$

33,549

 

Interest expense

 

20,461

 

 

38

 

20,499

 

Net revenues

 

8,971

 

2,302

 

1,777

 

13,050

 

Depreciation and amortization expense

 

284

 

31

 

65

 

380

 

Other expenses

 

5,158

 

1,746

 

1,350

 

8,254

 

Income before taxes and cumulative effect of

 

 

 

 

 

 

 

 

 

accounting change

 

$

3,529

 

$

525

 

$

362

 

$

4,416

 

Segment assets (in billions)

 

$

464.9

 

$

1.1

 

$

7.7

 

$

473.7

 

 

Net Revenues by Geographic Region

 

We organize our operations into three geographic regions:

 

                  Europe, inclusive of our operations in the Middle East;

 

                  Asia Pacific, inclusive of our operations in Australia and India; and

 

                  Americas, inclusive of our operations in North, South and Central America.

 

Net revenues presented by geographic region are based upon the location of the senior coverage banker or investment advisor in the case of Investment Banking or Asset Management, respectively, or where the position was risk managed within Capital Markets and Private Investment Management. In addition, certain revenues associated with U.S. products and services that result from relationships with international clients have been classified as international revenues using an allocation consistent with our internal reporting.

 

- 16 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

The following presents, in management’s judgment, a reasonable representation of each region’s contribution to net revenues.

 

Net Revenues by Geographic Region

 

 

 

Three Months

 

 

 

Nine Months

 

 

 

 

 

Ended August 31,

 

Percent

 

Ended August 31,

 

Percent

 

In millions

 

2007

 

2006

 

Change

 

2007

 

2006

 

Change

 

Europe

 

$

1,496

 

$

1,161

 

29

%

 

$

4,693

 

$

3,370

 

39

%

 

Asia Pacific

 

728

 

407

 

79

 

 

2,084

 

1,459

 

43

 

 

Total Non–Americas

 

2,224

 

1,568

 

42

 

 

6,777

 

4,829

 

40

 

 

U.S.

 

2,038

 

2,588

 

(21

)

 

7,954

 

8,130

 

(2

)

 

Other Americas

 

46

 

22

 

109

 

 

136

 

91

 

49

 

 

Total Americas

 

2,084

 

2,610

 

(20

)

 

8,090

 

8,221

 

(2

)

 

Net revenues

 

$

4,308

 

$

4,178

 

3

%

 

$

14,867

 

$

13,050

 

14

%

 

 

Note 3 Financial Instruments and Other Inventory Positions

 

Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased were comprised of the following:

 

 

 

 

 

 

 

Sold But Not

 

 

 

Owned

 

Yet Purchased

 

 

 

August 31,

 

November 30,

 

August 31,

 

November 30,

 

In millions

 

2007    

 

2006        

 

2007    

 

2006        

 

Mortgages and mortgage-backed positions (1)

 

$

88,007

 

$

57,726

 

$

246

 

$

80

 

Government and agencies

 

37,108

 

47,293

 

63,776

 

70,453

 

Corporate debt and other

 

52,151

 

43,764

 

8,620

 

8,836

 

Corporate equities

 

64,283

 

43,087

 

40,393

 

28,464

 

Derivatives and other contractual agreements

 

35,711

 

22,696

 

27,725

 

18,017

 

Real estate held for sale

 

20,044

 

9,408

 

 

 

Commercial paper and other money market instruments

 

4,993

 

2,622

 

80

 

110

 

 

 

$

302,297

 

$

226,596

 

$

140,840

 

$

125,960

 

 

(1)            Mortgages and mortgage-backed positions owned include approximately $13.6 billion and $5.5 billion at August 31, 2007 and November 30, 2006, respectively, of mortgage loans transferred to securitization trusts; however, the transactions did not meet the sale requirements of SFAS 140, and therefore have not been derecognized. The trusts to which the loans were transferred issued non-recourse financings and accordingly the investors in the trusts generally have no recourse to our other assets in the event the borrowers to the underlying loans fail to fulfill the terms of the lending contracts.

 

Mortgages and mortgage-backed positions include mortgage loans (both residential and commercial) and non-agency mortgage-backed securities. We originate residential and commercial mortgage loans as part of our mortgage trading and securitization activities and engage in mortgage-backed securities trading. We originated approximately $45 billion of residential mortgage loans in both nine months ended August 31, 2007 and 2006. In addition, we originated approximately $45 billion and $27 billion of commercial mortgage loans for the nine months ended August 31, 2007 and 2006, respectively. Residential and commercial mortgage loans originated as well as those acquired in the secondary market are typically sold through securitization or syndication activities. For further discussion of our securitization activities, see Note 6, “Securitizations and Special Purpose Entities,” to the Consolidated Financial Statements.

 

- 17 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Our net investment position related to Real estate held for sale, after giving effect to non-recourse financing, was $12.9 billion and $5.9 billion at August 31, 2007 and November 30, 2006, respectively.

 

Derivative Financial Instruments

 

The following table presents the fair value of derivatives and other contractual agreements at August 31, 2007 and November 30, 2006. Assets included in the table represent unrealized gains, net of unrealized losses, for situations in which we have a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. The fair value of assets/liabilities related to derivative contracts at August 31, 2007 and November 30, 2006 represents our net receivable/payable for derivative financial instruments before consideration of securities collateral, but after consideration of cash collateral. Assets and liabilities are presented net of cash collateral of approximately $12.4 billion and $13.6 billion, respectively, at August 31, 2007 and $11.1 billion and $8.2 billion, respectively, at November 30, 2006.

 

 

 

August 31,

 

November 30,

 

 

 

2007

 

2006

 

In millions

 

Assets

 

Liabilities

 

Assets

 

Liabilities

 

Interest rate, currency and credit default swaps and options

 

$

15,205

 

$

9,047

 

$

8,634

 

$

5,691

 

Foreign exchange forward contracts and options

 

1,930

 

1,965

 

1,792

 

2,145

 

Other fixed income securities contracts (including TBAs and forwards) (1)

 

5,984

 

4,107

 

4,308

 

2,604

 

Equity contracts (including equity swaps, warrants and options)

 

12,592

 

12,606

 

7,962

 

7,577

 

 

 

$

35,711

 

$

27,725

 

$

22,696

 

$

18,017

 

(1)            Includes commodity derivative assets of $1.1 billion and liabilities of $1.2 billion at August 31, 2007, and commodity derivative assets and liabilities of $0.3 billion at November 30, 2006.

 

At August 31, 2007 and November 30, 2006, the fair value of derivative assets included $5.9 billion and $3.2 billion, respectively, related to exchange-traded option and warrant contracts. Similarly and for the same periods, the fair value of derivative liabilities included $4.3 billion and $2.8 billion, respectively, related to exchange-traded option and warrant contracts. With respect to OTC contracts, we view our net credit exposure to be $24.7 billion at August 31, 2007 and $15.6 billion at November 30, 2006, representing the fair value of OTC contracts in a net receivable position, after consideration of collateral. Counterparties to our OTC derivative products are primarily U.S. and foreign banks, securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds. Collateral held related to OTC contracts generally includes U.S. government and federal agency securities and listed equities.

 

Concentrations of Credit Risk

 

A substantial portion of our securities transactions are collateralized and are executed with, and on behalf of, financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. Our exposure to credit risk associated with the non-performance of these clients and counterparties in fulfilling their contractual obligations with respect to various types of transactions can be directly affected by volatile or illiquid trading markets, which may impair the ability of clients and counterparties to satisfy their obligations to us.

 

Financial instruments and other inventory positions owned include U.S. government and agency securities and securities issued by non-U.S. governments, which in the aggregate represented 6% and 9% of total assets at August 31, 2007 and November 30, 2006, respectively. In addition, collateral held for resale agreements represented approximately 22% and 23% of total assets at August 31, 2007 and November 30, 2006, respectively, and primarily consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. Our most significant industry concentration is financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of business.

 

- 18 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 4 Fair Value of Financial Instruments

 

Financial instruments and other inventory positions owned, and Financial instruments and other inventory positions sold but not yet purchased, are presented at fair value. In addition, certain long and short-term borrowing obligations, principally structured notes, and certain deposits at banks, are reflected at fair value.

 

Fair value is defined as the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, willing parties. 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.

 

Beginning December 1, 2006, assets and liabilities recorded at fair value in the Consolidated Statement of Financial Condition are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels – defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities – are as follows:

 

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

 

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, structured notes and certain mortgage and asset backed securities, certain corporate debt, certain private equity investments and certain derivatives, including those for commitments or guarantees.

 

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 and certain derivatives.

 

An asset or a liability’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation.

 

- 19 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Fair valued Financial instruments and other inventory positions owned, and Financial instruments and other inventory positions sold but not yet purchased and other liabilities at August 31, 2007 were:

 

 

 

At August 31, 2007

 

In millions

 

Level I

 

Level II

 

Level III

 

Total

 

Financial instruments and other inventory positions owned:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgages and mortgage-backed positions

 

$

222

 

$

65,039

 

$

22,746

 

$

88,007

 

 

 

 

 

 

 

 

 

 

 

Government and agencies

 

24,092

 

13,016

 

 

37,108

 

 

 

 

 

 

 

 

 

 

 

Corporate debt and other

 

946

 

48,171

 

3,034

 

52,151

 

 

 

 

 

 

 

 

 

 

 

Corporate equities

 

42,973

 

16,255

 

5,055

 

64,283

 

 

 

 

 

 

 

 

 

 

 

Commercial paper and other money market instruments

 

4,993

 

 

 

4,993

 

 

 

 

 

 

 

 

 

 

 

Total non-derivative assets

 

$

73,226

 

$

142,481

 

$

30,835

 

$

246,542

 

 

 

 

 

 

 

 

 

 

 

Derivative assets(1)

 

5,928

 

25,936

 

3,847

 

35,711

 

Total Financial instruments and other inventory positions owned

 

$

79,154

 

$

168,417

 

$

34,682

 

$

282,253

 

Financial instruments and other inventory positions sold but not yet purchased:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgages and mortgage-backed positions

 

$

 

$

246

 

$

 

$

246

 

 

 

 

 

 

 

 

 

 

 

Government and agencies

 

59,949

 

3,827

 

 

63,776

 

 

 

 

 

 

 

 

 

 

 

Corporate debt and other

 

1,327

 

7,293

 

 

8,620

 

 

 

 

 

 

 

 

 

 

 

Corporate equities

 

39,758

 

635

 

 

40,393

 

 

 

 

 

 

 

 

 

 

 

Commercial paper and other money market instruments

 

80

 

 

 

80

 

Total non-derivative liabilities

 

$

101,114

 

$

12,001

 

$

 

$

113,115

 

 

 

 

 

 

 

 

 

 

 

Derivative liabilities(1)

 

4,262

 

21,218

 

2,245

 

27,725

 

Total Financial instruments and other inventory positions sold but not yet purchased:

 

$

105,376

 

$

33,219

 

$

2,245

 

$

140,840

 

Other liabilities carried at fair value: (2)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term borrowings

 

 

$

5,528

 

 

$

5,528

 

 

 

 

 

 

 

 

 

 

 

Deposits at banks

 

 

$

13,709

 

 

$

13,709

 

 

 

 

 

 

 

 

 

 

 

Long-term borrowings

 

 

$

22,956

 

 

$

22,956

 

 

(1)            Derivative assets and liabilities are presented on a net basis by level. Inter- and intra-level cash collateral, cross-product and counterparty netting at August 31, 2007 were approximately $25.9 billion and $27.1 billion, respectively.

(2)            In accordance with our adoption of SFAS 155, SFAS 157 and SFAS 159, we also measure certain non-inventory liabilities at fair value. See Note 1, “Summary of Significant Accounting Policies” for further discussion of our adoption of these accounting standards.

 

- 20 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Net revenues (both realized and unrealized) for Level III financial instruments are generally classified in Principal transactions in the Consolidated Statement of Income. Net revenues (realized and unrealized) associated with Level III financial instruments were approximately $49 million and $787 million for the three and nine months ended August 31, 2007, respectively. The following tables summarize the change in balance sheet carrying value associated with Level III financial instruments carried at fair value during the three and nine months ended August 31, 2007:

 

 

 

 

 

Periodic

 

 

 

 

 

 

 

 

 

In millions

 

Balance 

 

Payments,

 

Net

 

 

 

 

 

Balance

 

Three months ended

 

May 31, 

 

Purchases,

 

Transfers

 

Gains/(Losses) (2), (3)

 

August 31,

 

August 31, 2007

 

2007   

 

Sales, Net

 

In/(Out)

 

Realized

 

Unrealized

 

2007

 

Mortgages and mortgage-backed positions

 

$

11,920

 

$

1,854

 

$

9,588

 

$

213

 

$

(829

)

$

22,746

 

Corporate debt and other

 

3,592

 

(690

)

96

 

1

 

35

 

3,034

 

Corporate equities

 

4,048

 

658

 

261

 

37

 

51

 

5,055

 

Total non-derivative assets

 

19,560

 

1,822

 

9,945

 

251

 

(743

)

30,835

 

Derivative assets, net(1)

 

1,280

 

(59

)

(160

)

(2

)

543

 

1,602

 

 

 

$

20,840

 

$

1,763

 

$

9,785

 

$

249

 

$

(200

)

$

32,437

 

(1)              Derivatives are presented on a net basis.

(2)              Caution should be utilized when evaluating reported net revenues for Level III Financial instruments. These values are not presented net of hedging activities that may be transacted in instruments categorized within other hierarchy levels. Actual net revenues associated with Level III, inclusive of hedging activities, would differ materially.

(3)              The current period gains/(losses) from changes in values of Level III Financial instruments represent gains/(losses) from changes in values of those Financial instruments only for the period(s) in which the instruments were classified as Level III.

 

 

 

 

 

Periodic

 

 

 

 

 

 

 

 

 

In millions

 

Balance

 

Payments,

 

Net

 

 

 

 

 

Balance

 

Nine months ended

 

November 30,

 

Purchases,

 

Transfers

 

Gains/(Losses) (2), (3)

 

August 31,

 

August 31, 2007

 

2006

 

Sales, Net

 

In/(Out)

 

Realized

 

Unrealized

 

2007

 

Mortgages and mortgage-backed positions

 

$

8,205

 

$

5,396

 

$

9,577

 

$

687

 

$

(1,119

)

$

22,746

 

Corporate debt and other

 

2,430

 

270

 

188

 

54

 

92

 

3,034

 

Corporate equities

 

2,291

 

1,844

 

664

 

75

 

181

 

5,055

 

Total non-derivative assets

 

12,926

 

7,510

 

10,429

 

816

 

(846

)

30,835

 

Derivative assets, net(1)

 

686

 

226

 

(127

)

36

 

781

 

1,602

 

 

 

$

13,612

 

$

7,736

 

$

10,302

 

$

852

 

$

(65

)

$

32,437

 

(1)            Derivatives are presented on a net basis.

 

(2)            Caution should be utilized when evaluating reported net revenues for Level III Financial instruments. These values are not presented net of hedging activities that may be transacted in instruments categorized within other hierarchy levels. Actual net revenues associated with Level III, inclusive of hedging activities, would differ materially.

 

(3)            The year-to-date gains/(losses) from changes in values of Level III Financial instruments represent gains/(losses) from changes in values of those Financial instruments only for the period(s) in which the instruments were classified as Level III.

 

- 21 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

At August 31, 2007, the Company performed a goodwill impairment test which compares its carrying value of goodwill to a fair value measurement of its goodwill, determined utilizing Level III inputs. No impairment was identified. The following table summarizes the change in balance sheet carrying values associated with goodwill:

 

 

 

 

 

Investment

 

 

 

In millions

 

Capital Markets

 

Management

 

Total

 

Balance (net) at November 30, 2006

 

$321

 

 

$2,096

 

$2,417

 

Goodwill acquired

 

673

 

 

163

 

836

 

Goodwill disposed

 

(53

)

 

 

(53

)

Purchase price goodwill valuation adjustment

 

 

 

 

 

Balance (net) at August 31, 2007

 

$941

 

 

$2,259

 

$3,200

 

 

Note 5 Securities Received and Pledged as Collateral

 

We enter into secured borrowing and lending transactions to finance inventory positions, obtain securities for settlement and meet clients’ needs. We receive collateral in connection with resale agreements, securities borrowed transactions, borrow/pledge transactions, client margin loans and derivative transactions. We generally are permitted to sell or repledge these securities held as collateral and use them to secure repurchase agreements, enter into securities lending transactions or deliver to counterparties to cover short positions.

 

At August 31, 2007 and November 30, 2006, the fair value of securities received as collateral that we were permitted to sell or repledge was approximately $731 billion and $621 billion, respectively. The fair value of securities received as collateral that we sold or repledged was approximately $660 billion and $568 billion at August 31, 2007 and November 30, 2006, respectively.

 

We also pledge our own assets, primarily to collateralize certain financing arrangements. These pledged securities, where the counterparty has the right by contract or custom to sell or repledge the financial instruments were approximately $65 billion and $43 billion at August 31, 2007 and November 30, 2006, respectively. The carrying value of Financial instruments and other inventory positions owned that have been pledged or otherwise encumbered to counterparties where those counterparties do not have the right to sell or repledge, was approximately $92 billion and $75 billion at August 31, 2007 and November 30, 2006, respectively.

 

Note 6 Securitizations and Special Purpose Entities

 

Generally, residential and commercial mortgages, home equity loans, municipal and corporate bonds, and lease and trade receivables are financial assets that we securitize through SPEs. We may continue to hold an interest in the financial assets securitized in the form of either the securities created in the transaction or residual interests in the SPEs (“interests in securitizations”) established to facilitate the securitization transaction. Interests in securitizations are presented within Financial instruments and other inventory positions owned (primarily in mortgages and mortgage-backed and government and agencies) in the Consolidated Statement of Financial Condition. For additional information regarding the accounting for securitization transactions, see Note 1, “Summary of Significant Accounting Policies—Consolidation Accounting Policies,” to the Consolidated Financial Statements.

 

For the periods ended August 31, 2007 and 2006, we securitized the following financial assets:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

August 31,

 

August 31,

 

In millions

 

2007  

 

2006  

 

2007   

 

2006   

 

Residential mortgages

 

$26,112

 

$35,288

 

$

86,376

 

$102,418

 

Commercial mortgages

 

10,480

 

6,700

 

 

18,392

 

11,812

 

Municipal and other asset-backed financial instruments

 

2,122

 

696

 

 

4,039

 

1,130

 

Total

 

$38,714

 

$42,684

 

$

108,807

 

$115,360

 

 

- 22 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

At August 31, 2007 and November 30, 2006, we had approximately $1.8 billion and $2.0 billion, respectively, of non-investment grade interests from our securitization activities (primarily junior security interests in residential mortgage securitizations).

 

The tables below present: the fair value of our interests in securitizations at August 31, 2007 and November 30, 2006; model assumptions of market factors; sensitivity of valuation models to adverse changes in the assumptions; as well as cash flows received on such interests in the securitizations. The sensitivity analyses presented below are hypothetical and should be used with caution since the stresses are performed without considering the effect of hedges, which serve to reduce our actual risk. We mitigate the risks associated with the above interests in securitizations through dynamic hedging strategies. These results are calculated by stressing a particular economic assumption independent of changes in any other assumption (as required by U.S. GAAP). In reality, changes in one factor often result in changes in another factor which may counteract or magnify the effect of the changes outlined in the tables below. Changes in the fair value based on a 10% or 20% variation in an assumption should not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

 

Securitization Activity

 

 

 

August 31, 2007

 

November 30, 2006

 

 

 

Residential Mortgages

 

 

 

Residential Mortgages

 

 

 

 

 

 

 

Non-

 

 

 

 

 

Non-

 

 

 

 

 

Investment

 

Investment

 

 

 

Investment

 

Investment

 

 

 

Dollars in millions

 

Grade(1)

 

Grade

 

Other(2)

 

Grade(1)

 

Grade

 

Other(2)

 

Interests in securitizations
(in billions)(1)

 

$

9.2

 

$

1.7

 

$

3.4

 

$

5.3

 

$

2.0

 

$

0.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average life (years)

 

7

 

6

 

5

 

5

 

6

 

5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average constant prepayment rate

 

15.4

%

26.4

%

 

27.2

%

29.1

%

 

Effect of 10% adverse change

 

$

54

 

$

5

 

$

 

$

21

 

$

61

 

$

 

Effect of 20% adverse change

 

$

74

 

$

28

 

$

 

$

35

 

$

110

 

$

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average credit loss assumption

 

0.2

%

2.3

%

0.5

%

0.6

%

1.3

%

 

Effect of 10% adverse change

 

$

27

 

$

121

 

$

2.3

 

$

70

 

$

109

 

$

 

Effect of 20% adverse change

 

$

67

 

$

232

 

$

4.6

 

$

131

 

$

196

 

$

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average discount rate

 

8.7

%

23.7

%

6.4

%

7.2

%

18.4

%

5.8

%

Effect of 10% adverse change

 

$

308

 

$

102

 

$

85

 

$

124

 

$

76

 

$

13

 

Effect of 20% adverse change

 

$

594

 

$

163

 

$

165

 

$

232

 

$

147

 

$

22

 

(1)              The amount of investment-grade interests in securitizations related to agency collateralized mortgage obligations was approximately $4.5 billion and $1.9 billion at August 31, 2007 and November 30, 2006, respectively.

(2)              At August 31, 2007, other interests in securitizations included approximately $3.2 billion of investment grade commercial mortgages and approximately $0.1 billion of non-investment grade commercial mortgages. At November 30, 2006, other interests in securitizations included approximately $0.6 billion of investment grade commercial mortgages.

 

Cash flows received on interests in securitizations

 

 

 

 

 

 

 

 

 

Dollars in millions

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine months ended

 

Year ended

 

 

 

August 31, 2007

 

November 30, 2006

 

 

 

$   884

 

$   423

 

$    87

 

$   664

 

$   216

 

$    59

 

 

- 23 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Mortgage servicing rights. Mortgage servicing rights (“MSRs”) represent the right to future cash flows based upon contractual servicing fees for mortgage loans and mortgage-backed securities. Our MSRs generally arise from the securitization of residential mortgage loans that we originate. MSRs are presented within Financial instruments and other inventory positions owned on the Consolidated Statement of Financial Condition. At August 31, 2007 and November 30, 2006, the Company had MSRs of approximately $1.0 billion and $0.8 billion, respectively.

 

Our MSRs activities for the nine months ended August 31, 2007 and year ended November 30, 2006 are as follows:     

 

In millions

 

August 31, 2007

 

November 30, 2006

 

Balance, beginning of period

 

$

829

 

 

$

561

 

 

Additions, net

 

 

261

 

 

 

507

 

 

Changes in fair value:

 

 

 

 

 

 

 

 

 

Paydowns/servicing fees

 

 

(129

)

 

 

(192

)

 

Resulting from changes in valuation assumptions

 

 

88

 

 

 

(80

)

 

Change due to SFAS 156 adoption

 

 

 

 

 

33

 

 

Balance, end of period

 

$

1,049

 

 

$

829

 

 

 

The determination of MSRs fair value is based upon a discounted cash flow valuation model. Cash flow and prepayment assumptions used in our discounted cash flow model are: based on empirical data drawn from the historical performance of our MSRs; consistent with assumptions used by market participants valuing similar MSRs; and from data obtained on the performance of similar MSRs. These variables can, and generally will, vary from quarter to quarter as market conditions and projected interest rates change. For that reason, risk related to MSRs directly correlates to changes in prepayment speeds and discount rates. We mitigate this risk by entering into hedging transactions.

 

The following table shows the main assumptions used to determine the fair value of our MSRs at August 31, 2007 and November 30, 2006, the sensitivity of our fair value measurements to changes in these assumptions, and cash flows received on contractual servicing:

 

Dollars in millions

 

August 31, 2007

 

November 30, 2006

 

Weighted-average prepayment speed (CPR)

 

28.5

%

31.1

%

Effect of 10% adverse change

 

$

94

 

$

84

 

Effect of 20% adverse change

 

$

175

 

$

154

 

Discount rate

 

8.3

%

8.0

%

Effect of 10% adverse change

 

$

20

 

$

17

 

Effect of 20% adverse change

 

$

38

 

$

26

 

 

 

 

 

 

 

Cash flows received on contractual servicing

 

$

199

 

$

255

 

 

The above sensitivity analysis is hypothetical and should be used with caution since the stresses are performed without considering the effect of hedges, which serve to reduce our actual risk. These results are calculated by stressing a particular economic assumption independent of changes in any other assumption (as required by U.S. GAAP); in reality, changes in one factor often result in changes in another factor which may counteract or magnify the effect of the changes outlined in the above table. Changes in the fair value based on a 10% or 20% variation in an assumption should not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

 

Non-QSPE activities. We have transactional activity with SPEs that do not meet the QSPE criteria because their permitted activities are not limited sufficiently or the assets are non-qualifying financial instruments (e.g., real estate). Transactions with such SPEs include credit-linked notes, real estate investment vehicles and other structured financing transactions designed to meet clients’ investing or financing needs. Our involvement with such SPEs includes collateralized debt obligations (“CDOs”), credit-linked notes and other structured financing transactions designed to meet clients’ investing or financing needs.

 

A CDO transaction involves the purchase by an SPE of a diversified portfolio of securities and/or loans that are then managed by an independent asset manager. Interests in the SPE (debt and equity) are sold to third party investors. Our primary role is limited to acting as structuring and placement agent, warehouse provider, underwriter and market maker in the related CDO securities. In a typical CDO, at the direction of a third party asset manager, we

 

- 24 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

will temporarily warehouse securities or loans on our balance sheet pending the sale to the SPE once the permanent financing is completed. At August 31, 2007 and November 30, 2006, we owned approximately $469.3 million and $55.1 million of equity securities in CDOs, respectively. Because our investments do not represent a majority of any CDO equity class, we are not the primary beneficiary of the CDOs and therefore we do not consolidate such SPEs.

 

As a dealer in credit default swaps, we make a market in buying and selling credit protection on single issuers as well as on portfolios of credit exposures. We mitigate our credit risk, in part, by purchasing default protection through credit default swaps with SPEs. We pay a premium to the SPEs for assuming credit risk under the credit default swap. In these transactions, SPEs issue credit-linked notes to investors and use the proceeds to invest in high quality collateral. Our maximum potential loss associated with our involvement with such credit-linked note transactions is measured by the fair value of our credit default swaps with such SPEs. At August 31, 2007 and November 30, 2006, respectively, the fair values of these credit default swaps were $1.1 billion and $0.2 billion, respectively. The underlying investment grade collateral where we are the first-lien holder and that is held by SPEs was $13.2 billion and $10.8 billion at August 31, 2007 and November 30, 2006, respectively.

 

Because the investors assume default risk associated with both the reference portfolio and the SPEs’ assets, the investors in the SPEs bear a majority of the entity’s expected losses. Accordingly, we generally are not the primary beneficiary and therefore do not consolidate these SPEs.

 

In instances where we are the primary beneficiary of the credit default transaction, we consolidate the SPE. At August 31, 2007 and November 30, 2006, we consolidated approximately $168 million and $718 million of these credit default transactions, respectively. The assets associated with these consolidated credit default transactions are presented as a component of Financial instruments and other inventory positions owned.

 

We also invest in real estate directly through consolidated subsidiaries and through VIEs. We consolidate our investments in real estate VIEs when we are the primary beneficiary. We record the assets of these consolidated real estate VIEs as a component of Financial instruments and other inventory positions owned. At August 31, 2007 and November 30, 2006, we consolidated approximately $10.8 billion and $3.4 billion, respectively, of real estate-related investments. After giving effect to non-recourse financing, our net investment position in these consolidated real estate VIEs was $6.8 billion and $2.2 billion at August 31, 2007 and November 30, 2006, respectively.

 

The following table summarizes our non-QSPE activities at August 31, 2007 and November 30, 2006:

 

In millions

 

August 31, 2007

 

November 30, 2006

 

Credit default swaps with SPEs

 

$  1,088

 

 

$     155

 

 

Value of underlying investment-grade collateral

 

13,240

 

 

10,754

 

 

Value of assets consolidated

 

168

 

 

718

 

 

 

 

 

 

 

 

 

 

Consolidated VIE real estate investments

 

10,779

 

 

3,380

 

 

Net investment

 

6,819

 

 

2,180

 

 

 

In addition to the above, we enter into other transactions with SPEs designed to meet clients’ investment and/or funding needs. For further discussion of our SPE-related and other commitments, see Note 8, “Commitments, Contingencies and Guarantees,” to the Consolidated Financial Statements.

 

- 25 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 7 Borrowings and Deposit Liabilities

 

Total borrowings and deposits at August 31, 2007 and November 30, 2006, consisted of the following:

 

In millions

 

August 31, 2007

 

November 30, 2006

 

Short-term borrowings

 

 

 

 

 

Secured

 

$

495

 

$

227

 

Unsecured

 

 

 

 

 

Current portion of long-term

 

13,997

 

12,878

 

Commercial paper

 

1,202

 

1,653

 

Other

 

10,620

 

5,880

 

Total

 

$

26,314

 

$

20,638

 

Amount carried at fair value(1)

 

$

5,528

 

$

3,783

 

 

 

 

 

 

 

Deposit liabilities at banks

 

 

 

 

 

Time deposits

 

 

 

 

 

At US banks

 

$

14,088

 

$

14,592

 

At non-US banks

 

8,996

 

5,621

 

Savings deposits

 

 

 

 

 

At US banks

 

1,613

 

1,199

 

At non-US banks

 

238

 

 

Total

 

$

24,935

 

$

21,412

 

Amount carried at fair value(1)

 

$

13,709

 

$

14,708

 

 

 

 

 

 

 

Unsecured long-term borrowings

 

 

 

 

 

Senior notes

 

$

106,807

 

$

75,202

 

Subordinated notes

 

8,610

 

3,238

 

Junior subordinated notes

 

4,914

 

2,738

 

Total

 

$

120,331

 

$

81,178

 

Amount carried at fair value(1)

 

$

22,956

 

$

11,025

 

(1)              Borrowings and deposits are carried at fair value in accordance with SFAS 155 and SFAS 159. See Note 1, “Summary of Significant Accounting Polices,” for additional information. At August 31, 2007, the principal amounts of short-term borrowings, deposit liabilities and long-term borrowings carried at fair value were approximately $5.5 billion, $13.8 billion and $24.5 billion, respectively. At November 30, 2006, the principal amounts short-term borrowings, deposit liabilities and long-term borrowings carried at fair value were approximately $3.7 billion, $14.7 billion and $11.1 billion, respectively. Substantially all of the borrowings recorded at fair value are structured notes and contain two parts: a note and an embedded forward or option component. The difference between the aggregate principal balance and the aggregate fair value represents cumulative changes in Holdings’ credit spreads as well as changes to the embedded forward or option component. During the 2007 three and nine months, a substantial portion of the change in fair value is associated with the embedded forward or option component, which is risk managed and part of our capital markets activities.

 

Junior subordinated notes are notes issued to trusts or limited partnerships (collectively, the “Trusts”) which generally qualify as equity capital by leading rating agencies (subject to limitation). The Trusts were formed for the purposes of (a) issuing securities representing ownership interests in the assets of the Trusts; (b) investing the proceeds of the Trusts in junior subordinated notes of Holdings; and (c) engaging in activities necessary and incidental thereto.

 

Settled in June 2007 but issued in May 2007, Lehman Brothers UK Capital Funding V LP, a UK limited partnership (the “UK LP”), issued in aggregate $500 million Fixed Rate Enhanced Capital Advantage Preferred Securities (“ECAPS®”). A corresponding $500 million principal amount of junior subordinated notes were issued by Holdings to the UK LP. Distributions will accrue on the ECAPS® at a rate of 6.9% per annum. ECAPS® have no mandatory redemption date, but may be redeemed at our option on June 1, 2012, or annually thereafter. We did not consolidate the UK LP under the application of FIN 46(R).

 

For additional information about issuances and maturities of Unsecured long-term borrowings, see the Consolidated Statement of Cash Flows.

 

- 26 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Credit Facilities

 

We use both committed and uncommitted bilateral and syndicated long-term bank facilities to complement our long-term debt issuance. In particular, Holdings maintains a $2.0 billion unsecured, committed revolving credit agreement with a syndicate of banks which expires in February 2009. In addition, we maintain a $2.5 billion multi-currency unsecured, committed revolving credit facility (“European Facility”) with a syndicate of banks for Lehman Brothers Bankhaus AG (“Bankhaus”) and Lehman Brothers Treasury Co. B.V. which expires in April 2010. Our ability to borrow under such facilities is conditioned on complying with customary lending conditions and covenants. We have maintained compliance with the material covenants under these credit agreements at all times. We draw on both of these facilities from time to time in the normal course of conducting our business. As of August 31, 2007, there were no outstanding borrowings against Holdings’ credit facility. Additionally and as of August 31, 2007, there were outstanding borrowings of approximately $2.5 billion against the European Facility.

 

Note 8 Commitments, Contingencies and Guarantees

 

In the normal course of business, we enter into various commitments and guarantees, including lending commitments to high grade and high yield borrowers, private equity investment commitments, liquidity commitments and other guarantees.

 

Lending–Related Commitments

 

The following table summarizes lending-related commitments at August 31, 2007 and November 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

Expiration per Period at August 31, 2007

 

Contractual amount

 

 

 

 

 

 

 

2009-

 

2011-

 

2013 and

 

August

 

November

 

In millions

 

2007

 

2008

 

2010

 

2012

 

Later

 

31, 2007

 

30, 2006

 

Lending commitments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

High grade (1)

 

$

1,720

 

$

5,769

 

$

6,254

 

$

12,824

 

$

410

 

$

26,977

 

$

17,945

 

High yield (2)

 

1,083

 

2,018

 

960

 

3,900

 

3,536

 

11,497

 

7,558

 

Contingent acquisition facilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment grade

 

1,604

 

2,500

 

 

 

 

4,104

 

1,918

 

Non-investment grade

 

8,552

 

16,912

 

1,575

 

 

 

27,039

 

12,766

 

Mortgage commitments

 

8,591

 

421

 

1,841

 

973

 

606

 

12,432

 

12,246

 

Secured lending transactions

 

72,979

 

17,796

 

489

 

456

 

1,435

 

93,155

 

82,987

 

 

(1)              We view our net credit exposure for high grade commitments, after consideration of hedges, to be $14.4 billion and $4.9 billion at August 31, 2007 and November 30, 2006, respectively.

(2)              We view our net credit exposure for high yield commitments, after consideration of hedges, to be $10.4 billion and $5.9 billion at August 31, 2007 and November 30, 2006, respectively.

 

We use various hedging and funding strategies to actively manage our market, credit and liquidity exposures on these commitments. We do not believe total commitments necessarily are indicative of actual risk or funding requirements because the commitments may not be drawn or fully used and such amounts are reported before consideration of hedges.

 

High grade and high yield. Through our high grade (investment grade) and high yield (non-investment grade) sales, trading and underwriting activities, we make commitments to extend credit in loan syndication transactions. These commitments and any related drawdowns of these facilities typically have fixed maturity dates and are contingent on certain representations, warranties and contractual conditions applicable to the borrower. We define high yield exposures as securities of or loans to companies rated BB+ or lower or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans that, in management’s opinion, are non-investment grade.

 

- 27 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

We had commitments to investment grade borrowers at August 31, 2007 and November 30, 2006 of $27.0 billion (net credit exposure of $14.4 billion, after consideration of hedges) and $17.9 billion (net credit exposure of $4.9 billion, after consideration of hedges), respectively. We had commitments to non-investment grade borrowers of $11.5 billion (net credit exposure of $10.4 billion, after consideration of hedges) and $7.6 billion (net credit exposure of $5.9 billion, after consideration of hedges) at August 31, 2007 and November 30, 2006, respectively.

 

Contingent acquisition facilities. We provide contingent commitments to investment and non-investment grade counterparties related to acquisition financing. We do not believe contingent acquisition commitments are necessarily indicative of actual risk or funding requirements as funding is dependent both upon a proposed transaction being completed and the acquiror fully utilizing our commitment. Typically, these commitments are made to a potential acquiror in a proposed acquisition, which may or may not be completed depending on whether the potential acquiror to whom we have provided our commitment is successful. A contingent borrower’s ability to draw on the commitment is typically subject to there being no material adverse change in the borrower’s financial conditions, among other factors, and the commitments also generally contain certain flexible pricing features to adjust for changing market conditions prior to closing. In addition, acquirors generally utilize multiple financing sources, including other investment and commercial banks, as well as accessing the general capital markets for completing transactions. Further, our past practice, consistent with our credit facilitation framework, has been to syndicate acquisition financings to investors. Therefore, our contingent acquisition commitments are generally greater than the amounts we will ultimately fund. The ultimate timing, amount and pricing of a syndication, however, is influenced by market conditions that may not necessarily be consistent with those at the time the commitment was entered.

 

We provided contingent commitments to investment grade counterparties related to acquisition financing of approximately $4.1 billion and $1.9 billion at August 31, 2007 and November 30, 2006, respectively. In addition, we provided contingent commitments to non-investment grade counterparties related to acquisition financing of approximately $27.0 billion and $12.8 billion at August 31, 2007 and November 30, 2006, respectively.

 

Mortgage commitments. Through our mortgage origination platforms we make commitments to extend mortgage loans. At August 31, 2007 and November 30, 2006, we had outstanding mortgage commitments of approximately $12.4 billion and $12.2 billion, respectively. These commitments included $7.2 billion and $7.0 billion of residential mortgages at August 31, 2007 and November 30, 2006, respectively, and $5.2 billion of commercial mortgages at both comparative periods. The residential mortgage loan commitments require us to originate mortgage loans at the option of a borrower generally within 90 days at fixed interest rates. Our intention is to sell residential mortgage loans, once originated, primarily through securitizations.

 

Secured lending transactions. In connection with our financing activities, we had outstanding commitments under certain collateralized lending arrangements of approximately $9.6 billion and $7.4 billion at August 31, 2007 and November 30, 2006, respectively. These commitments require borrowers to provide acceptable collateral, as defined in the agreements, when amounts are drawn under the lending facilities. Advances made under these lending arrangements typically are at variable interest rates and generally provide for over-collateralization. In addition, at August 31, 2007, we had commitments to enter into forward starting secured resale and repurchase agreements, primarily secured by government and government agency collateral, of $44.0 billion and $39.6 billion, respectively, compared to $44.4 billion and $31.2 billion, respectively, at November 30, 2006.

 

- 28 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Other Commitments and Guarantees

 

The following table summarizes other commitments and guarantees at August 31, 2007 and November 30, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

Expiration per Period at August 31, 2007

 

Contractual amount

 

 

 

 

 

 

 

2009-

 

2011-

 

2013 and

 

August

 

November

 

In millions

 

2007

 

2008

 

2010

 

2012

 

Later

 

31, 2007

 

30, 2006

 

Derivative contracts(1)

 

$54,130

 

$83,843

 

$165,986

 

$215,165

 

$248,439

 

$767,563

 

$534,585

 

Municipal-securities-related commitments

 

535

 

31

 

643

 

137

 

5,967

 

7,313

 

1,599

 

Other commitments with variable interest entities

 

619

 

1,098

 

1,151

 

543

 

4,923

 

8,334

 

4,902

 

Standby letters of credit

 

1,476

 

312

 

4

 

 

 

1,792

 

2,380

 

Private equity and other principal investment commitments

 

1,811

 

1,736

 

1,040

 

429

 

 

5,016

 

1,088

 

 

(1)            We believe the fair value of these derivative contracts is a more relevant measure of the obligations because we believe the notional amount overstates the expected payout. At August 31, 2007 and November 30, 2006, the fair value of these derivative contracts approximated $11.1 billion and $9.3 billion, respectively.

 

Derivative contracts. Under FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN 45”), derivative contracts are considered to be guarantees if such contracts require us to make payments to counterparties based on changes in an underlying instrument or index (e.g., security prices, interest rates, and currency rates) and include written credit default swaps, written put options, written foreign exchange and interest rate options. Derivative contracts are not considered guarantees if these contracts are cash settled and we cannot determine if the derivative counterparty held the contracts’ underlying instruments at inception. We have determined these conditions have been met for certain large financial institutions. Accordingly, when these conditions are met, we have not included these derivatives in our guarantee disclosures.

 

At August 31, 2007 and November 30, 2006, the maximum payout value of derivative contracts deemed to meet the FIN 45 definition of a guarantee was approximately $768 billion and $535 billion, respectively. For purposes of determining maximum payout, notional values are used; however, we believe the fair value of these contracts is a more relevant measure of these obligations because we believe the notional amounts greatly overstate our expected payout. At August 31, 2007 and November 30, 2006, the fair value of such derivative contracts approximated $11.1 billion and $9.3 billion, respectively. In addition, all amounts included above are before consideration of hedging transactions. We substantially mitigate our risk on these contracts through hedges, using other derivative contracts and/or cash instruments. We manage risk associated with derivative guarantees consistent with our global risk management policies.

 

Municipal-securities-related commitments. At August 31, 2007 and November 30, 2006, we had municipal-securities-related commitments of approximately $7.3 billion and $1.6 billion, respectively, which are principally comprised of liquidity commitments related to trust certificates backed by investment grade municipal securities. We believe our liquidity commitments to these trusts involve a low level of risk because our obligations are supported by investment grade securities and generally cease if the underlying assets are downgraded below investment grade or upon an issuer’s default. In certain instances, we also provide credit default protection to investors, which approximated $423 million and $48 million at August 31, 2007 and November 30, 2006, respectively.

 

Other commitments with VIEs. We make certain liquidity commitments and guarantees to VIEs. We provided liquidity commitments of approximately $1.8 billion and $1.0 billion at August 31, 2007 and November 30, 2006, respectively, which represented our maximum exposure to loss, to commercial paper conduits in support of certain

 

- 29 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

clients’ secured financing transactions. However, we believe our actual risk to be limited because these liquidity commitments are supported by over-collateralization with investment grade collateral.

 

In addition, we provide limited downside protection guarantees to investors in certain VIEs by guaranteeing return of their initial principal investment. Our maximum exposure to loss under such commitments was approximately $5.8 billion and $3.9 billion at August 31, 2007 and November 30, 2006, respectively. We believe our actual risk to be limited because our obligations are collateralized by the VIEs’ assets and contain significant constraints under which downside protection will be available (e.g., the VIE is required to liquidate assets in the event certain loss levels are triggered).

 

At August 31, 2007, Holdings is also committed to provide $668 million of back-up liquidity to a VIE, which exists to provide funding for our contingent acquisition commitments, if necessary. Holdings’ commitment to provide financing is contingent upon the VIE being unable to remarket certain secured liquidity notes upon their maturity. Such financing from Holdings to the VIE is due, generally, one year after a failed remarketing event, if any.

 

Standby letters of credit. At August 31, 2007 and November 30, 2006, respectively, we had commitments under letters of credit issued by banks to counterparties for $1.8 billion and $2.4 billion. We are contingently liable for these letters of credit which are primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges.

 

Private equity and other principal investments.  At August 31, 2007 and November 30, 2006, we had private equity and other principal investment commitments of approximately $5.0 billion and $1.1 billion, respectively, comprising commitments to Lehman private equity partnerships and other principal investment opportunities that we intend to distribute and syndicate, in part, to investing clients.

 

Other. In the normal course of business, we provide guarantees to securities clearinghouses and exchanges. These guarantees generally are required under the standard membership agreements, such that members are required to guarantee the performance of other members. To mitigate these performance risks, the exchanges and clearinghouses often require members to post collateral.

 

In connection with certain asset sales and securitization transactions, we often make customary representations and warranties about the assets. Violations of these representations and warranties, such as early payment defaults by borrowers, may require us to repurchase loans previously sold, or indemnify the purchaser against any losses. To mitigate these risks, to the extent the assets being securitized may have been originated by third parties, we generally obtain equivalent representations and warranties from these third parties when we acquire the assets. We have established reserves which we believe to be adequate in connection with such representations and warranties.

 

In the normal course of business, we are exposed to credit and market risk as a result of executing, financing and settling various client security and commodity transactions. These risks arise from the potential that clients or counterparties may fail to satisfy their obligations and the collateral obtained is insufficient. In such instances, we may be required to purchase or sell financial instruments at unfavorable market prices. We seek to control these risks by obtaining margin balances and other collateral in accordance with regulatory and internal guidelines.

 

Certain of our subsidiaries, as general partners, are contingently liable for the obligations of certain public and private limited partnerships. In our opinion, contingent liabilities, if any, for the obligations of such partnerships will not, in the aggregate, have a material adverse effect on our Consolidated Statement of Financial Condition or Consolidated Statement of Income.

 

In connection with certain acquisitions and strategic investments, we agreed to pay additional consideration contingent on the acquired entity meeting or exceeding specified income, revenue or other performance thresholds. These payments will be recorded as amounts become determinable. Had the determination dates been August 31, 2007 and November, 30, 2006, our estimated obligations related to these contingent consideration arrangements would have been $524 million and $224 million, respectively.

 

Income Taxes

 

We are continuously under audit examination by the Internal Revenue Service (the “IRS”) and other tax authorities in jurisdictions in which we conduct significant business activities, such as the United Kingdom, Japan and various U.S. states and localities. We regularly assess the likelihood of additional tax assessments in each of these tax jurisdictions and the related impact on our Consolidated Financial Statements. We have established tax reserves,

 

- 30 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

which we believe to be adequate, in relation to the potential for additional tax assessments. Once established, tax reserves are adjusted only when additional information is obtained or an event occurs requiring a change to such tax reserves.

 

During 2006, the IRS completed its 1997 through 2000 federal income tax examination, which resulted in unresolved issues asserted by the IRS that challenge certain of our tax positions (the “proposed adjustments”). We believe our positions comply with the applicable tax law and intend to vigorously dispute the proposed adjustments through judicial procedures, as appropriate. We believe that we have adequate tax reserves in relation to these unresolved issues. However, it is possible that amounts greater than our reserves could be incurred, which we estimate would not exceed $100 million.

 

Litigation

 

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. We provide for potential losses that may arise out of legal and regulatory proceedings to the extent such losses are probable and can be estimated. 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, 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 excess of established reserves 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 income for such period.

 

- 31 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 9 Earnings per Common Share and Stockholders’ Equity

 

Earnings per common share were calculated as follows:

 

Earnings per Common Share

 

 

 

Three Months

 

Nine Months

 

 

 

Ended August 31,

 

Ended August 31,

 

In millions, except per share data

 

2007

 

2006

 

2007

 

2006

 

Numerator:

 

 

 

 

 

 

 

 

 

Income before cumulative effect of accounting change

 

$

887

 

$

916

 

$

3,306

 

$

2,956

 

Cumulative effect of accounting change

 

 

 

 

47

 

Preferred stock dividends

 

(17

)

(17

)

(51

)

(49

)

Numerator for basic earnings per share—net income applicable to common stock

 

$

870

 

$

899

 

$

3,255

 

$

2,954

 

Denominator:

 

 

 

 

 

 

 

 

 

Denominator for basic earnings per share—weighted-average common shares

 

540.4

 

540.9

 

539.9

 

544.2

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Employee stock options

 

22.7

 

27.7

 

24.9

 

29.4

 

Restricted stock units

 

2.7

 

4.7

 

5.0

 

6.6

 

Dilutive potential common shares

 

25.4

 

32.4

 

29.9

 

36.0

 

Denominator for diluted earnings per share—weighted-average common and dilutive potential common shares (1)

 

565.8

 

573.3

 

569.8

 

580.2

 

Earnings per Basic Share

 

 

 

 

 

 

 

 

 

Before cumulative effect of accounting change

 

$

1.61

 

$

1.66

 

$

6.03

 

$

5.34

 

Cumulative effect of accounting change

 

 

 

 

0.09

 

Earnings per basic share

 

$

1.61

 

$

1.66

 

$

6.03

 

$

5.43

 

Earnings per Common Diluted Share

 

 

 

 

 

 

 

 

 

Before cumulative effect of accounting change

 

$

1.54

 

$

1.57

 

$

5.71

 

$

5.01

 

Cumulative effect of accounting change

 

 

 

 

0.08

 

Earnings per common diluted share

 

$

1.54

 

$

1.57

 

$

5.71

 

$

5.09

 

(1)       Anti-dilutive options and restricted stock units excluded from the calculations of diluted earnings per share

 

15.9

 

7.9

 

6.9

 

5.6

 

 

On April 5, 2006, our Board of Directors approved a 2-for-1 common stock split, in the form of a stock dividend that was effected on April 28, 2006. The par value of the common stock remained at $0.10 per share. Accordingly, an adjustment from Additional paid-in capital to Common stock was required to preserve the par value of the post-split shares.

 

Note 10 Share-Based Employee Incentive Plans

 

We sponsor several share-based employee incentive plans. Amortization of compensation costs for grants awarded under these plans was approximately $315 million and $247 million for the three months ended August 31, 2007 and 2006, respectively, and approximately $948 million and $747 million for the nine months ended August 31, 2007 and 2006, respectively. The total income tax benefit recognized in the Consolidated Statement of Income for these plans was $126 million and $102 million for the three months ended August 31, 2007 and 2006, respectively, and $385 million and $309 million for the nine months ended August 31, 2007 and 2006, respectively.

 

At August 31, 2007, unrecognized compensation cost related to nonvested stock option and restricted stock unit (“RSU”) awards totaled $2.2 billion. The cost of these non-vested awards is expected to be recognized over the next 9.3 years over a weighted average period of 3.8 years.

 

- 32 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Below is a description of our share-based employee incentive plans.

 

Share-Based Employee Incentive Plans

 

We sponsor several share-based employee incentive plans. The total number of shares of common stock remaining available for future awards under these plans at August 31, 2007, was 83.2 million (not including shares that may be returned to the Stock Incentive Plan (the “SIP”) as described below, but including an additional 0.4 million shares authorized for issuance under the Lehman Brothers Holdings Inc. 1994 Management Ownership Plan (the “1994 Plan”) that have been reserved solely for issuance in respect of dividends on outstanding awards under this plan). In connection with awards made under our share-based employee incentive plans, we are authorized to issue shares of common stock held in treasury or newly-issued shares.

 

1994 and 1996 Management Ownership Plans and Employee Incentive Plan. The 1994 Plan, the Lehman Brothers Holdings Inc. 1996 Management Ownership Plan (the “1996 Plan”), and the Lehman Brothers Holdings Inc. Employee Incentive Plan (the “EIP”) all expired following the completion of their various terms. These plans provided for the issuance of RSUs, performance stock units, stock options and other share-based awards to eligible employees. At August 31, 2007, awards with respect to 605.7 million shares of common stock have been made under these plans, of which 145.7 million are outstanding and 460.0 million have been converted to freely transferable common stock.

 

Stock Incentive Plan. The SIP has a 10-year term ending in May 2015, with provisions similar to the previous plans. The SIP authorized the issuance of up to the total of (i) 95.0 million shares (20.0 million as originally authorized, plus an additional 75.0 million authorized by the stockholders of Holdings at its 2007 Annual Meeting), plus (ii) the 33.5 million shares authorized for issuance under the 1996 Plan and the EIP that remained unawarded upon their expiration, plus (iii) any shares subject to repurchase or forfeiture rights under the 1996 Plan, the EIP or the SIP that are reacquired by the Company, or the award of which is canceled, terminates, expires or for any other reason is not payable, plus (iv) any shares withheld or delivered pursuant to the terms of the SIP in payment of any applicable exercise price or tax withholding obligation. Awards with respect to 50.1 million shares of common stock have been made under the SIP as of August 31, 2007, 49.4 million of which are outstanding.

 

1999 Long-Term Incentive Plan. The 1999 Neuberger Berman Inc. Long-Term Incentive Plan (the “LTIP”) provides for the grant of restricted stock, restricted units, incentive stock, incentive units, deferred shares, supplemental units and stock options. The total number of shares of common stock that may be issued under the LTIP is 15.4 million. At August 31, 2007, awards with respect to approximately 14.0 million shares of common stock had been made under the LTIP, of which 4.2 million were outstanding.

 

- 33 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Restricted Stock Units

 

Eligible employees receive RSUs, in lieu of cash, as a portion of their total compensation. There is no further cost to employees associated with RSU awards. RSU awards generally vest over two to five years and convert to unrestricted freely transferable common stock five years from the grant date. All or a portion of an award may be canceled if employment is terminated before the end of the relevant vesting period. We accrue dividend equivalents on outstanding RSUs (in the form of additional RSUs), based on dividends declared on our common stock.

 

For RSUs granted prior to 2004, we measured compensation cost based on the market value of our common stock at the grant date in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, a discount from the market price of an unrestricted share of common stock on the RSU grant date was not recognized for selling restrictions subsequent to the vesting date. For awards granted beginning in 2004, we measure compensation cost based on the market price of our common stock at the grant date less a discount for sale restrictions subsequent to the vesting date in accordance with SFAS No. 123 Share-Based Payment (“SFAS 123”) and SFAS No.123 (revised) Share-Based Payment (“SFAS 123(R)”). The fair value of RSUs subject to post-vesting date sale restrictions are generally discounted by three to eight percent for each year based upon the duration of the post-vesting restriction. These discounts are based on market-based studies and academic research on securities with restrictive features. RSUs granted in each of the periods presented contain selling restrictions subsequent to the vesting date.

 

The fair value of RSUs converted to common stock without restrictions for the nine months ended August 31, 2007 was $346 million. Compensation costs previously recognized and tax benefits recognized in equity upon issuance of these awards were approximately $265 million.

 

The following table summarizes RSU activity for the nine months ended August 31, 2007:

 

Restricted Stock Units

 

 

 

 

 

 

 

 

 

Weighted
Average

 

 

 

 

 

 

 

Total Number

 

Grant Date

 

 

 

Unamortized

 

Amortized

 

of RSUs

 

Fair Value

 

Balance, November 30, 2006

 

34,904,500

 

65,543,498

 

100,447,998

 

$43.37

 

Granted

 

37,412,442

 

 

37,412,442

 

69.25

 

Canceled

 

(3,694,024

)

570,191

 

(3,123,833

)

52.46

 

Exchanged for stock without restrictions

 

 

(4,789,069

)

(4,789,069

)

43.06

 

Amortization

 

(28,749,652

)

28,749,652

 

 

 

Outstanding August 31, 2007

 

39,873,266

 

90,074,272

 

129,947,538

 

$50.63

 

 

Of the RSUs outstanding at August 31, 2007, approximately 90.1 million were amortized and included in basic earnings per share. Approximately 5.3 million will be amortized during the remainder of fiscal 2007 and the remainder will be amortized subsequent to November 30, 2007. At August 31, 2007 and November 30, 2006, RSUs outstanding, net of 80.8 million and 64.7 million shares, respectively, held in an irrevocable grantor trust (the “RSU Trust”), were 49.1 million and 35.7 million, respectively. The RSU Trust provides common stock voting rights to employees who hold outstanding RSUs. During fiscal 2007, 20.5 million shares have been issued out of treasury stock into the RSU Trust.

 

Stock Options

 

Employees and Directors may receive stock options, in lieu of cash, as a portion of their total compensation. Such options generally become exercisable over a one- to five-year period and generally expire 5 to 10 years from the date of grant, subject to accelerated expiration upon termination of employment.

 

During the nine months ended August 31, 2007, 10,200 stock options were granted. We use the Black-Scholes option-pricing model to measure the grant date fair value of stock options granted to employees. Stock options granted have exercise prices equal to the market price of our common stock on the grant date. The principal assumptions utilized in valuing options and our methodology for estimating such model inputs include: (i) risk-free interest rate - estimate is based on the yield of U.S. zero coupon securities with a maturity equal to the expected life

 

- 34 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

of the option; (ii) expected volatility - estimate is based on the historical volatility of our common stock for the three years preceding the award date, the implied volatility of market-traded options on our common stock on the grant date and other factors; and (iii) expected option life - estimate is based on internal studies of historical and projected exercise behavior based on different employee groups and specific option characteristics, including the effect of employee terminations.

 

Based on the results of the model, the weighted-average fair value of stock options granted during the nine months ended August 31, 2007 was $24.94. The weighted-average assumptions used during the nine months ended August 31, 2007 were as follows:

 

Weighted-Average Black-Scholes Assumptions

 

 

 

Risk-free interest rate

 

4.72

%

 

Expected volatility

 

25.12

%

 

Dividends per share

 

$0.15

 

 

Expected life

 

7.0 years

 

 

 

The valuation technique takes into account the specific terms and conditions of the stock options granted including vesting period, termination provisions, intrinsic value and time dependent exercise behavior.

 

The following table summarizes stock option activity for the nine months ended August 31, 2007:

 

Stock Option Activity

 

 

 

 

 

Weighted-Average

 

Expiration

 

 

 

Options

 

Exercise Price

 

Dates

 

Balance, November 30, 2006

 

81,396,371

 

$33.32

 

12/06—5/16

 

Granted

 

10,200

 

72.07

 

 

 

Exercised

 

(12,061,504

)

29.35

 

 

 

Canceled

 

(333,368

)

31.19

 

 

 

Balance, August 31, 2007

 

69,011,699

 

$34.03

 

10/07—4/17

 

 

The total intrinsic value of stock options exercised for the nine months ended August 31, 2007 was $593 million for which compensation costs previously recognized and tax benefits recognized in equity upon issuance totaled approximately $231 million. Cash received from the exercise of stock options for the nine months ended August 31, 2007 totaled $352 million.

 

The table below provides additional information related to stock options outstanding at August 31, 2007:

 

Dollars in millions, except per share data

 

Outstanding

 

Options Exercisable

 

Number of options

 

69,011,699

 

47,100,743

 

Weighted-average exercise price

 

$34.03

 

$30.14

 

Aggregate intrinsic value

 

$1,504

 

$1,164

 

Weighted-average remaining contractual terms in years

 

4.20

 

3.70

 

 

At August 31, 2007, the number of options outstanding, net of projected forfeitures, was approximately 68.1 million shares, with a weighted-average exercise price of $32.27, aggregate intrinsic value of $1.5 billion, and weighted-average remaining contractual terms of 4.2 years.

 

Restricted Stock

 

At August 31, 2007, there were approximately 382,404 shares of restricted stock outstanding. The fair value of the 285,442 shares of restricted stock that became freely tradable during the nine months ended August 31, 2007 was approximately $21 million.

 

Stock Repurchase Program

 

We maintain a common stock repurchase program to manage our equity capital. Our stock repurchase program is effected through regular open-market purchases, as well as through employee transactions where employees tender

 

- 35 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

shares of common stock to pay for the exercise price of stock options and the required tax withholding obligations upon option exercises and conversion of restricted stock units to freely-tradable common stock. For 2007, our Board of Directors has authorized the repurchase, subject to market conditions, of up to 100 million shares of Holdings’ common stock for the management of our equity capital, including offsetting dilution due to employee stock awards. During the three and nine months ended August 31, 2007, we repurchased approximately 8.5 million and 34.5 million shares, respectively, of our common stock through open-market purchases at an aggregate cost of $561 million and $2.6 billion, respectively, or $66.06 per share and $75.46 per share, respectively. In addition, and for the three and nine months ended August 31, 2007, we withheld approximately 1.1 million and 3.3 million shares, respectively, of common stock from employees at an equivalent cost of $76 million and $248 million, respectively. As of August 31, 2007, approximately 62.2 million shares remained available for repurchase under this authorization. See Part II, Item 2, “Unregistered Sales of Equity Securities and Use of Proceeds,” for more information.

 

Note 11 Employee Benefit Plans

 

We provide both funded and unfunded noncontributory defined benefit pension plans for the majority of our employees worldwide. In addition, we provide certain other postretirement benefits, primarily health care and life insurance, to eligible employees. The following table presents the components of net periodic cost related to these plans for the three and nine months ended August 31, 2007 and 2006:

 

Components of Net Periodic Cost

 

In millions

 

Pension Benefits

 

Other Postretirement

 

Three Months Ended

 

U.S.

 

Non–U.S.

 

Benefits

 

August 31,

 

2007

 

2006

 

2007

 

2006

 

2007

 

2006

 

Service cost

 

$

18

 

$

11

 

$

2

 

$

2

 

$

 

$

1

 

Interest cost

 

16

 

15

 

6

 

5

 

1

 

1

 

Expected return on plan assets

 

(21

)

(19

)

(10

)

(7

)

 

 

Amortization of net actuarial loss

 

8

 

7

 

3

 

3

 

 

 

Amortization of prior service cost

 

1

 

1

 

 

 

 

 

Net periodic cost

 

$

22

 

$

15

 

$

1

 

$

3

 

$

1

 

$

2

 

Nine Months Ended

 

 

 

 

 

 

 

 

 

 

 

 

 

August 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

Service cost

 

$

46

 

$

32

 

$

5

 

$

6

 

$

1

 

$

1

 

Interest cost

 

49

 

45

 

19

 

15

 

3

 

3

 

Expected return on plan assets

 

(64

)

(57

)

(29

)

(20

)

 

 

Amortization of net actuarial loss

 

22

 

21

 

9

 

8

 

 

 

Amortization of prior service cost

 

3

 

3

 

 

 

(1

)

 

Net periodic cost

 

$

56

 

$

44

 

$

4

 

$

9

 

$

3

 

$

4

 

 

Expected Contributions for the Fiscal Year Ending November 30, 2007

 

We do not expect it to be necessary to contribute to our U.S. pension plans in the fiscal year ending November 30, 2007. We expect to contribute approximately $24 million to our non-U.S. pension plans in the fiscal year ending November 30, 2007.

 

- 36 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 12 Regulatory Requirements

 

For regulatory purposes, Holdings and its subsidiaries are referred to collectively as a consolidated supervised entity (“CSE”). CSEs are supervised and examined by the SEC, which requires minimum capital standards on a consolidated basis. At August 31, 2007, Holdings was in compliance with the CSE capital requirements and held allowable capital in excess of the minimum capital requirements on a consolidated basis.

 

In the United States, LBI and Neuberger Berman, LLC (“NBLLC”) are registered broker-dealers that are subject to SEC Rule 15c3-1 and Rule 1.17 of the Commodity Futures Trading Commission, which specify minimum net capital requirements for the registrants. LBI and NBLLC have consistently operated with net capital in excess of their respective regulatory capital requirements. LBI has elected to calculate its minimum net capital in accordance to Appendix E of the Net Capital Rule which establishes alternative net capital requirements for broker-dealers that are part of CSEs. In addition to meeting the alternative net capital requirements, LBI is required to maintain tentative net capital in excess of $1 billion and net capital in excess of $500 million. LBI is also required to notify the SEC in the event that its tentative net capital is less than $5 billion. As of August 31, 2007, LBI had tentative net capital in excess of $6.1 billion, and had net capital of $3.1 billion, which exceeded the minimum net capital requirement by $2.6 billion. As of August 31, 2007, NBLLC had net capital of $297 million, which exceeded the minimum net capital requirement by $292 million.

 

LBIE, a United Kingdom registered broker-dealer and subsidiary of Holdings, is subject to the capital requirements of the Financial Services Authority (“FSA”) in the United Kingdom. Financial resources, as defined, must exceed the total financial resources requirement of the FSA. At August 31, 2007, LBIE’s financial resources of approximately $14.5 billion exceeded the minimum requirement by approximately $3.3 billion. LBJ, a regulated broker-dealer, is subject to the capital requirements of the Financial Services Agency in Japan and the Bank of Japan. At August 31, 2007, LBJ had net capital of approximately $1.2 billion, which was approximately $569 million in excess of Financial Services Agency in Japan’s required level and approximately $300 million in excess of Bank of Japan’s required level.

 

Lehman Brothers Bank, FSB (“LBB”), our thrift subsidiary, is regulated by the Office of Thrift Supervision (“OTS”). Lehman Brothers Commercial Bank (“LBCB”), our Utah industrial bank subsidiary is regulated by the Utah Department of Financial Institutions and the Federal Deposit Insurance Corporation. LBB and LBCB exceed all regulatory capital requirements and are considered to be well capitalized as of August 31, 2007. Bankhaus is subject to the capital requirements of the Federal Financial Supervisory Authority of the German Federal Republic. At August 31, 2007, Bankhaus’ financial resources, as defined, exceed its minimum financial resources requirement.

 

Certain other subsidiaries are subject to various securities, commodities and banking regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. At August 31, 2007, these other subsidiaries were in compliance with their applicable local capital adequacy requirements.

 

In addition, our “AAA” rated derivatives subsidiaries, Lehman Brothers Financial Products Inc. (“LBFP”) and Lehman Brothers Derivative Products Inc. (“LBDP”), have established certain capital and operating restrictions that are reviewed by various rating agencies. At August 31, 2007, LBFP and LBDP each had capital that exceeded the requirements of the rating agencies.

 

The regulatory rules referred to above, and certain covenants contained in various debt agreements, may restrict Holdings’ ability to withdraw capital from its regulated subsidiaries, which in turn could limit its ability to pay dividends to shareholders. Holdings provides guarantees of certain activities of its subsidiaries, including our fixed income derivative business conducted through Lehman Brothers Special Financing, Inc.

 

- 37 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 13 Condensed Consolidating Financial Statements

 

LBI, a wholly-owned subsidiary of Holdings, had approximately $0.8 billion of debt securities outstanding at August 31, 2007 that were issued in registered public offerings and were therefore subject to the reporting requirements of Sections 13(a) and 15(d) of the Securities Exchange Act of 1934. Holdings has fully and unconditionally guaranteed these outstanding debt securities of LBI (and any debt securities of LBI that may be issued in the future under these registration statements), which, together with the information presented in this Note 13, “Condensed Consolidating Financial Statements,” allows LBI to avail itself of an exemption provided by SEC rules from the requirement to file separate LBI reports under the Exchange Act. For further discussion on the regulatory requirements of our subsidiaries, see Note 13, “Regulatory Requirements,” to the 2006 Consolidated Financial Statements included in the Form 10-K for a discussion of restrictions on the ability of Holdings to obtain funds from its subsidiaries by dividend or loan.

 

The following schedules set forth our condensed consolidating statements of income for the three and nine months ended August 31, 2007 and 2006, our condensed consolidating balance sheets at August 31, 2007 and November 30, 2006, and our condensed consolidating statements of cash flows for the nine months ended August 31, 2007 and 2006. In the following schedules, “Holdings” refers to the unconsolidated balances of Holdings, “LBI” refers to the unconsolidated balances of Lehman Brothers Inc. and “Other Subsidiaries refers to the combined balances of all other subsidiaries of Holdings. “Eliminations” represents the adjustments necessary to eliminate intercompany transactions and our investments in subsidiaries.

 

- 38 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Condensed Consolidating Statement of Income

 

 

 

 

 

 

 

Other

 

 

 

 

 

In millions

 

Holdings

 

LBI

 

Subsidiaries

 

Eliminations

 

Total

 

Three months ended August 31, 2007

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

(420

)

$

15

 

$

4,713

 

$

 

$

4,308

 

Equity in net income of subsidiaries

 

1,258

 

406

 

 

(1,664

)

 

Total non-interest expenses

 

120

 

288

 

2,695

 

 

3,103

 

Income (loss) before taxes

 

718

 

133

 

2,018

 

(1,664

)

1,205

 

Provision (benefit) for income taxes

 

(169

)

(79

)

566

 

 

318

 

Net income (loss)

 

$

887

 

$

212

 

$

1,452

 

$

(1,664

)

$

887

 

Three months ended August 31, 2006

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

153

 

$

1,376

 

$

2,649

 

$

 

$

4,178

 

Equity in net income of subsidiaries

 

1,002

 

50

 

 

(1,052

)

 

Total non-interest expenses

 

230

 

942

 

1,639

 

 

2,811

 

Income (loss) before taxes

 

925

 

484

 

1,010

 

(1,052

)

1,367

 

Provision (benefit) for income taxes

 

9

 

169

 

273

 

 

451

 

Net income (loss)

 

$

916

 

$