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

 2/13/07  Lehman Brothers Holdings Inc … Tr 10-K       11/30/06   10:5.1M                                   Merrill Corp-MD/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report                                       HTML   2.91M 
 2: EX-10.31    Material Contract                                   HTML     16K 
 3: EX-12.01    Statement re: Computation of Ratios                 HTML     45K 
 4: EX-21.01    Subsidiaries of the Registrant                      HTML     90K 
 5: EX-23.01    Consent of Experts or Counsel                       HTML     28K 
 6: EX-24.01    Power of Attorney                                   HTML     28K 
 7: EX-31.01    Certification per Sarbanes-Oxley Act (Section 302)  HTML     14K 
 8: EX-31.02    Certification per Sarbanes-Oxley Act (Section 302)  HTML     14K 
 9: EX-32.01    Certification per Sarbanes-Oxley Act (Section 906)  HTML     10K 
10: EX-32.02    Certification per Sarbanes-Oxley Act (Section 906)  HTML     10K 

LEHMAN BROTHERS HOLDINGS INC.

TABLE OF CONTENTS

Available Information		2
Part I
Item 1.	Business	3
Item 1A.	Risk Factors	14
Item 1B.	Unresolved Staff Comments	20
Item 2.	Properties	20
Item 3.	Legal Proceedings	20
Item 4.	Submission of Matters to a Vote of Security Holders	25
Part II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters
	and Issuer Purchases of Equity Securities	26
Item 6.	Selected Financial Data	28
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	70
Item 8.	Financial Statements and Supplementary Data	71
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	121
Item 9A.	Controls and Procedures	121
Item 9B.	Other Information	121
Part III
Item 10.	Directors and Executive Officers of the Registrant	121
Item 11.	Executive Compensation	122
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	122
Item 13.	Certain Relationships and Related Transactions	122
Item 14.	Principal Accountant Fees and Services	122
Part IV
Item 15.	Exhibits and Financial Statement Schedules	123
Signatures		127
Index to Consolidated Financial Statements and Schedule		F-1
Schedule I—Condensed Financial Information of Registrant		F-2
Exhibit Index
Exhibits

 

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

“ECAPS”, “LehmanLive”, “Risk AdjustiNG Equity Range Securities” and “Stock Upside Note Securities” are registered trademarks, trademarks or service marks of Lehman Brothers Holdings Inc. in the United States and/or other countries.

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LEHMAN BROTHERS HOLDINGS INC.

PART I

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

FORWARD-LOOKING STATEMENTS

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

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

LEHMAN BROTHERS

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

Through our subsidiaries, we are a global market-maker in all major equity and fixed income products. To facilitate our market-making activities, we are a member of all principal securities and commodities exchanges in the United States, as well as NASD, Inc., and we hold memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Australian stock exchanges.

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

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See Part I, Item 1A, “Risk Factors,” in this Report for a discussion of certain material risks to our business, financial condition and results of operations.

We operate in three business segments (each of which is described below): Capital Markets, Investment Banking and Investment Management. Financial information concerning the Company for the fiscal years ended November 30, 2006, 2005 and 2004, including the amount of net revenues contributed by each segment in such periods, is set forth in the Consolidated Financial Statements and Notes thereto in Part II, Item 8, of this Report. Information with respect to our operations by business segment and net revenues by geographic area is set forth under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Segments” and “—Geographic Revenues” in Part II, Item 7, of this Report, and in Note 19 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

Capital Markets

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

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

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

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

Equities Capital Markets

The Equities Capital Markets business is responsible for our equities and equity-related operations and products worldwide. These products include listed and over-the-counter securities, American Depositary Receipts, convertibles, options, futures, warrants and derivatives.  We make markets in equity and equity-related securities as well as take positions for our own account. We participate in global equity markets through our worldwide presence and membership in major stock and option exchanges. Equities Capital Markets is composed of Liquid Markets, Leveraged Businesses and Private Equity.

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

Leveraged Businesses. Leveraged Businesses include Structured Derivatives and Convertibles. Our Structured Derivatives business offers customized equity derivative products across a wide spectrum of equity-related assets globally. We are a leading participant in the development and trading of equity derivative instruments. Our product development capabilities enable investors to take risk positions tailored to their specific needs or undertake sophisticated

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hedging and monetization strategies. The Convertibles business trades and makes markets in conventional and structured convertible securities.

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

Fixed Income Capital Markets

Lehman Brothers actively participates in key fixed income markets worldwide and maintains a 24-hour trading presence in global fixed income securities. We are a market-maker and participant in the new issue and secondary markets for a broad variety of fixed income securities.  Fixed Income businesses include the following:

Government and Agency Obligations. Lehman Brothers is one of the leading primary dealers in U.S. government securities, participating in the underwriting of and market-making in U.S. Treasury bills, notes and bonds, and securities of federal agencies. We are also a market-maker in the government securities of all G7 countries, and participate in other major European and Asian government bond markets.

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

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

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

Mortgage and Loan Origination and Mortgage- and Asset-Backed Securities. Lehman Brothers Bank, FSB (“LBB”), offers traditional and online mortgage banking services to individuals as well as institutions and their customers.  Lehman Brothers Bankhaus AG (“Bankhaus”), a German bank, offers lending and real estate financing to corporate and institutional borrowers worldwide. We originate commercial and residential mortgage loans through LBB, Bankhaus and other subsidiaries in the U.S., Europe and Asia. We are a leading underwriter of and market-maker in residential and commercial mortgage- and asset-backed securities and are active in all areas of secured lending, structured finance and securitized products. We underwrite and make markets in the full range of U.S. agency-backed mortgage products, mortgage-backed securities, asset-backed securities and whole loan products. We are also a leader in the global market for residential and commercial mortgages (including multi-family financing) and leases.

In 2005, we established Lehman Brothers Commercial Bank (“LBCB”), a Utah-chartered industrial loan company, in order to issue certificates of deposit to institutions and conduct certain lending activities. During 2006, we acquired an established private student loan origination platform and a European mortgage originator, allowing us to enter into new markets and expand the breadth of services we offer as well as provide additional loan product for our securitization pipeline.

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

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

Fixed Income Derivatives. We offer a broad range of interest rate- and credit-based derivative products and related services. Derivatives professionals are integrated into all of our Fixed Income areas in response to the worldwide convergence of the cash and derivative markets.  In 2005, Lehman Brothers established an energy trading business with global capability in power, natural gas and oil. The business includes futures, swaps, options and other structured products, as well as physical trading.

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

Global Principal Strategies and Global Trading Strategies

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

Capital Markets Prime Services

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

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

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

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

Capital Markets Global Distribution

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

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

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

Research

Research at Lehman Brothers encompasses the full range of research disciplines, including fundamental, quantitative, economic, strategic, credit, relative value and market-specific analysis. To ensure in-depth expertise within various

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markets, Equity Research has established regional teams on a worldwide basis that are staffed with industry and strategy specialists. Fixed Income Research provides expertise in U.S., European and Asian government and agency securities, derivatives, sovereign issues, corporate securities, high yield, asset- and mortgage-backed securities, indices, emerging market debt and municipal securities.

Investment Banking

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

Investment Banking is made up of Advisory Services and Global Finance activities that serve our corporate, institutional and government clients. The segment is organized into global industry groups—Communications, Consumer/Retailing, Financial Institutions, Financial Sponsors, Healthcare, Hedge Funds, Industrial, Insurance Solutions, Media, Natural Resources, Pension Solutions, Power, Real Estate and Technology—that include bankers who deliver industry knowledge and expertise to meet clients’ objectives. Specialized product groups within Advisory Services include mergers and acquisitions (“M&A”) and restructuring. Global Finance serves our clients’ capital-raising needs through specialized product groups in underwriting, private placements, leveraged finance and other activities associated with debt and equity products. Product groups are partnered with relationship managers in the global industry groups to provide comprehensive financial solutions for clients.

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

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

Mergers & Acquisitions. Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, spin-offs, targeted stock transactions, share repurchase strategies, government privatization programs, takeover defenses and other strategic advice.

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

Underwriting. We are a leading underwriter of initial and other public offerings of equity and fixed income securities (both listed and over-the-counter), including common, preferred, convertible and hybrid capital, high grade and high yield debt, government and agency securities, mortgage- and asset-backed securities and collateralized debt obligations.

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

Private Placements. We have a dedicated Private Placement group focused on capital raising in the private equity and debt markets. Clients range from pre-initial public offering (“IPO”) companies to well-established corporations that span many industries. The Private Placement group has experience in identifying sources, establishing structures and placing common stock, convertible preferred stock, subordinated debt and senior debt, as well as utilizing a variety of financing techniques, including mezzanine debt, securitizations, project financings and sale-leasebacks.

Investment Management

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

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

Asset Management

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

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

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

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

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

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

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

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

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Private Investment Management

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

High Net Worth Clients. For individuals needing such services, our investment professionals and strategists work together to provide asset allocation, portfolio strategy and manager selection, and integrate that advice with tax, trust and estate planning.

Driven by our clients’ goals for preserving and enhancing wealth across generations, we offer a wide range of investment opportunities including traditional and alternative investments. We are selective in creating our investment platform and look beyond proprietary products for opportunities.

As needed, our tax and estate strategists integrate our clients’ investment strategies with their overall tax and estate picture, recommending vehicles to minimize taxes and provide for future generations. Additionally, the Lehman Brothers Trust Company provides private clients with comprehensive trustee and executor services.

We address the specific needs of corporate executives and business owners through diversification and liquidity strategies. Additionally, where appropriate we partner with professionals across the Firm to deliver corporate finance and real estate solutions to our clients.

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

Technology

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

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

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

Corporate

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

Risk Management

A description of our Risk Management infrastructure and procedures is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management” in Part II, Item 7, of this Report. Information regarding our use of derivative financial instruments to hedge interest rate, currency, security and commodity price and other market risks is contained in Notes 1, 2, 3, 7, 9, 10 and 11 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

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Competition

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

Regulation

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

U.S. Regulation

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

Lehman Brothers Inc. (“LBI”), Neuberger Berman, LLC (“NB LLC”) and Neuberger Berman Management Inc. (“NBMI”) are registered with the SEC as broker-dealers; Lehman Brothers OTC Derivatives Inc. (“LOTC”) is registered with the SEC as an OTC derivatives dealer; and LBI, NB LLC, NBMI, Lehman Brothers Asset Management LLC (“LBAM”) and certain other of our subsidiaries are registered with the SEC as investment advisers. As such, these entities are subject to regulation by the SEC and by self-regulatory organizations, principally the NASD (which has been designated by the SEC as NBMI’s primary regulator), national securities exchanges such as the New York Stock Exchange, Inc. (“NYSE”) (which has been designated by the SEC as LBI’s and NB LLC’s primary regulator) and the Municipal Securities Rulemaking Board, among others.  Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. Various subsidiaries are registered as broker-dealers in all 50 states, the District of Columbia and the Commonwealth of Puerto Rico.

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

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

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

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

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

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

The SEC’s Regulation NMS, adopted in 2005, will be implemented in stages throughout 2007. It introduces significant changes to the regulation of trading equities on securities exchanges and marketplaces. Among other things, it requires “trading centers” (exchanges, alternative trading systems, exchange and OTC market makers and broker-dealers that execute orders internally by trading as principal or crossing orders as agent) to have policies designed to prevent the execution of trades at prices inferior to “protected quotations” (automated “best bid and offer” quotations that are immediately accessible) displayed by other trading centers. While it is too early to predict the impact that Regulation NMS will have, our equities trading businesses have incurred and will continue to incur technology and compliance costs associated with the regulation, and it will alter the competitive environment in which these businesses function.

Non-U.S. Regulation

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

The European Union (“E.U.”) Market Abuse Directive establishes a common regulatory framework for policing market manipulation and insider dealing in Europe, creating offenses of dealing on the basis of inside information and manipulating the market, and imposing obligations on issuers to disclose inside information to the market and to maintain lists of all those with access to inside information and obligations on investment firms to report suspicious transactions and disclose information about research sources and methods and conflicts of interest. U.K. regulations implementing the Directive came into effect on July 1, 2005. Other member states in which we do business have largely completed implementation of the Directive as well.

The E.U. Prospectus Directive, which regulates the drafting and publication of prospectuses when securities are offered to the public and/or admitted to trading on a regulated market in the E.U., has now been implemented in almost all member states including the U.K. The Directive allows issuers to raise capital in any E.U. member state using a prospectus drawn up and approved in a single member state.  It also enables a single competent authority to review and approve prospectuses. Companion legislation, the Transparency Directive, sets standards for periodic financial reporting for issuers whose securities are admitted to trading on a regulated market in the E.U., as well as for disclosure of major shareholdings; it is scheduled to be implemented in 2007.

We also expect in 2007 the implementation of the E.U. Markets in Financial Instruments Directive or “MiFID,” a major piece of legislation that updates and expands the current framework for regulating exchanges, multilateral trading facilities and investment firms on a pan-European basis.  MiFID will facilitate cross-border business among investment firms by generally establishing the regulatory regime of the member state in which a firm is operating as controlling, and will impose a new set of organizational and conduct of business requirements on investment firms. In the U.K., regulated firms are bound by a number of other laws and regulations, namely the First and Second E.U. Money Laundering Directives, the Proceeds of Crime Act 2002, the Terrorism Act 2000 and the Money Laundering Regulations 2003.

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Collectively, these require firms to have policies and controls around the identification of clients, reporting suspicious activity, staff training and awareness, record keeping and making use of international findings.  We have established appropriate policies, procedures and internal controls that are designed to comply with these rules and regulations.

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

Lehman Brothers Asia Limited (“LBAL”) is a licensed entity in Hong Kong regulated by the Securities and Futures Commission for dealing in securities and futures, and advising on securities and corporate finance. LBAL is also approved to act as a sponsor for Hong Kong initial public offering transactions.

Bankhaus is regulated by the German Federal Supervisory Authority for the Financial Service Industry.

LBI, LBIE, LBJ and many of our other subsidiaries are also subject to regulation by securities, banking and finance regulatory authorities, securities exchanges and other self-regulatory organizations in numerous other countries in which they do business.

Research

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

Mortgage Lending

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

Protection of Client Information

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

Anti-Money Laundering

The USA PATRIOT Act of 2001 contains anti-money laundering and anti-terrorism laws that mandate the implementation of various regulations applicable to banks, broker-dealers, futures commission merchants and other financial services companies, including standards for verifying client identity at account opening, standards for conducting enhanced due diligence and obligations to monitor client transactions and report suspicious activities.  Through these and other provisions, the PATRIOT Act seeks to promote cooperation among financial institutions,

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regulators and law enforcement in identifying parties that may be involved in terrorism or money laundering.  Anti-money laundering laws outside of the U.S. contain similar provisions.  We have established policies, procedures and internal controls that are designed to comply with these rules and regulations.

Judicial, Regulatory and Arbitration Proceedings

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

Capital Requirements

LBI, LOTC, NB LLC, NBMI, LBIE, LBJ, LBB, LBCB, Bankhaus, Trust N.A., Delaware Trust, and other subsidiaries of Holdings are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate.  In addition, our “AAA” rated derivatives subsidiaries (Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc.) are subject to capital targets established by various ratings agencies. The regulatory rules referred to above, and certain covenants contained in various debt agreements, may restrict Holdings’ ability to withdraw capital from certain subsidiaries, which in turn could limit its ability to commit capital to other businesses, meet obligations or pay dividends to shareholders. Further information about these requirements and restrictions is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources” in Part II, Item 7, of this Report and in Note 13 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

In June 2004, the SEC approved a rule establishing a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies.  We applied for permission to operate under the rule and received approval effective December 1, 2005. The rule allows LBI to use an alternative method, based on internal models, to calculate net capital charges for market and derivative-related credit risk. Under this rule, Lehman Brothers is subject to group-wide supervision and examination by the SEC and is subject to minimum capital requirements on a consolidated basis generally consistent with the International Convergence of Capital Measurement and Capital Standards published by the Basel Committee on Banking Supervision. The CSE Rules are designed to minimize the duplicative regulatory requirements on U.S. securities firms resulting from the E.U. Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the E.U. Under this Directive, non-E.U. financial groups that conduct business through regulated financial entities in the E.U. must first demonstrate that they are subject to equivalent consolidated supervision at the ultimate holding company level. On November 30, 2005, the FSA determined that the SEC undertakes equivalent consolidated supervision for Lehman Brothers. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Accounting and Regulatory Developments—Consolidated Supervised Entity” in Part II, Item 7, of this Report for more information.

Client Protection

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

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

Insurance

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

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Employees

As of November 30, 2006, Lehman Brothers employed approximately 25,900 persons.We consider our relationship with our employees to be good.

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

Market Risk

As a global investment bank, risk is an inherent part of our business. Our businesses are materially affected by conditions in the financial markets and economic conditions generally around the world. A favorable business environment is characterized by many factors, including a stable geopolitical climate, transparent and liquid financial markets, low inflation, low unemployment, global economic growth and high business and investor confidence. Concerns about geopolitical developments, energy prices and natural disasters, among other things, can affect the global financial markets.  In addition, economic or political pressures in a country or region may cause local market disruptions and currency devaluations, which may also affect markets generally. In the event of changes in market conditions, such as interest or foreign exchange rates, stock, commodity or real estate valuations or volatility, our businesses could be adversely affected in many ways, including those described below. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Market Risk” for a further discussion of the market risks to which we are exposed.

Our Client-Flow Revenues May Decline in Adverse Market Conditions. We have been operating in a low interest rate market for the past several years, though over the past two years some central banks, and in particular the U.S. Federal Reserve, have raised short-term rates. Further increases in interest rates and long-term rates in particular, especially if such changes are rapid, may create a less favorable environment for certain of our businesses. Rising interest rates may cause a decline in our mortgage origination and securitization businesses in particular, as the volume of our origination and securitization activity may decline. Recently, the residential real estate market in the U.S. has experienced a downturn due to declining real estate values. Further declines in real estate values could further reduce our level of mortgage loan originations and could also reduce our level of securitizations.

Our Investment Banking revenues, in the form of financial advisory and debt and equity underwriting fees, are directly related to the number and size of the transactions in which we participate and would therefore be adversely affected by a sustained market downturn.

A market downturn would also likely lead to a decline in the volume of capital market transactions that we execute for our clients and, therefore, to a decline in the revenues we receive from commissions and spreads earned from the trades we execute for our clients. In addition, because the fees that we charge for managing our clients’ portfolios are in many cases based on the value of those portfolios, a market downturn that reduces the value of our clients’ portfolios would reduce the revenues we receive from our asset management business. Even in the absence of a market downturn, below-market investment performance by our fund and portfolio managers could reduce Investment Management revenues and assets under management.

We May Incur Losses Due to Fluctuations in Market Rates, Prices and Volatility. Market risk is inherent in our client-driven market-making transactions and proprietary trading and principal investment activities in equity and fixed income securities, commodities, currencies and derivatives and our mortgage and loan origination and syndication activities. Fluctuations in market rates, prices and volatility can adversely affect the market value of our long or short inventory and proprietary and principal positions and, to the extent that such positions are not adequately hedged, cause the Firm to incur losses. In our market-making transactions, we maintain substantial inventory positions from time to time, acting as a financial intermediary for our clients, and we hold inventory positions in the normal course of business to allow clients to rebalance their portfolios and diversify risks across market cycles. To the extent that we hold long inventory positions, a downturn in the market could result in losses from a decline in the value of those positions. On the other hand, to the extent that we have sold inventory short, an upturn in those markets could expose us to losses as we attempt to cover our short positions by acquiring assets in a rising market.

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

Market credit spreads are at historically tight levels, and a widening of credit spreads could negatively impact the value of our corporate debt and other inventory.

We also maintain long and short positions through our other proprietary trading activities and make principal investments (such as in real estate and private equity), both of which are also subject to market risks.  The value of these positions can be adversely affected by changes in market rates, prices and volatility.  These risks will increase to the extent that we increase our proprietary trading and principal investing activities.

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

Holding Large and Concentrated Positions May Expose Us to Losses. Concentration of risk may reduce revenues or result in losses in our market-making, block trading, underwriting, proprietary trading, principal investment and lending businesses in the event of unfavorable market movements even when economic and market conditions are generally favorable for others in the industry. We have committed substantial amounts of capital to these businesses, which often require us to take large positions in the securities of, or make large loans to, a particular issuer or issuers in a particular industry, country or region. Moreover, the trend in all major capital markets is towards larger and more frequent commitments of capital in many of these activities, and we expect this trend to continue. For example, large positions of securities are increasingly being sold in block trades rather than on a marketed basis, which could increase the risk that we may be unable to resell the securities at favorable prices. Concentration of risk will increase to the extent we expand our proprietary trading and principal investing activities or commit additional capital to facilitate client-driven business.

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

Credit Risk

We May Incur Losses Associated with Our Credit Exposures. Credit risk represents the possibility a counterparty or an issuer of securities or other financial instruments we hold or a borrower of funds from us will be unable to honor its contractual obligations to us. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Default risk may also arise from events or circumstances that are difficult to foresee or detect, such as fraud. Credit risk may arise, for example, from holding securities of third parties; entering into swap or other derivative contracts under which counterparties have obligations to make payments to us; executing securities, futures, currency or commodity trades that fail to settle at the required time due to non-delivery by the counterparty or systems failure by clearing agents, exchanges, clearing houses or other financial intermediaries; and extending credit to our clients through bridge or margin loans or other arrangements. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk” for a further discussion of the credit risks to which we are exposed. Our principal focus has been acting as an intermediary of credit. In recent years, we have expanded our activities associated with providing our clients access to credit and liquidity and have also expanded our swaps and derivatives businesses. As a result, our credit exposures have increased in amount and in duration.

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

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Brothers.

Liquidity Risk

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

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

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

We Are a Holding Company and Are Dependent on Our Subsidiaries for Funds.Since Holdings is primarily a holding company, our cash flow and consequent ability to pay dividends and satisfy our obligations under securities we issue are dependent upon the earnings of our subsidiaries and the distribution of those earnings as dividends or loans or other payments by those subsidiaries to Holdings. Several of our principal subsidiaries are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate and/or to capital targets established by various ratings agencies. These regulatory rules, and certain covenants contained in various debt agreements, may restrict our ability to withdraw capital from our subsidiaries by dividends, loans or other payments. Further information about these requirements and restrictions is set forth in Note 13 to the Consolidated Financial Statements in Part II, Item 8, of this Report. Additionally, our ability to participate as an equity holder in any distribution of assets of any subsidiary upon liquidation is generally subordinate to the claims of creditors of the subsidiary.

Credit Ratings

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

Operational Risk

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

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we have substantially upgraded and expanded the capabilities of our data processing systems and other operating technology, and we expect that we will need to continue to upgrade and expand in the future to avoid disruption of, or constraints on, our operations.

Our businesses and operations rely on the secure processing, storage and transmission of confidential and other information, and, increasingly, on the internet. We take extensive protective measures for our computer systems, internet sites, software and networks to protect against vulnerabilities to unauthorized access, computer viruses, denial of service attacks or other events that could have a security or business impact. If, nevertheless, such events should occur, they could result in significant losses or reputational damage.

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

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

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

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

Legal, Regulatory and Reputational Risk

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

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

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Extensive Regulation of Our Businesses Limits Our Activities and May Subject Us to Significant Penalties. Lehman Brothers, as a participant in the financial services industry, is subject to extensive regulation under both federal and state laws in the U.S. and under the laws of the many global jurisdictions in which we do business. We are also regulated by a number of self-regulatory organizations. The industry has experienced increased scrutiny from a variety of regulators, including the SEC, NYSE, NASD and state attorney generals. Penalties and fines sought by regulatory authorities in our industry have increased substantially over the last several years. The requirements imposed by our regulators are designed to ensure the integrity of the financial markets and to protect customers and other third parties who deal with Lehman Brothers. Consequently, these regulations often serve to limit our activities, including through net capital, customer protection and market conduct requirements. If we were found to have breached certain of these rules or regulations, we could face the risk of significant intervention by regulatory authorities, including extended investigation and surveillance activity, adoption of costly or restrictive new regulations and judicial or administrative proceedings that may result in substantial penalties. Among other things, we could be fined or prohibited from engaging in some of our business activities.

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

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

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

Our Mortgage Origination Business is Subject to Special Litigation and Regulatory Risks. The laws and regulations of the various jurisdictions in which we conduct our mortgage lending business are complex, frequently changing and, in some cases, in direct conflict with each other.  In particular, this business is subject to various laws, regulations and guidance that restrict non-prime loan origination or purchase activities. Some of these laws and regulations provide for extensive assignee liability for warehouse lenders, whole loan buyers and securitization trusts.  In addition, the recent downturn in the U.S. residential real estate market could result in increased complaints and claims relating to non-prime mortgage origination practices. As our mortgage origination operations continue to grow, both internally and through acquisitions, it may be more difficult to comprehensively identify and accurately interpret, and to implement our risk-management policies, properly program our systems and effectively train our personnel with respect to, all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance, including possible civil and criminal liability, demands for indemnification or loan repurchases from purchasers of our loans (including securitization trusts), class action lawsuits or administrative enforcement actions. Moreover, our customer base and counterparties in this business is substantially different from the high-net-worth and institutional customers and counterparties of most of our other businesses, which presents a different litigation risk profile.

Exposure to Reputational Risks Could Impact the Value of Our Brand. Our reputation is critical in maintaining our relationships with clients, investors, regulators and the general public, and is a key focus in our risk management efforts. In recent years, there have been a number of highly publicized cases involving fraud, conflicts of interest or

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other misconduct by employees in the financial services industry, and we run the risk that misconduct by our employees could occur. Misconduct by employees could include binding Lehman Brothers to transactions that exceed authorized limits or present unacceptable risks, or hiding from Lehman Brothers unauthorized or unsuccessful activities, which, in either case, may result in unknown and unmanaged risks or losses. Employee misconduct could also involve the improper use or disclosure of confidential information, which could result in regulatory sanctions and serious reputational or financial harm. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases.  In addition, in certain circumstances our reputation could be damaged by activities of our clients in which we participate, or of hedge funds or other entities in which we invest, over which we have little or no control.

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

Competitive Environment

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

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

Our Revenues May Decline Due to Competition from Alternative Trading Systems. Securities and futures transactions are now being conducted through the internet and other alternative, non-traditional trading systems, and it appears that the trend toward alternative trading systems will continue and probably accelerate. A dramatic increase in computer-based or other electronic trading may adversely affect our commission and trading revenues.

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

Risk Management

We have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future. Nonetheless, our hedging strategies and other risk management techniques may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk, including risks that are unidentified or unanticipated. Some of our methods of managing risk are based upon our use of observed historical market behavior. As a result, these methods may not predict future risk exposures, which could be significantly greater than the historical measures indicate. Management of operational, legal and regulatory risk requires, among other things, policies and procedures to record properly and verify a large number of transactions and events, and these policies and procedures may not be fully effective. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Management” for a discussion of

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the policies and procedures we use to identify, monitor and manage the risks we assume in conducting our businesses.

None.

Our world headquarters is a 1,050,000 square-foot owned office tower at 745 Seventh Avenue in New York City.  We also lease approximately 1,700,000 square feet of office space in the New York metropolitan area.  In addition to our offices in the New York area, we have offices in approximately 33 principal locations in the Americas.

Our European headquarters is an 820,000 square-foot leased facility in the Canary Wharf development, east of the City of London.  In addition to our European headquarters, we have an additional 10 principal locations in Europe.

Our Asian headquarters is located in approximately 200,000 square feet of leased office space in the Roppongi Hills area of central Tokyo, Japan.  We lease office space in nine other principal locations in Asia.

In addition to our principal locations listed above, we occupy space in various other facilities. Including the locations noted above, we lease approximately 4,800,000 square feet in the Americas, 1,200,000 square feet in Europe and 800,000 square feet in Asia.

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

Additional information with respect to facilities and lease commitments is set forth under the caption “Lease Commitments” in Note 11 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

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

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

Bader v. Ainslie, et al.

On August 3, 2006, a purported shareholder derivative action captioned Bader v. Ainslie, et al., was filed against Holdings and the members of its Board of Directors (the “Directors”) in the United States District Court for the Southern District of New York (the “New York District Court”) seeking various types of equitable and injunctive relief. The complaint purports to bring claims under Section 14(a) of the Securities Exchange Act of 1934 and unspecified state law fiduciary duty claims alleging that the Firm’s proxy statements for the years 2002 through 2006 contained false or misleading statements or failed to disclose material facts. Specifically, the complaint alleges that the Black-Scholes method of valuing stock options granted to executive officers of Holdings and the deductibility of those options were incorrectly described and applied. Holdings and the Directors entered into a settlement agreement with the plaintiff on January 10, 2007. On February 9, 2007, the New York District Court preliminarily approved the settlement and scheduled a hearing on April 5, 2007 for final approval of the settlement.

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Actions Regarding Enron Corporation

Enron Securities Purchaser Actions.  In April 2002, a Consolidated Complaint for Violation of the Securities Laws was filed in the United States District Court for the Southern District of Texas (the “Texas District Court”), captioned In re Enron Corporation Securities Litigation (the “Enron Litigation”), based on the theory that the various investment bank defendants and other-related Enron individuals engaged or participated in manipulative devices to inflate Enron’s reported profits and financial condition, made false or misleading statements and participated in a scheme or course of business to defraud Enron’s shareholders. LBI and Holdings were originally named in this action, and settled any claims therein in 2005.  The matters discussed below were related to the Enron Litigation and remained pending at the time of the filing of Holdings’ most recent Report on Form 10-Q.

In May 2002, American National Insurance Company and certain of its affiliates filed a complaint against LBI, Holdings, Lehman Commercial Paper Inc. (“LCPI”) and a broker formerly employed by Lehman Brothers. The amended complaint, filed in October 2003, is based on allegations similar to those in the Enron Litigation and asserts that plaintiffs relied on defendants’ allegedly false and misleading statements in purchasing and continuing to hold Enron debt and equities in their LBI accounts. The amended complaint alleged violations of the Texas Securities Act, violations of the Texas Business and Commerce Code, fraud, breach of fiduciary duty, negligence and professional malpractice, and sought unspecified compensatory and punitive damages. The action was coordinated for pretrial purposes with the Enron Litigation. This action was settled in December 2006, and the Texas District Court dismissed it with prejudice on January 4, 2007.

In August 2002, a complaint was filed against Holdings and four other commercial or investment banks, among other defendants, by the Public Employees Retirement System of Ohio and three other state employee retirement plans, containing allegations similar to those in the Enron Litigation. Against Holdings, the complaint alleges claims for common law fraud and deceit, aiding and abetting common law fraud, conspiracy to commit fraud, negligent misrepresentation and violation of the Texas Securities Act, and seeks unspecified compensatory and punitive damages. This action was consolidated with the Enron Litigation, and the parties have agreed to a settlement which is subject to documentation and dismissal of the case.

In April 2003, Westboro Properties LLC and Stonehurst Capital, Inc. filed a complaint against LBI, Holdings and other commercial or investment banks. Plaintiffs alleged that defendants engaged in violations of the Texas Securities Act, statutory fraud in stock transactions, fraud, negligence and professional malpractice, and violations of Sections 12 and 15 of the Securities Act in inducing plaintiffs to purchase certain certificates, or investments, in two special purpose entities (“SPEs”), Osprey I and Osprey II and raised claims similar to those pending in the Enron Litigation.  Plaintiffs sought unspecified actual, special and punitive damages and equitable relief. The action was consolidated with the Enron Litigation.  LBI and Holdings settled this case in December 2005, and the final order of dismissal by the Texas District Court was entered on January 20, 2006.

In September 2003, a purported class action complaint was filed against Holdings and seven other commercial or investment banks, among other defendants, by Sara McMurray on behalf of purchasers of Enron common stock between October 16, 1998 and November 27, 2001, making similar allegations to those in the Enron Litigation.  Plaintiff alleged negligent misrepresentation, common law fraud, breach of fiduciary duty and aiding and abetting breach of fiduciary duty, and sought unspecified damages for lost investment opportunities and lost benefit of the bargain. This action was consolidated with the Enron Litigation in the Texas District Court. Similarly, in January 2004, a purported class action complaint was filed against Holdings and other commercial or investment banks, among other defendants, by William Young and Frank Conway on behalf of all persons who held Enron shares from April 13, 1999 through November 8, 2001. Making allegations similar to those in the Enron Litigation, plaintiffs allege claims for negligent misrepresentation and common law fraud and seek unspecified compensatory damages. This action was coordinated for pretrial purposes with the Enron Litigation in the Texas District Court. In both of these actions, plaintiffs filed motions to voluntarily dismiss Holdings from the action without prejudice. Before those motions were ruled upon, new complaints were filed that did not name Holdings.

Other Actions. In November 2003, Enron filed two nearly identical lawsuits against LCPI, LBIE and other commercial paper dealers and investors in the United States Bankruptcy Court for the Southern District of New York. The complaints allege that monies paid by Enron in October and November 2002 to repurchase its outstanding commercial paper shortly before its maturity were preferential payments and/or fraudulent conveyances under the Bankruptcy Code. Among other things, the complaints seek to avoid and recover these payments from the defendants. In total, approximately $500 million is sought from LCPI and LBIE, nearly all of which relates to LCPI’s

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role as intermediary between Enron and several co-defendant holders of the commercial paper.

In March 2004, LJM2 Liquidation Statutory Trust B and its managing trustee filed a complaint in Delaware Chancery Court (the “Delaware Chancery Court action”) against the limited partners in LJM2 Co-Investment L.P., including LB I Group Inc., alleging that the limited partners improperly rescinded a capital call. The complaint asserted claims against the LB I Group Inc. for violations of the Delaware Revised Uniform Limited Partnership Act, breach of the partnership and subscription agreements, breach of the credit agreement, tortious interference, aiding and abetting a breach of fiduciary duty, avoidable transfer, breach of the covenant of good faith and fair dealing, unjust enrichment, breach of the partnership agreement and conspiracy to engage in fraudulent transfer.  Plaintiffs sought monetary damages of approximately $75 million in the aggregate from the limited partners, plus interest and costs, as well as specific enforcement of the obligation to make capital contributions.

In April 2004, LJM2 Liquidation Statutory Trust B and its managing trustee filed an amended complaint against the limited partners of LJM2 Co-Investment, L.P., including LB I Group Inc., alleging that the distributions to the limited partners were fraudulent transfers and violated the Delaware Revised Uniform Limited Partnership Act.  Plaintiffs sought monetary damages of approximately $75 million in the aggregate from the limited partners, plus interest and costs.  That action was pending in the United States Bankruptcy Court for the Northern District of Texas (the “Texas proceeding”).

On September 8, 2006, the Delaware Chancery Court action and the Texas proceeding were settled pursuant to a confidential settlement agreement. On December 14, 2006, the parties to the Texas proceeding (including LB I Group Inc.) filed a stipulation of voluntary dismissal in the Texas Bankruptcy Court dismissing the Texas proceeding with prejudice. On December 15, 2006, the managing trustee of LJM2 Liquidation Statutory Trust B filed a notice of voluntary dismissal in the Delaware Chancery Court dismissing the Delaware Chancery Court action with prejudice.

First Alliance Mortgage Company Matters

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

In November 2001, the Official Joint Borrowers Committee (the “Committee”) initiated an adversary proceeding, on behalf of the FAMCO-related debtors, in the California Bankruptcy Court by filing a complaint ultimately against LCPI, LBI (the “Lehman defendants”) and several individual officers and directors of FAMCO and its affiliates. As to the Lehman defendants, the Committee asserted various bankruptcy claims for avoidance of liens, aiding and abetting and breach of fiduciary duty.

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

In June 2003, the California District Court dismissed plaintiffs’ claim for punitive damages.  Also in June 2003, the jury rendered its verdict, finding LBI and LCPI liable for aiding and abetting FAMCO’s fraud. The jury found damages of $50.9 million and held the Lehman defendants responsible for 10% of those damages. In July 2003, the California District Court entered findings of fact and conclusions of law relating to all claims still pending and holding that any transfers to LCPI were not fraudulent and its liens were not avoidable, nor was equitable subordination of amounts owed by FAMCO to LCPI at the time of the Chapter 11 filing warranted. Judgment was entered in November 2003 on the jury verdict.  On December 8, 2006, the United States Court of Appeals for the Ninth Circuit issued a decision on the appeals

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of all parties, affirming the jury verdict on liability, rejecting all plaintiffs’ claims for further relief, vacating the damages verdict and remanding the matter for further proceedings on the proper calculation of “out of pocket” damages rather than the higher benefit of the bargain damages upon which the jury based its verdict.

In June 2003, the Attorney General of the State of Florida filed a civil complaint against LCPI in the Circuit Court of the 17th Judicial Circuit in and for Broward County, Florida, alleging violations of the Florida Unfair and Deceptive Trade Practices Act and common law fraud.  The allegations arise out of LCPI’s relationship with FAMCO insofar as FAMCO did business with Florida borrowers. The Florida Attorney General alleges in the complaint that, among other things, LCPI provided financing to FAMCO, despite LCPI’s purported knowledge that FAMCO was engaged in “predatory lending” practices. The complaint seeks a permanent injunction, compensatory and punitive damages, civil penalties, attorney’s fees and costs.

IPO Allocation Cases

Securities Action. LBI was named as a defendant in numerous purported securities class actions that were filed between March and December 2001 in the New York District Court. The actions, which allege improper IPO allocation practices, were brought by persons who, either directly or in the aftermarket, purchased IPO securities during the period between March 1997 and December 2000. The plaintiffs allege that LBI and other IPO underwriters required persons receiving allocations of IPO shares to pay excessive commissions on unrelated trades and to purchase shares in the aftermarket at specified escalating prices. The plaintiffs, who seek unspecified compensatory damages, claim that these alleged practices violated various provisions of the federal securities laws, specifically Sections 11, 12(a)(2) and 15 of the Securities Act and Sections 10(b) and 20(a) of the Exchange Act.

Plaintiffs filed 310 actions, each relating to a distinct offering, which actions were consolidated for pretrial purposes before a single judge. LBI is named as a defendant in 83 of those cases. For pretrial coordination purposes, the parties also designated certain focus cases, which were to be used as guidance for decisions in all cases. In September 2003, plaintiffs moved for certification of a class of investors in each of six focus cases. On October 13, 2004, the New York District Court granted plaintiffs’ motion. The defendants (including LBI) appealed to the United States Court of Appeals for the Second Circuit (the “Second Circuit”), which on December 5, 2006, overturned the decision below, set forth the standards for class certification and concluded that classes could not be certified based on the facts alleged by plaintiffs.

Antitrust Action. In January 2002, a separate consolidated class action, entitled In re Initial Public Offering Antitrust Litigation, was filed in the New York District Court against LBI, among other underwriters, alleging violations of federal and state antitrust laws. The complaint alleges that the underwriter defendants conspired to require customers who wanted IPO allocations to pay the underwriters a percentage of their IPO profits in the form of commissions on unrelated trades to purchase other, less attractive securities and to buy shares in the aftermarket at predetermined escalating prices. In November 2003, the court dismissed the antitrust action on the grounds that the conduct alleged was impliedly immune from the antitrust laws. On appeal, the Second Circuit reversed the New York District Court’s decision in September 2005. The Supreme Court of the United States granted a petition for certiorari on December 7, 2006 to review the Second Circuit decision.

Issuer Action.In April 2002, a suit was filed in Delaware Chancery Court by Breakaway Solutions Inc. (“Breakaway”), which names LBI and two other underwriters as defendants (the “Delaware Action”). The complaint purports to be brought on behalf of a class of issuers who issued securities in IPOs through at least one of the defendants during the period January 1998 through October 2000 and whose securities increased in value 15% or more above the original price within 30 days after the IPO. It alleges that defendants under-priced IPO securities and allocated those under-priced securities to certain favored customers in return for alleged arrangements with the customers for increased commissions on other transactions and alleged tie-in arrangements. The complaint asserts claims for breaches of contract, of the implied covenant of good faith and fair dealing and of fiduciary duty, and for indemnification or contribution and unjust enrichment or restitution. Breakaway seeks, among other relief, class certification, injunctive relief, an accounting, declarations requiring defendants to indemnify Breakaway in the pending consolidated IPO securities class actions and determining that Breakaway has no indemnification obligation to defendants in those actions, and compensatory damages. In August 2004, the court denied defendants’ motion to dismiss. On motion by defendants, the court reconsidered its prior decision and by order dated December 8, 2005, dismissed all but Breakaway’s claim for breach of fiduciary duty.

In September 2005, Breakaway commenced an action in the New York State Supreme Court, New York County, naming the same defendants (the “New York Action”). This action alleges that LBI, as a co-manager of Breakaway’s

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initial public offering and in conjunction with the other underwriter defendants, breached a fiduciary duty to Breakaway and breached the covenant of good faith and fair dealing implied in the underwriting agreement among Breakaway and the underwriters by allegedly under-pricing Breakaway’s shares in the IPO. Unlike the Delaware Action, which Breakaway purports to bring on behalf of a class of issuers, the New York Action concerns claims brought only on behalf of Breakaway.

IPO Fee Litigation

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

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

Mirant Corporation Securities Litigation

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

Research Analyst Independence Litigations

Since the announcement of the final global regulatory settlement regarding alleged research analyst conflicts of interest at various investment banking firms in the United States, including LBI, in April 2003 (the “Final Global Settlement”), a number of purported class actions were filed relating to such alleged conflicts. Three, consolidated actions have been filed against LBI in federal court, two of which have since been dismissed, which are specific to LBI’s research of particular companies. The actions allege conflicts of interest between LBI’s investment banking business and research activities and seek to assert claims pursuant to Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 thereunder.  In the remaining pending action, relating to RSL Communications, plaintiffs have filed an amended consolidated complaint, containing essentially the same allegations as the original complaints, but adding two other investment banks as defendants (Fogarazzo, et al. v. Lehman Brothers Inc., et al.). On July 27,

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2005, the New York District Court granted plaintiffs’ motion for class certification. On January 26, 2007, the Second Circuit Court of Appeals accepted the defendants’ appeal and vacated and remanded the case to the New York District Court in light of the decision in the IPO Allocation Securities Action case discussed above.

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

Short Sales Related Litigation

Commencing in April 2006, LBI was named as a defendant in putative class actions relating to short selling filed in the New York District Court. In December 2006, the court ordered that the actions be consolidated and renamed the In re Short Sale Antitrust Litigation.  By January 2007, only one plaintiff, Electronic Trading Group, remained in the case (after earlier-named plaintiffs dropped out). A second amended complaint was filed, purportedly on behalf of those who had paid certain fees to broker dealers in connection with borrowing securities against 17 broker-dealers and other unnamed defendants, including LBI. The plaintiff alleges that the broker-dealers conspired to fix the minimum borrowing rate charged their clients for borrowing certain types of securities and to charge their clients fees, commissions and/or interest to execute short sale transactions when the broker-dealers failed to locate, borrow and/or deliver the shares, thereby earning illicit profits. The complaint asserts four causes of action: violations of Section 1 of the Sherman Act, breach of fiduciary duty, aiding and abetting breaches of fiduciary duty, and unjust enrichment. Plaintiff seeks injunctive relief and unspecified trebled compensatory and punitive damages.

In June 2006, LBI was named as a defendant in an action filed by 40 shareholders of Novastar Financial, Inc. (“NFI”) against 11 broker-dealers and other unnamed defendants in the Superior Court of California for San Francisco County. The action alleges that the broker-dealers participated in an illegal stock market manipulation scheme that involved accepting orders for purchases, sales and short sales of NFI stock with no intention of covering such orders with borrowed stock or stock issued by NFI. Plaintiffs claim that this scheme caused distortions with regard to the nature and amount of active trading in NFI stock, thereby causing its share price to decline. The complaints assert causes of action under California Corporations Code Sections 25400, et seq. and California Business and Professions Code Sections 17200, et seq. and 17500, et seq. The actions seek unspecified damages.

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

In August 2005, A. Vernon Wright and Dynoil Refining LLC sued Holdings, LBI and two current and one former LBI employees, in Los Angeles Superior Court. Plaintiffs claim negligence, breach of contract, breach of duties of good faith and fair dealing and of fiduciary duty, interference with prospective business advantage and misappropriation of trade secrets. Plaintiffs allege that Wright provided Lehman Brothers with confidential information that Wright, along with certain Chinese interests, intended to buy Unocal, which Lehman Brothers allegedly passed to Chevron, preventing Wright from executing his plan. Plaintiffs seek $9.2 billion, the alleged value of the U.S. assets plaintiffs say they would have acquired.

In March 2006, Carlton Energy Group, Muskeg Oil Co and Newco filed a similar suit against Holdings, LBI, two different LBI employees named in the Dynoil action and a third Lehman Brothers employee, in state court in Harris County, Texas. The three plaintiff entities are owned or controlled by Thomas O’Dell and Daniel Chiang, erstwhile business partners of Vernon Wright. Plaintiffs claim negligence, breach of contract, breach of fiduciary duty, intentional interference with business relationship, fraud, misrepresentation, misappropriation of trade secrets and quantum merit. Plaintiffs’ allegations mirror those by Wright and Dynoil. They further allege that Wright is no longer their business partner. Plaintiffs seek unspecified damages. Plaintiffs have agreed to stay their action and bring their claims in the action brought by A. Vernon Wright in Los Angeles Superior Court.

None.

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LEHMAN BROTHERS HOLDINGS INC.

PART II

Holdings’ common stock, par value $0.10 per share, is listed on the New York Stock Exchange. As of January 31, 2007, there were 526,088,102 shares of our common stock outstanding and approximately 22,580 holders of record. On February 12, 2007, the last reported sales price of our common stock was $82.22. The table below shows the high and low sale prices for the common stock for each fiscal quarter within the two most recent fiscal years:

Price Range of Common Stock

		Low Sale Price			High Sale Price			Dividends
Fiscal 2006:
Fourth Quarter		$	63.04		$	78.89		$	0.12
Third Quarter		$	58.37		$	69.48		$	0.12
Second Quarter		$	62.82		$	78.85		$	0.12
First Quarter		$	62.14		$	74.79		$	0.12
Fiscal 2005:
Fourth Quarter		$	51.86		$	66.58		$	0.10
Third Quarter		$	45.53		$	54.00		$	0.10
Second Quarter		$	42.96		$	48.47		$	0.10
First Quarter		$	41.63		$	47.35		$	0.10

 

In January 2007, our Board of Directors increased the fiscal 2007 annual common stock dividend rate to $0.60 per share from an annual dividend rate of $0.48 per share in fiscal 2006 and $0.40 per share in fiscal 2005. Dividends on the common stock are generally payable, following declaration by the Board of Directors, in February, May, August and November.

The above table and common stock dividend per share rates have been adjusted to reflect the April 28, 2006 2-for-1 stock split.

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LEHMAN BROTHERS HOLDINGS INC.

The table below sets forth information with respect to purchases made by or on behalf of Holdings or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended), of our common stock during the quarter ended November 30, 2006.

		Issuer Purchases of Equity Securities
						Total Number of		Maximum Number
						Shares Purchased		of Shares that May
		Total Number				as Part of Publicly		Yet Be Purchased
		of Shares		Average Price		Announced Plans		Under the Plans or
		Purchased(1)		Paid per Share		or Programs(2)		Programs (2)
Month # 1 (September 1— September 30, 2006):
Common stock repurchases (1)		1,440,000				1,440,000
Employee transactions (2)		191,130				191,130
Total		1,631,130		$68.56		1,631,130		69,249,981
Month # 2 (October 1—October 31, 2006):
Common stock repurchases (1)		3,835,100				3,835,100
Employee transactions (2)		600,673				600,673
Total		4,435,773		$76.64		4,435,773		64,814,208
Month # 3 (November 1—November 30, 2006):
Common stock repurchases (1)		54,000				54,000
Employee transactions (2)		7,640,967				7,640,967
Total		7,694,967		$73.74		7,694,967		57,119,241
Total September 1, 2006—November 30, 2006):
Common stock repurchases (1)		5,329,100				5,329,100
Employee transactions (2)		8,432,770				8,432,770
Total		13,761,870		$74.06		13,761,870		57,119,241

 

(1)          We have an ongoing common stock repurchase program, pursuant to which we repurchase shares in the open market on a regular basis. In January 2006, our Board of Directors authorized the repurchase in 2006, subject to market conditions, of up to 80 million shares of Holdings common stock, for the management of the Firm’s equity capital, including offsetting 2006 dilution due to employee stock plans. Our Board also authorized the repurchase in 2006, subject to market conditions, of up to an additional 30 million shares, for the possible acceleration of repurchases to offset a portion of 2007 dilution due to employee stock plans. The number of shares authorized to be repurchased in the open market is reduced by the actual number of Employee Offset Shares (as defined below) received.

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

In January 2007, our Board of Directors authorized the repurchase, subject to market conditions, of up to 100 million shares of Holdings common stock for the management of our equity capital, including offsetting dilution due to employee stock awards. This authorization supersedes the stock repurchase program authorized in 2006. For more information about the repurchase program and employee stock plans, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources—Equity Management” in Part II, Item 7, Notes 12 and 15 to the Consolidated Financial Statements in Part II, Item 8, and “Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters” in Part III, Item 12, of this Report.

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LEHMAN BROTHERS HOLDINGS INC.

The following table summarizes certain consolidated financial information.

Selected Financial Data

In millions, except per common share and selected data and financial ratios

Year ended November 30		2006			2005			2004			2003			2002
Consolidated Statement of Income
Total revenues		$	46,709		$	32,420		$	21,250		$	17,287		$	16,781
Interest expense		29,126			17,790			9,674			8,640			10,626
Net revenues		17,583			14,630			11,576			8,647			6,155
Non-interest expenses:
Compensation and benefits		8,669			7,213			5,730			4,318			3,139
Non-personnel expenses (1)		3,009			2,588			2,309			1,716			1,517
Real estate reconfiguration charge		—			—			19			77			128
September 11th related recoveries, net		—			—			—			—			(108		)
Regulatory settlement		—			—			—			—			80
Total non-interest expenses		11,678			9,801			8,058			6,111			4,756
Income before taxes and cumulative effect of accounting change		5,905			4,829			3,518			2,536			1,399
Provision for income taxes		1,945			1,569			1,125			765			368
Dividends on trust preferred securities (2)		—			—			24			72			56
Income before cumulative effect of accounting change		3,960			3,260			2,369			1,699			975
Cumulative effect of accounting change		47			—			—			—			—
Net income		$	4,007		$	3,260		$	2,369		$	1,699		$	975
Net income applicable to common stock		$	3,941		$	3,191		$	2,297		$	1,649		$	906
Consolidated Statement of Financial Condition (at November 30)
Total assets		$	503,545		$	410,063		$	357,168		$	312,061		$	260,336
Net assets(3)		268,936			211,424			175,221			163,182			140,488
Long-term borrowings(2) (4)		81,178			53,899			49,365			35,885			30,707
Preferred securities subject to mandatory redemption(2)		—			—			—			1,310			710
Total stockholders’ equity		19,191			16,794			14,920			13,174			8,942
Tangible equity capital(5)		18,567			15,564			12,636			10,681			9,439
Total long-term capital (6)		100,369			70,693			64,285			50,369			40,359
Per Common Share Data(7)
Net income (basic)		$	7.26		$	5.74		$	4.18		$	3.36		$	1.85
Net income (diluted)		$	6.81		$	5.43		$	3.95		$	3.17		$	1.73
Weighted average common shares (basic) (in millions)		543.0			556.3			549.4			491.3			490.7
Weighted average common shares (diluted) (in millions)		578.4			587.2			581.5			519.7			522.3
Dividends		$	0.48		$	0.40		$	0.32		$	0.24		$	0.18
Book value (at November 30) (8)		$	33.87		$	28.75		$	24.66		$	22.09		$	17.07
Selected Data (at November 30)
Leverage ratio (9)		26.2x			24.4x			23.9x			23.7x			29.1x
Net leverage ratio(10)		14.5x			13.6x			13.9x			15.3x			14.9x
Employees		25,936			22,919			19,579			16,188			12,343
Assets under management (in billions)		$	225		$	175		$	137		$	120		$	9
Financial Ratios (%)
Compensation and benefits/net revenues		49.3			49.3			49.5			49.9			51.0
Pre-tax margin		33.6			33.0			30.4			29.3			22.7
Return on average common stockholders’ equity (11)		23.4			21.6			17.9			18.2			11.2
Return on average tangible common stockholders’ equity (12)		29.1			27.8			24.7			19.2			11.5

 

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LEHMAN BROTHERS HOLDINGS INC.

 

Notes to Selected Financial Data:

(1)             Non-personnel expenses exclude the following items: 1) real estate reconfiguration charges of $19 million, $77 million and $128 million for the years ended November 2004, 2003 and 2002, respectively; and 2) September 11th related recoveries, net of $(108) million, and a regulatory settlement of $80 million for the year ended November 30, 2002.

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

(3)             Net assets represent total assets excluding: 1) cash and securities segregated and on deposit for regulatory and other purposes, 2) securities received as collateral, 3) securities purchased under agreements to resell, 4) securities borrowed and 5) identifiable intangible assets and goodwill. We believe net assets are a measure more useful to investors than total assets when comparing companies in the securities industry because it excludes certain low-risk non-inventory assets and identifiable intangible assets and goodwill. Net assets as presented are not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation. (a)

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

(5)             Tangible equity capital represents total stockholders’ equity plus junior subordinated notes (and at November 30, 2003 and 2002, preferred securities subject to mandatory redemption), less identifiable intangible assets and goodwill.(b) See “MD&A—Liquidity, Funding and Capital Resources—Balance Sheet and Financial Leverage” for additional information about tangible equity capital. We believe total stockholders’ equity plus junior subordinated notes to be a more meaningful measure of our equity because the junior subordinated notes are equity-like due to their, subordinated, long-term nature and interest deferral features. In addition, a leading rating agency views these securities as equity capital for purposes of calculating net leverage. Further, we do not view the amount of equity used to support identifiable intangible assets and goodwill as available to support our remaining net assets. Tangible equity capital as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation.

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

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

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

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

(10)       Net leverage ratio is defined as net assets (see note 3 above) divided by tangible equity capital (see note 5 above). We believe net leverage is a more meaningful measure of leverage to evaluate companies in the securities industry. In addition, many of our creditors and a leading rating agency use the same definition of net leverage. Net leverage as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation.

(11)       Return on average common stockholders’ equity is computed by dividing net income applicable to common stock for the period by average common stockholders’ equity. Average common stockholders’ equity for the years ended November 30, 2006, 2005, 2004, 2003 and 2002 was $16.9 billion, $14.7 billion, $12.8 billion, $9.1 billion, and $8.1 billion, respectively.

(12)       Return on average tangible common stockholders’ equity is computed by dividing net income applicable to common stock for the period by average tangible common stockholders’ equity. Average tangible common stockholders’ equity equals average total common stockholders’ equity less average identifiable intangible assets and goodwill. Average identifiable intangible assets and goodwill for the years ended November 30, 2006, 2005, 2004, 2003, and 2002 was $3.3 billion, $3.3 billion, $3.5 billion, $471 million and $191 million, respectively. Management believes tangible common stockholders’ equity is a meaningful measure because it reflects the common stockholders’ equity deployed in our businesses.

(a)                 Net assets:

 

November 30 (in millions)		2006			2005			2004			2003			2002
Total assets		$	503,545		$	410,063		$	357,168		$	312,061		$	260,336
Cash and securities segregated and on deposit for regulatory and other purposes		(6,091		)	(5,744		)	(4,085		)	(3,100		)	(2,803		)
Securities received as collateral		(6,099		)	(4,975		)	(4,749		)	(3,406		)	(1,994		)
Securities purchased under agreement to resell		(117,490		)	(106,209		)	(95,535		)	(87,416		)	(94,341		)
Securities borrowed		(101,567		)	(78,455		)	(74,294		)	(51,396		)	(20,497		)
Identifiable intangible assets and goodwill		(3,362		)	(3,256		)	(3,284		)	(3,561		)	(213		)
Net assets		$	268,936		$	211,424		$	175,221		$	163,182		$	140,488

 

(b)                 Tangible equity capital:

 

November 30 (in millions)		2006			2005			2004			2003			2002
Total stockholders’ equity		$	19,191		$	16,794		$	14,920		$	13,174		$	8,942
Junior subordinated notes (subject to limitation) (i)		2,738			2,026			1,000			1,068			710
Identifiable intangible assets and goodwill		(3,362		)	(3,256		)	(3,284		)	(3,561		)	(213		)
Tangible equity capital		$	18,567		$	15,564		$	12,636		$	10,681		$	9,439

 

(i)                Preferred securities subject to mandatory redemption at November 30, 2003 and 2002.

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LEHMAN BROTHERS HOLDINGS INC.

 

Contents

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction		31
Forward-Looking Statements		31
Certain Factors Affecting Results of Operations		32
Executive Overview		33
Consolidated Results of Operations		36
Business Segments		40
Geographic Revenues		46
Liquidity, Funding and Capital Resources		47
Contractual Obligations and Lending-Related Commitments		54
Off-Balance-Sheet Arrangements		55
Risk Management		57
Critical Accounting Policies and Estimates		62
2-for-1 Stock Split		67
Accounting and Regulatory Developments		68
Effects of Inflation		70

 

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LEHMAN BROTHERS HOLDINGS INC.

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

 

 

Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company,” “Lehman Brothers,” “we,” “us” or “our”) is one of the leading global investment banks, serving institutional, corporate, government and high-net-worth individual clients. Our worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by offices in additional locations in North America, Europe, the Middle East, Latin America and the Asia Pacific region. Through our subsidiaries, we are a global market-maker in all major equity and fixed income products. To facilitate our market-making activities, we are a member of all principal securities and commodities exchanges in the U.S. and we hold memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Australian stock exchanges.

Our primary businesses are capital markets, investment banking, and investment management, which, by their nature, are subject to volatility primarily due to changes in interest and foreign exchange rates, valuation of financial instruments and real estate, global economic and political trends and industry competition. Through our investment banking, trading, research, structuring and distribution capabilities in equity and fixed income products, we continue to build on our client-flow business model. The client-flow business model is based on our principal focus of facilitating client transactions in all major global capital markets products and services. We generate client-flow revenues from institutional, corporate, government and high-net-worth clients by (i) advising on and structuring transactions specifically suited to meet client needs; (ii) serving as a market-maker and/or intermediary in the global marketplace, including having securities and other financial instrument products available to allow clients to adjust their portfolios and risks across different market cycles; (iii) originating loans for distribution to clients in the securitization or principals market; (iv) providing investment management and advisory services; and (v) acting as an underwriter to clients. As part of our client-flow activities, we maintain inventory positions of varying amounts across a broad range of financial instruments that are marked to market daily and give rise to principal transactions and net interest revenue. In addition, we also maintain inventory positions (long and short) as part of our proprietary trading activities in our Capital Markets businesses, and make principal investments including real estate and private equity investments. The financial services industry is significantly influenced by worldwide economic conditions as well as other factors inherent in the global financial markets. As a result, revenues and earnings may vary from quarter to quarter and from year to year.

All references to the years 2006, 2005 and 2004 in this Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) refer to our fiscal years ended November 30, 2006, 2005 and 2004, or the last day of such fiscal years, as the context requires, unless specifically stated otherwise. All share and per share amounts have been retrospectively adjusted for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective April 28, 2006. See Note 12 to the Consolidated Financial Statements and “2-for-1 Stock Split” in this MD&A for more information.

 

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

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

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LEHMAN BROTHERS HOLDINGS INC.

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

 

 

The significant risks that could impact our businesses and therefore our financial condition and results of operations are included, but not limited, to the items below. Our risk management and liquidity management policies are designed to mitigate the effects of certain of these risks.  See “Liquidity, Funding and Capital Resources–Liquidity Risk Management” and “Risk Management” in this MD&A for more information.

Market Risk

As a global investment bank, market risk is an inherent part of our business, and our businesses can be adversely impacted by changes in market and economic conditions that cause fluctuations in interest rates, exchange rates, equity and commodity prices, credit spreads and real estate valuations. We maintain inventory positions (long and short) across a broad range of financial instruments to support our client-flow activities and also as part of our proprietary trading and principal investment activities. Our businesses can incur losses as a result of fluctuations in these market risk factors, including adverse impacts on the valuation of our inventory positions and principal investments. See “Risk Management—Market Risk” in this MD&A for more information.

Competitive Environment

All aspects of our business are highly competitive. Our competitive ability depends on many factors, including our reputation, the quality of our services and advice, intellectual capital, product innovation, execution ability, pricing, sales efforts and the talent of our employees. See Part I, Item 1, “Business—Competition” in this Form 10-K for more information about competitive matters.

Business Environment

Concerns about geopolitical developments, energy prices and natural disasters, among other things, can affect the global financial markets and investor confidence. Accounting and corporate governance scandals in recent years have had a significant effect on investor confidence. See “Executive Overview—Business Environment” and “—Economic Outlook” in this MD&A for more information.

Liquidity

Liquidity and liquidity management are of critical importance in our industry. Liquidity could be affected by the inability to access the long-term or short-term debt, repurchase or securities-lending markets or to draw under credit facilities, whether due to factors specific to us or to general market conditions. In addition, the amount and timing of contingent events, such as unfunded commitments and guarantees, could adversely affect cash requirements and liquidity. To mitigate these risks, we have designed our liquidity and funding policies to maintain sufficient liquid financial resources to continually fund our balance sheet and to meet all expected cash outflows for one year in a stressed liquidity environment. See “Liquidity, Funding and Capital Resources—Liquidity Risk Management” in this MD&A for more information.

Credit Ratings

Our access to the unsecured funding markets and our competitive position is dependent on our credit ratings. A reduction in our credit ratings could adversely affect our access to liquidity alternatives and could increase the cost of funding or trigger additional collateral requirements. See “Liquidity, Funding and Capital Resources—Credit Ratings” in this MD&A for more information.

Credit Exposure

Credit exposure represents the possibility that a counterparty will be unable to honor its contractual obligations. Although we actively manage credit exposure daily as part of our risk management framework, counterparty default risk may arise from unforeseen events or circumstances. See “Risk Management—Credit Risk” in this MD&A for more information.

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LEHMAN BROTHERS HOLDINGS INC.

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

 

Operational Risk

Operational risk is the risk of loss resulting from inadequate or failed internal or outsourced processes, people, infrastructure and technology, or from external events. We seek to minimize these risks through an effective internal control environment. See “Risk Management—Operational Risk” in this MD&A for more information.

Legal, Regulatory and Reputational Risk

The securities and financial services industries are subject to extensive regulation under both federal and state laws in the U.S. as well as under the laws of the many other jurisdictions in which we do business. We are subject to regulation in the U.S. by governmental agencies including the SEC and Commodity Futures Trading Commission, and outside the U.S. by various international agencies including the Financial Services Authority in the United Kingdom and the Financial Services Agency in Japan. We also are regulated by a number of self-regulatory organizations such as the National Association of Securities Dealers, the Municipal Securities Rulemaking Board and the National Futures Association, and by national securities and commodities exchanges, including the New York Stock Exchange. As of December 1, 2005, Holdings became regulated by the SEC as a consolidated supervised entity (“CSE”), and as such, we are subject to group-wide supervision and examination by the SEC, and accordingly, we are subject to minimum capital requirements on a consolidated basis. Violation of applicable regulations could result in legal and/or administrative proceedings, which may impose censures, fines, cease-and-desist orders or suspension of a firm, its officers or employees.

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

Our reputation is critical in maintaining our relationships with clients, investors, regulators and the general public, and is a key focus in our risk management efforts.

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

See Part I, Item 1A, “Risk Factors” in this Form 10-K for additional information about these and other risks inherent in our business.

 

Summary of Results

In 2006, we achieved our third consecutive year of record net revenues, net income and diluted earnings per share. Our 2006 results were driven by record net revenues in each business segment and geographic region. Net income totaled $4.0 billion, $3.3 billion and $2.4 billion in 2006, 2005 and 2004, respectively, increasing 23% in 2006 and 38% in 2005 from the corresponding 2005 and 2004 periods, respectively. Diluted earnings per share were $6.81, $5.43 and $3.95 in 2006, 2005 and 2004, respectively, up 25% in 2006 and 37% in 2005 from the corresponding prior periods, respectively. The 2006 results included an after-tax gain of $47 million ($0.08 per diluted common share) from the cumulative effect of an accounting change for equity-based compensation resulting from the Company’s adoption of Statement of Financial Accounting Standards (“SFAS”) No.123 (revised) Share-Based Payment (“SFAS 123(R)”). See Note 15 to the Consolidated Financial Statements for additional information.

1                   Market share, volume and ranking statistics in this MD&A were obtained from Thomson Financial.

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LEHMAN BROTHERS HOLDINGS INC.

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

 

Net revenues were $17.6 billion, $14.6 billion and $11.6 billion in 2006, 2005 and 2004, respectively. Net revenues increased 20% in 2006 from 2005. Capital Markets segment net revenues increased 22% to $12.0 billion in 2006 from $9.8 billion in 2005, as both Fixed Income Capital Markets and Equities Capital Markets achieved record net revenues. Fixed Income Capital Markets net revenues increased 15% to $8.4 billion in 2006 from $7.3 billion in 2005 due to broad based strength across products and regions. Equities Capital Markets net revenues rose 44% to $3.6 billion in 2006 from $2.5 billion in 2005, driven by solid client–flow activity in the cash and prime broker businesses and favorable equity markets globally. Investment Banking segment revenues increased 9% to $3.2 billion in 2006 from $2.9 billion in 2005, reflecting record Global Finance–Debt and Advisory Services revenues, partially offset by a slight decrease in Global Finance–Equity revenues from the prior year. Investment Management segment net revenues increased 25% to $2.4 billion in 2006 from $1.9 billion in 2005, reflecting record net revenues in both Private Investment Management and Asset Management, including record assets under management (“AUM”) of $225 billion. Non–U.S. net revenues increased 21% to $6.5 billion in 2006 from $5.4 billion in 2005, representing 37% of total net revenues for both the 2006 and 2005 periods. See “Business Segments” and “Geographic Revenues” in this MD&A for a detailed discussion of net revenues by business segment and geographic region.

Net revenues increased 26% to $14.6 billion in 2005 from $11.6 billion in 2004, reflecting higher net revenues in each of our three business segments and in each geographic region. Capital Markets business segment net revenues increased 27% to $9.8 billion in 2005 from $7.7 billion in 2004. Fixed Income Capital Markets net revenues increased 28% to a then-record $7.3 billion in 2005 from $5.7 billion in 2004, on improved client-flow activities, and an increased contribution from the non–U.S. regions across a number of products. Equities Capital Markets net revenues rose 26% to $2.5 billion in 2005 from $2.0 billion in 2004, benefiting from higher global trading volumes and market indices, particularly in Europe and Asia, as well as increased prime broker activities. Investment Banking segment revenues increased 32% to $2.9 billion in 2005 from $2.2 billion in 2004, reflecting improved Global Finance–Debt, Global Finance–Equity and Advisory Services revenues. Investment Management segment net revenues increased 14% to $1.9 billion in 2005 from $1.7 billion in 2004, reflecting then-record net revenues in both Private Investment Management and Asset Management, and AUM grew to $175 billion. Non–U.S. net revenues increased to 37% of total net revenues in 2005, up from 29% in 2004, resulting from higher revenues in Investment Banking and Capital Markets in both the Europe and Asia Pacific and other regions.

See “Business Segments” and “Geographic Revenues” in this MD&A for a detailed discussion of net revenues by business segment and geographic region.

Business Environment

As a global investment bank, our results of operations can vary in response to global economic and market trends and geopolitical events. A favorable business environment is characterized by many factors, including a stable geopolitical climate, transparent financial markets, low inflation, low unemployment, global economic growth, and high business and investor confidence. These factors can influence (i) levels of debt and equity issuance and merger and acquisition (“M&A”) activity, which can affect our Investment Banking business, (ii) trading volumes, financial instrument and real estate valuations and client activity in secondary financial markets, which can affect our Capital Markets businesses and (iii) wealth creation, which can affect both our Capital Markets and Investment Management businesses.

The global market environment was favorable again in 2006, and generally supportive for growth in our businesses. Positive market conditions in 2006 included a combination of factors - strong corporate profitability, deep pools of global liquidity, strong equity markets, low inflation and tightening credit spreads. Global equity markets rose to new highs on active trading levels. M&A and underwriting activities were also strong, driven by improved valuations, increased financial sponsor activity and a favorable interest rate environment.

Equity markets. Global equity markets rose 14% in local currency terms during 2006, as most major global indices posted double digit increases from 2005 levels. U.S. equity markets ended the year strong as concerns over oil prices and inflation earlier in the year subsided and the Federal Reserve Board (the “Fed”) paused its interest rate tightening. In 2006, the New York Stock Exchange, Dow Jones Industrial Average, S&P 500 and NASDAQ indices rose 17%, 13%, 12%, and 9%, respectively, from 2005. In the European equity markets, the FTSE and DAX rose 12% and 21%, respectively, from 2005. In Asia, the Nikkei and Hang Seng indices rose 9% and 27%, respectively, from 2005. These higher valuations served to fuel the equity origination calendar, and industry-wide market volumes increased 35% from 2005 levels. In the U.S., the New York Stock Exchange, Dow Jones Industrial Average, S&P 500 and NASDAQ average daily trading volumes increased 5%, 8%, 11%, and 29%, respectively, from 2005. In Europe, 2006 average

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

 

daily trading volumes of the FTSE and DAX increased 5% and 14%, respectively, from 2005. Average daily trading volumes on the Nikkei and Hang Seng exchanges rose 12% and 45%, respectively, in 2006 from 2005.

Fixed income markets. Global interest rates, while up slightly over 2005 levels, continued to remain low in absolute terms. The global economy grew at a strong pace in 2006, with particular strength in the first half of the year. With the exception of the United Kingdom, growth rates generally slowed in the second half of 2006 due to the impacts of higher oil prices and the slowdown in the U.S. housing market.

The U.S. yield curve continued to flatten, as longer term yields were little affected by the Federal Funds Rate increases of 100 basis points during calendar 2006. The Fed ended its interest rate tightening cycle in the third quarter as the U.S. economy began to slow down, and inflationary concerns lessened.

Conditions in Europe were favorable as the economy expanded by 3.1% during 2006, on strong profitability and improved exports. In Japan, prospects for growth improved throughout 2006 as the Bank of Japan signaled its confidence by ending its policy of zero percent interest rates in July. The yield curve ended the year inverted both in the U.S. and U.K., while flattening in Japan and continental Europe compared to 2005.

Strong global growth, deep pools of liquidity and low absolute interest rates all served to increase global trading volumes in fixed income in 2006 over 2005 levels. Total global debt origination increased 16% in 2006 from 2005, on higher issuances in virtually all products. Strong investor demand also led to a further tightening of credit spreads, most notably in high yield products.

Mergers and acquisitions. Stronger equity valuations, together with a favorable interest rate environment during 2006, led to a record M&A market. Financial sponsors in particular were very active, and had large pools of capital at their disposal. Announced M&A volumes increased 39% in 2006 from 2005, while completed M&A volumes increased 22% in 2006 compared to the prior year period.

Economic Outlook

The financial services industry is significantly influenced by worldwide economic conditions in both banking and capital markets. We expect global GDP growth of 3.1% in 2007, a slower rate than 2006, but a level that continues to be favorable for this industry. We expect the interest rate outlook to remain positive with the Fed not raising interest rates next year, the European Central Bank raising interest rates only one more time, the Bank of England raising rates twice during 2007 and the Bank of Japan increasing rates gradually throughout the year. We also expect global corporate profitability will remain resilient in spite of the slower growth, with corporate earnings growing by 7% in 2007. Additionally, corporate balance sheets will remain strong, as cash on hand currently comprises approximately 10% of total balance sheets. We expect that all of the above will lead to continued growth of capital markets activities across all regions, with prospects for growth in non—U.S. regions in particular being highly favorable.

Equity markets. We expect that solid corporate profitability and pools of excess liquidity will continue to have a positive effect upon the equity markets in 2007. We expect global equity indices to gain 10% in 2007. We also expect the equity offering calendar to increase by another 10% to 15% in 2007, as businesses continue to look to raise capital.

Fixed income markets. We expect fixed income origination to remain strong, which in turn should have a positive impact on secondary market flows. We expect approximately $9.6 trillion of global fixed income origination in calendar 2007, on par with 2006. As growth continues in Europe and Asia, we expect these regions to account for a more significant portion of global issuance. We also expect both fixed-income-related products and the fixed income investor base to continue to grow with a global trend of more companies’ debt financing requirements being sourced from the debt capital markets.

Fixed income activity is driven in part by the absolute level of interest rates, but also is highly correlated with the degree of volatility, the shape of the yield curve and credit quality, which in the aggregate impact the overall business environment. The fixed income investor base has changed dramatically from long-only investors of a few years ago to a continually growing hedge fund base and an expanding international investor base. Investors now employ far more developed risk mitigation tools to manage their portfolios. In addition, the size and diversity of the global fixed income marketplace have become significantly larger and broader over the last several years as capital markets continue to represent a deeper and more viable source of liquidity.

Mergers and acquisitions. We expect announced M&A activity to grow by 15% in 2007. Companies are looking to grow given the current market environment, and strategic M&A is a viable option, particularly for companies with

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

 

strong balance sheets and stronger stock valuations. Furthermore, given the high levels of uninvested capital among financial sponsors, together with a continued favorable interest rate environment, we expect financial sponsor-led M&A activity to remain strong.

Asset management and high net worth. We expect the rise of global equity indices and continued growth in economies to lead to further wealth creation. Given the growth in alternative products being offered coupled with favorable demographics and intergenerational wealth transfer, our outlook for asset management and services to high-net-worth individuals is positive. This growth will be further supported by high-net-worth clients continuing to seek multiple providers and greater asset diversification along with high service. We believe the significant expansion of our asset management offerings and the strong investment-return performances of our asset managers, coupled with our cross-selling initiatives, position us well for continued growth in 2007.

 

 

Overview

We achieved record net revenues, net income and diluted earnings per share in 2006 for the third consecutive fiscal year. Net revenues were $17.6 billion, $14.6 billion and $11.6 billion in 2006, 2005 and 2004, respectively, up 20% and 26% from the corresponding 2005 and 2004 periods. Net income totaled $4.0 billion, $3.3 billion and $2.4 billion in 2006, 2005 and 2004, respectively, up 23% and 38% from the corresponding 2005 and 2004 periods.

Diluted earnings per share were $6.81, $5.43 and $3.95 in 2006, 2005 and 2004, respectively, up 25% in 2006 and 37% in 2005 from the corresponding 2005 and 2004 periods, respectively. The full year 2006 results include an after-tax gain of $47 million, or $0.08 per diluted common share, as a cumulative effect of accounting change associated with our adoption of SFAS 123(R) on December 1, 2005.

Return on average common stockholders’ equity1 was 23.4%, 21.6% and 17.9% for 2006, 2005 and 2004, respectively. Return on average tangible common stockholders’ equity was 29.1%, 27.8% and 24.7% in 2006, 2005 and 2004, respectively.

Compensation and benefits expense as a percentage of net revenues was 49.3% in both 2006 and 2005 and 49.5% in 2004. Non-personnel expenses as a percentage of net revenues were 17.1%, 17.7% and 20.1% in 2006, 2005 and 2004, respectively. Pre-tax margin was 33.6%, 33.0% and 30.4% in 2006, 2005 and 2004, respectively.

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

Year ended November 30 (in millions)		2006			2005			2004
Average common stockholders’ equity		$	16,876		$	14,741		$	12,843
Average identifiable intangible assets and goodwill		(3,312		)	(3,272		)	(3,547		)
Average tangible common stockholders’ equity		$	13,564		$	11,469		$	9,296

 

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

 

Net Revenues

											Percent Change
In millions											2006/		2005/
Year ended November 30		2006			2005			2004			2005		2004
Principal transactions		$	9,802		$	7,811		$	5,699		25	%	37	%
Investment banking		3,160			2,894			2,188			9		32
Commissions		2,050			1,728			1,537			19		12
Interest and dividends		30,284			19,043			11,032			59		73
Asset management and other		1,413			944			794			50		19
Total revenues		46,709			32,420			21,250			44		53
Interest expense		29,126			17,790			9,674			64		84
Net revenues		$	17,583		$	14,630		$	11,576		20	%	26	%
Principal transactions, commissions and net interest revenue		$	13,010		$	10,792		$	8,594		21	%	26	%
Net interest revenue		$	1,158		$	1,253		$	1,358		(8	)%	(8	)%

 

Principal Transactions, Commissions and Net Interest Revenue

In both the Capital Markets segment and the Private Investment Management business within the Investment Management segment, we evaluate net revenue performance based on the aggregate of Principal transactions, Commissions and Net interest revenue (Interest and dividends revenue net of Interest expense). These revenue categories include realized and unrealized gains and losses, commissions associated with client transactions and the interest and dividend revenue and interest expense associated with financing or hedging positions. Caution should be used when analyzing these revenue categories individually because they may not be indicative of the overall performance of the Capital Markets and Investment Management business segments. Principal transactions, Commissions and Net interest revenue in the aggregate rose 21% in 2006 from 2005 and 26% in 2005 from 2004.

Principal transactions revenue improved 25% in 2006 from 2005, driven by broad based strength across fixed income and equity products. In Fixed Income Capital Markets, the notable increases in 2006 were in credit products, commercial mortgages and real estate. The 2006 increase in net revenues from Equities Capital Markets reflects higher client trading volumes, increases in financing and derivative activities, and higher revenues from proprietary trading strategies. Principal transactions in 2006 also benefited from increased revenues associated with certain structured products meeting the required market observability standard for revenue recognition. Principal transactions revenue improved 37% in 2005 from 2004, driven by improvements across both fixed income and equity products. In Fixed Income Capital Markets, businesses with higher revenues over the prior year included commercial mortgages and real estate, residential mortgages and interest rate products. Equities Capital Markets in 2005 benefited from higher trading volumes and improved equity valuations, as well as increases in financing and derivative activities from the prior year.

Commission revenues rose 19% in 2006 from 2005. The increase in 2006 reflects growth in institutional commissions on higher global trading volumes, partially offset by lower commissions in our Investment Management business segment as certain clients transitioned from transaction-based commissions to a traditional fee-based schedule.   Commission revenues rose 12% in 2005 from 2004 on higher global trading volumes.

Interest and dividends revenue and Interest expense are a function of the level and mix of total assets and liabilities (primarily financial instruments owned and sold but not yet purchased, and collateralized borrowing and lending activities), the prevailing level of interest rates and the term structure of our financings. Interest and dividends revenue and Interest expense are integral components of our evaluation of our overall Capital Markets activities. Net interest revenue declined 8% both in 2006 from 2005 and 2005 from 2004. The decrease in both comparison periods is a result of the change in the mix of asset composition, an increase in short-term U.S financing rates, and a flattened yield curve. Interest and dividends revenue and Interest expense rose 59% and 64%, respectively, in 2006 from 2005, and 73% and 84%, respectively in 2005 from 2004.   The increase in Interest and dividend revenues and Interest expenses in both comparison periods is attributable to higher short-term interest rates coupled with higher levels of interest- and dividend-earning assets and interest-bearing liabilities.

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

 

Investment Banking

Investment banking revenues represent fees and commissions received for underwriting public and private offerings of fixed income and equity securities, fees and other revenues associated with advising clients on M&A activities, as well as other corporate financing activities. Investment banking revenues rose to record levels in 2006, increasing 9% from 2005. Record Global Finance—Debt revenues increased 9% from 2005, reflecting significant growth in global origination market volumes. Global Finance—Equity net revenues decreased 1% compared to 2005, despite increased global origination market volumes. Record Advisory Services revenues increased 20% from 2005, reflecting higher completed global M&A transaction volumes. Investment banking revenues rose significantly in 2005, increasing 32% from 2004. See “Business Segments—Investment Banking” in this MD&A for a discussion and analysis of our Investment Banking business segment.

Asset Management and Other

Asset management and other revenues primarily result from asset management activities in the Investment Management business segment. Asset management and other revenues rose 50% in 2006 from 2005. The growth in 2006 primarily reflects higher asset management fees attributable to the growth in AUM, a transition to fee-based rather than commission-based pricing for certain clients, as well as higher private equity management and incentive fees. Asset management and other revenues rose 19% in 2005 from 2004, primarily due to higher asset management fees attributable to growth in AUM.

Non-Interest Expenses

											Percent Change
In millions											2006/		2005/
Year ended November 30		2006			2005			2004			2005		2004
Compensation and benefits		$	8,669		$	7,213		$	5,730		20	%	26	%
Non-personnel expenses:
Technology and communications		974			834			764			17		9
Brokerage, clearance and distribution fees		629			548			488			15		12
Occupancy		539			490			421			10		16
Professional fees		364			282			252			29		12
Business development		301			234			211			29		11
Other		202			200			173			1		16
Real estate reconfiguration charge		—			—			19			—		(100	)
Total non-personnel expenses		$	3,009		$	2,588		$	2,328		16	%	11	%
Total non-interest expenses		$	11,678		$	9,801		$	8,058		19	%	22	%
Compensation and benefits/Net revenues		49.3		%	49.3		%	49.5		%
Non-personnel expenses/Net revenues		17.1		%	17.7		%	20.1		%

 

Non-interest expenses were $11.7 billion, $9.8 billion, and $8.1 billion in 2006, 2005 and 2004, respectively. Significant portions of certain expense categories are variable, including compensation and benefits, brokerage and clearance, and business development. We expect these variable expenses as a percentage of net revenues to remain at the same proportions in future periods. We continue to maintain a strict discipline in managing our expenses.

Compensation and benefits. Compensation and benefits totaled $8.7 billion, $7.2 billion and $5.7 billion in 2006, 2005, and 2004, respectively. Compensation and benefits expense as a percentage of net revenues was 49.3%, in both 2006 and 2005 and 49.5% in 2004. Employees totaled approximately 25,900, 22,900 and 19,600 at November 30, 2006, 2005 and 2004, respectively. The increase in employees in both comparison periods was due to higher levels of business activity across the firm as we continue to make investments in the growth of the franchise, particularly in non—U.S. regions. Compensation and benefits expense includes both fixed and variable components. Fixed compensation, consisting primarily of salaries, benefits and amortization of previous years’ deferred equity awards, totaled $3.9 billion, $3.2 billion and $2.6 billion in 2006, 2005 and 2004, respectively, up approximately 21% in each of the comparative periods primarily attributable to an increase in salaries as a result of a higher number of employees. Amortization of employee stock compensation awards was $1,007 million, $1,055 million and $800 million in 2006, 2005 and 2004, respectively. The 2006 stock compensation amortization of $1,007 million excludes $699 million of stock awards granted to retirement eligible employees in December 2006, which were accrued as a component of variable compensation expense in 2006. Variable compensation, consisting primarily of incentive compensation and

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

 

commissions, totaled $4.8 billion, $4.0 billion and $3.1 billion in 2006, 2005 and 2004, respectively, up 20% in 2006 compared to 2005 and 30% in 2005 from 2004, as higher net revenues resulted in higher incentive compensation.

Non-personnel expenses. Non-personnel expenses totaled $3.0 billion, $2.6 billion and $2.3 billion in 2006, 2005 and 2004, respectively. Non-personnel expenses as a percentage of net revenues were 17.1%, 17.7%, and 20.1% in 2006, 2005, and 2004, respectively. The increase in non-personnel expenses in 2006 from 2005 is primarily attributable to increased technology and communications and occupancy costs, professional fees and costs associated with increased levels of business activity.

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

Technology and communications expenses rose 9% in 2005 from 2004, reflecting increased costs associated with the continued expansion and development of our Capital Markets platforms and infrastructure, and increased technology costs to create further efficiencies in our mortgage origination businesses. Occupancy expenses increased 16% in 2005 from 2004 primarily attributable to growth in our global space requirements due to a higher number of employees. Brokerage and clearance expenses rose 12% in 2005 from 2004, due primarily to higher transaction volumes in certain Capital Markets products. Professional fees and business development expenses increased 12% and 11%, respectively, in 2005 from 2004 due primarily to the higher levels of business activity. Other expenses increased 16% in 2005 from 2004 due to a number of factors, including an increase in charitable contributions.

Real estate reconfiguration charge. In March 2004, we reached an agreement to exit virtually all of our remaining leased space at our downtown New York City location, which clarified the loss on the location and resulted in a $19 million charge ($11 million after tax). See Note 18 to the Consolidated Financial Statements for additional information about the real estate reconfiguration charge.

Insurance settlement. During 2004, we entered into a settlement with our insurance carriers relating to several legal proceedings noticed to the carriers and initially occurring prior to January 2003. Under the terms of the insurance settlement, the insurance carriers agreed to pay us $280 million. During 2004, we also entered into a Memorandum of Understanding to settle the In re Enron Corporation Securities Litigation class action lawsuit for $223 million. The settlement with our insurance carriers and the settlement under the Memorandum of Understanding did not result in a net gain or loss in our Consolidated Statement of Income as the $280 million settlement with our insurance carriers represented an aggregate settlement associated with several matters, including Enron and WorldCom. See Part I, Item 3, “Legal Proceedings” in this Form 10-K for additional information about the Enron securities class action and related matters.

Income Taxes

The provisions for income taxes totaled $1.9 billion, $1.6 billion and $1.1 billion in 2006, 2005 and 2004, respectively. These provisions resulted in effective tax rates of 32.9%, 32.5% and 32.0% for 2006, 2005 and 2004, respectively. The increases in the effective tax rates in 2006 and 2005 compared with the prior years were primarily due to an increase in level of pretax earnings which minimizes the impact of tax benefit items, and in 2006 a net reduction in certain benefits from foreign operations, partially offset by a reduction in the state and local tax rate due to favorable audit settlements.  See Note 17 to the Consolidated Financial Statements for additional information about income taxes.

Business Acquisitions and Dispositions

Capital Markets. During 2006, we acquired an established private student loan origination platform, a European mortgage originator, and an electronic trading platform, increasing our goodwill and intangible assets by approximately $150 million. We believe these acquisitions will add long-term value to our Capital Markets franchise by allowing us to enter into new markets and expand the breadth of services offered as well as providing additional loan product for our securitization pipeline.

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

 

During 2004, we acquired three residential mortgage origination platforms, increasing our goodwill and intangible assets by approximately $61 million. We believe these acquisitions add long-term value to our mortgage franchise by allowing further vertical integration of the business platform. Mortgage loans originated by the acquired companies are intended to provide a more cost-efficient source of loan product for our securitization pipeline.

 

 

We operate in three business segments: Capital Markets, Investment Banking and Investment Management. These business segments generate revenues from institutional, corporate, government and high-net-worth individual clients across each of the revenue categories in the Consolidated Statement of Income. Net revenues also contain certain internal allocations, including funding costs and inter-regional transfer pricing, all of which are centrally managed.

The following table summarizes the net revenues of our business segments:

Business Segments

											Percent Change
In millions											2006/		2005/
Year ended November 30		2006			2005			2004			2005		2004
Net revenues:
Capital Markets		$	12,006		$	9,807		$	7,694		22	%	27	%
Investment Banking		3,160			2,894			2,188			9		32
Investment Management		2,417			1,929			1,694			25		14
Total net revenues		17,583			14,630			11,576			20		26
Compensation and benefits		8,669			7,213			5,730			20		26
Non-personnel expenses (1)		3,009			2,588			2,328			16		11
Income before taxes (1)		$	5,905		$	4,829		$	3,518		22	%	37	%

 

(1)          Includes the real estate reconfiguration charge of $19 million recognized in 2004 which has not been allocated to our segments.

Capital Markets

											Percent Change
In millions											2006/		2005/
Year ended November 30		2006			2005			2004			2005		2004
Principal transactions		$	9,285		$	7,393		$	5,255		26	%	41	%
Commissions		1,420			1,132			1,033			25		10
Interest and dividends		30,264			18,987			10,999			59		73
Other		105			33			49			218		(33	)
Total revenues		41,074			27,545			17,336			49		59
Interest expense		29,068			17,738			9,642			64		84
Net revenues		12,006			9,807			7,694			22		27
Non-interest expenses (1)		7,286			6,235			5,168			17		21
Income before taxes (1)		$	4,720		$	3,572		$	2,526		32	%	41	%

 

(1)   Excludes real estate reconfiguration charge in 2004.

The Capital Markets business segment includes institutional client-flow activities, prime brokerage, research, mortgage origination and securitization, and secondary-trading and financing activities in fixed income and equity products. These products include a wide range of cash, derivative, secured financing and structured instruments and investments. We are a leading global market-maker in numerous equity and fixed income products including U.S., European and Asian equities, government and agency securities, money market products, corporate high grade, high yield and emerging market securities, mortgage- and asset-backed securities, preferred stock, municipal securities, bank loans, foreign exchange, financing and derivative products. We are one of the largest investment banks in terms of U.S. and Pan-European listed equities trading volume, and we maintain a major presence in over-the-counter (“OTC”) U.S. stocks, major Asian large capitalization stocks, warrants, convertible debentures and preferred issues. In addition, the Capital

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

 

Markets Prime Services business manages our equity and fixed income matched book activities, supplies secured financing to institutional clients, and provides secured funding for our inventory of equity and fixed income products. The Capital Markets segment also includes proprietary activities as well as principal investing in real estate and private equity.

Capital Markets Net Revenues

											Percent Change
In millions											2006/		2005/
Year ended November 30		2006			2005			2004			2005		2004
Fixed Income		$	8,447		$	7,334		$	5,739		15	%	28	%
Equities		3,559			2,473			1,955			44		26
		$	12,006		$	9,807		$	7,694		22	%	27	%

 

Net revenues totaled $12.0 billion, $9.8 billion and $7.7 billion in 2006, 2005 and 2004, respectively. Capital Markets net revenues in 2006 reflect record performances in both Fixed Income and Equities. Fixed Income revenues increased 15% in 2006 from 2005 on strong performances across most products. Equities revenues increased 44% in 2006 from 2005 on very strong levels of client-flow activity and profitable proprietary trading strategies. Fixed Income revenues rose 28% in 2005 from 2004 on improved client-flow activities, an increased contribution from the non—U.S. regions and record revenues across a number of products. Equities revenues rose 26% in 2005 from 2004, benefiting from higher global trading volumes and market indices, particularly in Europe and Asia, as well as increased prime brokerage activities.

Fixed Income net revenues grew to a record $8.4 billion in 2006, an increase of 15% from 2005. This growth was attributable to strong client-flow activity and profitable trading strategies, leading to record revenues in most products. The products that contributed most to the increase in revenues year-over-year included credit, commercial mortgages and real estate and prime brokerage, partially offset by strong, but lower revenues in both interest rate products and residential mortgages. Credit product revenues benefited from continued tightening credit spreads, improved market opportunities and strong client—flow activity, as well as revenues associated with certain structured products meeting the required market observability standard for revenue recognition. Revenues in 2006 from our real estate businesses grew to a record as historically low interest rates and the continuing demand for commercial real estate properties led to increases in asset sales and securitization volumes. In 2006 and 2005, we originated approximately $34 billion and $27 billion, respectively, of commercial mortgage loans, the majority of which have been sold through securitization or syndication activities. Prime brokerage revenues were also higher in 2006 compared to 2005 on increased client activity levels. Interest rate products also were strong, but declined in 2006 from 2005, due to slightly lower client-flow and lower revenues in Europe and Asia. Residential mortgage securitization volumes increased in 2006 as compared with 2005, but revenues from our residential mortgage origination and securitization businesses decreased overall. This decrease was primarily attributable to a softer housing market and lower margins. We securitized approximately $146 billion and $133 billion of residential mortgage loans in 2006 and 2005, respectively, including both originated loans and those we acquired in the secondary market. In 2006, we originated approximately $60 billion in residential mortgage loans as compared with $85 billion in 2005. Residential origination volumes from our non—U.S. platform increased in 2006, including those in the U.K., the Netherlands, Korea and Japan.

Fixed Income net revenues were a then-record $7.3 billion in 2005, increasing 28% from 2004, driven by double digit revenue increases from each geographic region and record revenues across a number of products, including commercial mortgages and real estate, residential mortgages, and interest rate products. Revenues from our commercial mortgages and real estate increased substantially in 2005 reaching then-record levels. Revenues from our residential mortgage origination and securitization businesses increased in 2005 from the robust levels in 2004, reflecting record volumes and the continued benefits associated with the vertical integration of our mortgage origination platforms. We originated approximately $85 billion and $65 billion of residential mortgage loans in 2005 and 2004, respectively. We securitized approximately $133 billion and $101 billion of residential mortgage loans in 2005 and 2004, respectively, including both originated loans and those we acquired in the secondary market. While the performance in our mortgage businesses reached record levels, these businesses were affected by somewhat lower levels of mortgage origination volumes and revenues in the U.S. in the latter half of 2005, partly offset by stronger volumes and revenues outside the U.S. We originated approximately $27 billion and $13 billion of commercial mortgage loans in 2005 and 2004, respectively, the

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

 

majority of which has been sold through securitization or syndication activities during both 2005 and 2004. Interest rate product revenues increased in 2005 on higher activity levels, as clients repositioned portfolios in light of rising global interest rates and a flattening U.S. yield curve. Credit product revenues also increased in 2005 as compared to 2004 driven by strength in both high yield and high grade credit products.

Equities net revenues increased 44% to a record level in 2006 on strong client-flow and robust global trading volumes. Global equity indices were up 14% in local currency terms for 2006, helped by strong earnings reports, lower energy prices and the end to the interest rate tightening cycle by the Fed. Substantially all equity products in 2006 surpassed their 2005 performance, including gains in cash products, prime brokerage, equity derivatives, convertibles and proprietary and principal activities. Our cash business remained strong in 2006 due to solid client-flow, higher IPO and secondary market volumes and a gain on the conversion of our NYSE seats. Our prime brokerage business continued to grow as both client balances and the number of clients have increased, resulting in strong results in all regions. Revenues in equity derivatives for 2006 were strong across all regions due to increased client activity, in spite of challenging market conditions during the second half of the year. Revenues from the convertibles business rose to their second highest level on increased client-flow and successful trading strategies.

Equities net revenues rose 26% in 2005 from 2004, benefiting from increased client activity from rising global equity indices and higher trading volumes. Global equity indices advanced 16% in local currency terms in 2005, benefiting from positive economic data and strong earnings reports, despite volatile energy prices and concerns about inflation and rising interest rates. Equities net revenues in 2005 reflected improved client-flow activities across most products, higher net revenues in equity derivatives and the continued growth in our prime brokerage business. Equity derivatives business net revenues in 2005 were notably strong, benefiting from higher volumes and improved market opportunities. Our prime brokerage business continued to benefit from an expanding client base and growth in client financing balances, as total balances increased 22% in 2005 from 2004.

Interest and dividends revenue and Interest expense are a function of the level and mix of total assets and liabilities (primarily financial instruments owned and sold but not yet purchased and collateralized borrowing and lending activities), the prevailing level of interest rates and the term structure of our financings. Interest and dividends revenue and Interest expense are integral components of our evaluation of our overall Capital Markets activities. Net interest revenues decreased 4% in 2006 from 2005 primarily due to higher short-term U.S. interest rates, a flattened yield curve and a change in mix of asset composition. Interest and dividends revenue and Interest expense increased 59% and 64%, respectively, in 2006 from 2005 as a result of higher short-term interest rates coupled with higher levels of interest- and dividend-earning assets and interest-bearing liabilities. Net interest revenue in 2005 declined 8% from 2004, due to higher short-term interest rates and a flatter yield curve, partially offset by higher levels of interest and dividend-earning assets. Interest and dividends revenue and Interest expense rose 73% and 84%, respectively, in 2005 from 2004, attributable to higher short-term interest rates coupled with higher levels of interest- and dividend-earning assets and interest-bearing liabilities.

Non-interest expenses increased to $7.3 billion in 2006 from $6.2 billion in 2005 and $5.2 billion in 2004. The growth in non-interest expenses in both periods reflects higher compensation and benefits expense related to improved performance, coupled with higher non-personnel expenses. Non-personnel expenses in both periods grew primarily due to increased technology and communications expenses attributable to the continued investments in our trading platforms, integration of business acquisitions, and higher brokerage and clearance costs and professional fees from increased business activities. Occupancy expenses also increased due to continued growth in the number of employees and in 2005 grew from 2004 due to our new facilities in London and Tokyo.

Income before taxes totaled $4.7 billion, $3.6 billion and $2.5 billion in 2006, 2005 and 2004, respectively, up 32% in 2006 from 2005 and 41% in 2005 from 2004. Pre-tax margin was 39%, 36% and 33% in 2006, 2005 and 2004, respectively.

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LEHMAN BROTHERS HOLDINGS INC.

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

 

Investment Banking

 

											Percent Change
In millions											2006/		2005/
Year ended November 30		2006			2005			2004			2005		2004
Investment banking revenues		$	3,160		$	2,894		$	2,188		9	%	32	%
Non-interest expenses (1)		2,500			2,039			1,601			23		27
Income before taxes (1)		$	660		$	855		$	587		(23	)%	46	%

 

(1)          Excludes real estate reconfiguration charge in 2004.

The Investment Banking business segment is made up of Advisory Services and Global Finance activities that serve our corporate and government clients. The segment is organized into global industry groups—Communications, Consumer/Retailing, Financial Institutions, Financial Sponsors, Healthcare, Hedge Funds, Industrial, Insurance Solutions, Media, Natural Resources, Pension Solutions, Power, Real Estate and Technology—that include bankers who deliver industry knowledge and expertise to meet clients’ objectives. Specialized product groups within Advisory Services include M&A and restructuring. Global Finance serves our clients’ capital raising needs through underwriting, private placements, leveraged finance and other activities associated with debt and equity products. Product groups are partnered with relationship managers in the global industry groups to provide comprehensive financial solutions for clients.

Investment Banking Revenues1

 

								Percent Change
In millions								2006/		2005/
Year ended November 30		2006		2005		2004		2005		2004
Global Finance—Debt		$1,424		$1,304		$1,002		9	%	30	%
Global Finance—Equity		815		824		560		(1	)	47
Advisory Services		921		766		626		20		22
		$3,160		$2,894		$2,188		9	%	32	%

 

Investment Banking revenues totaled $3.2 billion, $2.9 billion and $2.2 billion in 2006, 2005 and 2004, respectively. Investment Banking revenues increased 9% in 2006 from 2005, reflecting record Global Finance—Debt and Advisory Services revenues and near record Global Finance—Equity revenues.

Global Finance—Debt revenues were a record $1,424 million in 2006, increasing 9% over 2005 with investment grade and leverage finance revenues both reaching record levels. Our investment grade origination volumes increased 21% over 2005, as investors took advantage of continued low interest rates, tight credit spreads and a flattened yield curve. Leveraged Finance revenues increased significantly over 2005 on relatively flat volumes due to higher margins on several large transactions. Partially offsetting these factors was a lower level of client-driven derivative and other capital markets—related transactions with our investment banking clients which totaled $222 million in 2006, compared with $318 million in 2005. Publicly reported global debt origination market volumes increased 16% in 2006 over 2005, with our origination market volumes increasing 2% over the same period. For the 2006 calendar year, our market ranking for publicly reported global debt originations was four with a 6.0% share, down from a rank of two with a 6.7% share in calendar year 2005. Our debt origination fee backlog of $247 million at November 30, 2006 increased 13% from November 30, 2005. Debt origination backlog may not be indicative of the level of future business due to the

1            Debt and equity underwriting volumes are based on full credit for single-book managers and equal credit for joint-book managers. Debt underwriting volumes include both publicly registered and Rule 144A issues of high grade and high yield bonds, sovereign, agency and taxable municipal debt, non-convertible preferred stock and mortgage- and asset-backed securities. Equity underwriting volumes include both publicly registered and Rule 144A issues of common stock and convertibles. Because publicly reported debt and equity underwriting volumes do not necessarily correspond to the amount of securities actually underwritten and do not include certain private placements and other transactions, and because revenue rates vary among transactions, publicly reported debt and equity underwriting volumes may not be indicative of revenues in a given period. Additionally, because Advisory Services volumes are based on full credit to each of the advisors in a transaction, and because revenue rates vary among transactions, Advisory Services volumes may not be indicative of revenues in a given period.

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LEHMAN BROTHERS HOLDINGS INC.

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

 

frequent use of the shelf registration process. In 2005, Global Finance—Debt revenues were a then-record $1,304 million, increasing 30% over 2004 with global debt origination market volumes and our volumes increasing 13% and 8%, respectively, over the same period. Revenues in 2005 reflected strong global investment grade underwriting, which benefited from continued low interest rates, strong investor demand across a flattening yield curve and credit spreads at historic average levels. Revenues in 2005 also benefited from a higher level of client-driven derivative and other capital market-related transactions with our investment banking clients providing fees of $318 million in 2005, compared with $140 million in 2004. For the 2005 calendar year, our market ranking for publicly reported global debt originations was two with a 6.7% share, up from a rank of four with a 6.8% share in calendar year 2004.

Global Finance—Equity revenues declined 1% in 2006 to $815 million from record 2005 revenues, despite a 35% increase in industry-wide global equity origination market volumes. Revenues in 2006 reflect a 16% increase in our equity origination volumes over 2005, with particular strength in initial public offering (“IPO”) activities, offset by lower revenues from the Asia region, which benefited from several large transactions in 2005. Our market share for publicly reported global equity underwriting transactions decreased to 3.7% in calendar 2006 from 4.8% for calendar year 2005 and 4.3% in calendar 2004. Our equity-related fee backlog (for both filed and unfiled transactions) at November 30, 2006 was approximately $285 million, down 7% from November 30, 2005. Global Finance—Equity revenues grew 47% in 2005 to a then-record $824 million from 2004. Our publicly reported equity underwriting volumes rose 7% in 2005 from 2004 while industry-wide global equity origination market volumes remained relatively flat over the same period. In addition to our increased volume, our 2005 revenues also reflected a change in the mix of underwriting revenues with particular strength in IPOs.

Advisory Services revenues were a record $921 million in 2006, up 20% from 2005. Industry-wide completed and announced transaction volumes increased 22% and 39%, respectively, in 2006 from 2005, while our completed and announced volumes increased 13% and 57%, respectively, for the same periods. M&A volumes have continued to rise due to rising equity markets, strong corporate profitability and balance sheets, and available capital raised by financial sponsors. Our global market share for publicly reported completed transactions increased to 16.4% for calendar 2006, up from 13.7% in calendar year 2005, and 15.5% in calendar year 2004. Our M&A fee backlog at November 30, 2006 was $243 million down 1% from November 30, 2005. Advisory Services revenues were a then-record $766 million in 2005, up 22% from 2004. Industry-wide completed and announced transaction volumes increased 31% and 56%, respectively, in 2005 from 2004, while our completed and announced volumes increased 24% and 98%, respectively, for the same periods. Increased M&A volumes benefited from stable equity markets, increased financial sponsor activity as well as improved world economies in 2005.

Non-interest expenses rose 23% in 2006 from 2005, attributable to an increase in compensation and benefits expense related to an increased number of employees and higher revenues, as well as higher non-personnel expenses from increased business activity. Non-interest expenses rose 27% in 2005 from 2004, attributable to an increase in compensation and benefits expense related to improved performance and higher non-personnel expenses related to increased business activity.

Income before taxes was $660 million, $855 million and $587 million in 2006, 2005 and 2004, respectively, down 23% in 2006 and up 46% in 2005 from the comparable prior year periods. Pre-tax margin decreased to 21% in 2006, down from 30% in 2005 and 27% in 2004.

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