10-Q 1 0001.txt LEHMAN BROTHERS HOLDINGS INC. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended August 31, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ___________ Commission file number 1-9466 Lehman Brothers Holdings Inc. (Exact Name of Registrant As Specified In Its Charter) Delaware 13-3216325 (State or other jurisdiction of incorporation(I.R.S.Employer Identification No.) or organization) 3 World Financial Center New York, New York 10285 (Address of principal (Zip Code) executive offices) Registrant's telephone number, including area code: (212) 526-7000 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ______ As of October 5, 2000, 119,251,627 shares of the Registrant's Common Stock, par value $0.10 per share, were outstanding. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED AUGUST 31, 2000 INDEX Part I. FINANCIAL INFORMATION Page Number Item 1. Financial Statements - (unaudited) Consolidated Statement of Income - Three and Nine Months Ended 3 August 31, 2000 and August 31, 1999.................... Consolidated Statement of Financial Condition - August 31, 2000 and November 30, 1999................. 5 Consolidated Statement of Cash Flows - Nine Months Ended August 31, 2000 and August 31, 1999................... 7 Notes to Consolidated Financial Statements ............9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.........19 Part II. OTHER INFORMATION Item 1. Legal Proceedings.....................................40 Item 6. Exhibits and Reports on Form 8-K......................43 Signature ................................................................44 EXHIBIT INDEX ................................................................45 Exhibits -------------------------------------------------------------------------------- 2 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of INCOME (Unaudited) (In millions, except per share data)
Three months ended ------------------------------------- August 31 August 31 2000 1999 ---------------- ---------------- Revenues Principal transactions $ 1,071 $ 492 Investment banking 582 499 Commissions 234 151 Interest and dividends 5,461 3,590 Other 11 33 ---------------- ---------------- Total revenues 7,359 4,765 Interest expense 5,307 3,409 ---------------- ---------------- Net revenues 2,052 1,356 ---------------- ---------------- Non-interest expenses Compensation and benefits 1,067 688 Technology and communications 80 79 Brokerage and clearance 68 56 Business development 52 33 Professional fees 53 31 Occupancy 35 29 Other 24 23 ---------------- ---------------- Total non-interest expenses 1,379 939 ---------------- ---------------- Income before taxes and dividends on trust preferred securities 673 417 Provision for income taxes 202 112 Dividends on trust preferred securities 14 15 ---------------- ---------------- Net income $ 457 $ 290 ================ ================ Net income applicable to common stock $ 444 $ 279 ================ ================ Earnings per common share Basic $ 3.67 $ 2.30 ================ ================ Diluted $ 3.37 $ 2.20 ================ ================
See notes to consolidated financial statements. 3 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of INCOME (Unaudited) (In millions, except per share data)
Nine months ended ------------------------------------- August 31 August 31 2000 1999 ---------------- ---------------- Revenues Principal transactions $ 3,055 $ 1,718 Investment banking 1,664 1,250 Commissions 690 465 Interest and dividends 14,512 10,798 Other 113 57 ---------------- ---------------- Total revenues 20,034 14,288 Interest expense 14,025 10,359 ---------------- ---------------- Net revenues 6,009 3,929 ---------------- ---------------- Non-interest expenses Compensation and benefits 3,125 1,992 Technology and communications 250 242 Brokerage and clearance 188 175 Business development 128 91 Professional fees 128 82 Occupancy 97 85 Other 68 70 ---------------- ---------------- Total non-interest expenses 3,984 2,737 ---------------- ---------------- Income before taxes and dividends on trust preferred securities 2,025 1,192 Provision for income taxes 607 334 Dividends on trust preferred securities 42 28 ---------------- ---------------- Net income $ 1,376 $ 830 ================ ================ Net income applicable to common stock $ 1,293 $ 745 ================ ================ Earnings per common share Basic $ 10.54 $ 6.12 ================ ================ Diluted $ 9.81 $ 5.86 ================ ================
See notes to consolidated financial statements. 4 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of FINANCIAL CONDITION (Unaudited) (In millions)
August 31 November 30 2000 1999 ASSETS Cash and cash equivalents $ 4,967 $ 5,186 Cash and securities segregated and on deposit for regulatory and other purposes 3,059 1,989 Securities and other financial instruments owned: Governments and agencies 31,642 29,959 Mortgages and mortgage-backed 25,302 22,643 Corporate equities 24,102 12,790 Corporate debt and other 13,571 11,096 Derivatives and other contractual agreements 10,652 10,306 Certificates of deposit and other money market instruments 2,430 2,265 ------------------ ------------------ 107,699 89,059 ------------------ ------------------ Collateralized short-term agreements: Securities purchased under agreements to resell 72,617 62,222 Securities borrowed 22,453 19,397 Receivables: Brokers, dealers and clearing organizations 1,610 1,674 Customers 9,447 9,332 Others 1,648 1,354 Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $859 in 2000 and $889 in 1999) 561 485 Other assets 1,474 1,408 Excess of cost over fair value of net assets acquired (net of accumulated amortization of $136 in 2000 and $129 in 1999) 133 138 ------------------ ------------------ Total Assets $ 225,668 $ 192,244 ================== ==================
See notes to consolidated financial statements. 5 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of FINANCIAL CONDITION - (Continued) (Unaudited) (In millions, except share data)
August 31 November 30 2000 1999 -------------- ---------------- LIABILITIES AND STOCKHOLDERS' EQUITY Commercial paper and short-term debt $ 5,667 $ 5,476 Securities and other financial instruments sold but not yet purchased: Governments and agencies 24,445 22,396 Corporate equities 9,612 12,344 Derivatives and other contractual agreements 9,749 9,582 Corporate debt and other 4,595 2,288 -------------- ---------------- 48,401 46,610 -------------- ---------------- Collateralized short-term financing: Securities sold under agreements to repurchase 97,098 81,083 Securities loaned 9,128 4,568 Payables: Brokers, dealers and clearing organizations 1,110 1,184 Customers 13,300 10,971 Accrued liabilities and other payables 7,307 4,668 Long-term debt: Senior notes 32,086 27,375 Subordinated indebtedness 3,321 3,316 -------------- ---------------- Total liabilities 217,418 185,251 -------------- ---------------- Commitments and contingencies Trust preferred securities subject to mandatory redemption 710 710 STOCKHOLDERS' EQUITY Preferred stock 850 688 Common stock, $0.10 par value; 300,000,000 shares authorized; Shares issued: 125,030,511 in 2000 and 122,619,460 in 1999; Shares outstanding: 120,111,536 in 2000 and 119,912,810 in 1999 12 12 Additional paid-in capital 3,507 3,387 Accumulated other comprehensive income (net of tax) (8) (2) Retained earnings 3,346 2,094 Other stockholders' equity, net 281 254 Common stock in treasury, at cost: 4,918,975 shares in 2000 and 2,706,650 in 1999 (448) (150) ---------------- -------------- Total stockholders' equity 7,540 6,283 -------------- ---------------- Total liabilities and stockholders' equity $ 225,668 $ 192,244 ============== ================
See notes to consolidated financial statements. 6 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of CASH FLOWS (Unaudited) (In millions)
Nine months ended -------------------------------------- August 31 August 31 2000 1999 ----------------- ---------------- CASH FLOWS FROM OPERATING ACTIVITES Net income $ 1,376 $ 830 Adjustments to reconcile net income to net cash provided by (used in)operating activities: Depreciation and amortization 72 71 Provisions for losses and other reserves 19 26 Compensation payable in common stock 203 151 Other adjustments 35 40 Net change in: Cash and securities segregated (1,070) (26) Securities and other financial instruments owned (18,640) (10,105) Securities borrowed (3,056) (11,819) Receivables from brokers, dealers and clearing organizations 64 (432) Receivables from customers (115) (1,155) Securities and other financial instruments sold but not yet purchased 1,791 19,612 Securities loaned 4,560 3,569 Payables to brokers, dealers and clearing organizations (74) 379 Payables to customers 2,329 (1,819) Accrued liabilities and other payables 2,620 (217) Other operating assets and liabilities, net (1,177) 437 ----------------- ---------------- Net cash provided by (used in) operating activities $ (11,063) $ (458) ----------------- ----------------
See notes to consolidated financial statements. 7 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of CASH FLOWS (Continued) (Unaudited) (In millions)
Nine months ended ------------------------------------- August 31 August 31 2000 1999 ---------------- ---------------- CASH FLOWS FROM FINANCING ACTIVITES Proceeds from issuances of senior notes $ 11,874 $ 7,756 Principal payments of senior notes (6,331) (4,821) Principal payments of subordinated indebtedness (202) Net proceeds from commercial paper and short-term debt 191 12 Resale agreements net of repurchase agreements 5,620 (728) Payments for treasury stock purchases (470) (207) Dividends paid (122) (117) Issuances of common stock 68 12 Issuance (redemption) of preferred stock 162 (150) Issuances of trust preferred securities, net of issuance costs 690 ---------------- ---------------- Net cash provided by (used in) financing activities 10,992 2,245 ---------------- ---------------- CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property, equipment and leasehold improvements (148) (54) ---------------- ---------------- Net cash used in investing activities (148) (54) ---------------- ---------------- Net change in cash and cash equivalents (219) 1,733 ---------------- ---------------- Cash and cash equivalents, beginning of period 5,186 3,055 ---------------- ---------------- Cash and cash equivalents, end of period $ 4,967 $ 4,788 ================ ================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions) Interest paid totaled $14,075 and $10,555 for the nine months ended August 31, 2000 and August 31, 1999, respectively. Income taxes paid/(received) totaled $308 and $(43) for the nine months ended August 31, 2000 and August 31, 1999, respectively. See notes to consolidated financial statements. 8 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation: The consolidated financial statements include the accounts of Lehman Brothers Holdings Inc. ("Holdings") and subsidiaries (collectively, the "Company" or "Lehman Brothers"). Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high-net-worth individual clients and customers. The Company's 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 Company is engaged primarily in providing financial services. The principal U.S. subsidiary of Holdings is Lehman Brothers Inc. ("LBI"), a registered broker-dealer. All material intercompany accounts and transactions have been eliminated in consolidation. The Company's financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the "SEC") with respect to the Form 10-Q and reflect all normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. Pursuant to such rules and regulations, certain footnote disclosures which are normally required under generally accepted accounting principles have been omitted. It is recommended that these consolidated financial statements be read in conjunction with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the twelve months ended November 30, 1999 (the "Form 10-K"). The Consolidated Statement of Financial Condition at November 30, 1999 was derived from the audited financial statements. The nature of the Company's business is such that the results of any interim period may vary significantly from quarter to quarter and may not be indicative of the results to be expected for the fiscal year. Certain prior period amounts reflect reclassifications to conform to the current period's presentation. 2. Long-Term Debt: During the nine months ended August 31, 2000, the Company issued $11,874 million of long-term debt (all of which were senior notes). Of the total issuances during the period, $4,151 million were U.S. dollar fixed rate, $3,944 million were U.S. dollar floating rate, $2,463 million were foreign currency denominated fixed rate, and $1,316 million were foreign currency denominated floating rate. These issuances were primarily utilized to refinance current maturities of long-term debt in 2000 and to increase total capital (stockholders' equity, long-term debt and trust preferred securities). The Company's floating rate new issuances contain contractual interest rates based primarily on London Interbank Offered Rates ("LIBOR"). All of the Company's fixed rate new issuances were effectively converted to floating rate obligations through the use of interest rate swaps. Of the foreign denominated new issuances totaling $3,779 million, $711 million were effectively swapped to U.S. Dollars, with the remainder match funding foreign currency denominated capital needs. The Company had $6,331 million of long-term debt mature during the nine months ended August 31, 2000. 9 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 3. Capital Requirements: The Company operates globally through a network of subsidiaries, with several being subject to regulatory requirements. In the United States, LBI, as a registered broker-dealer, is subject to SEC Rule 15c3-1, the Net Capital Rule, which requires LBI to maintain net capital of not less than the greater of 2% of aggregate debit items arising from customer transactions, as defined, or 4% of funds required to be segregated for customers' regulated commodity accounts, as defined. At August 31, 2000, LBI's regulatory net capital, as defined, of $1,828 million exceeded the minimum requirement by $1,689 million. Lehman Brothers International (Europe) ("LBIE"), a United Kingdom registered broker-dealer and subsidiary of Holdings, is subject to the capital requirements of the Securities and Futures Authority ("SFA") of the United Kingdom. Financial resources, as defined, must exceed the total financial resources requirement of the SFA. At August 31, 2000, LBIE's financial resources of approximately $1,914 million exceeded the minimum requirement by approximately $442 million. Lehman Brothers Japan Inc.'s Tokyo branch, a regulated broker-dealer, is subject to the capital requirements of the Financial Supervisory Agency and, at August 31, 2000, had net capital of approximately $373 million which was approximately $175 million in excess of the specified levels required. Lehman Brothers Bank, FSB (the "Bank"), the Company's thrift subsidiary, is regulated by the Office of Thrift Supervision ("OTS"). The Bank exceeds all regulatory capital requirements and is considered well capitalized by the OTS. Certain other non-U.S. subsidiaries are subject to various securities, commodities and banking regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. At August 31, 2000, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. In addition, the Company's "AAA" rated derivatives subsidiaries, Lehman Brothers Financial Products Inc. ("LBFP") and Lehman Brothers Derivative Products Inc. ("LBDP"), have established certain capital and operating restrictions which are reviewed by various rating agencies. At August 31, 2000, LBFP and LBDP each had capital which exceeded the requirement of the most stringent rating agency by approximately $63 million and $26 million, respectively. The regulatory rules referred to above, and certain covenants contained in various debt agreements may restrict Holdings' ability to withdraw capital from its regulated subsidiaries, which in turn could limit its ability to pay dividends to shareholders. 4. Derivative Financial Instruments: In the normal course of business, the Company enters into derivative transactions to satisfy the needs of its clients and to manage the Company's own exposure to market and credit risk resulting from its trading activities (collectively, "Trading-Related Derivative Activities"). Derivative transactions entered into for Trading-Related Derivative Activities are recorded at market or fair value with realized and unrealized gains and losses recognized currently in Principal transactions in the Consolidated Statement of Income. Market or fair value for trading-related instruments is generally determined by either quoted market prices (for exchange-traded futures and options) or pricing models (for over-the-counter swaps, forwards and options). 10 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required for credit risk and liquidity risk. Further valuation adjustments may be recorded, as deemed appropriate for new or complex products or for positions with significant concentrations. These adjustments are integral components of the mark-to-market process. Credit-related valuation adjustments incorporate business and economic conditions, historical experience, concentrations, estimates of expected losses and the character, quality and performance of credit sensitive financial instruments. Unrealized gains and losses on derivative contracts are recorded on a net basis in the Consolidated Statement of Financial Condition for those transactions with counterparties executed under a legally enforceable master netting agreement and are netted across products when such provisions are stated in the master netting agreement. Listed in the following table is the fair value and average fair value of the Company's Trading-Related Derivative Activities. Average fair values of these instruments were calculated based upon month-end statement of financial condition values, which the Company believes do not vary significantly from the average fair value calculated on a more frequent basis. Variances between average fair values and period-end values are due to changes in the volume of activities in these instruments and changes in the valuation of these instruments due to variations in market and credit conditions.
Average Fair Value* Fair Value* Nine Months Ended August 31, 2000 August 31, 2000 (in millions) Assets Liabilities Assets Liabilities -------------------------------------------------------- -------------- -- --------------- -------------- --- --------------- Interest rate and currency swaps and options (including caps, collars and floors) $ 4,680 $ 3,673 $ 4,853 $ 3,938 Foreign exchange forward contracts and options 1,092 1,515 893 1,262 Other fixed income securities contracts (including options and TBAs) 328 333 899 781 Equity contracts (including equity swaps, warrants and options) 4,552 4,228 7,525 7,194 -------------- -- --------------- -------------- --- --------------- Total $ 10,652 $ 9,749 $ 14,170 $ 13,175 -------------- -- --------------- -------------- --- ---------------
* Amounts represent carrying value (exclusive of collateral) and do not include receivables or payables related to exchange-traded futures contracts. 11 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Average Fair Value* Fair Value* Twelve Months Ended November 30, 1999 November 30, 1999 ---------------------------------- --------------------------------- (in millions) Assets Liabilities Assets Liabilities -------------------------------------------------------- -------------- -- ---------------- --------------- - --------------- Interest rate and currency swaps and options (including caps, collars and floors) $ 4,807 $ 3,633 $ 4,406 $ 3,030 Foreign exchange forward contracts and options 878 1,310 1,226 1,287 Other fixed income securities contracts (including options and TBAs) 254 195 257 240 Equity contracts (including equity swaps, warrants and options) 4,367 4,444 2,478 3,291 Commodity contracts (including swaps, forwards and options) 15 5 -------------- -- ---------------- --------------- - --------------- Total $ 10,306 $ 9,582 $ 8,382 $ 7,853
* Amounts represent carrying value (exclusive of collateral) and do not include receivables or payables related to exchange-traded futures contracts. Assets included in the table above and on the previous page represent the Company's unrealized gains, net of unrealized losses for situations in which the Company has a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. Therefore, the fair value of assets/liabilities related to derivative contracts at August 31, 2000 represents the Company's net receivable/payable for derivative financial instruments before consideration of collateral. Included within the $10,652 million fair value of assets at August 31, 2000 was $9,445 million related to swaps and other OTC contracts and $1,207 million related to exchange-traded option and warrant contracts. Included within the $10,306 million fair value of assets at November 30, 1999 was $9,002 million related to swaps and other OTC contracts and $1,304 million related to exchange-traded option and warrant contracts. With respect to OTC contracts, including swaps, the Company views its net credit exposure to be $6,058 million at August 31, 2000, representing the fair value of the Company's OTC contracts in an unrealized gain position, after consideration of collateral. Presented below is an analysis of the Company's net credit exposure at August 31, 2000 for OTC contracts based upon actual ratings made by external rating agencies or by equivalent ratings established and utilized by the Company's Credit Risk Management Department. 12 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS Counterparty S&P/Moody's Net Credit Risk Rating Equivalent Exposure ----------- ---------- -------- 1 AAA/Aaa 9% 2 AA-/Aa3 or higher 37% 3 A-/A3 or higher 34% 4 BBB-/Baa3 or higher 15% 5 BB-/Ba3 or higher 4% 6 B+/B1 or lower 1% The Company is also subject to credit risk related to its exchange-traded derivative contracts. Exchange-traded contracts, including futures and certain options, are transacted directly on the exchange. To protect against the potential for a default, all exchange clearinghouses impose net capital requirements for their membership. Additionally, the exchange clearinghouse requires counterparties to futures contracts to post margin upon the origination of the contract and for any changes in the market value of the contract on a daily basis (certain foreign exchanges provide for settlement within three days). Therefore, the potential for losses from exchange-traded products is limited. For a further discussion of the Company's derivative related activities, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations - Off-Balance Sheet Financial Instruments and Derivatives" and Notes 1 and 12 to the Consolidated Financial Statements, included in the Form 10-K. 5. Other Commitments and Contingencies: In connection with its financing activities, the Company had outstanding commitments under certain lending arrangements of approximately $3.1 billion at August 31, 2000 and $4.2 billion at November 30, 1999. These commitments require borrowers to provide acceptable collateral, as defined in the agreements, when amounts are drawn under the lending facilities. Advances made under the above lending arrangements are typically at variable interest rates and generally provide for over-collateralization based upon the borrowers' creditworthiness. The Company, through its high grade and high yield sales, trading and underwriting activities, makes commitments to extend credit in loan syndication transactions and then participates out a significant portion of these commitments. The Company had lending commitments to high grade borrowers of $3.4 billion and $2.9 billion at August 31, 2000 and November 30, 1999, respectively, and has established a facility for third parties to purchase a majority of these commitments when they are funded. In addition, lending commitments to high yield borrowers totaled $1.1 billion and $1.4 billion at August 31, 2000 and November 30, 1999, respectively. All of these commitments and any related draw-downs of these facilities are typically secured against the borrowers' assets, have fixed maturity dates and are generally contingent upon certain representations, warranties and contractual conditions applicable to the borrower. Total commitments are not indicative of actual risk or funding requirements as the commitments may not be drawn or fully utilized, and the Company will continue to syndicate and/or sell these commitments. 13 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS At August 31, 2000 and November 30, 1999, the Company had commitments to invest up to $455 million and $411 million, respectively, directly and through partnerships, in private equity-related investments. These commitments will be funded as required through the end of the respective investment periods, principally expiring in 2004. In addition to these specific commitments, the Company had various other commitments of approximately $300 million at both August 31, 2000 and November 30, 1999, respectively. In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the advice of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial position or results of operations. As a leading global investment bank, risk is an inherent part of all of the Company's businesses and activities. The extent to which the Company properly and effectively identifies, assesses, monitors and manages each of the various types of risks involved in its trading (including derivatives), brokerage, and investment banking activities is critical to the success and profitability of the Company. The principal types of risks involved in the Company's activities are market risk, credit or counterparty risk and transaction risk. Management has developed a control infrastructure throughout the Company to monitor and manage these risks on a global basis. For further discussion of these matters, refer to Note 14 to the Consolidated Financial Statements, in the Form 10-K. 6. Segments: Lehman Brothers operates in three business segments: Investment Banking, Capital Markets, and Client Services. The Investment Banking Division provides advice to corporate, institutional and government clients throughout the world on mergers, acquisitions, and other financial matters. The Division also raises capital for clients by underwriting public and private offerings of debt and equity securities. The Capital Markets Division includes the Company's institutional sales, trading, research and financing activities in equity and fixed income cash and derivatives products. Through the Division, the Company is a 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, municipal securities, bank loans, foreign exchange and derivatives products. The Division also includes the Company's risk arbitrage and secured financing businesses as well as realized and unrealized gains and losses related to the Company's direct private equity investments. The financing business manages the Company's equity and fixed income matched book activities, supplies secured financing to institutional clients and customers, and provides secured funding for the Company's inventory of equity and fixed income products. 14 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS Client Services revenues reflect earnings from the Company's private client and private equity businesses. Private client revenues reflect the Company's high-net-worth retail customer flow activities as well as asset management fees earned from these clients. Private equity net revenues include the management and incentive fees earned in the Company's role as General Partner for seventeen merchant banking and venture capital partnerships. In addition, these revenues also include the appreciation of its general partnership interests. The Company's segment information for the three months and nine months ended August 31, 2000 and August 31, 1999 is presented below.
Three Months Ended Nine Months Ended ----------------------------------- ------------------------------------ August 31 August 31 August 31 August 31 2000 1999 2000 1999 ---------------- ---------------- ---------------- ---------------- Investment Banking: Net Revenue $ 571 $ 495 $ 1,635 $ 1,239 ================ ================ ================ ================ Earnings before taxes(1) $ 143 $ 168 $ 381 $ 404 ================ ================ ================ ================ Segment assets (billions) $ 0.4 $ 0.3 $ 0.4 $ 0.3 ================ ================ ================ ================ Capital Markets: Net Revenue $ 1,282 $ 700 $ 3,703 $ 2,265 ================ ================ ================ ================ Earnings before taxes(1) $ 471 $ 207 $ 1,412 $ 685 ================ ================ ================ ================ Segment assets (billions) $ 212.7 $ 191.1 $ 212.7 $ 191.1 ================ ================ ================ ================ Client Services: Net Revenue $ 199 $ 161 $ 671 $ 425 ================ ================ ================ ================ Earnings before taxes(1) $ 59 $ 43 $ 232 $ 104 ================ ================ ================ ================ Segment assets (billions) $ 12.6 $ 10.7 $ 12.6 $ 10.7 ================ ================ ================ ================ Total: Net Revenue $ 2,052 $ 1,356 $ 6,009 $ 3,929 ================ ================ ================ ================ Earnings before taxes(1) $ 673 $ 418 $ 2,025 $ 1,193 ================ ================ ================ ================ Segment assets (billions) $ 225.7 $ 202.1 $ 225.7 $ 202.1 ================ ================ ================ ================
(1) And before dividends on trust preferred securities. 15 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS The following are net revenues by geographic region:
Three Months Ended Nine Months Ended ------------------------------------------ ------------------------------------------ August 31 August 31 August 31 August 31 2000 1999 2000 1999 ------------------- ------------------- ------------------- ------------------- Americas* $ 1,292 $ 752 $ 3,472 $ 2,323 Europe 629 522 1,900 1,274 Asia Pacific 131 82 637 332 ------------------- ------------------- ------------------- ------------------- Total $ 2,052 $ 1,356 $ 6,009 $ 3,929 =================== =================== =================== ===================
* Includes non-U.S. revenues of $18 million and $13 million for the three months ended August 31, 2000 and August 31, 1999 respectively, and includes non-U.S. revenues of $56 million and $32 million for the nine months ended August 31, 2000 and August 31, 1999, respectively. 16 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 7. Incentive Plans: In the third quarter of 2000, the Company delivered 5.7 million shares of its common stock to current and former employees in satisfaction of RSUs awarded in 1995. Substantially all of the shares delivered were funded from the RSU Trust. The Company increased additional paid-in capital by approximately $150 million for the tax effect of the appreciation in the Company's stock price from the grant date to the delivery date. The Company also received 1.8 million shares from current and former employees in satisfaction of applicable tax withholding requirements. Shares received were recorded as treasury stock at an aggregate value of $168 million. At August 31, 2000 and November 30, 1999, 21.5 million and 24.8 million shares were held in the RSU Trust, respectively. 8. Earnings Per Common Share: Earnings per share was calculated as follows (in millions, except for per share data):
Three Months Ended Nine Months Ended August 31 August 31 ------------------------------------- --------------------------------- 2000 1999 2000 1999 Numerator: Net income $ 457 $ 290 $ 1,376 $ 830 Preferred stock dividends (13) (11) (83) (85) ----------------- ----------------- --------------- -------------- Numerator for basic earnings per share-income available to common stockholders 444 279 1,293 745 Convertible preferred stock dividends 2 4 6 14 Numerator for diluted earnings per share-income available to common stock-holders (adjusted for assumed conversion of preferred stock) $ 446 $ 283 $ 1,299 $ 759 ================= ================= =============== ============== Denominator: Denominator for basic earnings per share - weighted-average shares 121.1 121.3 122.6 121.8 Effect of dilutive securities: Employee stock options 7.5 3.0 6.1 2.7 Employee restricted stock units 2.7 2.2 2.4 2.0 Preferred shares assumed converted into common 1.2 2.6 1.2 3.1 ----------------- ----------------- -------------- --------------- Dilutive potential common shares 11.4 7.8 9.7 7.8 ----------------- ----------------- --------------- -------------- Denominator for diluted earnings per share - adjusted weighted- average shares 132.5 129.1 132.3 129.6 ================= ================= =============== ============== Basic earnings per share $ 3.67 $ 2.30 $ 10.54 $ 6.12 ================= ================= =============== ============== Diluted earnings per share $ 3.37 $ 2.20 $ 9.81 $ 5.86 ================= ================= =============== ==============
Preferred Shares are convertible into common shares at a conversion price of approximately $123.00 per share. However, for purposes of calculating diluted earnings per share, preferred shares are assumed to be converted into common shares when basic earnings per share exceeds preferred dividends per share obtainable upon conversion (approximately $1.54 on a quarterly basis). 17 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 9. Subsequent Event: On September 20, 2000, Lehman's Board of Directors declared a two-for-one common stock split, to be effected in the form of a 100% stock dividend, payable on October 20, 2000 to stockholders of record on October 5, 2000. The par value of the common stock will remain at $0.10 per share. Accordingly, an adjustment from paid-in capital to common stock will be required to preserve the par value of the post-split shares. Pro forma earnings per share, giving retroactive effect to the two-for-one common stock split, for the three- and nine-month periods ended August 31, 2000 and August 31, 1999, respectively, follow:
Three Months Ended Nine Months Ended ------------------------------- ------------------------------- August 31 August 31 August 31 August 31 2000 1999 2000 1999 ------------- -------------- -------------- -------------- Earnings per common share: Basic $ 1.83 $ 1.15 $ 5.27 $ 3.06 Diluted $ 1.68 $ 1.10 $ 4.91 $ 2.93 Weighted average shares: Basic 242.2 242.6 245.2 243.6 Diluted 265.0 258.2 264.6 259.2
Financial information contained elsewhere in these financial statements has not been adjusted to reflect the impact of the common stock split. 18 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Business Environment The principal business activities of Lehman Brothers Holdings Inc. ("Holdings") and subsidiaries (collectively, the "Company" or "Lehman Brothers") are investment banking and securities trading and sales, which by their nature are subject to volatility, primarily due to changes in interest and foreign exchange rates and security valuations, global economic and political trends and industry competition. As a result, revenues and earnings may vary significantly from quarter to quarter and from year to year. The favorable market and economic conditions in the United States during 1999 continued through April 2000, became choppy throughout the remaining half of the second fiscal quarter, and then turned positive again in the third fiscal quarter. Boosted by a wealth effect stemming from previous gains in the stock market, consumer spending soared during 2000. In response to strong growth and rising inflation fears, the Federal Reserve raised the Federal Funds rate by a total of 100 basis points to 6.50% over the first half of the year, with the last increase occurring on May 16, 2000. In the third fiscal quarter, concerns about possible future rate hikes mitigated as the Federal Reserve left rates unchanged. As a result of the changing economic climate, the U.S. equity markets were very volatile during the nine-month period ending August 31, 2000. By the middle of January 2000, in anticipation of further Fed rate hikes, the price of old-economy stocks, as measured by the Dow Jones Industrial Average, started to decline, falling briefly through the 10,000 barrier in late January and early February before recovering to end the three-quarter period at 11,215. New-economy stocks, as measured by the NASDAQ Composite, experienced significantly more volatility: climbing 40% to a new all-time high of 5,133 in early March, before slipping 41% to 3,043 in late May. The NASDAQ Composite then moved 38% above the May low to 4,206 at the end of August as the market unwound its prior expectations for further Fed tightening in the months ahead. The S&P 500 Index, a broader market barometer, rallied to a new all-time high of 1,553 in March prior to correcting 14% into mid-April. The S&P 500 Index then recovered to close the quarter at 1,518 at August 30. Benign U.S. inflation, coupled with a more subdued U.S. equity market, paved the way for the Federal Reserve to conclude its interest rate-hike campaign on May 16, 2000. Increased U.S. Treasury buybacks, lower volumes of U.S. corporate debt issuance, and revised forecasts for higher future U.S. budget surpluses in the first half of 2000, led to improved market fundamentals during the third fiscal quarter of 2000. Investors' appetite for credit spread products improved in early June and set the tone for renewed vigor in the new issuance calendar. Nominal bid spreads above comparable U.S. Treasuries for U.S. investment-grade corporate debt crested in May and declined 10 basis points to 176 basis points by August 31, 2000. In Europe, the ten-year bellwether Bund rose 17 basis points from 5.12% on December 1, 1999 to 5.29% on August 31, 2000, as the European Central Bank continued its tightening mode campaign to combat the threat of higher inflation and a weak euro. 19 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Activity in the European corporate bond market for the nine months ended August 31, 2000, slowed significantly compared to the same period in 1999. Issuance of fixed rate euro-denominated corporate debt declined by 36%, as a result of higher yields, a flatter government yield curve, and rising investor concern around corporate credit quality. Credit spreads widened by 20 basis points since the beginning of 2000, leading to an underperformance of corporate bonds compared to government securities. Trading activity also became more muted, affected by a shift in investor focus to equities, as well as volatile trading conditions in high profile sectors such as telecommunications. European equity markets were among the leading performers in the nine months to August 2000, returning 15% in local currency terms (FTSE World Index). However, the bulk of these gains were achieved in the first four months of the period. Recent months have been a more difficult environment for stock markets, reflecting a rollover in regional growth expectations and a rise in euro area inflation and short-term interest rates. Trading volume increased on levels of a year ago and announced merger and acquisition activity continued to run at high levels, although there is some evidence that the trend peaked in late-1999. Financial advisory activities on a global basis continued at record levels. Industrywide, the volume of announced merger and acquisition transactions in the nine months ended August 31, 2000 soared to $ 2.7 trillion, even though influenced by the announcement of a few large transactions. The first nine months of the year also reflected continued activity involving European companies and cross-border mergers and acquisitions. The forces of consolidation, deregulation and globalization across industry sectors continued to drive strategic combinations. Equity new issuance during the first nine months ended August 31, 2000 was at record levels worldwide, with volumes more than doubling over the same period last year. In the U.S., equity issuance more than tripled year-over-year. Fueling the domestic market was increased IPO activity and continued equity raising in the technology, telecommunications and new media sectors. Debt issuance was initially dampened by the outward shift in the yield curve in January and later by the inversion of the yield curve and the anticipation of future interest rate hikes by the Federal Reserve. However, as it becomes apparent that the Fed was on hold, market fundamentals improved during the third fiscal quarter of 2000. In the Far East, Japanese stocks lost over 5% of their value over the period as a whole (TOPIX) on evidence that the cyclical recovery was losing momentum at a time when the Bank of Japan was preparing markets for the end of the zero interest rate policy in August. On August 11, 2000, the Bank of Japan abandoned its 17-month "zero-rate" policy, thereby raising interest rates. The ten-year JGB bellwether climbed 4 basis points from 1.84% on December 1, 1999 to 1.88% on August 31, 2000. Outside of Japan, Asian markets achieved a respectable 8% local currency return, helped by diminishing concerns over the need for US rates to move sharply higher, and Latin American stock markets gained 11%, led by Brazil. Note: Except for the historical information contained herein, this Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based on current expectations, estimates and projections about the industries in which the Company operates. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. 20 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Results of Operations For the Three Months Ended August 31, 2000 and August 31, 1999 The Company reported net income of $457 million for the third quarter ended August 31, 2000, representing an increase of 58% from net income of $290 million for the third quarter ended August 31, 1999. Earnings per common share (diluted) rose to $3.37 for the third quarter of 2000 from $2.20 for the third quarter of 1999, an increase of 53%. The quarter represented the second highest quarterly revenues, net income and earnings per common share posted by the Company. These results reflect the continued execution of the Company's growth strategy into higher margin businesses such as investment banking and equities; increasing its presence in certain strategic businesses in Europe; and, at the same time, maintaining a discipline with regard to its expenses. The Company's strategy is based on the belief that: (1) these businesses generate higher returns on equity because they are less capital intensive; (2) their rapid growth accelerates the Company's overall rate of growth; and (3) they help reduce earnings volatility by diversifying the Company's revenue base. The Company's emphasis on these high margin businesses generated operating margins of 32.8% in the third quarter of 2000 compared with 30.8% in the third quarter of 1999. Net revenues increased 51% in the third quarter of 2000 to $2,052 million from $1,356 million in the third quarter of 1999. Non-personnel expenses as a percentage of net revenues decreased to 15.2% compared to 18.5% in the third quarter of 1999. Non-personnel expenses in total increased 24% compared to the third quarter of 1999, reflecting the Company's growth plan, however this rate of growth continues to be substantially less than the Company's revenue growth rate. Return on common equity was 27.5% for the quarter ended August 31, 2000, compared with 22.1% a year ago. The Company's compensation and benefits ratio increased to 52% of net revenues from 50.7%, although unchanged from the first and second quarters of 2000, reflecting the Company's continued expansion of its investment banking, equities, and European franchises as well as its investments in technology and e-commerce capabilities. In the following tables, the Company's results have been segregated into three business segments: Investment Banking, Capital Markets and Client Services. Each segment represents a group of activities and products with similar characteristics. These business activities result in revenues from both institutional clients as well as high-net-worth retail clients and are recognized within the different revenue categories in the Company's Consolidated Statement of Income. Net revenues by segment contain certain internal allocations, including funding costs, which are centrally managed. 21 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Three Months Ended August 31, 2000 and August 31, 1999 ----------------------------------------------------------------------------- (in millions) ----------------------------------------------------------------------------- Three Months Ended ---------------------------------- August 31 August 31 2000 1999 --------------- --------------- Investment Banking $ 571 $ 495 Capital Markets 1,282 700 Client Services 199 161 --------------- --------------- Total $ 2,052 $ 1,356 =============== =============== ----------------------------------------------------------------------------- The following discussion provides an analysis of the Company's net revenues for the periods above. Investment Banking This segment's net revenues result from fees earned by the Company for underwriting public and private offerings of fixed income and equity securities, raising capital and advising Investment Banking Net Revenues clients on merger and acquisition activities and other services. Investment Banking's net revenues increased 15% in the third quarter of 2000 to $571 million from $495 million in the third quarter of 1999, principally as a result of an increase in financial advisory and equity underwriting activities partially offset by a decrease in debt underwriting activities. Investment Banking Net Revenues ------------------------ ------------------------------ (in millions) Three Months Ended August 31 August 31 2000 1999 ------------------------ --------------- -------------- Equity Underwriting $ 194 $ 116 Debt Underwriting 150 239 Financial Advisory 227 140 ------------------------ --------------- -------------- $ 571 $ 495 --------------------------------------------------------------- Equity underwriting revenues increased 67% to $194 million in the third quarter of 2000 from $116 million in the third quarter of 1999, as the markets recovered from the April/May sell-off and deal flow remained strong through mid-August. Debt underwriting revenues decreased 37% from the third quarter of 1999 as global debt underwriting volumes lagged 1999 levels due to continued nervousness surrounding interest rates. High yield and mortgage backed products were particularly impacted. However, debt underwriting revenue increased approximately 30% from the second quarter of 2000, as market conditions started to become more favorable. Financial advisory revenues increased 62% to a record $227 million in the third quarter of 2000 from $140 million in the third quarter of 1999. The Company's market share for completed M&A transactions increased to 8.9% on a calendar year-to-date basis from 7.7% for calendar year 1999. 22 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Capital Markets This segment's net revenues reflect institutional flow activities and secondary trading and financing activities related to a broad spectrum of fixed income and equity products principally related to its customer flow business. These products include dollar and non-dollar government securities, mortgages, mortgage- and asset-backed securities, money market products, dollar and non-dollar corporate debt securities, emerging market securities, municipal securities, foreign exchange, fixed income and equity related derivatives, convertible securities and common and preferred Capital Markets Net Revenues equity securities. Capital Markets' net revenues were $1,282 million for the third quarter of 2000 compared to $700 million for the third quarter of 1999, an increase of 83%. Capital Markets Net Revenues ------------------ --------------------------------- (in millions) Three Months Ended August 31 August 31 2000 1999 ------------------ --------------- ----------------- Equities $ 725 $ 466 Fixed Income 557 234 ------------------ --------------- ----------------- $ 1,282 $ 700 ------------------ --------------- ----------------- Net revenues from the equity component of Capital Markets increased 56% to $725 million in the third quarter of 2000 from $466 million in the third quarter of 1999. Revenues benefited in the third quarter of 2000 from continued strong institutional customer flow and trading volumes primarily in European cash products, which experienced a record quarter. An unrealized gain of approximately $100 million from a direct investment in the Company's private equity portfolio also contributed to the increase. Net revenues from the fixed income component of Capital Markets increased 138% to $557 million in the third quarter of 2000 from $234 million in the third quarter of 1999. Market conditions improved during the quarter as interest rate concerns subsided and institutional flows increased across most fixed income products. Client Services Client Services net revenues reflect earnings from the Company's private client and private equity businesses. Private client net revenues reflect the Company's high-net-worth retail customer flow activities as well as asset management fees. Private equity net revenues include the management and incentive fees earned in the Company's role as General Partner for seventeen merchant banking and venture capital partnerships. Client Services Net Revenues --------------------- ---------------------------------- (in millions) Three Months Ended August 31 August 31 2000 1999 --------------------- -------------- ------------------- Private Client $ 186 $ 165 Private Equity 13 (4) --------------------- -------------- ------------------- $ 199 $ 161 --------------------- -------------- ------------------- Client Services' net revenues were $199 million in the third quarter of 2000 and $161 million in the third quarter of 1999. The 24% increase reflected continued strength in retail trading volume, particularly in equities, which was in part driven by the higher sales activity related to the Company's 10 Uncommon Values campaign. In addition, Private Equity management fees increased as the Company continues to sponsor new funds. 23 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Non-Interest Expenses Non-interest expenses were $1,379 million for the third quarter of 2000 and $939 million for the third quarter of 1999. Compensation and benefits expense as a percentage of net revenues increased to 52% for the quarter compared to the prior year's ratio of 50.7%. The increase reflects the Company's continued expansion of its investment banking, equities and European franchises as well as investment spending in technology and e-commerce capabilities. Nonpersonnel expenses were $312 million for the third quarter of 2000 and $251 million for the third quarter of 1999, an increase of 24.3% that reflected the impact of the Company's growth plan. However, nonpersonnel expenses as a percentage of net revenues declined to 15.2% for the third quarter of 2000 from 18.5% for the third quarter of 1999 as the Company's net revenues continued to grow at a faster rate than spending. Increased spending in personnel, business development, recruiting (professional fees), real estate (occupancy) and technology were consistent with the Company's planned growth. Higher brokerage and clearance costs were a result of increased customer volumes in equity cash products. Income Taxes The Company's income tax provision was $202 million for the third quarter of 2000 compared to $112 million for the third quarter of 1999. The effective tax rate was 30.0% for the third quarter of 2000 and 26.9% for the third quarter of 1999. This higher tax rate reflected the overall increase in the level of pre-tax income, which reduced the relative impact of certain tax preference revenues. 24 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Results of Operations For the Nine Months Ended August 31, 2000 and August 31, 1999 The Company reported record net income of $1,376 million for the nine months ended August 31, 2000, representing an increase of 66% from net income of $830 million for the nine months ended August 31, 1999. Earnings per common share (diluted) rose to $9.81 for the nine months of 2000 from $5.86 for the comparable period in 1999, an increase of 67%. Earnings per share computations for both periods include the recognition of $50 million in dividends on the Company's Redeemable Voting Preferred Stock. These results reflected the Company's continued ability to execute its strategy of growing its high margin investment banking and equities businesses; increasing its presence in certain strategic businesses in Europe; and, at the same time, maintaining a strict discipline with regard to its expenses. Net revenues increased to a record $6,009 million for the nine months of 2000 from $3,929 million for the nine months of 1999, surpassing full fiscal year 1999 revenues of $5,340. The Company's emphasis on high margin businesses supported an increase in the Company's operating margin to 33.7% for the nine months of 2000 from 30.3% for the nine months of 1999. Return on equity (excluding the impact of the $50 million in dividends on the Company's Redeemable Voting Preferred Stock) increased to 29.2% from 21.9% for the comparable period. Revenues in each of the Company's three segments grew by over 30% compared to the first nine months of the prior year. Non-personnel expenses increased only 15% in the nine months of 2000, despite an overall 53% increase in net revenues. As the result of the Company's continued emphasis on expense discipline, non-personnel expenses as a percentage of revenues has declined to 14.3% from 19.0%. The Company's compensation and benefits ratio increased to 52% of net revenues from 50.7% as the Company continued to increase headcount, making significant additions in areas where the Company is focusing its growth. In the following tables, the Company's results have been segregated into three business segments: Investment Banking, Capital Markets and Client Services. Each segment represents a group of activities and products with similar characteristics. These business activities result in revenues from both institutional clients as well as high-net-worth retail clients and are recognized within the different revenue categories in the Company's Consolidated Statement of Income. (Net revenues by segment contain certain internal allocations, including funding costs, which are centrally managed.) 25 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Nine Months Ended August 31, 2000 and August 31, 1999 ------------------------------------------------------------------------------- (in millions) Nine Months Ended --------------------------------- August 31 August 31 2000 1999 --------------- --------------- Investment Banking $ 1,635 $ 1,239 Capital Markets 3,703 2,265 Client Services 671 425 --------------- --------------- Total $ 6,009 $ 3,929 =============== =============== ------------------------------------------------------------------------------- The following discussion provides an analysis of the Company's net revenues for the periods above. Investment Banking This segment's net revenues result from fees earned by the Company for underwriting public and private offerings of fixed income and equity securities, raising capital and advising clients on merger and acquisition activities and other services. Investment Banking's net revenues increased 32% in the nine months of 2000 to $1,635 million from $1,239 million in the prior year, principally as a result of a significant increase in equity underwriting and financial advisory activities partially offset by lower debt underwriting activities. Equity underwriting revenues increased 127% to $682 million in the nine months of 2000 and have exceeded full year 1999 amounts. Investment Banking Net Revenues The strong results in equity underwriting were driven by increased issuances in the communications/media and technology sectors and strong growth in the European banking franchise. Investment Banking Net Revenues ------------------------ ---------------------------- (in millions) Nine Months Ended August 31 August 31 2000 1999 ------------------------ ------------- -------------- Equity Underwriting $ 682 $ 301 Debt Underwriting 419 563 Financial Advisory 534 375 ------------------------ ------------- -------------- $ 1,635 $ 1,239 ------------------------ ------------- -------------- Debt underwriting revenues decreased 26% to $419 million in the nine months of 2000 from $563 million in the nine months of 1999. The decrease resulted from challenging market conditions, which commenced in fiscal 2000, as rising interest rates led to decreased underwriting volume most prominently in the high yield market. Global debt underwriting volume was down 20% versus the nine months ended August 31, 1999 and high yield issuance was down 50% on the same basis. Financial advisory revenues increased 42% to $534 million in the nine months of 2000 as the Company continued its expansion in the investment banking segment and the overall M&A market remained robust. The value of the Company's completed M&A deals through the end of August 2000 was 50% higher than the value through the end of August 1999. In addition, market share for completed M&A transactions increased to 8.9% on a calendar year-to-date basis from 7.7% for calendar year 1999. 26 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Capital Markets This segment's net revenues reflect institutional flow activities and secondary trading and financing activities related to a broad spectrum of fixed income and equity products. These products include dollar and non-dollar government securities, mortgages, mortgage- and asset-backed securities, money market products, dollar and non-dollar corporate debt securities, emerging market securities, municipal securities, foreign exchange, fixed income and equity related derivatives, convertible securities and common and preferred equity securities. Capital Markets' net revenues were $3,703 million for the nine Capital Markets Net Revenues months of 2000 and $2,265 million for the nine months of 1999. Customer flow sales and trading volumes continued to increase at healthy rates, significantly contributing to this increase. Capital Markets Net Revenues ----------------- --------------------------------- (in millions) Nine Months Ended August 31 August 31 2000 1999 ----------------- --------------- ----------------- Equities $ 2,300 $ 1,105 Fixed Income 1,403 1,160 ----------------- --------------- ----------------- $ 3,703 $ 2,265 ----------------- --------------- ----------------- Net revenues from the equity component of Capital Markets increased 108% to $2,300 million in the nine months of 2000 from $1,105 million in the comparable 1999 period. Revenues benefited from significantly increased institutional customer flow activity in cash products, and record performance in equity derivatives driven by higher levels of market volatility, particularly in the first half of this year. Net revenues from the fixed income component of Capital Markets increased 21% to $1,403 million in the nine months of 2000 from $1,160 million in the comparable period last year. This was a result of increased institutional flow across most fixed income products. Client Services Client Services net revenues reflect earnings from the Company's private client and private equity businesses. Private client net revenues reflect the Company's high-net-worth retail customer flow activities as well as asset management fees. Private equity net revenues include the management and incentive fees earned in the Company's role as General Partner for seventeen merchant banking and venture capital partnerships. Client Services Net Revenues ---------------------- -------------------------------- (in millions) Nine Months Ended August 31 August 31 2000 1999 ---------------------- -------------- ----------------- Private Client $ 638 $ 420 Private Equity 33 5 ---------------------- -------------- ----------------- $ 671 $ 425 ---------------------- -------------- ----------------- Client Services' net revenues were $671 million in the nine months of 2000 and $425 million in the nine months of 1999. The 58% increase was driven by record customer activity due in part to the Company's increased equity syndicate activity, as well as performance fees resulting from higher portfolio returns in the Company's London-based managed assets in the first quarter of 2000. In addition, Private Equity management fees increased as the Company continues to sponsor new funds. 27 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Non-Interest Expenses Non-interest expenses were $3,984 million for the nine months of 2000 and $2,737 million for the comparable period in 1999. Compensation and benefits expense as a percentage of net revenues increased to 52.0% compared to 50.7% in 1999. This increase reflects the Company's continued expansion of its investment banking, equities and European franchises as well as its investments in technology and e-commerce capabilities. Nonpersonnel expenses were $859 million for the nine months of 2000 and $745 million for the nine months of 1999, an increase of 15.3% that reflected the impact of the Company's strategic growth plan. However, nonpersonnel expenses declined as a percentage of net revenues to 14.3% for the nine months of 2000 from 19.0% in the prior year's period, as the Company's net revenues increased at a significantly faster rate than expenses. Income Taxes The Company's income tax provision was $607 million for the nine months of 2000 compared to $334 million for the nine months of 1999. The effective tax rate was 30.0% for the first half of 2000 and 28.0% for prior year's period. The higher rate reflected an overall increase in the level of pre-tax income, which lessened the relative impact of certain tax preference revenues. 28 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Funding, Capital Resources and Liquidity Funding and Capital Policies The Company's Finance Committee is responsible for establishing and managing the funding and liquidity policies of the Company. These policies include recommendations for capital and balance sheet size as well as the allocation of capital and balance sheet to the Company's product areas. Members of the Company's treasury department and business unit financing groups work with the Finance Committee to ensure coordination of global funding efforts and implementation of the funding and liquidity policies. Regional asset and liability committees in the Company's principal funding centers are responsible for implementing funding strategies for their respective regions. The primary goal of the Company's funding policies is to provide sufficient liquidity and availability of funding sources to meet the needs of the Company's businesses. The key elements of these policies are to: (1) Maintain a total capital structure that supports the business activities in which the Company is engaged. (2) Finance the Company's assets, primarily on a secured basis. Together with Total Capital, secured funding provides a stable funding base and enables the Company to minimize its reliance on short-term unsecured debt. (3) Maintain funding availability in excess of actual utilization and obtain diversified funding through a global investor base which increases liquidity and reduces concentration risk. (4) Maintain sufficient financial resources to enable the Company to meet its obligations in periods of financial stress, defined as any event that severely constrains the Company's access to unsecured funding sources. Total Capital Total Capital (defined as long-term debt, trust preferred securities and stockholders' equity) was $43.7 billion at August 31, 2000 compared to $37.7 billion at November 30, 1999. The increase in Total Capital resulted from a net increase in long-term debt of $4.7 billion, the retention of earnings, amortization associated with RSU awards, the exercise of stock options granted to employees, tax credits arising from stock-based employee awards, and the issuance of $250 million of Series E Preferred Stock. These were offset by repurchases of common stock (to fund RSUs and option awards) and of $88 million (2.3 million shares) in convertible Series B Preferred Stock. 29 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS
August 31 November 30 (in millions) 2000 1999 ---------------------------------------- -------------------------------------- -------------------------------------- Long-term Debt Senior Notes $ 32,086 $ 27,375 Subordinated Indebtedness 3,321 3,316 --------- --------- 35,407 30,691 Trust Preferred Securities 710 710 Stockholders' Equity Preferred Equity 850 688 Common Equity 6,690 5,595 --------- --------- 7,540 6,283 ---------------------------------------- -------------------------------------- -------------------------------------- Total Capital $ 43,657 $ 37,684 ---------------------------------------- -------------------------------------- --------------------------------------
During the nine months of 2000, the Company issued $11,874 million in long-term debt, which was $5,543 million in excess of its maturing debt. Long-term debt increased to $35.4 billion at August 31, 2000 from $30.7 billion at November 30, 1999 with a weighted-average maturity of 3.9 years at August 31, 2000 and 3.7 years at November 30, 1999. Secured Funding The Company strives to maximize the portion of the Company's balance sheet that is funded on a secured basis. Secured funding includes securities and other financial instruments sold but not yet purchased, as well as collateralized short-term financings, defined as securities sold under agreements to repurchase ("repos") and securities loaned. Because of their secured nature, repos have historically been a stable financing source irrespective of market conditions. At August 31, 2000 and November 30, 1999, $145 billion and $123 billion, respectively, of the Company's total balance sheet of $226 billion and $192 billion at August 31, 2000 and November 30, 1999, respectively, was financed on a secured basis. By maximizing its use of secured funding, the Company minimizes its reliance on unsecured financing. As of August 31, 2000 and November 30, 1999, commercial paper and short-term debt outstanding totaled $5.7 billion and $5.5 billion, respectively. Of these amounts, commercial paper outstanding was $3.4 billion and $3.6 billion at August 31, 2000 and November 30, 1999, respectively. Back-Up Credit Facilities Holdings maintains a Revolving Credit Agreement (the "Credit Agreement") with a syndicate of banks. Under the terms of the Credit Agreement, the banks have committed to provide up to $2 billion for up to 364 days. Any loans outstanding on the commitment termination date may be extended for up to an additional year at the option of Holdings. The Credit Agreement contains covenants which require, among other things, that the Company maintain a specified level of tangible net worth. 30 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS In July 2000, the Company entered into a $1 billion Committed Securities Repurchase Facility (the "Facility") for LBIE, the Company's major operating entity in Europe. The Facility provides secured multi-currency financing for a broad range of collateral types. Under the terms of the Facility, the bank group will agree to provide funding for up to one year on a secured basis. Any loans outstanding on the commitment termination date may be extended for up to an additional year at the option of LBIE. The Facility contains covenants which require, among other things, that LBIE maintain specified levels of tangible net worth. There are no borrowings outstanding under either the Credit Agreement or the Facility. The Company may use the Credit Agreement and the Facility for general corporate purposes from time to time. The Company has maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times. Balance Sheet The Company's total assets increased to $225.7 billion at August 31, 2000 from $192.2 billion at November 30, 1999. The Company's adjusted total assets, defined as total assets less the lower of securities purchased under agreements to resell or securities sold under agreements to repurchase were $153.1 billion at August 31, 2000 compared to $130.0 billion at November 30, 1999. The Company believes adjusted total assets is a more effective measure of evaluating balance sheet usage when comparing companies in the securities industry. The increase in adjusted total assets primarily reflects higher levels of securities owned and borrowed associated with increased customer flow activities across most of its Capital Markets businesses. The Company's balance sheet consists primarily of cash and cash equivalents, securities and other financial instruments owned, and collateralized short-term financing agreements. The liquid nature of these assets provides the Company with flexibility in financing and managing its business. The majority of these assets are funded on a secured basis through collateralized short-term financing agreements with the remaining assets being funded through short-term unsecured financing and Total Capital. 31 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Financial Leverage Balance sheet leverage ratios are one measure used to evaluate the capital adequacy of a company. Leverage ratios are commonly calculated using either total assets or adjusted total assets divided by total stockholders' equity and trust preferred securities. The Company believes that the adjusted leverage ratio is a more effective measure of financial risk when comparing companies in the securities industry. The Company's adjusted leverage ratio based on adjusted total assets at both August 31, 2000 and November 30, 1999 was 18.6x. Due to the nature of the Company's sales and trading activities, the overall size of the Company's assets and liabilities fluctuates from time to time and at specific points in time may be higher than the fiscal quarter ends or the quarterly average. [CHART NOT REPRODUCED] 32 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Credit Ratings The Company, like other companies in the securities industry, relies on external sources to finance a significant portion of its day-to-day operations. The Company's access to and cost of funding is generally dependent upon its short- and long- term debt ratings. On September 14, 2000, Moody's Investors Service placed the ratings of Lehman Brothers Holdings Inc. as well as those of its rated subsidiaries, on review for possible upgrade. As of August 31, 2000 the short- and long-term debt ratings of Holdings and LBI were as follows:
Holdings LBI ----------------------------------- ----------------------------------- Short-term Long-term Short-term Long-term** ------------------------------------------- ---------------- ------------------ --- --------------- ------------------- Fitch F-1 A F-1 A/A- Moody's P-2 A3 P-1 A2*/A3 Standard & Poor's Corp. A-1 A A-1 A+*/A Thomson BankWatch TBW-1 A TBW-1 A+/A * Provisional ratings on shelf registration ** Senior/subordinated
33 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Other The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade-rated companies. For purposes of this discussion, high yield debt instruments are defined as securities or loans to companies rated BB+ or lower, or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities due to the issuer's creditworthiness and the liquidity of the market for such securities. In addition, these issuers have higher levels of indebtedness, resulting in an increased sensitivity to adverse economic conditions. The Company recognizes these risks and aims to reduce market and credit risk through the diversification of its products and counterparties. High yield debt instruments are carried at fair value, and unrealized gains or losses from these instruments are recognized in the Company's Consolidated Statement of Income. Such instruments at August 31, 2000 and November 30, 1999 included long positions with an aggregate market value of approximately $3.2 billion and $3.0 billion, respectively, and short positions with an aggregate market value of approximately $514 million and $290 million, respectively. The Company mitigates its aggregate and single issuer net exposure through the use of derivatives, sole-recourse securitization financing and other financial instruments. Additional information about the Company's high yield securities and lending activities, including related commitments, can be found in Note 5 to the Consolidated Financial Statements (Other Commitments and Contingencies). The Company has investments in seventeen merchant banking and venture capital-related partnerships, for which the Company acts as general partner, as well as related direct investments. At August 31, 2000, the Company's investment in these partnerships totaled $162 million and related direct investments totaled $793 million. The Company's policy is to carry its investments, including the appreciation of its general partnership interests, at fair value based upon the Company's assessment of the underlying investments. Additional information about the Company's private equity activities, including related commitments, can be found in Note 5 to the Consolidated Financial Statements (Other Commitments and Contingencies). 34 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Risk Management As a leading global investment banking company, risk is an inherent part of the Company's businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks of Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk Management is considered to be of paramount importance. Consequently, the Company devotes significant resources across all of its worldwide trading operations to the measurement, management and analysis of risk, including investments in personnel and technology. The Company seeks to reduce risk through the diversification of its businesses, counterparties and activities in geographic regions. The Company accomplishes this objective by allocating the usage of capital to each of its businesses, establishing trading limits for individual products and traders and setting credit limits for individual counterparties, including regional concentrations. The Company seeks to achieve adequate returns from each of its businesses commensurate with the risks that they assume. Overall risk management policy is established by a Risk Management Committee (the "Committee") comprised of the Chief Executive Officer, the Global Risk Manager, the Chief Financial Officer, the Chief Administrative Officer, the Co-Heads of Capital Markets, the Head of Investment Banking and the Head of Private Equity. The Committee brings together senior management with the sole intent of discussing risk-related issues and provides an effective forum for managing risk at the highest levels within the Company. The Committee meets on a monthly basis, or more frequently if required, to discuss, among other matters, significant market exposures, concentrations of positions (e.g., counterparty, market risk), potential new transactions or positions and risk limit exceptions. The Global Risk Management Group (the "Group") supports the Committee, is independent of the trading areas and reports directly to the Chief Executive Officer. The Group combines two departments, credit risk management and market risk management, into one unit. This facilitates the analysis of counterparty credit and market risk exposures and leverages personnel and information technology resources in a cost-efficient manner. The Group maintains staff in each of the Company's regional trading centers and has daily contact with trading staff at all levels within the Company. These discussions include a review of trading positions and risk exposures. Credit Risk Credit risk represents the possibility that a counterparty will be unable to honor its contractual obligations to the Company. Credit risk management is therefore an integral component of the Company's overall risk management framework. The Credit Risk Management Department ("CRM Department") has global responsibility for implementing the Company's overall credit risk management framework. 35 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS The CRM Department manages the credit exposure related to trading activities by giving initial credit approval for counterparties, establishing credit limits by counterparty, country and industry group and by requiring collateral in appropriate circumstances. In addition, the CRM Department strives to ensure that master netting agreements are obtained whenever possible. The CRM Department also considers the duration of transactions in making its credit decisions, along with the potential credit exposure for complex derivative transactions. The CRM Department is responsible for the continuous monitoring and review of counterparty credit exposure and creditworthiness and recommending valuation adjustments where appropriate. Credit limits are reviewed periodically to ensure that they remain appropriate in light of market events or the counterparty's financial condition. Market Risk Market risk represents the potential change in value of a portfolio of financial instruments due to changes in market rates, prices and volatilities. Market risk management also is an essential component of the Company's overall risk management framework. The Market Risk Management Department ("MRM Department") has global responsibility for implementing the Company's overall market risk management framework. It is responsible for the preparation and dissemination of risk reports, developing and implementing the firmwide Risk Management Guidelines and evaluating adherence to these guidelines. These guidelines provide a clear framework for risk management decision-making. To that end the MRM Department identifies and quantifies risk exposures, develops limits, and reports and monitors these risks with respect to the approved limits. The identification of material market risks inherent in positions includes, but is not limited to, interest rate, equity, and foreign exchange risk exposures. In addition to these risks, the MRM Department also evaluates liquidity risks, and credit and sovereign concentrations. The MRM Department utilizes qualitative as well as quantitative information in managing trading risk, believing that a combination of the two approaches results in a more robust and complete approach to the management of trading risk. Quantitative information is developed from a variety of risk methodologies based upon established statistical principles. To ensure high standards of qualitative analysis, the MRM Department has retained seasoned risk managers with the requisite experience and academic and professional credentials. Market risk is present in cash products, derivatives, and contingent claim structures that exhibit linear as well as non-linear profit and loss sensitivity. The Company's exposure to market risk varies in accordance with the volume of client-driven market-making transactions, the size of the Company's proprietary and arbitrage positions, and the volatility of financial instruments traded. The Company seeks to mitigate, whenever possible, excess market risk exposures through the use of futures and option contracts and offsetting cash market instruments. The Company participates globally in interest rate, equity, and foreign exchange markets. The Company's Fixed Income division has a broadly diversified market presence in U.S. and foreign government bond trading, emerging market securities, corporate debt (investment and non-investment grade), money market instruments, mortgages and mortgage-backed securities, asset- 36 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS backed securities, municipal bonds, and interest rate derivatives. The Company's Equities division facilitates domestic and foreign trading in equity instruments, indices, and related derivatives. The Company's foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts. The Company incurs short-term interest rate risk when facilitating the orderly flow of customer transactions through the maintenance of government and high grade corporate bond inventories. Market-making in high yield instruments exposes the Company to additional risk due to potential variations in credit spreads. Trading in international markets exposes the Company to spread risk between the term structure of interest rates in differing countries. Mortgages and mortgage-related securities are subject to prepayment risk and changes in the level of interest rates. Trading in derivatives and structured products exposes the Company to changes in the level and volatility of interest rates. The Company actively manages interest rate risk through the use of interest rate futures, options, swaps, forwards, and offsetting cash market instruments. Inventory holdings, concentrations and agings are monitored closely and used by management to selectively hedge or liquidate undesirable exposures. The Company is a significant intermediary in the global equity markets through its market-making in U.S. and non-U.S. equity securities, including common stock, convertible debt, exchange-traded and OTC equity options, equity swaps and warrants. These activities expose the Company to market risk as a result of price and volatility changes in its equity inventory. Inventory holdings are also subject to market risk resulting from concentrations, aging and liquidity that may adversely impact market valuation. Equity market risk is actively managed through the use of index futures, exchange-traded and OTC options, swaps and cash instruments. The Company enters into foreign exchange transactions in order to facilitate the purchase and sale of non-dollar instruments, including equity and interest rate securities. The Company is exposed to foreign exchange risk on its holdings of non-dollar assets and liabilities. The Company is active in many foreign exchange markets and has exposure to the euro, Japanese yen, British pound, Swiss franc, and Canadian dollar as well as a variety of developed and emerging market currencies. The Company hedges its risk exposures primarily through the use of currency forwards, swaps, futures, and options. Value-at-Risk For purposes of Securities and Exchange Commission ("SEC") risk disclosure requirements, the Company discloses an estimate of an entity-wide value-at-risk for virtually all of its trading activities. In general, value-at-risk measures potential loss of revenues at a given confidence level over a specified time horizon. Value-at-risk over a one-day holding period measured at a 95% confidence level implies that potential loss of daily trading revenue will be at least as large as the value-at-risk amount on one out of every 20 trading days. Our methodology estimates a reporting day value-at-risk using actual daily trading revenues over the previous 250 trading days. This estimate is measured as the loss, relative to the median daily trading revenue. We also estimate an average value-at-risk measure over 250 rolling reporting days, thus looking back a total of 500 trading days. 37 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS Estimated value-at-risk as described above at August 31, 2000 and November 30, 1999 was $20.5 million and $19.2 million, respectively. Average estimated value-at-risk as described above was $20.4 million and $30.9 million for the periods ended August 31, 2000 and November 30, 1999, respectively. Value-at-risk is one measure of potential loss in trading revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. As with all measures of value-at-risk, our estimate has substantial limitations due to its reliance on historical performance, which is not necessarily a predictor of the future Consequently, this value-at-risk estimate is only one of a number of tools the Company utilizes in its daily risk management activities. As discussed throughout Management's Discussion and Analysis, the Company seeks to reduce risk through the diversification of its businesses and a focus on customer flow activities. This diversification and focus, combined with the Company's risk management controls and processes, helps mitigate the net revenue volatility inherent in the Company's trading activities. Although historical performance is not necessarily indicative of future performance, the Company believes its focus on business diversification and customer flow activities should continue to help mitigate the volatility of future net trading revenues. 38 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION and ANALYSIS of FINANCIAL CONDITION and RESULTS of OPERATIONS New Accounting Developments In September 1999, the FASB issued an Exposure Draft, "Business Combinations and Intangible Assets." The proposal would eliminate the use of the pooling-of-interests method and require that all business combinations be accounted for using the purchase method. The provisions of the Exposure Draft related to business combinations are expected to be applied only for those business combinations initiated after the issuance of a final statement, projected to be in the first quarter of 2001. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), which requires all derivatives to be recorded on the balance sheet at fair value. In June 1999, the FASB extended the implementation date of SFAS 133 by one year. In June 2000, the FASB issued SFAS No. 138, which amended SFAS 133. The Company will adopt SFAS 133 as amended on December 1, 2000 (Fiscal Year 2001). SFAS 133 will not affect the accounting for Lehman's Trading-Related Derivative Activities as such derivatives are already recognized on a mark-to-market basis through earnings. Rather, SFAS 133 will affect the accounting for derivatives utilized as hedging instruments as part of Lehman's end user activities. As an end user, Lehman primarily utilizes derivatives to modify the interest rate characteristics of its long-term debt and secured financing activities ("End User Derivative Activities"). The Company currently accounts for its End-User Derivative activities on an accrual basis provided that the derivative is deemed a highly effective hedge. SFAS 133 generally will require Lehman to recognize its end user derivatives at fair value through earnings, with an offset recognized through earnings for changes in the fair value of the hedged item. Any ineffectiveness in a hedging relationship generally will require immediate earnings recognition. In addition to these changes, SFAS 133, will result in certain derivatives no longer qualifying for hedge accounting, requiring such derivatives to be marked to market through earnings without offset. Derivatives not likely to qualify for hedge accounting under SFAS 133 include U.S. dollar and foreign currency basis swaps. The Company has devoted significant resources preparing for the adoption of SFAS 133. While the impact of adopting SFAS 133 will be ultimately dependent upon the fair value of the end user derivatives portfolio at December 1, 2000 and their related hedge designations, the Company expects adoption will not materially impact the Company's stockholders' equity, results of operations, or statement of financial condition. 39 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1 Legal Proceedings The Company is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its business. Such proceedings include actions brought against the Company and others with respect to transactions in which the Company acted as an underwriter or financial advisor, actions arising out of the Company's 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 the Company. Although there can be no assurance as to the ultimate outcome, the Company has denied, or believes it has meritorious defenses and will deny, liability in all significant cases pending against it, including the matters described below, and intends to defend vigorously each such case, and based on information currently available and established reserves, the Company believes that the eventual outcome of the actions against it, including the matters described below, will not, in the aggregate, have a material adverse effect on its business or consolidated financial condition. Lehman Brothers Commercial Corporation and Lehman Brothers Special Financing Inc. v. Minmetals International Non-Ferrous Metals Trading Company (Reported in Holdings' 1999 Annual Report on Form 10-K) On August 10, 2000, the Court denied both parties' motions for summary judgment. A trial date has not yet been scheduled. AIA Holdings SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co., Inc. (Reported in Holdings' 1999 Annual Report on Form 10-K) The first trial is now scheduled to commence in mid-2001. Actions Relating to Bre-X Minerals Ltd. McNamara et al. v. Bre-X Minerals Ltd. et al. (Reported in Holdings' 1999 Annual Report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ended May 31, 2000) On July 14, 2000, LBI moved to dismiss the Fourth Amended Complaint. 40 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1 Legal Proceedings - continued Harold Gillet, et al. v. Goldman Sachs & Co, et al. (Reported in Holdings' 1999 Annual Report on Form 10-K) On April 29, 1999, LBI and the other defendants moved to dismiss the Consolidated Amended Complaint. On July 21, 2000, plaintiffs moved for leave to file a Second Amended Complaint that added a new plaintiff and new factual allegations. LBI and the other defendants have jointly opposed the plaintiffs' motion to amend the complaint. Both the defendants' motion to dismiss and the plaintiffs' motion to amend are pending before the Court. CHS Electronics, Inc. v. Credit Suisse First Boston Corp., et al. On August 3, 2000, a class action was filed in the United States District Court for the Southern District of Florida against 18 underwriters of IPO securities, including LBI. Plaintiffs seek compensatory 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. On October 2, 2000, LBI and the other defendants jointly moved to transfer this action to the Southern District of New York, where the Gillet case (see above) is pending, and to stay all proceedings in the Southern District of Florida pending the Court's resolution of the motion to transfer. Corporacion Nacional del Cobre de Chile v. Lehman Brothers Inc., Lehman Brothers Commercial Corp., Lehman Brothers Commodities Ltd. and Lehman Brothers Holdings Inc. (Reported in Holdings' 1999 Annual Report on Form 10-K) On August 31, 2000, the parties settled the matter and dismissed the arbitration. Pamahi Investment Corp., et al. v. Lehman Brothers Inc., et al. (Reported in Holdings' 1999 Annual Report on Form 10-K and Quarterly Report on Form 10-Q for the quarter ended February 29, 2000) On August 7, 2000, the parties settled the matter and dismissed the arbitration. Bowser v. First Alliance Mortgage Company, et al. (Reported in Holdings' Quarterly Report on Form 10-Q for the quarter ended May 31, 2000) On August 15, 2000, the United States Bankruptcy Court for the Central District of California entered an order dismissing with prejudice plaintiffs' claims against Holdings. 41 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1 Legal Proceedings - continued Island Venture Corporation, et al. v. Lehman Brothers Inc. and Lehman Brothers Securities Asia, Ltd. On August 3, 2000, Island Venture Corporation, Continental Resources Corporation, Recola Investment Corporation, Grand Concord Corporation, Goodwell Industrial Corporation, and Capital Pacific Corporation filed a lawsuit in the United States District Court for the District of New Jersey against LBI and Lehman Brothers Securities Asia, Ltd. The complaint arises in connection with the plaintiffs' purchase of various promissory notes issued by Indonesian companies in 1997 and upon which the issuers have defaulted. It also asserts claims relating to an alleged unauthorized liquidation for $8.5 million of a $10 million Asia Investment Grade Default Note ("Basket Note") issued by Lehman Brothers Holdings PLC. The complaint seeks rescission and damages under various common law theories of mutual mistake, breach of fiduciary duty, negligence and constructive fraud, as well as asserting claims under the New Jersey Blue Sky Laws and Section 10(b) of the Securities Exchange Act of 1934. The plaintiffs seek to recover damages in the face amount of approximately $66 million on all the notes they purchased and difference between the liquidation price and the face value of the Basket Note plus lost coupon payments. The plaintiffs have not yet served the complaint. 42 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES PART II - OTHER INFORMATION ITEM 6 Exhibits and Reports on Form 8-K The following exhibits and reports on Form 8-K are filed as part of this Quarterly Report, or where indicated, were heretofore filed and are hereby incorporated by reference: (a) Exhibits: 12 Computation in Support of Ratio of Earnings to Fixed Charges and Combined Fixed Charges and Preferred Dividends 27 Financial Data Schedule (b) Reports on Form 8-K: 1. Form 8-K dated June 16, 2000, Items 5 and 7. Financial Statements: Exhibit 99.2 Consolidated Statement of Income (Three Months Ended May 31, 2000) (Preliminary and Unaudited) Exhibit 99.3 Consolidated Statement of Income (Nine Months Ended August 31, 2000) (Preliminary and Unaudited) Exhibit 99.4 Segment Net Revenue Information (Three and Nine Months Ended August 31, 2000) (Preliminary and Unaudited) Exhibit 99.5 Selected Statistical Information (Preliminary and Unaudited) 2. Form 8-K dated July 7, 2000, Item 7. 43 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LEHMAN BROTHERS HOLDINGS INC. ----------------------------- (Registrant) Date: October 16, 2000 By: /s/ David Goldfarb Chief Financial Officer 44 EXHIBIT INDEX Exhibit No. Exhibit Exhibit 12 Computation in Support of Ratio of Earnings to Fixed Charges and Combined Fixed Charges and Preferred Dividends Exhibit 27 Financial Data Schedule 45 Exhibit 12 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION of RATIOS of EARNINGS to FIXED CHARGES and COMBINED FIXED CHARGES and PREFERRED STOCK DIVIDENDS (Dollars in millions) (Unaudited)
For the For the For the For the For the For the Twelve Twelve Twelve Twelve Twelve Nine Months Months Months Months Months Months Ended Ended Ended Ended Ended Ended November 30 November 30 November 30 November 30 November 30 August 31 1995 1996 1997 1998 1999 2000 ------------- ------------- ------------- ------------- ------------- -------------- Pre-tax earnings from continuing operations $ 369 $ 637 $ 937 $ 1,052 $ 1,631 $ 2,025 Add: Fixed charges (excluding capitalized interest) 10,449 10,852 13,043 15,813 13,681 14,052 ------------- ------------- ------------- ------------- ------------- -------------- Pre-tax earnings before fixed charges 10,818 11,489 13,980 16,865 15,312 16,077 ============= ============= ============= ============= ============= ============== Fixed charges: Interest 10,405 10,816 13,010 15,781 13,649 14,024 Other(a) 72 50 41 47 71 44 ------------- ------------- ------------- ------------- ------------- -------------- Total fixed charges 10,477 10,866 13,051 15,828 13,720 14,068 ------------- ------------- ------------- ------------- ------------- -------------- Preferred stock dividend requirements 64 58 109 124 174 162 ------------- ------------- ------------- ------------- ------------- -------------- Total combined fixed charges and preferred stock dividends $ 10,541 $ 10,924 $ 13,160 $ 15,952 $ 13,894 $ 14,230 ============= ============= ============= ============= ============= ============== RATIO OF EARNINGS TO FIXED CHARGES 1.03 1.06 1.07 1.07 1.12 1.14 RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED STOCK DIVIDENDS 1.03 1.05 1.06 1.06 1.10 1.13
(a) Other fixed charges consist of the interest factor in rentals and capitalized interest. Exhibit 27 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES This schedule contains summary financial information extracted from the Company's Consolidated Statement of Financial Condition at August 31, 2000 (Unaudited) and the Consolidated Statement of Income for the nine months ended August 31, 2000 (Unaudited) and is qualified in its entirety by reference to such financial statements. 1,000,000 PERIOD TYPE 9 MOS FISCAL YEAR END NOV-30-2000 PERIOD START DEC-01-1999 PERIOD END AUG-31-2000 CASH 8,026 RECEIVABLES 12,705 SECURITIES-RESALE 72,617 SECURITIES BORROWED 22,453 INSTRUMENTS OWNED 107,699 PP&E 561 TOTAL ASSETS 225,668 SHORT TERM 5,667 PAYABLES 14,410 REPOS SOLD 97,098 SECURITIES LOANED 9,128 INSTRUMENTS SOLD 48,401 LONG-TERM 35,407 PREFERRED-MANDATORY 710 PREFERRED 850 COMMON 12 OTHER SE 6,678 TOTAL LIABILITY AND EQUITY 225,668 TRADING REVENUE 3,055 INTEREST AND DIVIDENDS 14,512 COMMISSIONS 690 INVESTMENT BANKING 1,664 FEE REVENUE 0 INTEREST EXPENSE 14,025 COMPENSATION 3,125 INCOME-PRETAX 2,025 INCOME PRE-EXTRAORDINARY 1,376 EXTRAORDINARY 0 CHANGES 0 NET INCOME 1,376 EPS-BASIC $10.54 EPS-DILUTED $ 9.81