-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Enycm7q4+oELtwxmFBBHJFciDhbfyP8SB9PvMamY4Gb9NKpvjv01Vr6zwdKawW9B y4Ml8y5rnAr5Co+UOe86lw== 0000806085-98-000155.txt : 19981016 0000806085-98-000155.hdr.sgml : 19981016 ACCESSION NUMBER: 0000806085-98-000155 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19980831 FILED AS OF DATE: 19981015 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: LEHMAN BROTHERS HOLDINGS INC CENTRAL INDEX KEY: 0000806085 STANDARD INDUSTRIAL CLASSIFICATION: SECURITY BROKERS, DEALERS & FLOTATION COMPANIES [6211] IRS NUMBER: 133216325 STATE OF INCORPORATION: DE FISCAL YEAR END: 1130 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 001-09466 FILM NUMBER: 98726280 BUSINESS ADDRESS: STREET 1: AMERICAN EXPRESS TWR STREET 2: 3 WORLD FINANCIAL CNTR CITY: NEW YORK STATE: NY ZIP: 10285 BUSINESS PHONE: 2125267000 MAIL ADDRESS: STREET 1: AMERICAN EXPRESS TOWER 15TH FL STREET 2: 2 WORLD TRADE CENTER CITY: NEW YORK STATE: NY ZIP: 10048 FORMER COMPANY: FORMER CONFORMED NAME: SHEARSON LEHMAN HUTTON HOLDINGS INC DATE OF NAME CHANGE: 19901017 10-Q 1 LEHMAN BROTHERS HOLDINGS INC. 3RD QUARTER 10Q 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, 1998 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 (I.R.S. Employer Identification No.) of incorporation 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 September 30, 1998, 115,980,030 shares of the Registrant's Common Stock, par value $.10 per share, were outstanding. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED AUGUST 31, 1998 INDEX Part I. FINANCIAL INFORMATION Page Number Item 1. Financial Statements - (unaudited) Consolidated Statement of Income - Three and Nine Months Ended August 31, 1998 and 1997 ........................... 3 Consolidated Statement of Financial Condition - August 31, 1998 and November 30, 1997 .............. 5 Consolidated Statement of Cash Flows - Nine Months Ended August 31, 1998 and November 30, 1997............... 7 Notes to Consolidated Financial Statements............ 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............ 16 Part II. OTHER INFORMATION Item 1. Legal Proceedings ..................................... 39 Item 5. Other Information ..................................... 40 Item 6. Exhibits and Reports on Form 8-K ................. 40 Signatures............................................................ 41 EXHIBIT INDEX .................................................. 42 Exhibits LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of INCOME (Unaudited) (In millions, except per share data) Three months ended August 31 August 31 1998 1997 --------------- ---------- Revenues Investment banking $ 493 $ 396 Principal transactions 131 389 Commissions 137 111 Interest and dividends 5,254 3,554 Other (52) 19 ------ ------ Total revenues 5,963 4,469 Interest expense 5,033 3,398 ----- ----- Net revenues 930 1,071 ------ ----- Non-interest expenses Compensation and benefits 472 543 Brokerage, commissions and clearance fees 61 54 Professional services 49 43 Communications 37 35 Occupancy and Equipment 34 35 Business development 29 25 Depreciation and amortization 23 22 Other 18 33 ----- ------ Total non-interest expenses 723 790 ----- ------ Income before taxes 207 281 Provision for income taxes 56 84 ----- ------ Net income $151 $197 ==== ===== Net income applicable to common stock $139 $160 ==== ===== Weighted average shares Basic 121.5 118.7 ===== ===== Diluted 126.2 122.4 ===== ===== Earnings per common share Basic $1.15 $1.34 ===== ===== Diluted $1.10 $1.30 ===== ===== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of INCOME (Unaudited) (In millions, except per share data) Nine months ended August 31 August 31 1998 1997 --------------- --------- Revenues Investment banking $1,336 $ 910 Principal transactions 1,142 1,061 Commissions 378 299 Interest and dividends 13,235 9,931 Other 6 73 ------ ------ Total revenues 16,097 12,274 Interest expense 12,649 9,424 ------ ------ Net revenues 3,448 2,850 ----- ------ Non-interest expenses Compensation and benefits 1,749 1,445 Brokerage, commissions and clearance fees 175 172 Professional services 134 131 Communications 111 105 Occupancy and equipment 102 104 Business development 84 76 Depreciation and amortization 67 65 Other 68 80 ----- ------- Total non-interest expenses 2,490 2,178 ----- ----- Income before taxes 958 672 Provision for income taxes 296 210 ------ ------ Net income $ 662 $ 462 ===== ===== Net income applicable to common stock $ 587 $ 412 ===== ===== Weighted average shares Basic 120.9 117.9 ===== ===== Diluted 125.8 120.6 ===== ===== Earnings per common share Basic $4.86 $3.49 ===== ===== Diluted $4.67 $3.41 ===== ===== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Unaudited) (In millions) August 31 November 30 ASSETS 1998 1997 ------ ----- -------- Cash and cash equivalents $ 4,732 $ 1,685 Cash and securities segregated and on deposit for regulatory and other purposes 1,605 1,149 Securities and other financial instruments owned: Governments and agencies 29,762 33,037 Corporate equities 15,161 10,877 Corporate debt and other 11,400 10,892 Mortgages and mortgage-backed 20,244 11,455 Derivatives and other contractual agreements 10,712 8,353 Certificates of deposit and other money market instruments 3,430 2,248 ------- ------- 90,709 76,862 ------ ------ Collateralized short-term agreements: Securities purchased under agreements to resell 57,287 43,606 Securities borrowed 21,815 14,146 Receivables: Brokers, dealers and clearing organizations 2,651 2,193 Customers 9,106 9,105 Others 1,478 1,540 Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $790 in 1998 and $735 in 1997) 483 468 Other assets 1,043 787 Excess of cost over fair value of net assets acquired (net of accumulated amortization of $118 in 1998 and $111 in 1997) 165 164 -------- -------- Total assets $191,074 $151,705 ======== ======== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Continued) (Unaudited) (In millions, except share data)
August 31 November 30 1998 1997 -------------- -------- LIABILITIES AND STOCKHOLDERS' EQUITY Commercial paper and short-term debt $12,703 $ 7,818 Securities and other financial instruments sold but not yet purchased: Governments and agencies 16,058 16,201 Corporate equities 6,546 4,293 Corporate debt and other 2,712 2,219 Derivatives and other contractual agreements 8,502 7,367 ------- -------- 33,818 30,080 Collateralized short-term financings: Securities sold under agreements to repurchase 84,496 63,204 Securities loaned 6,110 7,846 Payables: Brokers, dealers and clearing organizations 5,265 2,155 Customers 10,776 11,702 Accrued liabilities and other payables 4,176 4,116 Long-term debt: Senior notes 24,711 17,049 Subordinated indebtedness 3,670 3,212 --------- --------- Total liabilities 185,725 147,182 ------- ------- Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock, $1.00 par value; 38,000,000 shares authorized: 5% Cumulative Convertible Voting, 13,000,000 shares Authorized; $39.10 liquidation preference per share Series A - shares issued and outstanding:12,800, in 1998 and 33,050 in 1997 1 1 Series B - shares issued and outstanding:12,987,200 in 1998 and 12,966,950 in 1997 507 507 5.94% Cumulative, Series C - 500,000 shares issued and outstanding; $500 liquidation 250 preference per share 5.67% Cumulative, Series D - 40,000 shares issued and outstanding; $5,000 liquidation 200 preference per share Redeemable Voting, 1,000 shares issued and outstanding; $1.00 liquidation preference per share Common stock, $0.10 par value; 300,000,000 shares authorized; Shares issued: 121,782,299 in 1998 and 119,513,337 in 1997; Shares outstanding: 116,673,240 in 1998 and 116,612,074 in 1997 12 12 Common stock issuable 150 155 Additional paid-in capital 3,503 3,436 Foreign currency translation adjustment 5 12 Retained earnings 1,053 498 Common stock in treasury, at cost: 5,109,059 shares in 1998 and 2,901,263 shares in 1997 (332) (98) ---------- ---------- Total stockholders' equity 5,349 4,523 ---------- ---------- Total liabilities and stockholders' equity $191,074 $151,705 ========== ========
See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited) (In millions)
Nine Months Ended August 31 August 31 1998 1997 ---------- --------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 662 $ 462 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 67 65 Provisions for losses and other reserves 107 41 Deferred tax benefit (60) (33) Other adjustments 51 (262) Net change in: Cash and securities segregated (456) (239) Securities and other financial instruments owned (13,847) (10,230) Securities purchased under agreements to resell (13,680) (10,928) Securities borrowed (7,670) 4,369 Receivables from brokers, dealers and clearing organizations (458) (1,208) Receivables from customers (1) (1,656) Securities and other financial instruments sold but not yet purchased 3,738 5,948 Securities sold under agreements to repurchase 21,292 1,683 Securities loaned (1,736) 2,438 Payables to brokers, dealers and clearing organizations 3,110 2,649 Payables to customers (926) 2,363 Accrued liabilities and other payables (97) 330 Other operating assets and liabilities, net (166) (244) -------- ------- Net cash used in operating activities $(10,070) $(4,452) --------- --------
See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Continued) (Unaudited) (In millions)
Nine months ended August 31 August 31 1998 1997 --------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of senior notes $10,042 $5,503 Principal payments of senior notes (2,321) (2,071) Proceeds from issuance of subordinated indebtedness 600 395 Principal payments of subordinated indebtedness (150) (550) Net proceeds from commercial paper and short-term debt 4,885 404 Payments for treasury stock purchases (315) Dividends paid (49) (45) Issuances of common stock 57 20 Issuances of preferred stock 444 -------- ------ Net cash provided by financing activities 13,193 3,656 -------- ------ CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property, equipment and leasehold improvements (76) (53) --------- ------- Net cash used in investing activities (76) (53) ---------- ------- Net change in cash and cash equivalents 3,047 (849) ------- ------- Cash and cash equivalents, beginning of period 1,685 2,149 ------- ------- Cash and cash equivalents, end of period $ 4,732 $1,300 ======= =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions) Interest paid totaled $12,501 and $9,541 for the nine months ended August 31, 1998 and 1997, respectively. Income taxes paid totaled $323 and $127 for the nine months ended August 31, 1998 and 1997, respectively. See notes to consolidated financial statements. 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, 1997 (the "Form 10-K"). The Consolidated Statement of Financial Condition at November 30, 1997 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. Accounting Policies: In 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share," which is effective for fiscal periods ending after December 15, 1997. SFAS No. 128 replaced the presentation of primary and fully diluted earnings per common share ("EPS") with basic and diluted EPS. The Company adopted SFAS No. 128 during the first quarter of 1998 and restated EPS data for the prior periods to conform with the provisions of the Statement. On January 1, 1998, SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" became fully effective. Previously, the FASB had deferred until that date certain provisions of SFAS No. 125 pertaining to repurchase agreements, securities lending and similar financing transactions. As a result of adopting the deferred provisions of SFAS No. 125, the Company has recognized on its August 31, 1998 Consolidated Statement of Financial Condition, approximately $1 billion of collateral controlled on certain financing transactions and a corresponding obligation to return such collateral at the termination of such transactions. In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" (the "SOP"). The SOP requires that certain costs LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS incurred in connection with developing or obtaining software for internal use be capitalized. The SOP requires prospective application as of the beginning of an entity's fiscal year without adjustment for costs that would have been capitalized had the SOP been in effect in prior periods. The Company has elected early adoption of this accounting pronouncement effective as of the beginning of its 1998 fiscal year and capitalized approximately $8.7 million of purchased software and other internal use software costs during the nine months of fiscal 1998. In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and for Hedging Activities, which requires all derivatives to be recorded on the balance sheet at fair value. SFAS No. 133 is effective for years beginning after June 15, 1999. The expected impact of adoption on the Company's results of operations has not yet been determined, however it is not likely to be material since most of the Company's derivatives are carried at fair value. 3. Long-Term Debt: During the nine months ended August 31, 1998, the Company issued $10,642 million of long-term debt (comprised of $10,042 million of senior notes and $600 million of subordinated debt). Of the total issuances during the period, $3,569 million were U.S. dollar fixed rate, $5,335 million were U.S. dollar floating rate, $545 million were foreign currency denominated fixed rate, and $1,193 million were foreign currency denominated floating rate. These issuances were primarily utilized to refinance maturities of long-term debt in 1998 and to increase total capital (stockholders' equity plus long-term debt). 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 currency denominated new issuances totaling $1,738 million, $1,061 million were effectively swapped to U.S. dollars with the remainder match funding foreign currency denominated capital needs. The Company had $2,471 million of long-term debt mature during the nine months ended August 31, 1998. 4. 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, 1998, LBI's regulatory net capital, as defined, of $1,376 million exceeded the minimum requirement by $1,247 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, 1998, LBIE's financial resources of approximately $2.4 billion exceeded the minimum requirement by approximately $650 million. Lehman Brothers Japan Inc.'s Tokyo branch, a regulated broker-dealer, is subject to the capital LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS requirements of the Japanese Ministry of Finance and, at August 31, 1998, had net capital of approximately $500 million which was approximately $200 million in excess of the specified levels required. 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, 1998, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. The Company's "AAA" rated derivatives subsidiary, Lehman Brothers Financial Products Inc. ("LBFP"), has established certain capital and operating restrictions which are reviewed by various rating agencies. At August 31, 1998, LBFP had capital which exceeded the requirement of the most stringent rating agency by approximately $140 million. 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. 5. 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 risks resulting from its trading activities in cash instruments (collectively, "Trading-Related Derivative Activities"). The Company records its Trading-Related Derivative Activities on a mark-to-market basis with realized and unrealized gains and losses recognized currently in Principal transactions in the Consolidated Statement of Income. 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 and against cash collateral 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, 1998 August 31, 1998 ------------------------ -------------------- (in millions) Assets Liabilities Assets Liabilities - --------------------------------------------------------------------------------------------------------------------------------- Interest rate and currency swaps and options (including caps, collars and floors) $ 6,871 $3,905 $5,124 $3,262 Foreign exchange forward contracts and options 2,247 1,866 1,581 1,523 Options on other fixed income securities, mortgage-backed securities forward contracts and options 388 378 516 555 Equity contracts (including equity swaps, warrants and options) 1,084 2,217 2,929 3,767 Commodity contracts (including swaps, forwards, and options) 122 136 166 166 ------------------------------------------------------- Total $10,712 $8,502 $10,316 $9,273 --------------------------------------------------------
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Average Fair Value* Fair Value* Twelve Months Ended November 30, 1997 November 30, 1997 ----------------- ------------------- (in millions) Assets Liabilities Assets Liabilities - ----------------------------------------------------------------------------------------------------------------------------- Interest rate and currency swaps and options (including caps, collars and floors) $4,704 $3,303 $4,306 $3,224 Foreign exchange forward contracts and options 1,840 1,885 1,236 1,532 Options on other fixed income securities, mortgage-backed securities forward contracts and options 310 297 275 246 Equity contracts (including equity swaps, warrants and options) 1,304 1,696 2,134 1,681 Commodity contracts (including swaps, forwards, and options) 195 186 304 465 -------------------------------------------------------- Total $8,353 $7,367 $8,255 $7,148 -------------------------------------------------------
* 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, 1998 represents the Company's net receivable/payable for derivative financial instruments before consideration of collateral. Included within the $10,712 million fair value of assets at August 31, 1998 was $10,265 million related to swaps and OTC contracts and $447 million related to exchange-traded option and warrant contracts. Included within the $8,353 million fair value of assets at November 30, 1997 was $8,016 million related to swaps and OTC contracts and $337 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 $6,730 million at August 31, 1998, representing the fair value of the Company's OTC contracts in an unrealized gain position, after consideration of collateral of $3,535 million. Presented below is an analysis of the Company's net credit exposure (after allocation of collateral) at August 31, 1998 for OTC contracts based upon actual ratings made by external rating agencies or by equivalent ratings established and utilized by the Company's Corporate Credit Department. Counterparty S&P/Moody's Risk Rating Equivalent Net Credit Exposure ------------ ------------------------- ------------------- 1 AAA/Aaa 18% 2 AA-/Aa3 or higher 23% 3 A-/A3 or higher 35% 4 BBB-/Baa3 or higher 11% 5 BB-/Ba3 or higher 6% 6 B+/B1 or lower 7% LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 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 clearing houses impose net capital requirements for their membership. Additionally, the exchange clearing house 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 11 to the Consolidated Financial Statements, included in the Form 10-K. 6. Other Commitments and Contingencies: In connection with its financing activities, the Company has outstanding commitments under certain lending arrangements of approximately $4.8 billion at August 31, 1998 and $2.4 billion at November 30, 1997. 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 yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and then participates a significant portion of these commitments. These commitments, net of syndications and participations, totaled $2.8 billion and $1.6 billion at August 31, 1998 and November 30, 1997, respectively, are typically secured against the borrower's assets and have fixed maturity dates. The draw down of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. Total commitments may not be indicative of actual funding requirements as the Company intends to continue syndicating, selling, and/or participating these commitments. In addition, the Company had lending commitments to high grade borrowers of $474 million at August 31, 1998. These commitments are typically secured against the borrower's assets, have fixed maturity dates, and are generally contingent upon certain representations, warranties and contractual conditions of the borrower. The Company has commitments to invest up to $353 million in partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. In June 1998, the Company, together with a consortium of other financial services companies, sponsored a $5 billion interim loan fund, designed to extend financing to clients in connection with a wide range of domestic and international leveraged transactions, including acquisitions, corporate recapitalization and refinancing of existing debt. In connection therewith, the Company intends to provide up to $400 million to be used by the fund. Any drawdowns under the facility are expected to be repaid within a short-term period. At August 31, 1998, the fund had no outstanding loans. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 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 13 to the Consolidated Financial Statements, in the Form 10-K. 7. Capital Stock: On July 21, 1998, the Company issued 4,000,000 Depository Shares (each representing 1/100th of a share) of 5.67% Cumulative Preferred Stock, Series D ("Series D Preferred Stock"), $1.00 par value. The Series D Preferred Stock has a redemption price of $5,000 per share, together with accrued and unpaid dividends. Redemption of the Series D Preferred Stock is at the option of the Company for any or all of the outstanding shares after August 31, 2008. The $200 million redemption value of the shares outstanding at August 31, 1998 is classified on the Company's Consolidated Statement of Financial Condition as 5.67% Cumulative Series D Preferred Stock. 8. Earnings Per Share Earnings per share was calculated as follows (in millions, except for per share data):
Three months Nine months Ended ended August 31 August 31 ---------------------------- ---------------------------- Numerator: 1998 1997 1998 1997 ---------- -------------- ------------ ------------ Net income $ 151 $197 $ 662 $462 Preferred stock dividends (12) (37) (75) (50) ------ ----- ------ ----- Numerator for basic and diluted earnings per share - income available to common stockholders $ 139 $160 $587 $412 ==== ==== ==== ==== Denominator: Denominator for basic earnings per share - weighted-average shares 121 119 121 118 Effect of dilutive securities: Employee stock options 3 2 3 2 Common stock equivalents 2 1 2 1 ------- ------ ------ ----- Dilutive potential common shares 5 3 5 3 ------- ------ ------ ----- Denominator for diluted Earnings per share - adjusted Weighted-average shares 126 122 126 121 ===== ===== ===== ===== Basic earnings per share $1.15 $1.34 $4.86 $3.49 ===== ===== ===== ===== Diluted earnings per share $1.10 $1.30 $4.67 $3.41 ===== ===== ===== =====
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 the Company 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, the Company's revenues and earnings may vary significantly from quarter to quarter and from year to year. The generally favorable market and economic conditions that characterized fiscal 1997 continued into the first eight months of the Company's current fiscal year ("fiscal 1998"). During the first eight months of fiscal 1998, investor demand in the worldwide debt and equity markets remained strong led by continued growth in the U.S. economy and the favorable interest-rate environment. The pace of underwriting for combined fixed income and equity securities accelerated to record levels. The pace of global merger and acquisition activity fueled financing of all types. Investors were focused on worldwide market conditions, particularly with respect to the potential effects of the Asian crisis, as well as any signs of potential weakening in the U.S. economy. Following this period of relative stability, the turmoil in various emerging markets erupted in mid-August particularily with respect to Russia. Events in Russia drove all emerging market bond yields sharply higher. As investors sought safe havens, U.S. Treasury and European government bond yields moved sharply lower while spreads on other fixed income products widened. Ten-year U.S. Treasury yields fell by over 50 basis points (bp) to just under 5%, while yields on ten-year German Bunds fell by just over 60bp to 4.2%, both representing new global lows. The yields on bonds of lower rated corporations also rose abruptly. Deleveraging and reduced risk-taking disrupted the flow of funds throughout the financial markets and new issuances of debt and equity securities slowed. Since reaching record levels in the middle of July, the U.S. equity market is in the midst of the most serious correction of the 1990's with the S&P 500 index down almost 20% from its peak to the trough on August 31. The marketplace continues to reflect concerns over the lingering Asian economic troubles, which spread to Russia and threaten Latin America, as well as political uncertainty in Washington. This increased risk aversion has resulted in a reduction in the availability of credit and lower equity prices. After providing an annual return of about 24% from the beginning of the fiscal year to the July peak, equity returns have fallen to almost zero for the first nine months of the fiscal year. Over the nine months to August, European equities have returned 16% in dollar terms alongside healthy trading volumes, although this overall performance masks an extremely strong 40% gain for the FT/S&P European Index through the July peak, followed by a 17% fall to the end of August. While the bond environment was supportive throughout, the impact of the crisis sweeping emerging markets, including Russia's devaluation and debt restructuring, sparked a severe correction amid highly volatile market conditions. Far Eastern and Latin American stock markets became the focus of the turmoil and lost a substantial proportion of their value over this LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS period with total returns of minus 23% and 40% as measured by the FT/S&P Pacific Basin Index and IFC Latin America Investable Index, respectively. Worldwide underwriting volumes, which had been running at an unprecedented rate for the first seven months of fiscal 1998, saw a significant slowdown in the last two months of the third quarter. While volumes for the entire year will be record setting, the Company is not anticipating a return to the flow of issuance volume it experienced earlier this year due to the extreme volatility in the credit markets. Similarly, equity and equity-related underwriting activity has mirrored the market as a whole, with record new issuance in the first eight months of fiscal year 1998 followed by significantly reduced activity as a result of less favorable market conditions. Corporate Finance Advisory activities continued at record levels during the first nine months of fiscal 1998. Coming off a strong pace in 1997, the volume of announced transactions during the first nine months of 1998 continued to reflect the trend of consolidation, deregulation and globalization across industry sectors. However, as a direct result of global market turmoil caused by economic uncertainties throughout the world, the volume of announced transactions has recently slowed. Although strong financial markets characterized the first eight months of fiscal 1998, recent events have highlighted the cyclicality of the financial services industry. The current adverse market conditions impact competitors and counterparties throughout the industry to varying degrees, including the Company and all aspects of the Company's activities. Management is responding to the changes and risks inherent in this environment by reducing the Company's risk exposure, shifting the mix of its balance sheet and reducing certain positions. 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. 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, 1998 and 1997 The Company reported net income of $151 million for the third quarter ended August 31, 1998 representing a decrease of 23% from net income of $197 million for the third quarter ended August 31, 1997. The Company enjoyed strong results during June and July across its businesses. However, results in August were affected by several unfavorable economic factors, including the impact of significant volatility in Russia and other emerging markets and the related widening of spreads across U.S. and European core fixed income markets. Earnings per common share (diluted) decreased to $1.10 for the third quarter of 1998 from $1.30 for the third quarter of 1997. Included in the 1997 earnings per common share computation was the recognition of $31 million in dividends on the Company's Redeemable Voting Preferred Stock. American Express Company and Nippon Life Insurance Company are entitled to receive an annual non-cumulative preferred dividend equal to 50 percent of the amount by which the company's net income for the full fiscal year exceeds $400 million, up to a maximum of $50 million per year, through 2002. In 1998, the Redeemable Voting Preferred Stock dividend was recognized in the second quarter, when the Company's year to date net income exceeded the $400 million threshold. Net revenues decreased to $930 million for the third quarter of 1998 from $1,071 million for the third quarter of 1997. The decrease in net revenues from the third quarter of 1997 was driven by widening of spreads in U.S. fixed income markets, trading and credit losses in Russia and other emerging markets, the reduced contribution from risk arbitrage strategies, and reduced customer flow activity during August in certain U.S. cash equity products. This negative impact was mitigated by strong performances in the advisory, debt and equity origination businesses and equity derivatives, demonstrating the revenue diversity of the company. Compensation and benefits expense as a percentage of net revenues was 50.7% for both fiscal 1998 and 1997, reflecting the fourteenth successive quarter of consistent compensation levels relative to net revenues. Nonpersonnel expenses were $251 million in the third quarter of fiscal 1998, essentially unchanged from the $247 million in the third quarter of fiscal 1997. Decreased net revenues and unchanged expense levels led to a decline in the Company's pretax operating margin to 22.3% in the third quarter of fiscal 1998 from 26.2% in the third quarter of fiscal 1997. The Company, through its subsidiaries, is a market-maker of equity and fixed income products in major domestic and international markets. As part of its market-making activities, the Company maintains inventory positions of varying amounts across a broad range of financial instruments that are marked-to-market on a daily basis and, along with the Company's proprietary trading positions, give rise to principal transactions revenues. The Company utilizes various hedging strategies to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets. Net revenues from the Company's market-making and trading activities in fixed income and equity products are recognized as either principal transactions or net interest revenues depending upon the method of financing and/or hedging related to specific inventory positions. The Company evaluates its trading strategies on an overall profitability basis which includes both principal transactions revenues and net interest. Therefore, changes in net interest should not be viewed in isolation but should be LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS viewed in conjunction with revenues from principal transactions. Principal transactions and net interest revenues decreased 35% to $352 million in the third quarter of 1998 from $545 million in the third quarter of 1997 as a result of events described above. Net interest revenues increased as a result of an increase in inventory, and a shift in the composition of the Company's fixed income portfolio. The following table of net revenues by business unit and the accompanying discussion have been prepared in order to present the Company's net revenues in a format that reflects the manner in which the Company manages its businesses. For internal management purposes, the Company has been segregated into four major business units: fixed income, equity, corporate finance advisory, and merchant banking. Each business unit represents a grouping of financial activities and products with similar characteristics. These business activities result in revenues that are recognized in multiple revenue categories contained in the Company's Consolidated Statement of Income. Net revenues by business unit contain certain internal allocations, including funding costs, which are centrally managed. Three Months Ended August 31, 1998
Principal Transactions and Investment Net Interest Commissions Banking Other Total - --------------------------------------------------------------------------------------------------------------------------------- Fixed Income $301 $ 11 $181 $(79) $414 Equity 39 121 117 277 Corporate Finance Advisory (2) 155 153 Merchant Banking (11) 40 29 Other 25 5 27 57 - --------------------------------------------------------------------------------------------------------------------------------- $352 $137 $493 $(52) $930 - ---------------------------------------------------------------------------------------------------------------------------------
Three Months Ended August 31, 1997 Principal Transactions and Investment Net Interest Commissions Banking Other Total - --------------------------------------------------------------------------------------------------------------------------------- Fixed Income $400 $ 8 $ 97 $ 5 $ 510 Equity 141 99 101 1 342 Corporate Finance Advisory (1) 81 80 Merchant Banking 117 117 Other 5 4 13 22 - --------------------------------------------------------------------------------------------------------------------------------- $545 $111 $396 $19 $1,071 - ---------------------------------------------------------------------------------------------------------------------------------
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Fixed Income. The Company's fixed income net revenues reflect customer flow activities (both institutional and high-net-worth retail), secondary trading, debt underwriting, syndicate and financing activities related to fixed income products. Fixed income products include dollar- and non-dollar government securities, mortgage- and asset-backed securities, money market products, dollar- and non-dollar corporate debt securities, emerging market securities, municipal securities, financing (global access to debt financing sources including repurchase and reverse repurchase agreements), foreign exchange and fixed income derivative products. Fixed income net revenues decreased 19% to $414 million for the third quarter of 1998 from $510 million for the third quarter of 1997. Results in the third quarter of 1998 were negatively impacted by the widening of spreads in credit sensitive fixed income products as a result of investors' "flight to quality" into U.S. Treasury securities. This translated into lower revenues in mortgages, emerging markets, high yield and high grade corporates partially offset by strong results in fixed income derivatives, foreign exchange and municipals. Also negatively affecting these results were market and credit losses relating to the volatility in Russia and other emerging markets during August which reduced revenues by approximately $165 million. Investment banking revenues, as a component of fixed income revenues, increased to $181 million for the third quarter of 1998 from $97 million for the third quarter of 1997 due to significantly increased underwriting fees. Equity. Equity net revenues reflect customer flow activities (both institutional and high-net-worth retail), secondary trading, equity underwriting, equity finance, equity derivatives and equity arbitrage activities. The Company's equity net revenues decreased 19% to $277 million for the third quarter of 1998 from $342 million for the third quarter of 1997. Lower revenues resulted from reduced customer flow activity during August in certain U.S. cash products and decreased revenues from risk arbitrage activities due to the widening of spreads and the cancellation of several anticipated mergers. Investment Banking revenues, as a component of equity revenues, increased to $117 million for the third quarter of 1998 from $101 million for the third quarter of 1997 due to increased underwriting volumes in U.S. listed and convertible securities. Corporate Finance Advisory. Corporate finance advisory net revenues, classified in the Consolidated Statement of Income as a component of investment banking revenues, result primarily from fees earned by the Company in its role as strategic advisor to its clients. This role consists of advising clients on mergers and acquisitions, divestitures, leveraged buyouts, financial restructurings, and a variety of cross-border transactions. Net revenues from corporate finance advisory activities increased to $153 million for the third quarter of 1998, reflecting a 91% increase from the $80 million recognized in the third quarter of 1997. This increase reflected the closing of several large transactions in the third quarter of 1998. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Merchant Banking. The Company is the general partner for nine active merchant banking partnerships. Current merchant banking investments held by the partnerships include both publicly traded and privately held companies. Merchant banking net revenues represent the Company's proportionate share of net unrealized gains and losses from the revaluation of investments held by the partnerships. Such amounts are classified in the Consolidated Statement of Income as a component of investment banking revenues. Merchant banking net revenues also reflect the net interest expense relating to the financing of the Company's investment in the partnerships. Merchant banking net revenues were $29 million for the third quarter of 1998 down from $117 million in the third quarter of 1997. Net revenues in the third quarter of 1997 reflects the realized gains on the sale of the Company's remaining positions in certain publicly traded investments held by the partnerships. Non-Interest Expenses. Non-interest expenses were $723 million for the third quarter of 1998 and $790 million for the third quarter of 1997. Compensation and benefits expense as a percentage of net revenues remained unchanged from the prior year quarter at 50.7%. Nonpersonnel expenses were $251 million in the third quarter of 1998 compared to $247 million in the third quarter of 1997. Income Taxes. The Company's income tax provision was $56 million for the third quarter of 1998 compared to $84 million for the third quarter of 1997. The effective tax rate was 27% for the third quarter of 1998 and 30% for the third quarter of 1997. The 1998 effective tax rate reflects a reduction in state taxes and a higher level of tax benefits attributable to income and transactions subject to preferential tax treatment, which are further magnified in the effective rate due to a lower level of pretax earnings for the quarter. 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, 1998 and 1997 The Company reported net income of $662 million for the nine months ended August 31, 1998, representing an increase of 43% from net income of $462 million for the nine months ended August 31, 1997. Earnings per common share (diluted) increased to $4.67 for the nine months of 1998 from $3.41 for the nine months of 1997. Included in the 1998 and 1997 earnings per common share computation was the recognition of $50 million and $31 million, respectively, in dividends on the Company's Redeemable Voting Preferred Stock. American Express Company and Nippon Life Insurance Company are entitled to receive an annual non-cumulative preferred dividend equal to 50 percent of the amount by which the company's net income for the full fiscal year exceeds $400 million, up to a maximum of $50 million per year, through 2002. Net revenues increased to $3,448 million for the nine months of 1998 from $2,850 million for the nine months of 1997. The increase in net revenues for the nine months of 1998 resulted from strong performances in the global merger and acquisition advisory, fixed income and equity businesses. Compensation and benefits expense as a percentage of net revenues was 50.7% for both the first nine months of 1998 and 1997. Nonpersonnel expenses increased slightly to $741 million in the nine months of 1998 from $733 million in the nine months of 1997; however, nonpersonnel expenses declined as a percentage of net revenues to 21.5% for the nine months of 1998 from 25.7% for the comparable period in 1997. Increased net revenues and essentially unchanged expense levels led to an improvement in the Company's pretax operating margin to 27.8% in the first nine months of 1998 from 23.6% in the first nine months of 1997. Principal transactions and net interest revenues increased to $1,728 million for the nine months of 1998 from $1,568 million for the nine months of 1997. Principal transactions revenues increased as favorable market conditions characterized by low interest rates and low inflation supported debt markets and helped to spur growth in the equity markets in both the U.S. and Europe. Net interest revenues increased as a result of an increase in inventory and a shift in the composition of the Company's fixed income portfolio. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table of net revenues by business unit and the accompanying discussion have been prepared in order to present the Company's net revenues in a format that reflects the manner in which the Company manages its businesses. Net revenues by business unit contain certain internal allocations, including funding costs, which are centrally managed.
Nine Months Ended August 31, 1998 Principal Transactions and Investment Net Interest Commissions Banking Other Total - --------------------------------------------------------------------------------------------------------------------------------- Fixed Income $1,421 $ 28 $ 558 $ (74) $1,933 Equity 302 336 299 4 941 Corporate Finance Advisory (4) 355 351 Merchant Banking (17) 125 108 Other 26 14 (1) 76 115 - --------------------------------------------------------------------------------------------------------------------------------- $1,728 $378 $1,336 $6 $3,448 - ---------------------------------------------------------------------------------------------------------------------------------
Nine Months Ended August 31, 1997 Principal Transactions and Investment Net Interest Commissions Banking Other Total - --------------------------------------------------------------------------------------------------------------------------------- Fixed Income $1,226 $ 28 $270 $13 $1,537 Equity 346 259 207 4 816 Corporate Finance Advisory (4) 231 227 Merchant Banking (8) 200 192 Other 8 12 2 56 78 - --------------------------------------------------------------------------------------------------------------------------------- $1,568 $299 $910 $73 $2,850 - ---------------------------------------------------------------------------------------------------------------------------------
Fixed Income. Fixed income net revenues increased to $1,933 million for the nine months of 1998 from $1,537 million for the nine months of 1997. The increase in the nine months of 1998 versus the prior year nine months reflected increased revenues from a number of fixed income products including improved performance in both sales and trading and syndicate activities in high yield corporates as well as increased contributions from fixed income derivatives, foreign exchange and mortgages partially offset by decreased results in emerging markets and governments. Investment banking revenues, as a component of fixed income revenues, increased to $558 million for the nine months of 1998 from $270 million for the nine months of 1997 due to increased underwriting fees, particularly in high yield corporates. Equity. The Company's equity net revenues increased to $941 million for the nine months of 1998 from $816 million for the nine months of 1997. Higher revenues resulted from increased levels of customer flow activities in U.S. listed securities, increased underwriting volumes and improved contributions from equity derivatives. Investment banking revenues, as a component of equity revenues, increased to $299 million for the nine months of 1998 from $207 million for the nine months of 1997 due to increased underwriting volumes in U.S. listed and convertible securities. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Corporate Finance Advisory. Net revenues from corporate finance advisory activities increased to $351 million for the nine months of 1998 reflecting a 55% increase from the $227 million recognized in the nine months of 1997. This increase reflected improved market share and continued strength in the overall merger and acquisition market environment. For completed M&A transactions, Lehman has improved its worldwide ranking from #8 to #4, increasing its market share from 6.5% to 15.4%, in part through participation in 3 of the 5 largest deals in the first nine months of the 1998 calendar year based on data supplied by Securities Data Company. Merchant Banking. Merchant banking net revenues were $108 million for the nine months of 1998 and $192 million in the nine months of 1997. 1998 net revenues reflect the unrealized gains recognized on the publicly traded investments as well as realized gains on the sales of other investments. 1997 net revenues reflect the realized gains on the sales of the partnerships' interest in certain publicly traded investments. Non-Interest Expenses. Non-interest expenses were $2,490 million for the nine months of 1998 and $2,178 million for the nine months of 1997. Compensation and benefits expense as a percentage of net revenues remained unchanged from the comparable prior year period at 50.7%. Nonpersonnel expenses increased slightly to $741 million in the nine months of 1998 from $733 million in the nine months of 1997, however, nonpersonnel expenses declined as a percentage of net revenues to 21.5% for the nine months of 1998 from 25.7% for the comparable period in 1997. Income Taxes. The Company's income tax provision was $296 million for the nine months of 1998 compared to $210 million for the nine months of 1997. The effective tax rate was 31% for the nine months of 1998 and 1997. The 1998 effective tax rate, although the same as that of 1997, reflects a higher level of tax benefits attributable to income and transactions subject to preferential tax treatment, which are minimized by a higher level of pretax earnings for the year. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Overview As a leading global investment bank that actively participates in the global capital markets, the Company has large and diverse capital requirements. Many of the businesses in which the Company operates are capital intensive. Capital is required to finance, among other things, the portion of the Company's securities inventories not funded on a secured basis, merchant banking activities and investments in fixed assets. The Company's primary activities are based on the execution of customer-related transactions. This flow of customer business supports the rapid asset turnover rate of the Company's inventory. 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 vast majority of these assets are funded on a secured basis through collateralized short-term financing agreements with the remaining assets being funded through unsecured financing and capital. The Company's total assets increased to $191.1 billion at August 31, 1998 from $151.7 billion at November 30, 1997, reflecting an increase in secured customer financing activities and the expansion of certain higher margin business lines in strategic growth areas (i.e., equity derivatives and mortgages). 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 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, aligned with the Company's geographic 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. Total Capital is defined as long-term debt, preferred stock and common stockholders' equity. (2) Minimize liquidity and refinancing risk by funding the Company's assets primarily on a secured basis. (3) Obtain diversified funding through a global investor base which increases liquidity and reduces concentration risk. (4) Maintain funding availability in excess of actual utilization. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (5) Maintain sufficient financial resources to enable the Company to meet its obligations in periods of financial stress through a combination of collaterized short term financings and Total Capital, as well as the implementation of a contingency funding plan. Short-Term Funding The Company strives to maximize the portion of the Company's balance sheet that is funded through collateralized borrowing sources, which in turn minimizes the reliance placed upon unsecured short-term debt. Collateralized borrowing sources include cash market 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, OECD government repos and other investment grade types of collateralized borrowings are less credit-sensitive and have historically been a stable financing source irrespective of market conditions. The amount of the Company's collateralized borrowing activities will vary reflecting changes in the mix and overall levels of securities and other financial instruments owned which are driven by strategic business objectives and global market conditions. The majority of the Company's assets are funded with collateralized borrowing sources. At August 31, 1998 and November 30, 1997, $116 billion and $94 billion, respectively, of the Company's total balance sheet of $191 billion and $151 billion at August 31, 1998 and November 30, 1997, respectively, were financed using collateralized borrowing sources. As of August 31, 1998 and November 30, 1997, commercial paper and short-term debt outstanding were $12.7 billion and $7.8 billion, respectively. At October 9, 1998, commercial paper and short-term debt outstanding was $10.6 billion. Of this amount, commercial paper outstanding was $6.4 billion with an average maturity of 74 days. 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 specified levels of liquidity and tangible net worth, as defined. In July 1998, the Company entered into a new $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 broader range of collateral types than LBIE's previous committed secured credit facility. 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 Holdings. There have been 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. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Total Capital As part of the Company's liquidity plan, the Company increased its Total Capital base in 1998 to $33.7 billion at August 31, 1998 from $24.8 billion at November 30, 1997 primarily due to an increase in long-term debt and the retention of earnings. August 31 November 30 (in millions) 1998 1997 - -------------------------------------------------------------+----------------- Long-term Debt Senior Notes $24,711 $17,049 Subordinated Indebtedness 3,670 3,212 ------- ------- 28,381 20,261 Stockholders' Equity Preferred Equity 958 508 Common Equity 4,391 4,015 ------ ------- 5,349 4,523 - ------------------------------------------------------------------------------- Total Capital $33,730 $24,784 - ------------------------------------------------------------------------------- During the first nine months of 1998, the Company issued $10.6 billion in long-term debt, which was $8.2 billion in excess of its maturing debt. Long-term debt increased to $28.4 billion at August 31, 1998 from $20.3 billion at November 30, 1997 with a weighted average maturity of 3.7 years at August 31, 1998 and 4.1 years at November 30, 1997. On September 23, 1998, the Board of Directors authorized the repurchase of up to an additional 7.5 million shares of Holdings common stock, as part of the Company's program to actively manage its capital position and common shares outstanding. Earlier this year the Board authorized, and the Company has since completed, the repurchase of 4.5 million shares. Capital Resources and Capital Adequacy 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. The Company believes that the adjusted leverage ratio, rather than the gross leverage ratio, is a more effective measure of financial risk when comparing companies in the securities industry. Adjusted total assets represent total assets less the lower of securities purchased under agreements to resell or securities sold under agreements to repurchase. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 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. The Company's average gross leverage ratio and average adjusted leverage ratio for the quarter ended August 31, 1998 were 38.4x and 26.3x, respectively and for the quarter ended November 30, 1997 were 38.5x and 25.9x, respectively. [OBJECT OMITTED] [OBJECT OMITTED] In early 1997, the Company implemented a business performance measurement system. This system is a management reporting tool which charges for capital utilization across the Company's products. It provides detailed profitability and return on equity information for each of the Company's lines of business. The results of charging each of the respective businesses for its capital utilization are that businesses optimize their use of balance sheet and capital resources, resulting in an improved return on assets and overall decreased levels of both quarterly average gross and adjusted leverage. 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. In September 1998, Moody's reaffirmed the "stable" long-term debt ratings of Holdings and changed its outlook on the Company from positive to stable. Also in September, Standard & Poor's, as part of its change in outlook for firms throughout the securities industry, put the Company's debt rating on Credit Watch with negative implications. As of August 31, 1998, the short- and long-term senior debt ratings of Holdings and LBI were as follows: Holdings LBI -------- --- Short-term Long-term Short-term Long-term** - ------------------------------------------------------------------------------- Duff & Phelps Credit Rating Co. D-1 A D-1 A/A- Fitch IBCA, Inc. F-1 A F-1 A/A- Moody's P2 Baa1 P2 A3*/Baa1 S&P A-1 A A-1 A+*/A Thomson BankWatch TBW-1 A TBW-1 A+/A * Provisional ratings on shelf registration ** Senior/subordinated Insurance Subsidiary The Company has established a new subsidiary to underwrite and accumulate insurance and reinsurance risks. The new subsidiary, Lehman Re Ltd., is a Bermuda licensed Class 4 and Long-Term insurance company and is expected to operate with capital of $500 million. Lehman Re Ltd. intends to underwrite property and casualty, as well as life and annuity insurance risks. It expects to focus its business initially in four areas: finite and structured financial products; political risk and trade credit insurance; property catastrophe reinsurance; and life and annuity reinsurance. Lehman Brothers Derivative Products On July 16, 1998, the Company announced that it had established a special purpose subsidiary that will provide counterparties around the world with a wide variety of derivative products and services. The new company, Lehman Brothers Derivative Products Inc. ("LBDP") has been assigned Aaa and AAAt credit ratings by Moody's Investor Services Inc. and Standard & Poor's Corporation, respectively. LBDP was created to provide clients with the most efficient delivery of a broad range of derivative product opportunities. Its termination structure compliments the continuation structure of LBFP. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS High Yield Securities 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 securities 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. The definition excludes sovereign debt. 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 securities are carried at market value, and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Income. The Company's portfolio of such securities at August 31, 1998 and November 30, 1997 included long positions with an aggregate market value of approximately $2.9 billion and $3.2 billion, respectively, and short positions with an aggregate market value of approximately $506 million and $172 million, respectively. The portfolio may, from time to time, contain concentrated holdings of selected issues. The Company may also, from time to time, mitigate its net exposure to any single issuer through the use of derivatives and other financial instruments. At August 31, 1998, the Company had no single net exposure to an issuer of high yield securities or loans greater than $110 million. Lending Activities The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and participates a significant portion of these commitments. These commitments, which are net of syndications and participations, totaled $2.8 billion at August 31, 1998, are typically secured against the borrower's assets and have fixed maturity dates. The utilization of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. Total commitments may not be indicative of actual funding requirements as the Company intends to continue syndicating, selling, and/or participating these commitments. In addition, the Company had lending commitments to high grade borrowers of $474 million at August 31, 1998. These commitments are typically secured against the borrower's assets, have fixed maturity dates, and are generally contingent upon certain representations, warranties and contractual conditions of the borrower. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Merchant Banking and Related Lending Activities The Company's merchant banking activities include investments in nine partnerships, for which the Company acts as general partner, as well as direct investments. At August 31, 1998, the investment in merchant banking partnerships was $170 million and direct investments were $157 million. The Company's policy is to carry its investments, including its partnership interests, at fair value based upon the Company's assessment of the underlying investments. The Company has commitments to invest up to $353 million in the partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. In June 1998, the Company, together with a consortium of other financial services companies, sponsored a $5 billion interim loan fund, designed to extend financing to clients in connection with a wide range of domestic and international leveraged transactions, including acquisitions, corporate recapitalizations and refinancings of existing debt. In connection therewith, the Company intends to provide up to $400 million to be used by the fund. Any drawdowns under the facility are expected to be repaid within a short-term period. At August 31, 1998, the fund had no outstanding loans. 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. The Company devotes significant resources across all of its worldwide trading operations to the measurement, management and analysis of risk, including investments in personnel, information technology infrastructure and systems. 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 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-backed securities, municipal bonds, and interest rate derivatives. The Company's equity 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. Value at Risk For purposes of Securities and Exchange Commission disclosure requirements, the Company has elected to disclose an entity-wide value at risk analysis of virtually all of the Company's trading activities. The value at risk related to non-trading financial instruments has been excluded from this analysis and not reported separately because the amounts were not material. The value at risk calculation measures potential losses in expected revenues and is based on a methodology which uses a one-day holding period and a 95% confidence level. Value at risk as of each date presented below was measured by analyzing the distribution of actual trading revenues during the preceding one year period and assumed a relatively consistent portfolio mix. Value at risk is one measurement of potential losses in revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. Value at risk has substantial limitations, including its reliance on historical performance and data as valid predictors of the future. Consequently, value at risk is only one of a number of tools the Company utilizes in its daily risk management activities. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company's value at risk for each component of market risk, and in total was as follows (in millions): August 31, 1998 November 30, 1997 --------------- ----------------- Interest rate risk $18.5 $12.2 Equity price risk 15.3 7.1 Foreign exchange risk 2.4 4.5 Diversification benefit (12.9) (9.0) ------ ---- Total Company $23.3 $14.8 ===== ===== Value at risk increased at August 31, 1998 because of dramatic increases in volatility across a broad spectrum of asset classes. On October 5, 1998, the Company issued a press release disclosing its exposures to hedge funds and emerging markets. Hedge Fund Exposures. The Company's exposure to hedge funds arises when the Company has mark-to-market gains on transactions with these counterparties. This exposure is offset by the value of collateral held against those gains. The Company was over-collateralized across its overall business with hedge funds. The Company held $583 million of collateral, primarily in the form of cash, U.S. Treasuries and U.S. agency securities, against total credit exposure to active hedge fund counterparties of $447 million on a mark-to-market basis across all products. The Company has adequately reserved for credit exposures to inactive hedge funds. Within its overall portfolio, the Company may have small uncollateralized exposures to reduce the frequency of small transfers of funds and facilitate operational efficiency. The Company's total uncollateralized exposure to active hedge funds was $72 million across 54 counterparties. The Company's largest single active hedge fund credit exposure was $10 million. The Company's gross mark-to-market exposure to Long-Term Capital Management was $32 million which is over-collateralized with $41 million of U.S. Treasuries. In connection with the recapitalization of Long Term Capital by a consortium of financial institutions, the Company made an equity investment of $100 million. The Company manages these fund relationships closely and mark-to-market exposures and collateral are reviewed on a daily basis. Emerging Markets Exposures. The Company carries positions in emerging market securities primarily to meet the needs of its customers and clients. The Company's total net emerging markets position on a mark-to-market basis amounted to $305 million, inclusive of hedges. The composition of this net emerging market position was $49 million from Asian countries, $99 million from European emerging markets and $157 million from Latin America. The Company also conducts business with counterparties in emerging markets countries. Across its entire client base and all products, the Company held collateral of $266 million, primarily in the form of cash, U.S. Treasuries and U.S. agency securities, against its mark-to-market exposure to emerging market counterparties of $337 million. Within this overall portfolio, the Company had a net credit exposure to LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 66 counterparties, totaling $164 million. This exposure was spread across 34 different countries. The Company's largest net credit exposure to any one counterparty was $25 million. In any one country, the Company's largest total exposure to all counterparties combined was $33 million. All exposures are monitored actively, and are consistent with the Company's risk limits and are included in the Company's credit reserve calculation. The Company utilizes a wide variety of market risk management methods, including stress and scenario analysis, limits for each trading activity; marking all positions to market on a daily basis; daily profit and loss analyses; position reports; aged inventory position analyses; and independent verification of all inventory pricing. The Company believes that these procedures, which stress timely communication between the risk and trading areas and senior management, are critical elements of the risk management process. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Impact of EMU As of January 1, 1999, 11 European countries will enter into the European economic and monetary union ("EMU") and replace their local currencies with a single currency, the Euro. During a three-year transition period, the national currencies will continue to circulate but only as fixed denominations of the Euro. Commencing on January 1, 1999, the settlement of non-cash transactions previously denominated in the participating national currencies will predominately be effected in Euros. To date, the Council of Ministers of the European Union has approved the following states for entry into EMU: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. In order to have all areas of the Company prepared for EMU before the scheduled start date of January 1, 1999, the Company has implemented a worldwide EMU conversion and testing plan. A full-time team has been assigned to assess the impact on the Company's global infrastructure and to perform all required systems changes. The Company has also been reviewing and planning for the impact of the conversion in its various business areas. The Company has completed the analysis, design, and build phases of the conversion and will focus on testing throughout the next several months. In addition, the Company will be directing its efforts toward the detailed planning of the conversion weekend (December 31, 1998 to January 3, 1999). The Company's plan is currently on schedule, and integrated systems testing has commenced. Dress rehearsals of the conversion weekend are planned. These rehearsals will simulate the actual conversion weekend as closely as possible. High volume tests are being run with production volumes to ensure that systems can handle the conversion volume within acceptable time-frames. The Company's test programs are designed to establish its ability to process all transactions in the new environment. The Company is also participating in industry testing where practicable, as organized by regulatory and market agencies. Many areas of the Company will be affected by the introduction of the single currency. As with the Year 2000 issue, EMU poses various operating risks. EMU will require many changes to the Company's operations and technology, including currency conversions, modifications of trading payment and settlement systems, and the redenomination of securities. This will require the conversion of exceptionally large amounts of data in the Company's systems The Company has incurred and expects to continue to incur expenses for the internal technology and operations staff, as well as costs for outside consultants, in order to implement its EMU conversion plan. Management currently estimates that the cost of its EMU conversion program will be approximately $30 million, of which $12 million has been incurred to date and expensed. The changes to the Company's data and computer systems will affect its clearance, settlement and financial reporting activities, along with other key operations of the Company. If not properly implemented, these changes could lead to failed settlements, inability to reconcile trading positions and funding disruptions. In addition, the Company is dependent for proper transactions clearance and reporting on many third parties, including LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS counterparties, clearing agents, banks, exchanges, clearing houses and providers of information. Errors arising in the Company's or third parties' systems could also lead to erroneous entries in the Company's books and records. These events could result in misstatement of the Company's financial condition and results of operations, could impair its ability to manage its risks, and result in a material loss, regulatory actions, reputational harm and legal liability. While convergence to the Euro has reduced client demand for certain transactions, which has impacted the Company's foreign exchange and fixed income activities in Europe, the Company anticipates that new opportunities in Europe will be created through an expansion of activities in mergers and acquisitions, investment grade and high yield debt capital markets, and equity issuance and asset allocation. Overall, management anticipates that implementation of EMU will not, by itself, materially affect the financial results of the Company in an adverse manner. Although all key suppliers have committed that they will be Euro compliant, the Company can give no assurance that third parties on whom it depends, will have the systems necessary to process Euro-denominated transactions. Moreover, disruption in the activity in the European markets because of the conversion to the Euro could hurt the Company's businesses in those markets, resulting in lost revenues and increased costs. Management cannot predict the magnitude of any such reduction or its impact on the Company's financial results. As part of the conversion process, the Company is establishing detailed contingency plans. The contingency plans will provide mechanisms to assess and communicate the impact of any delays. These plans also address likely problems in the aftermath of conversion with a view to maximizing the Company's ability to avoid disruption. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Impact of the Year 2000 The Year 2000 issue is the result of many computer programs and imbedded chips being written using two digits rather than four to define the applicable year. Many of the Company's computer programs that have date-sensitive software may recognize a date using "00"as the year 1900 rather than the year 2000. If not addressed and completed on a timely basis, failure of the Company's computer systems to process Year 2000 related data correctly could have a material adverse effect. Failures of this kind could, for example, lead to incomplete or inaccurate accounting, settlement failures, trade processing or recording errors in securities, currencies, commodities or other assets. It could also lead to uncertainty regarding risk, exposures and liquidity. If not addressed, the potential risks to the Company include financial loss, legal liability, interruption to business and regulatory actions. The Company established a team in 1996 to modify or replace and then test the appropriate software and equipment to ensure that Year 2000 issues are addressed. The Company presently believes that with modifications to existing software and conversions to new software, the Year 2000 issue will be resolved for all the Company's own systems worldwide. However, even if these changes are successful, the Company remains at risk from Year 2000 failures caused by third parties. The Company has therefore initiated efforts with key counterparties, exchanges, agencies, utilities and suppliers, among others, to assess and wherever possible remediate Year 2000 issues. To date, the Company has not received sufficient information from certain vendors and international markets to complete its assessment of Year 2000 awareness. Examples of problems that could result from the failure by third parties with whom the Company interacts to remediate Year 2000 bugs include: (i) in the case of exchanges and clearing agents, funding disruptions, failure to trade in certain markets and settlement failures; (ii) in the case of counterparties and clients, accounting and financial difficulties to those parties that may expose the Company to increased credit risk and lost business; (iii) in the case of vendors, service failures such as power, telecommunications, elevator operations and loss of security access control; (iv) in the case of banks and other lenders, the potential for liquidity stress due to disruptions in funding flows; and, (v) in the case of data providers, inaccurate or out of date information that would impair the Company's ability to perform critical functions such as pricing securities and currencies. Additionally, general uncertainty regarding the success of remediation may cause many market participants to reduce their market activities temporarily as they address and assess their Year 2000 efforts in 1999. This could result in a general reduction in market activities and revenue opportunities in late 1999 and early 2000. Management cannot predict the magnitude of any such reduction or its impact on the Company's financial results. However, the Company's Risk Management Department has undertaken a comprehensive review of third party and credit risks posed by Year 2000. Additionally, recognizing the uncertainty of external dependencies, the Company is preparing a contingency plan that identifies potential problems, actions to minimize the likelihood of their occurrence and action plans to be invoked should they occur. These plans will include backup processes that do not rely on computer systems, where appropriate. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company has taken a lead in industry efforts to deal with the Year 2000 issue by actively participating, and in some cases leading, industry-wide testing in 1998 and 1999. The Company has already successfully participated in a July industry-wide Beta test conducted by the Securities Industry Association. This industry-wide testing is the forum in which firms within the financial industry test the applications that transfer data between them. However, as stated above, there can be no guarantee or assurance that the systems of other companies on which the Company's systems rely will be timely converted in a timely fashion, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company. The Company plans to complete the Year 2000 project, including industry-wide testing, no later than August 1999. The Company has established an internal auditing plan to record results and ensures ongoing compliance of tested applications. It should be noted that efforts focused on addressing EMU have delayed the finalization of internal and industry-wide testing in Europe. The Company's total Year 2000 project cost is based on presently available information. The total remaining cost of the Year 2000 project is estimated at approximately $38 million which will be funded through operating cash flows and expensed as incurred over the next one and one-half years. The Company has incurred and expensed approximately $16 million in 1997, and $22.5 million through August 31, 1998, related to the Year 2000 project. The costs of Year 2000 testing, modifications and/or replacements and the date on which the Company plans to complete the project are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1 Legal Proceedings Lehman Brothers 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 LBI and others with respect to transactions in which LBI acted as an underwriter or financial advisor, actions arising out of LBI'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 of which LBI is one. Although there can be no assurance as to the ultimate outcome, Lehman Brothers 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. Although there can be no assurance as to the ultimate outcome, 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. Actions Relating to First Capital Holdings Inc. (Reported in Holdings' Annual Report on Form 10-K and First and Second Quarter Reports on Form 10-Q) The Virginia Commissioner of Insurance Action. On July 7, 1998, the Commissioner filed a Notice of Appeal to the United States Court of Appeals for the Fourth Circuit from the Order filed on May 21, 1998. Actions relating to National Association of Securities Dealers Automated Quotations System ("NASDAQ") Market Maker Antitrust and Securities Litigation. The Stipulation and Order were approved by the United States District Court for the Southern District of New York, which decision has been affirmed on appeal by the Second Circuit Court of Appeals. AIA Holding SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co., Inc. (Reported in Holdings' Annual Report on Form 10-K and First and Second Quarter Reports on Form 10-Q). The plaintiffs filed a First Amended Complaint on July 3, 1998 which LBI answered on August 12, 1998. Discovery is proceeding Actions relating to Sales and Marketing of Limited Partnerships Klein, et al. v. Lehman Brothers Inc., et al. (Reported in Holdings' Annual Report on Form 10-K) On September 24, 1998, the Court filed an opinion dismissing the complaint. ITEM 5 Other Information Pursuant to the Securities and Exchange Commission Proxy Rule 14a-8, Stockholder proposals intended to be presented at the Company's 1999 annual meeting of stockholders must be delivered to the Secretary of the Company, 3 World Financial Center, 24th Floor, New York, New York 10285 on or before October 23, 1998, in order to be included in the proxy statement and proxy card relating to that meeting. 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: 11 Computation of Per Share Earnings 12.1 Computation in Support of Ratio of Earnings to Fixed Charges 12.2 Computation in Support of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends 27 Financial Data Schedule (b) Reports on Form 8-K: 1. Form 8-K dated September 3, 1998, Item 5 and 7. 2. Form 8-K dated September 23, 1998, Item 5 and 7. 3. Form 8-K dated September 25, 1998, Item 5 and 7. 4. Form 8-K dated October 5, 1998, Item 5 and 7. SIGNATURES 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 15, 1998 By /s/ John Cecil ----------------------- Chief Financial and Administrative Officer (Principal Financial Officer) EXHIBIT INDEX Exhibit No. Exhibit Exhibit 11 Computation of Per Share Earnings Exhibit 12.1 Computation in Support of Ratio of Earnings to Fixed Charges Exhibit 12.2 Computation in Support of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends Exhibit 27 Financial Data Schedule Exhibit 11 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION of PER SHARE EARNINGS (Unaudited) (In millions, except share data)
Three months Nine months Ended Ended August 31 August 31 -------------------------------------------------------------------------- 1998 1997 1998 1997 ---------------- ---------------- ----------------- ----------------- Numerator: Net income $151 $197 $662 $462 Preferred stock dividends (12) (37) (75) (50) ---------------- ---------------- -------------- ----------------- Numerator for basic and diluted earnings per share - income available to common stockholders $139 $160 $587 $412 ================ ================ =============== ================= Denominator: Denominator for basic earnings per share - weighted-average shares 121,523,227 118,722,434 120,908,771 117,901,989 Effect of dilutive securities Employee stock options 2,609,299 2,458,397 2,881,356 1,867,283 Common stock equivalents 2,089,957 1,182,397 1,960,663 858,362 ---------------- --------------- ---------------- ----------------- Dilutive potential common shares 4,699,256 3,640,794 4,842,019 2,725,645 ---------------- --------------- ----------------- ---------------- Denominator for diluted earnings per share - adjusted weighted-average shares 126,222,483 122,363,228 125,750,790 120,627,634 ================ ============== ================== ================== Basic earnings per share $1.15 $1.34 $4.86 $3.49 ================ ============== ================== ================== Diluted earnings per share $1.10 $1.30 $4.67 $3.41 ================ ============== ================== ==================
Exhibit 12.1 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION in SUPPORT of RATIO of EARNINGS to FIXED CHARGES (Dollars in millions) (Unaudited)
For the For the For the For the For the For the Twelve Months Eleven Months Twelve Months Twelve Months Twelve Months Nine Months Ended Ended Ended Ended Ended Ended December 31 November 30 November 30 November 30 November 30 August 31 1993 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- ---- Fixed Charges: Interest expense: Subordinated indebtedness $ 144 $ 158 $ 206 $ 220 $ 240 $ 184 Bank loans and other borrowings* 5,224 6,294 10,199 10,596 12,770 12,465 Interest component of rentals of office and equipment 76 42 44 34 32 24 Other adjustments** 7 4 28 16 9 15 --------- --------- --------- --------- ----------- --------- TOTAL (A) $5,451 $6,498 $10,477 $10,866 $13,051 $12,688 ====== ========= ======== ======= ======== ======= Earnings: Pretax income (loss) from continuing operations $ 27 $ 193 $ 369 $ 637 $ 937 $ 958 Fixed charges 5,451 6,498 10,477 10,866 13,051 12,688 Other adjustments*** (6) (4) (28) (14) (8) (14) -------------------- --- --- ---- ---- --- ---- TOTAL (B) $5,472 $6,687 $10,818 $11,489 $13,980 $13,632 ====== ====== ======= ======= ======= ======= (B / A) 1.00 1.03 1.03 1.06 1.07 1.07
* Includes amortization of long-term debt discount. ** Other adjustments include capitalized interest and debt issuance costs and amortization of capitalized interest. *** Other adjustments include adding the net loss of affiliates accounted for at equity whose debt is not guaranteed by the Company and subtracting capitalized interest and debt issuance costs and undistributed net income of affiliates accounted for at equity. Exhibit 12.2 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION in SUPPORT of RATIO of EARNINGS to COMBINED FIXED CHARGES and PREFERRED DIVIDENDS (Dollars in millions) (Unaudited)
For the For the For the For the For the For the Twelve Months Eleven Months Twelve Months Twelve Months Twelve Months Nine Months Ended Ended Ended Ended Ended Ended December 31 November 30 November 30 November 30 November 30 August 31 1993 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- ---- Combined Fixed Charges and Preferred Dividends: Interest expense: Subordinated indebtedness $ 144 $ 158 $ 206 $ 220 $ 240 $ 184 Bank loans and other borrowings* 5,224 6,294 10,199 10,596 12,770 12,465 Interest component of rentals of office and equipment 76 42 44 34 32 24 Other adjustments** 7 4 28 16 9 15 --------- --------- --------- --------- ----------- -------- Total fixed charges 5,451 6,498 10,477 10,866 13,051 12,688 Preferred dividends (tax equivalent basis) 48 58 64 58 109 110 -------- -------- --------- --------- -------- --------- TOTAL (A) $5,499 $6,556 $10,541 $10,924 $13,160 $12,798 ====== ====== ======= ======= ======= ======= Earnings: Pretax income (loss) from continuing operations $ 27 $ 193 $ 369 $ 637 $ 937 $ 958 Fixed charges 5,451 6,498 10,477 10,866 13,051 12,688 Other adjustments*** (6) (4) (28) (14) (8) (14) -------------------- --- --- ---- ---- --- ------- TOTAL (B) $5,472 $6,687 $10,818 $11,489 $13,980 $13,632 ====== ====== ======= ======= ======= ======= (B / A) **** 1.02 1.03 1.05 1.06 1.07
* Includes amortization of long-term debt discount. ** Other adjustments include capitalized interest and debt issuance costs and amortization of capitalized interest. *** Other adjustments include adding the net loss of affiliates accounted for at equity whose debt is not guaranteed by the Company and subtracting capitalized interest and debt issuance costs and undistributed net income of affiliates accounted for at equity. **** Earnings were inadequate to cover fixed charges and preferred dividends and would have had to increase $27 million in 1993 in order to cover the deficiency. EX-27 2 FDS -- LEHMAN BROTHERS HOLDINGS INC.
BD This schedule contains summary financial information extracted from the Company's Consolidated Statement of Financial Condition at August 31, 1998 (Unaudited) and the Consolidated Statement of Income for the nine months ended August 31, 1998 (Unaudited) and is qualified in its entirety by reference to such financial statements. 9-MOS NOV-30-1998 DEC-01-1997 AUG-31-1998 6,337 13,235 57,287 21,815 90,709 483 191,074 12,703 16,041 84,496 6,110 33,818 28,381 0 958 12 4,379 191,074 1,142 13,235 378 1,336 0 12,649 1,749 958 662 0 0 662 4.86 4.67
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