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, 1997
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 1-6817
Lehman Brothers Inc.
(Exact Name of Registrant As Specified In Its Charter)
Delaware 13-2518466
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
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 ______
The Registrant meets the conditions set forth in General Instructions H 1 (a)
and (b) of Form 10-Q and therefore is filing this form with the reduced
disclosure format contemplated thereby.
As of October 13, 1997 1,006 shares of the Registrant's Common Stock, par value
$.10 per share, were issued and outstanding.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED AUGUST 31, 1997
INDEX
Part I. FINANCIAL INFORMATION Page Number
Item 1. Financial Statements - (unaudited)
Consolidated Statement of Operations -
Three and Nine Months Ended
August 31, 1997 and 1996 ............................... 3
Consolidated Statement of Financial Condition -
August 31, 1997 and November 30, 1996 .................. 5
Consolidated Statement of Cash Flows -
Nine Months Ended
August 31, 1997 and 1996................................ 7
Notes to Consolidated Financial Statements................ 9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations................ 17
Part II. OTHER INFORMATION
Item 1. Legal Proceedings ......................................... 30
Item 6. Exhibits and Reports on Form 8-K ..................... 31
Signatures................................................................. 32
EXHIBIT INDEX ..................................................... 33
Exhibits
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of OPERATIONS
(Unaudited)
(In millions)
Three months ended
August 31 August 31
1997 1996
------------- ---------
Revenues
Principal transactions $ 195 $ 85
Investment banking 295 189
Commissions 90 65
Interest and dividends 3,339 2,717
Other 8 1
--------- --------
Total revenues 3,927 3,057
Interest expense 3,228 2,614
----- -----
Net revenues 699 443
------ ------
Non-interest expenses
Compensation and benefits 391 267
Brokerage, commissions and clearance fees 45 51
Communications 22 24
Professional services 21 16
Business development 16 17
Occupancy and equipment 17 20
Depreciation and amortization 13 13
Management fees 16 7
Other 47 38
------- -------
Total non-interest expenses 588 453
------ ------
Income (loss) before taxes 111 (10)
Provision for (benefit from) income taxes 27 (10)
------- ------
Net income (loss) $ 84 $ 0
====== ========
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of OPERATIONS
(Unaudited)
(In millions)
Nine months ended
August 31 August 31
1997 1996
------------- -----------
Revenues
Principal transactions $ 579 $ 664
Investment banking 697 530
Commissions 247 223
Interest and dividends 9,224 7,800
Other 25 15
-------- -------
Total revenues 10,772 9,232
Interest expense 8,897 7,567
------ -----
Net revenues 1,875 1,665
------ -----
Non-interest expenses
Compensation and benefits 1,010 884
Brokerage, commissions and clearance fees 150 150
Communications 66 74
Professional services 64 54
Business development 51 55
Occupancy and equipment 49 57
Depreciation and amortization 39 40
Management fees 47 51
Other 133 137
------- ------
Total non-interest expenses 1,609 1,502
------ -----
Income before taxes 266 163
Provision for income taxes 76 63
-------- -------
Net income $ 190 $ 100
====== ======
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of FINANCIAL CONDITION
(Unaudited)
(in millions)
<TABLE>
<CAPTION>
August 31 November 30
ASSETS 1997 1996
--------------- -----------
<S> <C> <C>
Cash and cash equivalents $ 129 $ 396
Cash and securities segregated and on deposit
for regulatory and other purposes 905 663
Securities and other financial instruments owned:
Governments and agencies 17,426 21,251
Corporate stocks 4,227 3,164
Corporate debt and other 4,784 4,739
Derivatives and other contractual agreements 5,319 5,298
Mortgages and mortgage-backed 2,059 2,055
Certificates of deposit and other money market instruments 2,296 3,819
------- -------
36,111 40,326
------ ------
Collateralized short-term agreements:
Securities purchased under agreements to resell 48,872 33,145
Securities borrowed 15,212 19,035
Receivables:
Brokers, dealers and clearing organizations 3,969 4,909
Customers 3,951 3,956
Others 3,902 4,611
Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization
of $529 in 1997 and $502 in 1996) 267 283
Deferred expenses and other assets 218 214
Excess of cost over fair value of net assets
acquired (net of accumulated amortization
of $99 in 1997 and $94 in 1996) 161 166
----------- -----------
Total assets $113,697 $107,704
======== ========
</TABLE>
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of FINANCIAL CONDITION - (Continued)
(Unaudited)
(in millions, except per share data)
<TABLE>
<CAPTION>
August 31 November 30
LIABILITIES AND STOCKHOLDER'S EQUITY 1997 1996
<S> <C> <C>
Commercial paper and short-term debt $ 758 $ 2,299
Securities and other financial instruments sold but not yet purchased:
Governments and agencies 10,590 9,326
Corporate stocks 3,176 1,143
Corporate debt and other 1,593 2,735
Derivatives and other contractual agreements 3,428 4,662
-------- -------
18,787 17,866
------ ------
Collateralized short-term financing:
Securities sold under agreements to repurchase 53,943 52,200
Securities loaned 10,124 10,085
Advances from Holdings and other affiliates 12,679 8,552
Payables:
Brokers, dealers and clearing organizations 3,865 2,200
Customers 5,283 6,395
Accrued liabilities and other payables 2,081 2,250
Long-term debt:
Senior notes 225 215
Subordinated indebtedness 4,060 3,950
--------- ---------
Total liabilities 111,805 106,012
------- -------
Commitments and contingencies
Stockholder's Equity:
Preferred stock, $.10 par value; 10,000 shares authorized;
none outstanding
Common Stock, $.10 par value; 10,000 shares authorized; 1,006 shares issued
and outstanding in 1997 and 1996;
Additional paid-in capital 1,838 1,828
Foreign currency translation adjustment 3 3
Retained earnings (accumulated deficit) 51 (139)
------------- ------------
Total stockholder's equity 1,892 1,692
----------- -----------
Total liabilities and stockholder's equity $113,697 $107,704
======== ========
</TABLE>
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
(In millions)
<TABLE>
<CAPTION>
Nine months ended
August 31 August 31
1997 1996
--------------------- --------------
CASH FLOWS FROM OPERATING ACTIVITIES
<S> <C> <C>
Net income $ 190 $ 100
Adjustments to reconcile income to net cash
used in operating activities:
Depreciation and amortization 39 40
Provisions for losses and other reserves 41 30
Deferred tax benefit (24)
Other adjustments 13 15
Net change in:
Cash and securities segregated (242) (43)
Securities and other financial instruments owned 4,215 (411)
Securities purchased under agreements to resell (15,727) (341)
Securities borrowed 3,823 (6,849)
Receivables from brokers, dealers and clearing
organizations 940 (2,019)
Receivables from customers 5 (893)
Securities and other financial instruments sold but
not yet purchased 921 1,643
Securities sold under agreements to repurchase 1,743 1,549
Securities loaned 39 6,859
Payables to brokers, dealers and clearing organizations 1,665 (54)
Payables to customers (1,112) 1,027
Accrued liabilities and other payables (210) 109
Other operating assets and liabilities, net 723 (4,625)
------ ------
Net cash used in operating activities $(2,958) $(3,863)
------ -------
</TABLE>
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS -- (Continued)
(Unaudited)
(In millions)
<TABLE>
<CAPTION>
Nine months ended
August 31 August 31
1997 1996
--------------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES
<S> <C> <C>
Principal payments of senior notes $ (1) $ (210)
Proceeds from issuance of subordinated indebtedness 858 975
Principal payments of subordinated indebtedness (750) (261)
Net (payments for) proceeds from commercial paper and
short-term debt (1,541) 3,835
Increase (decrease) in advances from Holdings
and other affiliates 4,127 (256)
Capital contributions 48 4
Dividends and capital distributions paid (38) (151)
-------- ------
Net cash provided by financing activities 2,703 3,936
----- -----
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property, equipment and
leasehold improvements (12) (3)
------- --------
Net cash used in investing activities (12) (3)
------- --------
Net change in cash and cash equivalents (267) 70
------ -------
Cash and cash equivalents, beginning of period 396 287
------ ------
Cash and cash equivalents, end of period $ 129 $ 357
====== ======
</TABLE>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions)
Interest paid totaled $8,930 and $7,400 for the nine months ended
August 31, 1997 and 1996, respectively. Income taxes paid totaled $313 and $11
for the nine months ended August 31, 1997 and 1996, respectively.
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation:
The consolidated financial statements include the accounts of Lehman
Brothers Inc., a registered broker-dealer ("LBI") and subsidiaries
(collectively, the "Company"). LBI is a wholly-owned subsidiary of Lehman
Brothers Holdings Inc. ("Holdings"). LBI 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 are
complemented by offices in additional locations in North America, Europe, the
Middle East, Latin and South America and the Asia Pacific Region. Holdings
provides investment banking and capital markets services in Europe and Asia. The
Company is engaged primarily in providing financial services. 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. The Consolidated Statement of
Financial Condition at November 30, 1996 was derived from the audited financial
statements. 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, 1996 (the "Form 10-K").
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:
Derivatives, typically defined as instruments whose value is "derived"
from an underlying instrument, index or rate, include futures, forwards, swaps
and options and other similar instruments. A derivative contract generally
represents future commitments to exchange interest payment streams based on the
contract or notional amount or to purchase or sell financial instruments at
specified terms and future dates. In the normal course of business, the Company
enters into derivative transactions both in a trading capacity and as an end
user. Acting in a trading capacity, 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's accounting methodology for derivatives depends on both the type and
purpose of the derivative instrument.
Derivative transactions entered into for Trading-Related Derivative
Activities are recorded at market or fair value with realized gains and losses
reflected currently in principal transactions in the Consolidated Statement of
Operations. Market or fair value for trading related instruments is generally
determined by either quoted market prices (for exchange-traded futures and
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
options) or pricing models (for over-the-counter swaps, forwards and options).
Pricing models utilize a series of market inputs to determine the present value
of future cash flows, with adjustments, as required for credit risk, liquidity
risk, and ongoing costs. Further valuation adjustments may be recorded, as
deemed appropriate for new or complex products or for significant positions.
These adjustments are integral components of the mark-to-market process.
The market or fair value associated with derivatives utilized for
trading purposes is recorded in the Consolidated Statement of Financial
Condition on a net by counterparty basis where a legal right of set-off exists
and is netted across products and against cash collateral when such provisions
are stated in the master netting agreement. The market or fair value of swap
agreements, caps and floors, and forward contracts in an unrealized gain
position, as well as options owned and warrants held, are reported in the
Consolidated Statement of Financial Condition as assets in derivatives and other
contractual agreements. Similarly, swap agreements, caps and floors, and forward
contracts in an unrealized loss position, as well as options written and
warrants issued, are reported as liabilities in derivatives and other
contractual agreements. Margin on futures contracts is included in receivables
and payables, as applicable.
In addition to Trading-Related Derivative Activities, the Company
enters into various derivative instruments for non-trading purposes as an
end-user to modify the interest rate exposure of certain assets and liabilities.
In this regard, the Company utilizes interest rate swaps, caps, collars and
floors to manage the interest rate exposure associated with its long-term debt
obligations and secured financing activities, including securities purchased
under agreements to resell, securities borrowed, securities sold under
agreements to repurchase and securities loaned.
In addition to modifying the interest rate exposure of existing assets
and liabilities, the Company utilizes derivative instruments as an end user to
modify the interest rate characteristics of certain anticipated transactions
related to its secured financing activities, where there is a high degree of
certainty that the Company will enter into such contracts. These derivative
instruments are designated against existing secured financing transactions based
upon their applicable maturity. The remaining term of the derivative instruments
are designated against anticipated secured financing transactions which will
replace the existing secured financing transactions upon maturity. The Company
continuously monitors the level of secured financing transactions to ensure that
there is a high degree of certainty that it will enter into the anticipated
secured financing transactions at a level in excess of the designated derivative
product transactions.
Derivatives that have been designated as non-trading related positions
and are effective in modifying the interest rate characteristics of existing
assets and liabilities or anticipated transactions are accounted for on an
accrual basis. Under the accrual basis, interest is accrued into income or
expense over the life of the contract, resulting in the net interest impact of
the derivative and the underlying hedged item being recognized in income
throughout the hedge period.
The Company monitors the effectiveness of its end user hedging
activities by periodically comparing the change in the value of the hedge
instrument to the underlying item being hedged, and reassessing the likelihood
of the occurrence of anticipated transactions. In the event that the Company
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
determines that a hedge is no longer effective, such as upon extinguishment of
the underlying asset or liability or a change in circumstances whereby there is
not a high degree of certainty that the anticipated transaction will occur, the
derivative transaction is no longer accounted for as a hedge. Instead, the
Company immediately records the market or fair value of the derivative
instrument on the Statement of Financial Condition. Changes in the fair value of
the derivative contract would then be accounted for as a derivative used for
trading purposes as discussed above. In the event that a derivative designated
as a hedge is terminated early, any unrealized gain or loss on the termination
would be deferred and amortized to interest income or interest expense over the
original period of the hedge as long as the underlying hedged item is still
outstanding.
3. Long-Term Debt:
During the nine months ended August 31, 1997, the Company issued $858
million of subordinated indebtedness with maturities ranging from 1998 to 2007.
Of the total issuances for the first nine months of 1997, $300 million were
fixed rate and $558 million were floating rate. The Company's fixed rate
issuances have been effectively converted to floating rate obligations, based on
the London Interbank Offered Rates ("LIBOR") through the use of interest rate
swaps. In addition, $751 million of long-term debt matured during the nine
months ended August 31, 1997.
4. Capital Requirements:
As a registered broker-dealer, LBI 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, 1997, LBI's regulatory net
capital, as defined, of $1,364 million exceeded the minimum requirement by
$1,262 million.
The Company's triple-A 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, 1997,
LBFP had capital which exceeded the requirement of the most stringent rating
agency by $90 million.
Repayment of subordinated indebtedness and certain advances and
dividend payments by LBI are restricted by the regulations of the SEC and other
regulatory agencies. In addition, certain instruments governing the indebtedness
of LBI contractually limit its ability to pay dividends.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
5. Derivative Financial Instruments:
The Company records its Trading-Related Derivative Activities on a
mark-to-market basis with realized and unrealized gains (losses) recognized in
principal transactions in the Consolidated Statement of Operations. Unrealized
gains and losses on derivative contracts are currently 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 (in millions):
<TABLE>
<CAPTION>
Average Fair Value*
Fair Value* Nine Months Ended
August 31, 1997 August 31, 1997
--------------- ---------------
Assets Liabilities Assets Liabilities
- ---------------------------------------------------------------------------------------------------------------------------
Interest rate and currency swaps and options
<S> <C> <C> <C> <C>
(including caps, collars and floors) $4,211 $2,264 $4,377 $2,253
Foreign exchange forward contracts and options 845 932 835 1,202
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 171 157 239 214
Equity contracts (including equity swaps, warrants
and options) 64 55 105 43
Commodity contracts (including swaps, forwards,
and options) 28 20 33 23
--------------------------------------------------------
Total $5,319 $3,428 $5,589 $3,735
--------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Average Fair Value*
Fair Value* Twelve Months Ended
November 30, 1996 November 30, 1996
----------------- -----------------
Assets Liabilities Assets Liabilities
- ---------------------------------------------------------------------------------------------------------------------------
Interest rate and currency swaps and options
<S> <C> <C> <C> <C>
(including caps, collars and floors) $3,943 $3,159 $3,336 $1,917
Foreign exchange forward contracts and options 834 1,089 668 1,118
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 221 248 236 237
Equity contracts (including equity swaps, warrants
and options) 254 127 233 74
Commodity contracts (including swaps, forwards,
and options) 46 39 51 50
------------------------------------------------------
Total $5,298 $4,662 $4,524 $3,396
-----------------------------------------------------
</TABLE>
* Amounts represent carrying value (exclusive of collateral) of contracts and do
not include receivables or payables related to exchange-traded futures
contracts.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Assets included in the table 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 related to
derivative contracts at August 31, 1997 represents the Company's net receivable
for derivative financial instruments before consideration of collateral.
Included within the $5,319 million fair value of assets at August 31, 1997 was
$5,227 million related to swaps and OTC contracts and $92 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 $3,871 million at August 31, 1997, representing the
fair value of the Company's OTC contracts in an unrealized gain position, after
consideration of collateral of $1,356 million. Presented below is an analysis of
the Company's net credit exposure for OTC contracts based upon internal
designations of counterparty credit quality.
Counterparty S&P/Moody's August 31, 1997
Risk Rating Equivalent Net Credit Exposure
- ------------ ------------------------- -------------------
1 AAA/Aaa 19%
2 AA-/Aa3 or higher 17%
3 A-/A3 or higher 50%
4 BBB-/Baa3 or higher 7%
5 BB-/Ba3 or higher 6%
6 B+/B1 or lower 1%
- --------------------------------------------------------------------------------
These designations are based on actual ratings made by external rating
agencies or by equivalent ratings established and utilized by the Company's
Corporate Credit Department.
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 extend settlement to 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 Note 8 to the Consolidated Financial Statements, included
in the Form 10-K.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
6. Other Commitments and Contingencies:
In connection with its secured financing activities, the Company has
commitments under certain secured lending arrangements of approximately $3.2
billion at August 31, 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.
In addition, the Company has commitments to extend credit in loan
syndication transactions of $1.3 billion at August 31, 1997. These commitments
are typically secured against the borrower's assets, have fixed maturity dates
and are contingent on certain contractual conditions that may require payment of
a fee by the counterparty and are drawn down at the discretion of the borrower.
The total commitment above may not be indicative of actual funding requirements
as the commitments may expire without being drawn upon by the borrower. The
Company frequently syndicates or participates a portion of these commitments.
The Company is also a co-sponsor of an interim acquisition funding
facility. In connection therewith, the Company is committed to provide up to
$150 million to be used by the facility to provide short-term bridge financing.
Any draw downs under the facility would be expected to be refinanced, and the
outstanding amounts repaid, within a short-term period.
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 to monitor
and manage each type of risk on a global basis throughout the Company. For
further discussion of these matters, refer to Note 10 to the Consolidated
Financial Statements, in the Form 10-K.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
7. Related Party Transactions:
In the normal course of business, the Company engages in various
securities trading, investment banking and financing activities with Holdings
and many of its affiliates (the "Related Parties"). In addition, various
charges, such as compensation, occupancy, administration and computer processing
are allocated among the Related Parties, based upon specific identification and
allocation methods.
During the nine months ended August 31, 1997, the Company paid $38
million to Holdings as a return of capital.
8. Incentive Plans:
In the first quarter of 1997, Holdings granted approximately 2.3
million options (the "1997 Options") under the 1996 Management Ownership Plan to
members of the Corporate Management Committee and to certain senior officers. At
the grant date, the 1997 Options were to become exercisable in four and one-half
years and expire five years after grant date; exercisability was to be
accelerated ratably in one-third increments at such time as the closing price of
the Company's common stock met, or exceeded, $39, $42, and $45 for fifteen out
of twenty consecutive trading days. As of August 31, 1997, all of the 1997
Options were exercisable. No compensation expense has been recognized for these
stock options as they were issued with an exercise price above the market price
of the common stock on the date of the grant.
9. 1996 Severance Charge:
Holdings recorded an $84 million severance charge ($50 million
aftertax) in the fourth quarter of 1996 related to certain strategic actions
taken to improve ongoing profitability. The severance charge reflected the
culmination of a worldwide business unit economic performance review that was
undertaken in the fourth quarter of 1996 to focus Holdings on its core
investment banking, equity and fixed income sales and trading areas. This
formalized review resulted in personnel reductions of approximately 270 people
across a number of underperforming fixed income and equity businesses, including
exiting the precious metals business in the U.S., Europe and Asia; exiting
energy trading in the U.S. and Europe; consolidating Asian fixed income risk
management activities into one center in Tokyo; refocusing foreign exchange
trading activities, and combining the New York Private Client Services offices.
Additionally, the charge reflects various other strategic personnel reductions
aimed at delayering management. The Holdings severance charge has led to
personnel cost savings of approximately $90 million annually. Holdings' charge
also resulted in a permanent decrease in nonpersonnel expenses of approximately
$20 million annually. Holdings intends to reinvest substantially all these
savings into certain businesses to expedite Holdings' strategic initiatives;
these actions are expected to result in improved operating revenues.
The Company recorded a $23 million severance charge ($14 million
aftertax) in the fourth quarter of 1996 related to these actions. The Company's
cash outlays relating to the charge were approximately $12 million in the
fourth quarter of 1996 and approximately $11 million during the first six
months of 1997.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
10. New Accounting Pronouncements:
In June 1997, the Financial Accounting Standards Board issued SFAS No.
130, "Reporting Comprehensive Income" and SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information." These statements are
effective for fiscal years beginning after December 15, 1997 and establish
standards for the reporting and display of comprehensive income and disclosure
related to segments.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Business Environment
Market conditions in the first nine months of 1997 reflected record
corporate finance advisory activities, strong underwriting volumes in worldwide
fixed income products, and generally active trading in worldwide debt and equity
markets. These favorable conditions were mitigated in part by reduced global
equity underwriting volumes and increased volatility in the foreign exchange
markets, particularly in Europe and Asia.
Global fixed income markets were robust throughout most of 1997, with
heavy trading volumes in both the U.S. and Europe. Trading activity in the U.S.
continued to reflect investor optimism that the environment of sustained growth
and low inflation levels would continue. Additionally, U.S. trading activity
was bolstered by active purchases of U.S. securities by foreign investors due
to the favorable U.S. macroeconomic environment and the strong dollar.
In March 1997, the Federal Reserve raised the overnight lending rate by
0.25% to 5.50%. However, the deceleration of GDP growth and continued low
inflation indicators kept the Federal Reserve from raising interest rates for a
second time in 1997. The decline experienced in trading volumes and origination
activities in the U.S. fixed income market from the increase in the overnight
lending rate was short-lived. Towards the end of April, the U.S. fixed income
markets recovered as interest rates declined and trading volumes regained
strength. This trend continued through the beginning of October.
The interest rate on the 30-year U.S. Treasury, which peaked at 7.17%
on April 11th, declined to 6.28% on October 7, 1997. However, on October 8,
1997, investors again became concerned about a possible tightening in U.S.
interest rates based upon remarks by the Federal Reserve Board Chairman that it
would be difficult to maintain a balance between tight labor markets and low
growth. In addition he cautioned investors not to expect stock prices to
continue to rally indefinitely. As a result, the interest rate on the 30-year
U.S. Treasury rose to 6.43% on October 10, 1997
Trading activities in worldwide equity markets continued to show
strength in 1997. U.S. trading volumes improved over the prior year's record
levels, as investor demand remained strong and the equity markets benefited from
increasing capital flows. The U.S. equity markets continued to show strength
through October 1997, reaching new highs on most major indexes. A brief
correction in August and September was the result of several concerns: currency
turmoil in Southeast Asia, which investors believed would hurt profits of U.S.
companies; profit warnings; and, once again, fears that a strengthening economy
would induce the Federal Reserve to raise rates. As these concerns diminished,
the equity market resumed its upward trend. While intraday moves in the equity
market have become large and provide the appearance of a more volatile market,
the upward trend in prices and the lower volatility since August have benefited
the origination and trading activities of securities firms. European equity
markets saw improved trading volumes and valuations in 1997, despite an
adjustment in March, as the stronger U.S. dollar and declining European rate
environment contributed to a favorable equity environment.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Worldwide underwriting volumes in fixed income products remained strong
in the first nine months of 1997. U.S. underwriting volumes, while experiencing
a slowdown in March and April, strengthened over the prior year led by the
issuance of corporate, asset-backed, high yield, and emerging market bonds.
Issuers came to market to take advantage of the historically attractive yields,
as well as favorable pricing in the spread sectors. Equity and equity-related
underwriting volumes declined from the strong 1996 levels, as uncertainty
regarding both interest rates and prospective earnings performance of U.S.
companies contributed to U.S. equity market corrections. New issuance activity
was also negatively impacted by a lower volume of large international
privatizations over the period.
Corporate finance advisory activities outpaced the record 1996 levels,
reflecting increased consolidation and globalization across industry sectors as
well as the overall strength in the global capital markets. The pace of
strategic merger and acquisition activity is expected to remain strong
throughout the fourth quarter of 1997, resulting in a record year for worldwide
merger and acquisition activities.
While fiscal 1996 and 1997 have been characterized by favorable
financial markets, nevertheless, the financial services industry is cyclical. As
a result, the Company's businesses are evaluated across the market cycles for
operating profitability and their contribution to the Company's long-term
strategic product base, its global presence, and its risk management practices.
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.
<PAGE>
LEHMAN BROTHERS 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, 1997 and 1996
The Company reported net income of $84 million for the third quarter
ended August 31, 1997, and a net loss of $264 thousand for the third quarter
ended August 31, 1996. This increase reflected across-the-board strength in the
Company's equity, fixed income and investment banking businesses.
Net revenues increased to $699 million for the third quarter of 1997
from $443 million for the third quarter of 1996 as all four of the Company's
major business units (fixed income, equity, corporate finance advisory, and
merchant banking) had improved performance.
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 viewed in conjunction with
revenues from principal transactions. Principal transactions and net interest
revenues increased to $306 million for the third quarter of 1997 from $188
million for the third quarter of 1996. The increase in combined revenues from
principal transactions and net interest in the third quarter of 1997 was due to
increased revenues across almost all equity and fixed income product lines .
<PAGE>
LEHMAN BROTHERS 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. 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 Operations. Net revenues by
business unit contain certain internal allocations, including funding costs,
which are centrally managed.
<TABLE>
<CAPTION>
Three Months Ended August 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $258 $ 6 $87 $2 $353
Equity 40 81 81 202
Corporate Finance Advisory 66 66
Merchant Banking 4 61 65
Other 4 3 6 13
- ---------------------------------------------------------------------------------------------------------------------------
$306 $90 $295 $8 $699
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Three Months Ended August 31, 1996
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Fixed Income $232 $11 $67 $310
Equity (40) 49 53 62
Corporate Finance Advisory 50 50
Merchant Banking (4) 19 15
Other 5 $1 6
- ---------------------------------------------------------------------------------------------------------------------------
$188 $65 $189 $1 $443
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
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 increased 14% to
$353 million for the third quarter of 1997 from $310 million for the third
quarter of 1996. The increase in the third quarter results versus the prior year
quarter reflected increased revenues from a number of fixed income products
including high yield corporates, preferreds, and mortgages partially offset by
decreased results in derivatives. Investment banking revenues, as a component of
fixed income revenues, increased to $87 million for the third quarter of 1997
from $67 million for the third quarter of 1996 due to increased underwriting
fees, particularly in high yield corporates.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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 increased to $202 million for the
third quarter of 1997 from $62 million for the third quarter of 1996. Higher
revenues resulted from improved contributions from NASDAQ and derivative
activities. Investment banking revenues, as a component of equity revenues,
increased to $81 million for the third quarter of 1997 from $53 million for the
third quarter of 1996 due to increased underwriting volumes as markets rebounded
from the Fed tightening in the second quarter.
Corporate Finance Advisory. Corporate finance advisory net revenues,
classified in the Consolidated Statement of Operations 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 $66 million for the third
quarter of 1997, reflecting a 32% increase from the $50 million recognized in
the third quarter of 1996. This increase reflected the closing of several large
deals in the third quarter of 1997 and continued strength in the overall merger
and acquisition market environment.
Merchant Banking. The Company is the general partner for four active
merchant banking partnerships. Current merchant banking investments held by the
partnerships include both publicly traded and privately held companies
diversified on a geographic and industry basis. Merchant banking net revenues
primarily represent the Company's proportionate share of net realized and net
unrealized gains and losses from the sale and revaluation of investments held by
the partnerships. Such amounts are classified in the Consolidated Statement of
Operations 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 $65
million for the third quarter of 1997 and $15 million in the third quarter of
1996. This increase was principally due to realized gains on the sale of the
Company's remaining position in two publicly traded investments held by the
partnerships.
Non-Interest Expenses. Non-interest expenses were $588 million for the
third quarter of 1997 and $453 million for the third quarter of 1996.
Compensation and benefits expense increased to $391 million for the third
quarter of 1997 from $267 million for the third quarter of 1996 reflecting the
higher level of revenues in 1997.
Income Taxes. The Company's income tax provision was $27 million on
pretax earnings of $111 million for the third quarter of 1997 as compared to a
benefit of $10 million on a pretax loss of $10 million for the third quarter of
1996. The increase in the tax provision reflects an overall higher level of
earnings partially offset by an increase in tax benefits attributable to income
subject to preferential tax treatment.
<PAGE>
LEHMAN BROTHERS 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, 1997 and 1996
The Company reported net income of $190 million for the nine months
ended August 31, 1997, representing an increase of 90% from net income of $100
million for the nine months ended August 31, 1996.
Net revenues increased to $1,875 million for the nine months of 1997
from $1,665 million for the nine months of 1996 as improved performances in the
Company's equity, corporate finance advisory, and merchant banking businesses
were partially offset by reduced revenues from fixed income.
The Company ranked fourth in worldwide lead managed debt and equity
underwritings in 1997 up from its fifth place ranking in the comparable prior
year period. In equity and equity - related underwriting, the Company's ranking
improved significantly, rising to sixth place from its tenth place ranking in
1996. In worldwide lead managed fixed income underwriting, the Company
maintained its second place ranking. In worldwide mergers and acquisitions, the
Company ranked tenth for 1997 in completed transactions and ended the third
quarter of 1997 with a strong transaction pipeline which stood at $38 billion in
terms of total dollar value. These rankings are based on data compiled by
Securities Data Company for the nine month periods December through August in
both fiscal 1997 and 1996.
Principal transactions and net interest revenues increased to $906
million for the nine months of 1997 from $897 million for the nine months of
1996. The increase in the combined revenues from principal transactions and net
interest in the nine months of 1997 was the result of increased revenues across
almost all equity products partially offset by reduce revenues in certain fixed
income products.
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.
<TABLE>
<CAPTION>
Nine Months Ended August 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $791 $ 24 $240 $ 4 $1,059
Equity 110 213 172 1 496
Corporate Finance Advisory 168 168
Merchant Banking (3) 117 114
Other 8 10 20 38
- ---------------------------------------------------------------------------------------------------------------------------
$906 $247 $697 $25 $1,875
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
<TABLE>
<CAPTION>
Nine Months Ended August 31, 1996
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $902 $ 42 $198 $ 3 $1,145
Equity 5 167 161 4 337
Corporate Finance Advisory 137 137
Merchant Banking (10) 34 24
Other 14 8 22
- ---------------------------------------------------------------------------------------------------------------------------
$897 $223 $530 $15 $1,665
- ---------------------------------------------------------------------------------------------------------------------------
</TABLE>
Fixed Income. Fixed income net revenues decreased to $1,059 million for
the nine months of 1997 from $1,145 million for the nine months of 1996. The
reduced revenues from derivatives and foreign exchange were partially offset by
improved revenues from high yield and preferreds. Investment banking revenues,
as a component of fixed income revenues, increased to $240 million for the nine
months of 1997 from $198 million for the nine months of 1996 due to increased
underwriting fees on certain higher margin debt products. The Company improved
its ranking in high yield underwriting to seventh from ninth as well as its
market share to 5.4% from 4.4%.
Equity. The Company's equity net revenues increased to $496 million for
the nine months of 1997 from $337 million for the nine months of 1996. Higher
revenues for the nine months of 1997 resulted from improved contributions from
NASDAQ and derivative activities. Investment banking revenues, as a component of
equity revenues, increased to $172 million for the nine months of 1997 from $161
million for the nine months of 1996 due to increased underwriting volumes.
Corporate Finance Advisory. Net revenues from corporate finance
advisory activities increased to $168 million for the nine months of 1997
reflecting a 23% increase from the $137 million recognized in the nine months of
1996. This increase reflected continued strength in the overall merger and
acquisition market environment.
Merchant Banking. Merchant banking net revenues were $114 million for
the nine months of 1997 and $24 million in the nine months of 1996. This
increase was principally due to realized gains on the sale of the Company's
remaining position in two publicly traded investments held by the partnerships.
Non-Interest Expenses. Non-interest expenses were $1,609 million for
the nine months of 1997 and $1,502 million for the nine months of 1996.
Compensation and benefits expense was $1,010 million for 1997 and $884 million
for 1996.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Income Taxes. The Company's income tax provision was $76 million on
pretax earnings of $266 million for the nine months ended August 31, 1997 as
compared to $63 million on pretax earnings of $163 million for the nine months
ended August 31, 1996. The increase in the tax provision reflects an overall
higher level of earnings partially offset by an increase in tax benefits
attributable to income subject to preferential tax treatment.
<PAGE>
LEHMAN BROTHERS 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 Company's securities
inventory, underwriting activities, principal investments, merchant banking
activities and investments in fixed assets.
The Company's balance sheet is liquid and consists primarily of cash
and cash equivalents, securities and other financial instruments owned, and
collateralized short-term financing agreements. The highly liquid nature of
these assets provides the Company with flexibility in financing and managing its
business. The Company's primary activities are based on customer execution
transactions. This flow of customer business supports the rapid asset turnover
rate of the Company's inventory. Due to the nature of the Company's 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 at fiscal quarter ends.
The Company's total assets increased to $113.7 billion at August 31,
1997 from $107.7 billion at November 30, 1996. The increase in total assets is
primarily attributable to an increase in customer financing activities.
Funding and Capital Policies
The Company's Finance Committee is responsible for establishing and
managing the funding and liquidity policies of the Company. The Finance
Committee's funding and liquidity policies include recommendations for capital
and balance sheet size as well as the allocation of capital and balance sheet to
product areas. Under the authority of the Finance Committee, members of the
Company's treasury work with Regional Asset and Liability Committees to
ensure coordination of global funding efforts and implementation of the
funding and liquidity policies. The Regional Asset and Liability Committees
are aligned with the Company's geographic funding centers and are responsible
for implementing funding strategies for their respective region.
The primary goal of the Company's funding policies is to provide
sufficient liquidity and availability of funding sources across a wide range of
market environments. There are five key elements of its funding strategy that
the Company attempts to achieve:
o To maintain an appropriate Total Capital structure to support the business
activities in which the Company is engaged.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
o To minimize liquidity and refinancing risk by funding the Company's assets
on a global basis with unsecured liabilities which have maturities similar
to the anticipated liquidation period of the assets.
o To maintain sufficient liquidity during a period of financial stress
through a combination of collateralized short-term financings, Total
Capital and a contingency funding plan. Financial stress is defined as any
event which severely constrains the Company's access to unsecured funding
sources.
o To obtain diversified funding through a global investor base which maximizes
liquidity and reduces concentration risk.
o To maintain funding availability in excess of actual utilization.
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 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 certain other types of collateralized borrowing sources are less
credit-sensitive and have historically been a more stable financing source under
adverse 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 and global market conditions. The majority of the
Company's assets are funded with collateralized borrowing sources. At August 31,
1997 and November 30, 1996, $83 billion and $80 billion, respectively, of the
Company's total balance sheet was financed using collateralized borrowing
sources.
As of August 31, 1997 and November 30, 1996, short-term debt
outstanding was $758 million and $2,299 million, respectively. There was no
commercial paper outstanding as of August 31, 1997 and November 30, 1996.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Total Capital
In accordance with the Company's liquidity plan, the Company increased
its Total Capital base in 1997 to $6.2 billion at August 31, 1997 from $5.9
billion at November 30, 1996. Total Capital increased primarily due to the
retention of earnings and an increase in long-term debt.
August 31 November 30
(in millions) 1997 1996
- --------------------------------------------------------------------------------
Long-Term Debt
Senior Notes $ 225 $ 215
Subordinated Indebtedness 4,060 3,950
------- -------
4,285 4,165
Stockholder's Equity 1,892 1,692
- --------------------------------------------------------------------------------
Total Capital $6,177 $5,857
- --------------------------------------------------------------------------------
During the nine months of 1997, the Company issued $858 million in
long-term debt, which was $107 million in excess of its maturing debt. Long-term
debt increased to $4.3 billion at August 31, 1997 from $4.2 billion at November
30, 1996 with a weighted average maturity of 3.9 years at August 31, 1997 and
4.5 years at November 30, 1996.
The increase in Total Capital also reflects an increase in
stockholder's equity to $1.9 billion at August 31, 1997 from $1.7 billion at
November 30, 1996. The net increase in stockholder's equity was primarily due to
the retention of earnings.
At August 31, 1997, the Company had approximately $1.1 billion
available for the issuance of debt securities under various shelf registrations.
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. As of August 31, 1997, the current short- and
long-term senior debt ratings of Holdings and Lehman Brothers Inc. ("LBI") were
as follows:
<TABLE>
<CAPTION>
Holdings LBI
Short-term Long-term Short-term Long-term**
- ---------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Duff & Phelps Credit Rating Co. D-1 A D-1 A/A-
Fitch Investors Service Inc. F-1 A F-1 A/A-
IBCA A1 A- A1 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-
- -----------------------------------------------------------------------------------------------------------------------------
</TABLE>
* Provisional ratings on shelf registration
** Senior/subordinated
+ Long-term ratings outlook revised to negative on September 21, 1994
<PAGE>
LEHMAN BROTHERS 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. 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 Operations. The
Company's portfolio of such securities at August 31, 1997 and November 30, 1996
included long positions with an aggregate market value of approximately $2.1
billion and $1.3 billion, respectively, and short positions with an aggregate
market value of approximately $210 million and $99 million, respectively. The
portfolio may, from time to time, contain concentrated holdings of selected
issues. The Company's largest high yield position was $85 million and $78
million at August 31, 1997 and November 30, 1996, respectively.
Lending Activities
The Company has commitments to extend credit in loan syndication
transactions of $1.3 billion at August 31, 1997. These commitments are primarily
to below investment grade borrowers and, if drawn upon, would represent
additional high yield debt securities as defined above. These commitments are
typically secured against the borrower's assets, have fixed maturity dates, and
are contingent on certain contractual conditions that may require payment of a
fee by the counterparty and are drawn down at the discretion of the borrower.
The total commitment may not be indicative of actual funding requirements as the
commitments may expire without being drawn upon by the borrower. The Company
frequently syndicates or participates a portion of these commitments.
Merchant Banking and Bridge Lending Activities
The Company's merchant banking activities include investments in four
partnerships, for which the Company acts as general partner, as well as direct
investments. At August 31, 1997, the investments in merchant banking
partnerships were $36 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 is also a co-sponsor of an interim acquisition funding
facility. In connection therewith, the Company is committed to provide up to
$150 million to be used by the facility to provide short-term bridge financing.
Any draw downs against the facility would be expected to be refinanced, and the
outstanding amounts repaid, within a short-term period.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
In addition, at August 31, 1997, the Company had direct short-term
bridge financings outstanding of $24 million.
Non-Core Activities and Investments
In March 1990, the Company discontinued the origination of partnerships
(the assets of which are primarily real estate) and investments in real estate.
Currently, the Company acts as a general partner or co-general partner for
approximately $3.0 billion of partnership investment capital and manages the
remaining real estate investment portfolio. At August 31, 1997, the Company's
investments in these real estate activities as well as commitments and
contingent liabilities under guarantees and credit enhancements were fully
reserved. In certain circumstances, the Company has elected to provide financial
and other support and assistance to such investments to maintain investment
values. There is no contractual requirement that the Company continue to provide
this support.
Management's intention with regard to non-core assets is the prudent
liquidation of these investments as and when possible.
Year 2000
The Company has developed a detailed plan to modify its computer
systems in anticipation of the year 2000. Many of the existing systems process
transactions based on storing two digits for the year of a transaction, rather
than the full four digits. If these systems are not identified and reconfigured,
year 2000 transactions would be processed as year "00", which would lead to
processing inaccuracies and potential inoperability. Costs incurred relating to
this project are expensed as technology maintenance costs in accordance with
generally accepted accounting principles.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1 Legal Proceedings
The Company is involved in a number of judicial, regulatory and
arbitration proceedings concerning matters arising in connection with the
conduct of its business. Such proceedings include actions brought against 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, the
Company has denied, or believes it has meritorious defenses and will deny,
liability in all significant cases pending against it including the matters
described below, and intends to defend vigorously each such case. 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 National Association of Securities Dealers
Automated Quotations System ("NASDAQ") Market Maker Antitrust and Securities
Litigation (Reported in LBI's Annual Report on Form 10-K)
The Stipulation and Order was approved by the United States District
Court for the Southern District of New York on April 22, 1997. The class action
plaintiffs intervened to appeal the Court's approval of the Stipulation and
Order to the United States Court of Appeals for the Second Circuit. That appeal
is pending.
AIA Holding SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co. Inc.
(Reported in LBI's Second Quarter Report on Form 10-Q)
On July 9, 1997, LBI was served with a complaint in the U.S. District
Court for the Southern District of New York in which 277 named plaintiffs assert
24 causes of action against LBI and Bear Stearns & Co., Inc. The amount of
damages claimed is unspecified. The claims arise from the activities of an
individual named Ahmad Daouk, who was employed as by introducing broker which
introduced accounts to Shearson Lehman Hutton between 1988 and 1992. Daouk
allegedly perpetrated a fraud upon the claimants, who are mostly investors of
Middle Eastern origin, and the complaint alleges that Shearson breached various
contractual and common law duties owed to the investors.
<PAGE>
ITEM 6 EXHIBITS AND REPORTS ON FORM 8-K
The following exhibits and reports on Form 8-K are filed as part of this
Quarterly Report, or where indicated, were heretofore filed and are hereby
incorporated by reference:
(a) Exhibits:
12 Computation in Support of Ratio of Earnings to Fixed Charges
27 Financial Data Schedule
<PAGE>
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 INC.
(Registrant)
Date: October 15, 1997 By /s/ Richard S. Fuld Jr.
-------------------------------
Richard S. Fuld, Jr.
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Date: October 15, 1997 By /s/ Charles B. Hintz
-----------------------------
Charles B. Hintz
Chief Financial Officer
(Principal Financial Officer)
<PAGE>
EXHIBIT INDEX
Exhibit No. Exhibit
Exhibit 12 Computation in Support of Ratio of Earnings to Fixed Charges
Exhibit 27 Financial Data Schedule
<PAGE>
Exhibit 12
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
COMPUTATION in SUPPORT of RATIO of EARNINGS to FIXED CHARGES
(Unaudited)
(Dollars in millions)
<TABLE>
<CAPTION>
For the For the For the For the
For the Year Eleven Months Year Year Nine Months
Ended Ended Ended Ended Ended
December 31 November 30 November 30 November 30 August 31
----------- ----------- ----------- ----------- ---------
1992 1993 1994 1995 1996 1997
---- ---- ---- ---- ---- ----
Fixed charges:
Interest expense:
<S> <C> <C> <C> <C> <C> <C>
Subordinated indebtedness $ 210 $ 192 $ 184 $ 204 $ 221 $ 185
Bank loans and other
borrowings* 4,363 4,393 5,661 9,750 9,900 8,712
Interest component of rentals
of office and equipment 64 62 27 25 18 11
Other adjustments** 127 101 53 2 7 2
---- ------ ------ ------- ------- -----
TOTAL (A) $4,764 $4,748 $5,925 $9,981 $10,146 $8,910
====== ====== ====== ====== ======= ======
Earnings:
Pre-tax income (loss) from
continuing operations $ 319 $ $ 1 $ 78 $ 309 $ 266
(146)
Fixed charges 4,764 4,748 5,925 9,981 10,146 8,910
Other adjustments*** (68) (68) (52) (1) (6) (2)
-------- -------- -------- ----------- ----------- ---------
TOTAL (B) $5,015 $4,534 $5,874 $10,058 $10,449 $9,174
====== ====== ====== ======= ======= ======
(B / A) 1.05 **** **** 1.01 1.03 1.03
</TABLE>
* Includes amortization of long-term debt discount.
** Other adjustments include capitalized interest and debt issuance costs,
amortization of capitalized interest and preferred stock dividends of a
wholly owned subsidiary.
*** 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 costs and undistributed net income of
affiliates accounted for at equity and preferred stock dividends of a
wholly owned subsidiary.
**** Earnings were inadequate to cover fixed charges and would have had to
increase approximately $214 million in 1993 and $51 million in 1994
in order to cover the deficiencies.
<PAGE>
Exhibit 27
<TABLE> <S> <C>
<ARTICLE> BD
<LEGEND>
This schedule contains summary financial information extracted
from the Consolidated Statement of Financial Condition at August 31, 1997
(Unaudited) and the Consolidated Statement of Operations for the nine months
ended August 31, 1997 (Unaudited) and is qualified in its entirety by reference
to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> NOV-30-1997
<PERIOD-START> DEC-01-1996
<PERIOD-END> AUG-31-1997
<CASH> 1,034
<RECEIVABLES> 11,822
<SECURITIES-RESALE> 48,872
<SECURITIES-BORROWED> 15,212
<INSTRUMENTS-OWNED> 36,111
<PP&E> 267
<TOTAL-ASSETS> 113,697
<SHORT-TERM> 758
<PAYABLES> 21,827
<REPOS-SOLD> 53,943
<SECURITIES-LOANED> 10,124
<INSTRUMENTS-SOLD> 18,787
<LONG-TERM> 4,285
<COMMON> 0
0
0
<OTHER-SE> 1,892
<TOTAL-LIABILITY-AND-EQUITY> 113,697
<TRADING-REVENUE> 579
<INTEREST-DIVIDENDS> 9,224
<COMMISSIONS> 247
<INVESTMENT-BANKING-REVENUES> 697
<FEE-REVENUE> 0
<INTEREST-EXPENSE> 8,897
<COMPENSATION> 1,010
<INCOME-PRETAX> 266
<INCOME-PRE-EXTRAORDINARY> 190
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 190
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
