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 May 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 1-6817
Lehman Brothers Inc.
(Exact Name of Registrant As Specified In Its Charter)
Delaware 13-2518466
(State or other jurisdiction of (I.R.S. Employer Identification No.)
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 June 30, 1998, 1,006 shares of the Registrant's Common Stock, par value
$.10 per share, were outstanding.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED MAY 31, 1998
INDEX
Part I. FINANCIAL INFORMATION Page Number
Item 1. Financial Statements - (unaudited)
Consolidated Statement of Income -
Three and Six Months Ended
May 31, 1998 and 1997 ...............................3
Consolidated Statement of Financial Condition -
May 31, 1998 and 1997 ...............................5
Consolidated Statement of Cash Flows -
Six Months Ended
May 31, 1998 and 1997............................7
Notes to Consolidated Financial Statements.............9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations...............14
Part II. OTHER INFORMATION
Item 1. Legal Proceedings...........................................30
Item 6. Exhibits and Reports on Form 8-K ...........................32
Signatures................................................................33
EXHIBIT INDEX ....................................................34
Exhibits
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of INCOME
(Unaudited)
(In millions)
Three months ended
May 31 May 31
1998 1997
--------- --------
Revenues
Principal transactions $ 324 $ 158
Investment banking 424 210
Commissions 97 74
Interest and dividends 3,943 2,954
Other 3 9
----- -----
Total revenues 4,791 3,405
Interest expense 3,783 2,850
----- -----
Net revenues 1,008 555
----- -----
Non-interest expenses
Compensation and benefits 512 259
Brokerage, commissions and clearance fees 48 55
Professional services 17 22
Occupancy and equipment 14 16
Communications 24 22
Business development 22 18
Depreciation and amortization 13 13
Management fees 16 16
Other 12 48
----- -----
Total non-interest expenses 678 469
----- -----
Income before taxes 330 86
Provision for income taxes 130 27
----- -----
Net income $ 200 $ 59
===== ======
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of INCOME
(Unaudited)
(In millions)
Six months ended
May 31 May 31
1998 1997
---------- ----------
Revenues
Principal transactions $ 607 $ 384
Investment banking 682 402
Commissions 192 157
Interest and dividends 7,403 5,885
Other 9 17
------ ------
Total revenues 8,893 6,845
Interest expense 7,139 5,669
------ ------
Net revenues 1,754 1,176
------ ------
Non-interest expenses
Compensation and benefits 876 619
Brokerage, commissions and clearance fees 90 105
Professional services 37 43
Communications 47 44
Occupancy and equipment 30 32
Business development 41 35
Depreciation and amortization 27 26
Management fees 24 31
Other 50 86
----- -----
Total non-interest expenses 1,222 1,021
----- -----
Income before taxes 532 155
Provision for income taxes 206 49
----- -----
Net income $ 326 $ 106
===== =====
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
(Unaudited)
(In millions)
May 31 November 30
ASSETS 1998 1997
- ------ ---- ----
Cash and cash equivalents $ 512 $ 220
Cash and securities segregated and on deposit
for regulatory and other purposes 1,259 1,128
Securities and other financial instruments owned:
Governments and agencies 23,918 17,467
Corporate equities 7,148 5,439
Corporate debt and other 7,765 5,544
Mortgages and mortgage-backed 5,967 2,751
Derivatives and other contractual agreements 5,543 5,528
Certificates of deposit and other money market
instruments 2,834 2,248
------ ------
53,175 38,977
------ ------
Collateralized short-term agreements:
Securities purchased under agreements to resell 54,204 49,610
Securities borrowed 20,148 13,661
Receivables:
Brokers, dealers and clearing organizations 3,372 3,148
Customers 3,421 3,874
Others 4,937 3,107
Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization
of $546 in 1998 and $533 in 1997) 262 262
Other assets 183 146
Excess of cost over fair value of net assets
acquired (net of accumulated amortization
of $105 in 1998 and $102 in 1997) 155 158
-------- --------
Total assets $141,628 $114,291
======== ========
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Continued)
(Unaudited)
(In millions, except share data)
May 31 November 30
1998 1997
---- ----
LIABILITIES AND STOCKHOLDER'S EQUITY
Commercial paper and short-term debt $ 1,554 $ 740
Securities and other financial instruments sold but
not yet purchased:
Governments and agencies 10,459 8,556
Corporate equities 4,830 3,124
Corporate debt and other 1,960 1,664
Derivatives and other contractual agreements 3,789 3,685
-------- --------
21,038 17,029
------- -------
Collateralized short-term financings:
Securities sold under agreements to repurchase 64,473
56,017
Securities loaned 12,010 7,764
Advances from Holdings and other affiliates 20,881 14,777
Payables:
Brokers, dealers and clearing organizations 5,377 3,127
Customers 7,291 6,118
Accrued liabilities and other payables 2,172 2,166
Long-term debt:
Senior notes 159 229
Subordinated indebtedness 4,336 4,313
--------- ---------
Total liabilities 139,291 112,280
------- -------
Commitments and contingencies
STOCKHOLDER'S EQUITY
Preferred stock, $0.10 par value; 10,000
shares authorized;
None outstanding
Common stock, $0.10 par value; 10,000 shares
authorized;
1,006 shares issued and outstanding
Additional paid-in capital 1,756 1,756
Foreign currency translation adjustment 3 3
Retained earnings 578 252
---------- -----------
Total stockholder's equity 2,337 2,011
---------- ----------
Total liabilities and stockholder's equity $141,628 $114,291
======== ========
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
(In millions)
Six months ended
May 31 May 31
1998 1997
--------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 326 $ 106
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 27 26
Provisions for losses and other reserves 24 19
Deferred tax benefit (24)
Other adjustments 39 7
Net change in:
Cash and securities segregated (131) (143)
Securities and other financial instruments owned (14,198) 2,630
Securities purchased under agreements to resell (4,594) (9,739)
Securities borrowed (6,487) (1,866)
Receivables from brokers, dealers and clearing
organizations (224) 1,625
Receivables from customers 453 192
Securities and other financial instruments sold but
not yet purchased 4,009 5,141
Securities sold under agreements to repurchase 8,456 (2,222)
Securities loaned 4,246 3,594
Payables to brokers, dealers and clearing organizations 2,250 59
Payables to customers 1,173 (1,354)
Accrued liabilities and other payables (18) (356)
Other operating assets and liabilities, net (1,877) (554)
------ -------
Net cash used in operating activities $(6,526) $(2,859)
------- -------
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (Continued)
(Unaudited)
(In millions)
Six months ended
May 31 May 31
1998 1997
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Principal payments of senior notes $ (79)
Proceeds from issuance of subordinated indebtedness 600 $ (409)
Principal payments of subordinated indebtedness (607) 508
Net (payments for) proceeds from commercial paper and
short-term debt 814 (539)
Increase in advances from Holdings and other affiliates 6,104 3,094
Capital contributions 48
Dividends and capital distributions paid (18)
------ ------
Net cash provided by financing activities 6,832 2,684
------ ------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property, equipment and leasehold improvements (14) (6)
------ ------
Net cash used in investing activities (14) (6)
------ ------
Net change in cash and cash equivalents 292 (181)
------ ------
Cash and cash equivalents, beginning of period 220 396
------ ------
Cash and cash equivalents, end of period $ 512 $ 215
====== ======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions)
Interest paid totaled $7,139 and $5,676 for the six months ended May
31, 1998 and 1997, respectively. Income taxes paid totaled $298 and $307 for the
six months ended May 31, 1998 and 1997, 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 America and the Asia Pacific Region. The Company is engaged
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. 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:
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 recognized approximately $100 million 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 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 $4.0 million of internal use
software costs during the first half of 1998.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
3. Long-Term Debt:
During the six months ended May 31, 1998, the Company issued $600
million of subordinated indebtedness maturing 2008. These issuances have been
effectively converted to floating rate obligations, based on the London
Interbank Offered Rate ("LIBOR") through the use of interest rate swaps. In
addition, $686 million of long-term debt matured during the six months ended May
31, 1998.
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 May 31, 1998, LBI's regulatory net capital,
as defined, of $1,435 million exceeded the minimum requirement by $1,307
million. 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 May 31, 1998,
LBFP had capital which exceeded the requirement of the most stringent rating
agency by approximately $95 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.
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
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
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.
<TABLE>
<CAPTION>
Average Fair Value*
Fair Value* Six Months Ended
May 31, 1998 May 31, 1998
------------------------ ------------------
(in millions) Assets Liabilities Assets Liabilities
- ---------------------------------------------------------------------------------------------------------------------------
Interest rate and currency swaps and options
<S> <C> <C> <C> <C>
(including caps, collars and floors) $4,300 $2,294 $4,241 $2,420
Foreign exchange forward contracts and options 754 993 745 712
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 237 202 234 218
Equity contracts (including equity warrants
and options) 224 293 196 226
Commodity contracts (including swaps, forwards,
and options) 28 7 34 8
-------------------------------------------------------
Total $5,543 $3,789 $5,450 $3,584
-------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
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
<S> <C> <C> <C> <C>
(including caps, collars and floors) $4,123 $2,344 $4,227 $2,295
Foreign exchange forward contracts and options 1,066 1,072 847 1,120
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 200 200 244 221
Equity contracts (including equity warrants
and options) 87 63 102 50
Commodity contracts (including swaps, forwards,
and options) 52 6 34 19
---------------------------------------------------------
Total $5,528 $3,685 $5,454 $3,705
--------------------------------------------------------
</TABLE>
* 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 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 May 31, 1998 represents the Company's net
receivable/payable for derivative financial instruments before consideration of
collateral. Included within the $5,543 million fair value of assets at May 31,
1998 was $5,403 million related to swaps and OTC contracts and $140 million
related to exchange-traded option and warrant contracts. Included within the
$5,528 million fair value of assets at November 30, 1997 was $5,444 million
related to swaps and OTC contracts and $84 million related to exchange-traded
option and warrant contracts.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
With respect to OTC contracts, including swaps, the Company views its
net credit exposure to be $4,631 million at May 31, 1998 (including $668 million
from affiliates), representing the fair value of the Company's OTC contracts in
an unrealized gain position, after consideration of collateral of $772 million.
Presented below is an analysis of the Company's net credit exposure at May 31,
1998 for OTC contracts based upon internal designations of counterparty credit
quality.
Counterparty S&P/Moody's
Risk Rating Equivalent Net Credit Exposure
- ------------ ------------------------- -------------------
1 AAA/Aaa 17%
2 AA-/Aa3 or higher 24%
3 A-/A3 or higher 45%
4 BBB-/Baa3 or higher 8%
5 BB-/Ba3 or higher 5%
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 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 8 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 $2.5
billion at May 31, 1998 and $1.9 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 $1.9 billion and $1.4 billion at May 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.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Total commitments may not be indicative of actual funding requirements as the
Company intends to continue syndicating, selling, and/or participating these
commitments.
The Company has commitments to invest up to $205 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 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 draw downs under the facility are expected to be 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.
7. Related Party Transactions:
In the normal course of business, the Company engages in various
securities trading, investment banking and financial activities with Holdings
and many of its subsidiaries (the "Related Parties"). Various charges, such as
compensation and benefits, occupancy, administration and computer processing are
allocated between the Related Parties, based upon specific identification and
allocation methods.
<PAGE>
LEHMAN BROTHERS 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 six months of the Company's
fiscal year ("fiscal 1998"). During the first six 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 unabated pace of global merger and
acquisition activity fueled financing of all types. Investors continued to focus
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.
In the global fixed income markets, fiscal 1998 began with uncertainty
as investors focused on whether the U.S. Federal Reserve Board (the "Fed") would
raise the overnight lending rate from 5.5% and whether the crisis which began in
the Asian region in the latter half of 1997 would have a negative impact on the
U.S. economy. By the end of January, however, the bond markets rallied when the
Fed left rates unchanged: interest rates on the 30-year U.S. Treasury bond
remained below 6% for most of the first half of fiscal 1998. In Europe, the
economic environment remained extremely favorable throughout this period. Low
levels of inflation, the continued strength of the U.S. dollar and the prospects
of European Monetary Union propelled the European bond markets, especially in
some of the smaller markets (e.g., Italy and Spain). In Japan, the weakening
economy drove bond yields to historic lows not seen by any modern,
industrialized country. In the six months ending May 31, 1998, Japanese 10 year
yields fell 50bp to 1.45% as the Yen fell 8% to Y/$ 138.8.
U.S. equity markets continued to recover from the 1997 Asian
correction, with most equity indices posting successive record highs during this
period. However, concerns about earnings weakness related to Asia and an
increase in corporate profit warnings, prompted analysts to reduce their
earnings expectations. Earnings growth slowed considerably with the turmoil in
Asia; indeed, most of the markets' rise came from an increase in the "price to
earnings" multiple for the equity market as a whole. The forward "price to
earnings" multiple on the U.S. stock market (measured by the S&P 500) rose from
19 times at the beginning of the fiscal year to above 21 times now. This
increase was facilitated by moderate inflation and the 30 year U.S. Treasury
bond yield staying below 6% for almost the entire period. Thus, despite slowing
profit growth, the S&P 500 returned almost 14% for the first half of 1998.
Supported by a favorable bond market environment, together with increasing
evidence of a recovery in domestic demand, European equity markets performed
very strongly. The FT/S&P European Index gained 28.5% in dollar terms over the
period, while trading volumes remained buoyant. By contrast, in late spring,
increasing pessimism over Japan's ability to resolve its bad debt and structural
problems and the associated weakness in the yen sparked off a wave of negative
sentiment towards markets across the Far East and throughout emerging markets
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
globally. In the six months ending May, the FT/S&P Pacific Basin Index fell
11.6% in U.S. dollar terms, and Latin American equities (IFC Investable Index)
declined 11.4%.
Worldwide underwriting volumes in fixed income products were
unprecedented during the first six months of fiscal 1998. U.S. underwriting
volumes, while experiencing a slowdown in December 1997 and January 1998,
strengthened over the prior year, with heavy issuance of corporate, high yield
and asset-backed 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 also increased during
fiscal 1998 from the comparable period in fiscal 1997 as increased stock prices
and favorable valuations induced capital raising by issuers. However, the actual
number of equity and equity-related deals was overshadowed by the significant
number of debt transactions, where issuance proceeded at a rate not seen since
the fourth quarter of 1990.
Corporate Finance Advisory activities continued at record levels during
the first six months of fiscal 1998. Coming off a strong pace in 1997, the
volume of announced transactions in the first half of 1998 continued to reflect
the trend of consolidation, deregulation and globalization across industry
sectors as well as the overall strength in the global capital markets.
Strong financial markets have characterized fiscal 1998; nevertheless,
the financial services industry is cyclical. As a result, the Company's
businesses are evaluated across market cycles for operating profitability and
their contribution to the Company's long-term strategic objectives. The Company
strives to minimize the effects of economic downturns through its diversified
product base; stringent cost controls, global presence and 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 May 31, 1998 and 1997
The Company reported net income of $200 million for the second quarter
ended May 31, 1998 representing an increase of 239% from net income of $59
million for the second quarter ended May 31, 1997. This increase reflected
across-the-board strength in the Company's fixed income, equity and investment
banking businesses. The Company's earnings momentum and profitability increased
significantly throughout the second quarter of 1998.
Net revenues increased to $1,008 million for the second quarter of 1998
from $555 million for the second quarter of 1997. The increase in net revenues
from the second quarter of 1997 resulted from continued strong performance in
the global merger and acquisition advisory business, fixed income derivatives,
leveraged lending and high yield origination, and real estate and mortgage
activities.
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 85% to $484 million in the second quarter of 1998 from $262
million in the second quarter 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. Growth in fixed income revenues was paced by
mortgages, derivatives and high yields, while growth in equities revenue was
driven by U.S. and European listed securities. 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.
<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 Income. Net revenues by
business unit contain certain internal allocations, including funding costs,
which are centrally managed.
Three Months Ended May 31, 1998
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- -------------------------------------------------------------------------------
Fixed Income $424 $ 7 $212 $ (1) $ 642
Equity 59 86 99 244
Corporate Finance
Advisory (5) 96 91
Merchant Banking 5 17 22
Other 1 4 4 9
- -------------------------------------------------------------------------------
$484 $ 97 $424 $ 3 $1,008
- -------------------------------------------------------------------------------
Three Months Ended May 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- -------------------------------------------------------------------------------
Fixed Income $231 $ 9 $ 64 $ 2 $306
Equity 34 62 37 133
Corporate Finance
Advisory 56 56
Merchant Banking (4) 54 50
Other 1 3 (1) 7 10
- --------------------------------------------------------------------------------
$262 $74 $210 $ 9 $555
- --------------------------------------------------------------------------------
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 110% to
$642 million for the second quarter of 1998 from $306 million for the second
quarter of 1997. The increase in the second quarter results versus the prior
year quarter reflected increased revenues from a number of fixed income products
including improved performance in both sales and trading and syndicate
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
activities in high yield corporates as well as increased contributions from
mortgages, fixed income derivative products and high grade corporates.
Investment banking revenues, as a component of fixed income revenues, increased
to $212 million for the second quarter of 1998 from $64 million for the second
quarter of 1997 due to increased underwriting fees, particularly in high yield
corporates.
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 $244 million for the
second quarter of 1998 from $133 million for the second quarter of 1997. Higher
revenues resulted from increased underwriting volumes, higher levels of customer
flow activities in U.S. and European listed securities and improved
contributions from NASDAQ and equity financing products. Investment Banking
revenues, as a component of equity revenues, increased to $99 million for the
second quarter of 1998 from $37 million for the second 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 $91 million for the second
quarter of 1998, reflecting a 63% increase from the $56 million recognized in
the second quarter of 1997. This increase reflected the closing of several large
transactions in the second quarter of 1998 and continued strength in the overall
merger and acquisition market environment. The Company ended the second quarter
with a strong transaction pipeline which stood at $166 billion in terms of total
dollar value based on data supplied by Securities Data Company.
Merchant Banking. The Company is the general partner for five active
merchant banking partnerships. Current merchant banking investments held by the
partnerships include both publicly traded and privately held companies. Merchant
banking net revenues primarily represent the Company's proportionate share of
net realized and unrealized gains and losses from the sale and 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 $22 million for the second quarter of 1998 down from $50
million in the second quarter of 1997. The second quarter of 1997 reflects the
realized gain on the sale of a significant portion of a publicly traded
investment held by the partnerships.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Non-Interest Expenses. Non-interest expenses were $678 million for the
second quarter of 1998 and $469 million for the second quarter of 1997.
Management fees represent the allocation of various charges, such as
compensation and benefits, occupancy, administration and computer processing
between the Company, Holdings and other affiliates based upon certain allocation
methods.
Income Taxes. The Company's income tax provision was $130 million for
the second quarter of 1998 compared to $27 million for the second quarter of
1997. The effective tax rate was 39% for the second quarter of 1998 and 31% for
the second quarter of 1997. The increase in the effective tax rate relates
primarily to a significantly higher level of pretax income (which reduces the
impact of permanent differences), and an increase in income subject to state and
local taxes, partially offset by an increase in tax benefits attributable to
income and transactions 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 Six Months Ended May 31, 1998 and 1997
The Company reported net income of $326 million for the six months
ended May 31, 1998, representing an increase of 208% from net income of $106
million for the six months ended May 31, 1997.
Net revenues increased to $1,754 million for the six months of 1998
from $1,176 million for the six months of 1997. The increase in net revenues
from the first half of 1997 resulted from continued strong performances in the
global merger and acquisition advisory, fixed income and equity businesses.
Principal transactions and net interest revenues increased to $871
million for the six months of 1998 from $600 million for the six 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. Growth
in fixed income revenue was paced by mortgages, derivatives and high yields,
while growth in equities revenue was driven by U.S. and European listed
securities. 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. Net revenues by business unit contain certain internal allocations,
including funding costs, which are centrally managed.
Six Months Ended May 31, 1998
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- --------------------------------------------------------------------------------
Fixed Income $797 $ 12 $337 $ 1 $1,147
Equity 81 173 150 1 405
Corporate Finance
Advisory (8) 169 161
Merchant Banking (1) 26 25
Other 2 7 7 16
- --------------------------------------------------------------------------------
$871 $192 $682 $ 9 $1,754
- --------------------------------------------------------------------------------
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Six Months Ended May 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- --------------------------------------------------------------------------------
Fixed Income $533 $ 18 $152 $ 3 $ 706
Equity 70 132 91 1 294
Corporate Finance
Advisory 102 102
Merchant Banking (7) 57 50
Other 4 7 13 24
- --------------------------------------------------------------------------------
$600 $157 $402 $17 $1,176
- --------------------------------------------------------------------------------
Fixed Income. Fixed income net revenues increased to $1,147 million for
the six months of 1998 from $706 million for the six months of 1997. The
increase in the six months of 1998 versus the prior year six 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 mortgages and fixed income
derivative products. Investment banking revenues, as a component of fixed income
revenues, increased to $337 million for the six months of 1998 from $152 million
for the six months of 1997 due to increased underwriting fees, particularly in
high yield corporates.
Equity. The Company's equity net revenues increased to $405 million for
the six months of 1998 from $294 million for the six months of 1997. Higher
revenues resulted from increased underwriting volumes, higher levels of customer
flow activities in U.S. and European listed securities and improved
contributions from NASDAQ and equity financing products. Investment banking
revenues, as a component of equity revenues, increased to $150 million for the
six months of 1998 from $91 million for the six months of 1997 due to increased
underwriting volumes in U.S. listed and convertible securities.
Corporate Finance Advisory. Net revenues from corporate finance
advisory activities increased to $161 million for the six months of 1998
reflecting a 58% increase from the $102 million recognized in the six months of
1997. This increase reflected continued strength in the overall merger and
acquisition market environment. For completed M&A transactions involving U.S.
targets, Lehman has improved its ranking from number 8 to number 4, increasing
its market share from 9% to 19%, for the first six months of calendar year 1998
compared to the first six months of calendar year 1997.
Merchant Banking. Merchant banking net revenues were $25 million for
the six months of 1998 and $50 million in the six months of 1997. 1998 net
revenues reflect the realized gains on the sales of the partnerships' interest
in several investments as well as net unrealized gains recognized on the
publicly traded investments. 1997 net revenues reflect a realized gain on the
sale of a significant portion of a publicly traded investment held by the
partnerships which was completely divested in the third quarter of 1997.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Non-Interest Expenses. Non-interest expenses were $1,222 million
for the six months of 1998 and $1,021 million for the six months of 1997.
Income Taxes. The Company's income tax provision was $206 million for
the six months of 1998 compared to $49 million for the six months of 1997. The
effective tax rate was 39% for the six months of 1998 and 32% for the six months
of 1997. The increase in the effective tax rate relates primarily to a
significantly higher level of pretax income (which reduces the impact of
permanent differences), and an increase in income subject to state and local
taxes, partially offset by an increase in tax benefits attributable to income
and transactions 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 inventories,
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 liquid nature of these
assets provides the Company with flexibility in financing and managing its
business. 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 total assets increased to $141.6 billion at May 31, 1998 from
$114.3 billion at November 30, 1997, reflecting the strategic expansion of
certain business lines. The Company's continued focus on growing higher margin
businesses resulted in across the board increases in inventory positions at May
31, 1998 compared to November 30, 1997. The Company also positioned itself to
benefit from favorable conditions in the worldwide fixed income markets by
increasing its secured 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. These 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 department 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
regions.
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:
(1) Maintain an appropriate Total Capital structure to support 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 on a
global basis with secured and unsecured liabilities, which have maturities equal
to or exceeding the anticipated liquidation period of the assets.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
(3) Maintain sufficient financial resources to enable the Company to meet its
obligations in a period of financial stress through a combination of
collateralized short-term financings and Total Capital, as well as the
implementation of a contingency funding plan. Financial stress is defined as any
event which severely constrains the Company's access to unsecured funding
sources.
(4) Obtain diversified funding through a global investor base which maximizes
liquidity and reduces concentration risk.
(5) 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 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 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 May 31,
1998 and November 30, 1997, $94 billion and $77 billion, respectively, of the
Company's total balance sheet was financed using collateralized borrowing
sources.
As of May 31, 1998 and November 30, 1997, short-term debt was $1.6 billion and
$740 million, respectively. There was no commercial paper outstanding at May 31,
1998 or November 30, 1997.
<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 1998 to $6.83 billion at May 31, 1998 from $6.55 billion at
November 30, 1997. Total Capital increased primarily due to an increase in
long-term debt and the retention of earnings.
May 31 November 30
(in millions) 1998 1997
- --------------------------------------------------------------------------
Long-term Debt
Senior Notes $ 159 $ 229
Subordinated Indebtedness 4,336 4,313
----- -----
4,495 4,542
Stockholder's Equity 2,337 2,011
- --------------------------------------------------------------------------
Total Capital $6,832 $6,553
- --------------------------------------------------------------------------
During the six months of 1998, the Company issued $600 million in long-term
debt, and $686 million of long-term debt matured. Long-term debt decreased to
$4.50 billion at May 31, 1998 from $4.54 billion at November 30, 1997 with a
weighted average maturity of 4.8 years at May 31, 1998 and 4.5 years at November
30, 1997.
At May 31, 1998, the Company had approximately $2.0 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. In May 1998, Thomson Bank Watch, upgraded its
long-term senior and subordinated debt ratings of the Company to "A+" from "A"
and "A" from "A-", respectively. As of May 31, 1998, the short- and long-term
senior debt ratings of the Company were as follows:
LBI
--------------------------
Short-term Long-term**
- --------------------------------------------------------------------------------
Duff & Phelps Credit Rating Co. D-1 A/A-
Fitch IBCA, Inc. F-1 A/A-
Moody's P2 A3*/Baa1
S&P A-1 A+*/A
Thomson BankWatch TBW-1 A+/A
* Provisional ratings on shelf registration
** Senior/subordinated
<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 Income. The Company's
portfolio of such securities at May 31, 1998 and November 30, 1997 included long
positions with an aggregate market value of approximately $2.8 billion and $2.6
billion, respectively, and short positions with an aggregate market value of
approximately $369 million and $151 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 May 31, 1998,
the Company had no single exposure to an issuer of high yield securities greater
than $100 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 $1.9 billion at May 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.
Merchant Banking and Related Lending Activities
The Company's merchant banking activities include investments in five
partnerships, for which the Company acts as general partner, as well as direct
investments. At May 31, 1998, the investment in merchant banking partnerships
was $22 million and direct investments were $192 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 $205 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.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
In June 1998, the Company 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 draw
downs under the facility are expected to be repaid within a short-term period.
In addition, at May 31, 1998, the Company had $727 million direct bridge
financings outstanding. Subsequent to May 31, 1998, the Company syndicated a
significant portion of these financings.
<PAGE>
LEHMAN BROTHERS 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.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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.
The Company's value at risk for each component of market risk, and in total was
as follows (in millions):
May 31, 1998 November 30, 1997
------------ -----------------
Interest rate risk $8.9 $ 9.8
Equity price risk 5.6 4.7
Foreign exchange risk 0.9 1.3
Diversification benefit (3.8) (4.8)
----- -----
Total Company $11.6 $11.0
===== =====
The Company utilizes a wide variety of market risk management methods,
including: 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 risk, trading and senior management, are critical elements of the risk
management process.
Other
Recent Development
On April 17, 1998, the United States District Court for the Northern District of
Texas approved the settlement of a class action captioned Warren Chisum, et al.
v. Lehman Brothers Inc., et al. The class action alleged violations of the
federal securities laws and breaches of fiduciary duty by defendants in
connection with the origination, sale and operation of nine E.F. Hutton net
lease real estate limited partnerships sold in the early 1980's. The settlement
cost of $75 million was charged against existing reserves.
<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 the
Company and others with respect to transactions in which the Company 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,
including the Company.
Although there can be no assurance as to the ultimate outcome, the
Company has denied, or believes it has meritorious defenses and will deny,
liability in all significant cases pending against it including the matters
described below, and intends to defend vigorously each such case. 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 LBI's Annual
Report on Form 10-K and First Quarter Report on Form 10-Q)
The Virginia Commissioner of Insurance. On May 21, 1988 after trial,
the Court entered a Judgment Order in accord with the jury verdict, ordering
that the plaintiffs recover nothing from the defendants and dismissing the
complaint.
Warren D. Chisum, et al. v. Lehman Brothers Inc. et al. (Reported in LBI's
Annual Report on Form 10-K and First Quarter Report on Form 10-Q)
On April 17, 1988, the Court entered a final order approving the
settlement of this action.
Bamaodah v. E.F. Hutton & Company Inc. (Reported in LBI's' Annual Report on
Form 10-K and First Quarter Report on Form 10-Q)
The Court has ordered the experts to conduct a review of certain
additional documents and has set October 25, 1998 as the next hearing date.
<PAGE>
AIA Holding SA et al. V. Lehman Brothers Inc. and Bear Stearns & Co., Inc.
(Reported in LBI's Annual Report on Form 10-K and First Quarter Report on
Form 10-Q)
On July 3, 1998 the Plaintiffs served their First Amended Complaint
which contains eighteen causes of action against Lehman Brothers and/or Bear
Stearns.
In re MobileMedia Securities Litigation.
LBI was named as a defendant in several purported class actions filed
in December, 1996 in the United States District Court for the District of New
Jersey in connection with (i) a November 7, 1995 offering of common stock of
MobileMedia Corporation; and (ii) a November 7, 1995 offering of 9-3/8% senior
subordinated notes of MobileMedia Communications Inc due in 2007. On November 3,
1997 a consolidated amended class action complaint was filed naming certain of
MobileMedia Corporation's officers and directors and the four co-lead
underwriters of these offerings, including LBI. MobileMedia filed for Chapter 11
bankruptcy protection on January 30, 1997, and therefore, is not named as a
defendant. The complaint alleges that the underwriters violated Sections 11 and
12 of the 1933 Securities Act. Plaintiffs seek rescission and unspecified
compensatory damages.
<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
(b) Reports on Form 8-K:
None.
<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: July 15, 1998 By /s/ Richard S. Fuld Jr.
--------------------------
Richard S. Fuld, Jr.
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Date: July 15, 1998 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
(Dollars in millions)
(Unaudited)
<TABLE>
<CAPTION>
For the For the For the For the For the For the
Twelve Months Eleven Months Twelve Months Twelve Months Twelve Months Six Months
Ended Ended Ended Ended Ended Ended
December 31 November 30 November 30 November 30 November 30 May 31
1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ----
Fixed Charges:
Interest expense:
<S> <C> <C> <C> <C> <C> <C>
Subordinated indebtedness $ 192 $ 184 $ 204 $ 221 $ 236 $ 116
Bank loans and other
borrowings* 4,393 5,661 9,750 9,900 11,980 7,024
Interest component of rentals
of office and equipment 62 27 25 18 16 8
Other adjustments** 101 53 2 7 3 4
------ ------- ------ ------- -------- ------
TOTAL (A) $4,748 $5,925 $9,981 $10,146 $12,235 $7,152
====== ======== ====== ======= ======== ======
Earnings:
Pretax income (loss) from
continuing operations $ (146) $ 1 $ 78 $ 309 $ 593 $ 532
Fixed charges 4,748 5,925 9,981 10,146 12,235 7,152
Other adjustments*** (68) (52) (1) (6) (2) (4)
------- ------ -------- ------- ------- ------
TOTAL (B) $4,534 $5,874 $10,058 $10,449 $12,826 $7,680
====== ====== ======= ======= ======= ======
(B / A) **** **** 1.01 1.03 1.05 1.07
</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 and debt issuance costs, 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
Company's Consolidated Statement of Financial Condition at May 31, 1998
(Unaudited) and the Consolidated Statement of Income for the six months ended
May 31, 1998 (Unaudited) and is qualified in its entirety by reference to such
financial statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> NOV-30-1998
<PERIOD-START> DEC-01-1997
<PERIOD-END> MAY-31-1998
<CASH> 1,771
<RECEIVABLES> 11,730
<SECURITIES-RESALE> 54,204
<SECURITIES-BORROWED> 20,148
<INSTRUMENTS-OWNED> 53,175
<PP&E> 262
<TOTAL-ASSETS> 141,628
<SHORT-TERM> 1,554
<PAYABLES> 12,668
<REPOS-SOLD> 64,473
<SECURITIES-LOANED> 12,010
<INSTRUMENTS-SOLD> 21,038
<LONG-TERM> 4,495
0
0
<COMMON> 0
<OTHER-SE> 2,337
<TOTAL-LIABILITY-AND-EQUITY> 141,628
<TRADING-REVENUE> 607
<INTEREST-DIVIDENDS> 7,403
<COMMISSIONS> 192
<INVESTMENT-BANKING-REVENUES> 682
<FEE-REVENUE> 0
<INTEREST-EXPENSE> 7,139
<COMPENSATION> 876
<INCOME-PRETAX> 532
<INCOME-PRE-EXTRAORDINARY> 326
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 326
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
