SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended August 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ____________
Commission file number 1-6817
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 September 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 AUGUST 31, 1998
INDEX
Part I. FINANCIAL INFORMATION Page Number
Item 1. Financial Statements - (unaudited)
Consolidated Statement of Income -
Three and Nine Months Ended
August 31, 1998 and 1997 .........................3
Consolidated Statement of Financial Condition -
August 31, 1998 and November 30, 1997 ............5
Consolidated Statement of Cash Flows -
Nine Months Ended
August 31, 1998 and November 30, 1997.............7
Notes to Consolidated Financial Statements..........9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations..........14
Part II. OTHER INFORMATION
Item 1. Legal Proceedings ...................................33
Item 6. Exhibits and Reports on Form 8-K ...............34
Signatures...........................................................35
EXHIBIT INDEX ....................................................36
Exhibits
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of INCOME
(Unaudited)
(In millions, except per share data)
Three months ended
August 31 August 31
1998 1997
--------------- ----------
Revenues
Investment banking $ 406 $ 295
Principal transactions 145 195
Commissions 108 90
Interest and dividends 4,083 3,339
Other 24 8
------- ------
Total revenues 4,766 3,927
Interest expense 3,928 3,228
----- -----
Net revenues 838 699
------ -----
Non-interest expenses
Compensation and benefits 375 391
Brokerage, commissions and
clearance fees 50 45
Professional services 18 21
Communications 23 22
Occupancy and Equipment 14 17
Business development 18 16
Management fees 22 36
Depreciation and amortization 14 13
Other 6 27
------ -----
Total non-interest expenses 540 588
------ -----
Income before taxes 298 111
Provision for income taxes 106 27
------ ------
Net income $192 $ 84
===== ====
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of INCOME
(Unaudited)
(In millions, except per share data)
Nine months ended
August 31 August 31
1998 1997
--------------- ---------
Revenues
Investment banking $ 1,088 $ 697
Principal transactions 752 579
Commissions 300 247
Interest and dividends 11,486 9,224
Other 33 25
------- ------
Total revenues 13,659 10,772
Interest expense 11,067 8,897
------ -----
Net revenues 2,592 1,875
------ -----
Non-interest expenses
Compensation and benefits 1,251 1,010
Brokerage, commissions and
clearance fees 140 150
Professional services 55 64
Communications 70 66
Occupancy and equipment 44 49
Business development 59 51
Management fees 70 127
Depreciation and amortization 41 39
Other 32 53
----- -----
Total non-interest expenses 1,762 1,609
----- -----
Income before taxes 830 266
Provision for income taxes 312 76
----- -----
Net income $ 518 $ 190
===== =====
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 1998
------ ---- ----
<S> <C> <C>
Cash and cash equivalents $ 604 $ 220
Cash and securities segregated and on deposit
for regulatory and other purposes 1,587 1,128
Securities and other financial instruments owned:
Governments and agencies 25,148 17,467
Corporate equities 8,467 5,439
Corporate debt and other 7,441 5,544
Mortgages and mortgage-backed 6,352 2,751
Derivatives and other contractual agreements 5,803 5,528
Certificates of deposit and other money market instruments 3,430 2,248
------ -------
56,641 38,977
------ ------
Collateralized short-term agreements:
Securities purchased under agreements to resell 57,940 49,610
Securities borrowed 18,167 13,661
Receivables:
Brokers, dealers and clearing organizations 2,088 3,148
Customers 4,793 3,874
Others 5,570 3,107
Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization
of $553 in 1998 and $533 in 1997) 263 262
Other assets 251 146
Excess of cost over fair value of net assets
acquired (net of accumulated amortization
of $107 in 1998 and $102 in 1997) 154 158
-------- --------
Total assets $148,058 $114,291
======== ========
</TABLE>
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Continued)
(Unaudited)
(In millions, except share data)
<TABLE>
<CAPTION>
August 31 November 30
1998 1997
---------- -----------
LIABILITIES AND STOCKHOLDER'S EQUITY
<S> <C> <C>
Short-term debt $1,067 $ 740
Securities and other financial instruments sold but not yet purchased:
Governments and agencies 12,787 8,556
Corporate equities 4,373 3,124
Corporate debt and other 1,976 1,664
Derivatives and other contractual agreements 4,049 3,685
------- -------
23,185 17,029
Collateralized short-term financings:
Securities sold under agreements to repurchase 67,555 56,017
Securities loaned 8,447 7,764
Advances from Holdings and other affiliates 25,344 14,777
Payables:
Brokers, dealers and clearing organizations 5,715 3,127
Customers 7,852 6,118
Accrued liabilities and other payables 1,948 2,166
Long-term debt:
Senior notes 163 229
Subordinated indebtedness 4,313 4,313
-------- ---------
Total liabilities 145,589 112,280
------- -------
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 2 3
Retained earnings 711 252
------------ ---------
Total stockholder's equity 2,469 2,011
------------ ----------
Total liabilities and stockholder's equity $148,058 $114,291
========= ========
</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
1998 1997
---------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
<S> <C> <C>
Net income $ 518 $ 190
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 41 39
Provisions for losses and other reserves 29 41
Deferred tax benefit (24)
Other adjustments 20 13
Net change in:
Cash and securities segregated (459) (242)
Securities and other financial instruments owned (17,664) (4,215)
Securities purchased under agreements to resell (8,330) (15,727)
Securities borrowed (4,506) 3,823
Receivables from brokers, dealers and clearing organizations 1,060 940
Receivables from customers (919) 5
Securities and other financial instruments sold but
not yet purchased 6,156 921
Securities sold under agreements to repurchase 11,538 1,743
Securities loaned 683 39
Payables to brokers, dealers and clearing organizations 2,588 1,665
Payables to customers 1,734 (1,112)
Accrued liabilities and other payables (247) (210)
Other operating assets and liabilities, net (2,581) 723
---------- --------
Net cash used in operating activities $(10,339) $(2,958)
--------- -------
</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
1998 1997
------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
<S> <C> <C>
Principal payments of senior notes $(79) $(1)
Proceeds from issuance of subordinated indebtedness 750 858
Principal payments of subordinated indebtedness (757) (750)
Net proceeds from (payments for) short-term debt 327 (1,541)
Increase in advances from Holdings and other
affiliates 10,567 4,127
Capital contributions 48
Dividends and capital distributions paid (60) (38)
-------- -----
Net cash provided by financing activities 10,748 2,703
-------- -----
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (25) (12)
-------- -----
Net cash used in investing activities (25) (12)
-------- -----
Net change in cash and cash equivalents 384 (267)
-------- -----
Cash and cash equivalents, beginning of period 220 396
-------- -----
Cash and cash equivalents, end of period $ 604 $129
======= ====
</TABLE>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions)
Interest paid totaled $11,070 and $8,930 for the nine months ended
August 31, 1998 and 1997, respectively. Income taxes paid totaled $482 and $313
for the nine months ended August 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 has recognized on its
August 31, 1998 Consolidated Statement of Financial Condition, 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 $6.1 million of purchased software and other internal use
software costs during the nine months of fiscal 1998.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, Accounting for Derivative Instruments and for Hedging Activities, which
requires all derivatives to be recorded on the balance sheet at fair value.
SFAS No. 133 is effective for years beginning after June 15, 1999. The
expected impact of adoption on the Company's results of operations has not
yet been determined, however it is not likely to be material since most of
the Company's derivatives are carried at fair value.
3. Long-Term Debt:
During the nine months ended August 31, 1998, the Company issued $750
million of subordinated U.S. debt of which $600 million was fixed rate debt
maturing in 2008, and $150 million was floating rate debt with a maturity in
2002.
The fixed rate debt has been effectively converted to floating rate
obligations, based on the London Interbank Offered Rates ("LIBOR"), through
the use of interest rate swaps
In addition, $836 million of long-term debt matured during the nine
months ended August 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 August 31, 1998,
LBI's regulatory net capital, as defined, of $1,376 million exceeded the
minimum requirement by $1,247 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
August 31, 1998, LBFP had capital which exceeded the requirement of the most
stringent rating agency by approximately $140 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 investments 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.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
Listed in the following table is the fair value and average fair value of
the Company's Trading-Related Derivative Activities. Average fair values of
these instruments were calculated based upon month-end statement of
financial condition values, which the Company believes do not vary
significantly from the average fair value calculated on a more frequent
basis. Variances between average fair values and period-end values are due
to changes in the volume of activities in these instruments and changes in
the valuation of these instruments due to variations in market and credit
conditions.
<TABLE>
<CAPTION>
Average Fair Value*
Fair Value* Nine Months Ended
August 31, 1998 August 31, 1998
------------------------ --------------------
(in millions) Assets Liabilities Assets Liabilities
- -----------------------------------------------------------------------------------------------------------------------------
Interest rate and currency swaps and options
<S> <C> <C> <C> <C>
(including caps, collars and floors) $4,674 $2,781 $ 4,323 $2,435
Foreign exchange forward contracts and options 506 502 586 570
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 382 375 511 552
Equity contracts (including equity, warrants
and options) 223 384 190 236
Commodity contracts (including swaps, forwards,
and options) 18 7 24 7
-------------------------------------------------------
Total $ 5,803 $4,049 $5,634 $3,800
--------------------------------------------------------
</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 66 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
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
to derivative contracts at August 31, 1998 represents the Company's net
receivable/payable for derivative financial instruments before consideration
of collateral. Included within the $5,803 million fair value of assets at
August 31, 1998 was $5,615 million related to swaps and OTC contracts and
$188 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.
With respect to OTC contracts, including swaps, the Company views its
net credit exposure to be $4,666 million at August 31, 1998 (including $711
million from affiliates), representing the fair value of the Company's OTC
contracts in an unrealized gain position, after consideration of collateral
of $949 million. Presented below is an analysis of the Company's net credit
exposure (after allocation of collateral) at August 31, 1998 for OTC
contracts based upon actual ratings made by external rating agencies or by
equivalent ratings established and utilized by the Company's Corporate
Credit Department.
Counterparty S&P/Moody's
Risk Rating Equivalent Net Credit Exposure
------------ ------------------------- -------------------
1 AAA/Aaa 19%
2 AA-/Aa3 or higher 21%
3 A-/A3 or higher 49%
4 BBB-/Baa3 or higher 8%
5 BB-/Ba3 or higher 3%
6 B+/B1 or lower -%
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
$3.5 billion at August 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.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
The Company, through its high yield sales and trading activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and then participates a significant portion
of these commitments. These commitments, net of syndications and
participations, totaled $2.8 billion and $1.6 billion at August 31, 1998 and
November 30, 1997, respectively, are typically secured against the
borrower's assets and have fixed maturity dates. The draw down of these
facilities is generally contingent upon certain representations, warranties
and contractual conditions of the borrower. Total commitments may not be
indicative of actual funding requirements as the Company intends to continue
syndicating, selling, and/or participating these commitments.
In addition, the Company had lending commitments to high grade
borrowers of $474 milliion at August 31, 1998. These commitments also are
typically secured against the borrower's assets, have fixed maturity dates,
and are generally contingent upon certain representatives, warranties and
contractual conditions of the borrower.
The Company has commitments to invest up to $207 million in
partnerships, which in turn will make direct merchant banking related
investments. These commitments will be funded as required through the end of
the respective partnerships' investment periods, principally expiring in
2004.
In June 1998, the Company, together with a consortium of other
financial services companies, sponsored a $5 billion interim loan fund,
designed to extend financing to clients in connection with a wide range of
domestic and international leveraged transactions, including acquisitions,
corporate recapitalization and refinancing of existing debt. In connection
therewith, the Company intends to provide up to $400 million to be used by
the fund. Any drawdowns under the facility are expected to be repaid within
a short-term period. At August 31, 1998, the fund had no outstanding loans.
In the normal course of its business, the Company has been named a
defendant in a number of lawsuits and other legal proceedings. After
considering all relevant facts, available insurance coverage and the advice
of outside counsel, in the opinion of the Company such litigation will not,
in the aggregate, have a material adverse effect on the Company's
consolidated financial position or results of operations.
As a leading global investment bank, risk is an inherent part of all of
the Company's businesses and activities. The extent to which the Company
properly and effectively identifies, assesses, monitors and manages each of
the various types of risks involved in its trading (including derivatives),
brokerage, and investment banking activities is critical to the success and
profitability of the Company. The principal types of risks involved in the
Company's activities are market risk, credit or counterparty risk and
transaction risk. Management has developed a control infrastructure
throughout the Company to monitor and manage these risks on a global basis.
For further discussion of these matters, refer to Note 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 and from year to year.
The generally favorable market and economic conditions that characterized
fiscal 1997 continued into the first eight months of the Company's current
fiscal year ("fiscal 1998"). During the first eight months of fiscal 1998,
investor demand in the worldwide debt and equity markets remained strong led by
continued growth in the U.S. economy and the favorable interest-rate
environment. The pace of underwriting for combined fixed income and equity
securities accelerated to record levels. The pace of global merger and
acquisition activity fueled financing of all types. Investors were focused on
worldwide market conditions, particularly with respect to the potential effects
of the Asian crisis, as well as any signs of potential weakening in the U.S.
economy.
Following this period of relative stability, the turmoil in various
emerging markets erupted in mid-August particularily with respect to Russia.
Events in Russia drove all emerging market bond yields sharply higher. As
investors sought safe havens, U.S. Treasury and European government bond yields
moved sharply lower while spreads on other fixed income products widened.
Ten-year U.S. Treasury yields fell by over 50 basis points (bp) to just under
5%, while yields on ten-year German Bunds fell by just over 60bp to 4.2%, both
representing new global lows. The yields on bonds of lower rated corporations
also rose abruptly. Deleveraging and reduced risk-taking disrupted the flow of
funds throughout the financial markets and new issuances of debt and equity
securities slowed.
Since reaching record levels in the middle of July, the U.S. equity market
is in the midst of the most serious correction of the 1990's with the S&P 500
index down almost 20% from its peak to the trough on August 31. The marketplace
continues to reflect concerns over the lingering Asian economic troubles, which
spread to Russia and threaten Latin America, as well as political uncertainty in
Washington. This increased risk aversion has resulted in a reduction in the
availability of credit and lower equity prices. After providing an annual return
of about 24% from the beginning of the fiscal year to the July peak, equity
returns have fallen to almost zero for the first nine months of the fiscal year.
Over the nine months to August, European equities have returned 16% in
dollar terms alongside healthy trading volumes, although this overall
performance masks an extremely strong 40% gain for the FT/S&P European Index
through the July peak, followed by a 17% fall to the end of August. While the
bond environment was supportive throughout, the impact of the crisis sweeping
emerging markets, including Russia's devaluation and debt restructuring, sparked
a severe correction amid highly volatile market conditions. Far Eastern and
Latin American stock markets became the focus of the turmoil and lost a
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
substantial proportion of their value over this period with total returns of
minus 23% and 40% as measured by the FT/S&P Pacific Basin Index and IFC Latin
America Investable Index, respectively.
Worldwide underwriting volumes, which had been running at an unprecedented
rate for the first seven months of fiscal 1998, saw a significant slowdown in
the last two months of the third quarter. While volumes for the entire year will
be record setting, the Company is not anticipating a return to the flow of
issuance volume it experienced earlier this year due to the extreme volatility
in the credit markets. Similarly, equity and equity-related underwriting
activity has mirrored the market as a whole, with record new issuance in the
first eight months of fiscal year 1998 followed by significantly reduced
activity as a result of less favorable market conditions.
Corporate Finance Advisory activities continued at record levels during the
first nine months of fiscal 1998. Coming off a strong pace in 1997, the volume
of announced transactions during the first nine months of 1998 continued to
reflect the trend of consolidation, deregulation and globalization across
industry sectors. However, as a direct result of global market turmoil caused by
economic uncertainties throughout the world, the volume of announced
transactions has recently slowed.
Although strong financial markets characterized the first eight months of
fiscal 1998, recent events have highlighted the cyclicality of the financial
services industry. The current adverse market conditions impact competitors and
counterparties throughout the industry to varying degrees, including the Company
and all aspects of the Company's activities. Management is responding to the
changes and risks inherent in this environment by reducing the Company's risk
exposure, shifting the mix of its balance sheet and reducing certain positions.
Note:Except for the historical information contained herein, this Management's
Discussion and Analysis of Financial Condition and Results of Operations
contains forward-looking statements that are based on current expectations,
estimates and projections about the industries in which the Company
operates. These statements are not guarantees of future performance and
involve certain risks, uncertainties and assumptions which are difficult to
predict. The Company undertakes no obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise.
<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, 1998 and 1997
The Company reported net income of $192 million for the third quarter
ended August 31, 1998 representing an increase of 129% from net income of $84
million for the third quarter ended August 31, 1997. This increase reflected
across the board strength in the Company's fixed income, equity and investment
banking businesses especially in June and July. However, results in August were
affected by several unfavorable economic factors, including the widening of
spreads across U.S. and European fixed income markets. Spreads widened due to
the impact of significant volatility in Russia and other emerging markets.
Net revenues increased to $838 million for the third quarter of 1998 from
$699 million for the third quarter of 1997. The increase in net revenues from
the third quarter of 1997 resulted from continued strong performance in the
global merger and acquisition advisory business, the debt and equity origination
businesses as well as foreign exchange and municipal bonds.
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.
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.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Three Months Ended August 31, 1998
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- --------------------------------------------------------------------------------
Fixed Income $264 $ 8 $147 $ 2 $421
Equity 21 95 108 2 226
Corporate Finance
Advisory (5) 142 137
Merchant Banking (5) 9 4
Other 25 5 20 50
- --------------------------------------------------------------------------------
$300 $108 $406 $24 $838
- --------------------------------------------------------------------------------
Three Months Ended August 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- --------------------------------------------------------------------------------
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
- --------------------------------------------------------------------------------
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 19% to $421 million for the third quarter of 1998 from $353
million for the third quarter of 1997. The increase in the third quarter
results versus the prior year reflected improved results in foreign
exchange, municipal bonds and derivative products. Investment banking
revenues, as a component of fixed income revenues, increased to $147 million
for the third quarter of 1998 from $87 million for the third quarter of 1997
due to significantly increased underwriting fees in high yield and high
grade 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 $226 million for
the third quarter of 1998 from $202 million for the third quarter of 1997.
Higher revenues resulted from higher levels of customer flow activities in
certain U.S. and European listed securities, as well as increased
underwriting volumes in convertible securities. Investment Banking revenues,
as a component of equity revenues, increased to $108 million for the third
quarter of 1998 from $81 million for the third quarter of 1997 due to
increased underwriting volumes in convertible securities.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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 $137 million for the third quarter of 1998, reflecting a 108%
increase from the $66 million recognized in the third quarter of 1997. This
increase reflected the closing of several large transactions in the third
quarter of 1998.
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 represent the Company's proportionate share of
net unrealized gains and losses from the revaluation of investments held by
the partnerships. Such amounts are classified in the Consolidated Statement
of Income as a component of investment banking revenues. Merchant banking
net revenues also reflect the net interest expense relating to the financing
of the Company's investment in the partnerships. Merchant banking net
revenues were $4 million for the third quarter of 1998 down from $65 million
in the third quarter of 1997. Net revenues in the third quarter of 1997
reflects the realized gains on the sale of the Company's remaining positions
in certain publicly traded investments held by the partnerships.
Non-Interest Expenses. Non-interest expenses were $540 million for the
third quarter of 1998 and $588 million for the third 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. Management fees were $22 million for the third quarter
of 1998 and $36 million for the third quarter of 1997. During the third
quarter of 1998, the decrease in management fees was a result of reduced
affiliate activities on behalf of LBI as well as increased Company
activities on behalf of affiliates.
Income Taxes. The Company's income tax provision was $106 million for
the third quarter of 1998 compared to $27 million for the third quarter of
1997. The effective tax rate was 36% for the third quarter of 1998 and 24%
for the third quarter of 1997. The increase in the effective tax rate
relates primarily to a significantly higher level of pre-tax income, which
minimizes the impact of permanent adjustments.
<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, 1998 and 1997
The Company reported net income of $518 million for the nine months
ended August 31, 1998, representing an increase of 173% from net income of
$190 million for the nine months ended August 31, 1997.
Net revenues increased to $2,592 million for the nine months of 1998
from $1,875 million for the nine months of 1997. The increase in net
revenues for the nine months of 1998 resulted from strong performances in
the global merger and acquisition advisory, fixed income and equity
businesses.
Principal transactions and net interest revenues increased to $1,171
million for the nine months of 1998 from $906 million for the nine months of
1997. Principal transactions revenues increased as favorable market
conditions through the first eight months were characterized by low interest
rates. In addition, 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 derivatives, municipal bonds, and foreign
exchange product lines. 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. Net revenues by business unit contain certain
internal allocations, including funding costs, which are centrally managed.
Nine Months Ended August 31, 1998
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- --------------------------------------------------------------------------------
Fixed Income $1,062 $ 20 $ 484 $ 3 $1,569
Equity 102 268 259 2 631
Corporate Finance
Advisory (13) 311 298
Merchant Banking (7) 35 28
Other 27 12 (1) 28 66
- --------------------------------------------------------------------------------
$1,171 $300 $1,088 $33 $2,592
- --------------------------------------------------------------------------------
Nine Months Ended August 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- -------------------------------------------------------------------------------
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
- -------------------------------------------------------------------------------
Fixed Income. Fixed income net revenues increased to $1,569 million for
the nine months of 1998 from $1,059 million for the nine months of 1997. The
increase in the nine months of 1998 versus the prior year nine months
reflected improved performances in a number of fixed income products
including both sales and trading and syndicate activities in high yield
corporates as well as increased contributions from fixed income derivatives,
foreign exchange and municipal bonds partially offset by decreased results
in mortgages. Investment banking revenues, as a component of fixed income
revenues, increased to $484 million for the nine months of 1998 from $240
million for the nine months of 1997 due to increased underwriting fees,
particularly in high yield corporates.
Equity. The Company's equity net revenues increased to $631 million for
the nine months of 1998 from $496 million for the nine months of 1997.
Higher revenues resulted from increased levels of customer flow activities
in U.S. and European listed securities, increased underwriting volumes and
improved contributions from convertible securities. Investment banking
revenues, as a component of equity revenues, increased to $259 million for
the nine months of 1998 from $172 million for the nine months of 1997 due to
increased underwriting volumes in U.S. listed and convertible securities.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Corporate Finance Advisory. Net revenues from corporate finance
advisory activities increased to $298 million for the nine months of 1998
reflecting a 77% increase from the $168 million recognized in the nine
months of 1997. This increase reflected improved market share and continued
strength in the overall merger and acquisition market environment. For
completed M&A transactions, Lehman has improved its worldwide ranking from
#8 to #4, increasing its market share from 6.5% to 15.4%, in part through
participation in 3 of the 5 largest deals in the first nine months of the
1998 calendar year based on data supplied by Securities Data Company.
Merchant Banking. Merchant banking net revenues were $28 million for
the nine months of 1998 and $114 million in the nine months of 1997. 1998
net revenues reflect the unrealized gains recognized on the publicly traded
investments as well as realized gains on the sales of other investments.
1997 net revenues reflect the realized gains on the sales of the
partnerships' interest in certain publicly traded investments.
Non-Interest Expenses. Non-interest expenses were $1,762 million for
the nine months of 1998 and $1,609 million for the nine months 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. Management fees were $70 million for the nine months of
1998 and $127 million for the nine months of 1997. During the nine months of
1998, the decrease in management fees was a result of reduced affiliate
activities on behalf of LBI as well as increased Company activities on
behalf of affiliates.
Income Taxes. The Company's income tax provision was $312 million for
the nine months of 1998 as compared to $76 million for the nine months of
1997. The effective tax rate was 38% for the nine months of 1998 and 29% for
the nine months of 1997. The increase in the effective tax rate relates
primarily to a significantly higher level of pre-tax income, which minimizes
the impact of permanent adjustments.
<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 portion of the
Company's securities inventories not funded on a secured basis, merchant
banking activities and investments in fixed assets. The Company's primary
activities are based on the execution of customer-related transactions. This
flow of customer business supports the rapid asset turnover rate of the
Company's inventory.
The Company's balance sheet consists primarily of cash and cash
equivalents, securities and other financial instruments owned, and
collateralized short-term financing agreements. The liquid nature of these
assets provides the Company with flexibility in financing and managing its
business. The vast majority of these assets are funded on a secured basis
through collateralized short-term financing agreements with the remaining
assets being funded through unsecured financing and capital.
The Company's total assets increased to $148.1 billion at August 31, 1998
from $114.3 billion at November 30, 1997, reflecting an increase in secured
customer financing activities and the expansion of certain higher margin
business lines in strategic growth areas (i.e., high yields and
mortgage-backed).
Funding and Capital Policies
The Company's Finance Committee is responsible for establishing and managing
the funding and liquidity policies of the Company. These policies include
recommendations for capital and balance sheet size as well as the allocation
of capital and balance sheet to product areas. Members of the Company's
treasury department and business unit financing groups work with the Finance
Committee to ensure coordination of global funding efforts and
implementation of the funding and liquidity policies. Regional asset and
liability committees, aligned with the Company's geographic funding centers,
are responsible for implementing funding strategies for their respective
regions.
The primary goal of the Company's funding policies is to provide sufficient
liquidity and availability of funding sources to meet the needs of the
Company's businesses. The key elements of these policies are to:
(1) Maintain a Total Capital structure that supports the business
activities in which the Company is engaged. Total Capital is defined
as long-term debt, preferred stock and common stockholders' equity.
(2) Minimize liquidity and refinancing risk by funding the Company's
assets primarily on a secured basis.
(3) Obtain diversified funding through a global investor base which
increases liquidity and reduces concentration risk.
(4) Maintain funding availability in excess of actual utilization.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
(5) Maintain sufficient financial resources to enable the Company
to meet its obligations in periods of financial stress through a
combination of collateralized short-term financings and Total Capital,
as well as the implementation of a contingency funding plan.
Short-Term Funding
The Company strives to maximize the portion of the Company's balance sheet
that is funded through collateralized borrowing sources, which in turn
minimizes the reliance placed upon unsecured short-term debt. Collateralized
borrowing sources include cash market securities and other financial
instruments sold but not yet purchased, as well as collateralized short-term
financings, defined as securities sold under agreements to repurchase
("repos") and securities loaned. Because of their secured nature, OECD
government repos and other investment grade types of collateralized
borrowings are less credit-sensitive and have historically been a stable
financing source irrespective of market conditions.
The amount of the Company's collateralized borrowing activities will vary
reflecting changes in the mix and overall levels of securities and other
financial instruments owned which are driven by strategic business
objectives and global market conditions. The majority of the Company's
assets are funded with collateralized borrowing sources. At August 31, 1998
and November 30, 1997, $95 billion and $77 billion, respectively, of the
Company's total balance sheet of $148 billion and $114 billion at August 31,
1998 and November 30, 1997, respectively, were financed using collateralized
borrowing sources.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Total Capital
The Company increased its Total Capital base in 1998 to $6.9 billion at
August 31, 1998 from $6.6 billion at November 30, 1997 primarily due to the
retention of earnings.
August 31 November 30
(in millions) 1998 1997
- --------------------------------------------------------------------------------
Long-term Debt
Senior Notes $163 $229
Subordinated Indebtedness 4,313 4,313
------- -------
4,476 4,542
Stockholders' Equity 2,469 2,011
- --------------------------------------------------------------------------------
Total Capital $6,945 $6,553
- --------------------------------------------------------------------------------
During the first nine months of 1998, the Company issued $750 million in
long-term debt, and $836 million of long-term debt matured. Long-term debt
increased to $4.48 billion at August 31, 1998 from $4.54 billion at November
30, 1997 with a weighted average maturity of 4.7 years at August 31, 1998
and 4.5 years at November 30, 1997.
Credit Ratings
The Company, like other companies in the securities industry, relies on
external sources to finance a significant portion of its day-to-day
operations. The Company's access to and cost of funding is generally
dependent upon its short- and long- term debt ratings. In September 1998,
Moody's reaffirmed the "stable" long-term debt ratings of Holdings and
changed its outlook on the Company from positive to stable. Also in
September, Standard & Poor's, as part of its change in outlook for firms
throughout the securities industry, put the Company's debt rating on Credit
Watch with negative implications. As of August 31, 1998, the short- and
long-term senior debt ratings of Holdings and LBI were as follows:
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*/Baal
S&P A-1 A+*/A
Thomas 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
Lehman Brothers Derivative Products
On July 16, 1998, the Company announced that it had established a special
purpose subsidiary that will provide counterparties around the world with a
wide variety of derivative products and services. The new company, Lehman
Brothers Derivative Products Inc. has been assigned Aaa and AAAt credit
ratings by Moody's Investor Services Inc. and Standard & Poor's Corporation,
respectively.
High Yield Securities
The Company underwrites, trades, invests and makes markets in high yield
corporate debt securities. The Company also syndicates, trades and invests
in loans to below investment grade-rated companies. For purposes of this
discussion, high yield debt securities are defined as securities or loans to
companies rated BB+ or lower, or equivalent ratings by recognized credit
rating agencies, as well as non-rated securities or loans which, in the
opinion of management, are non-investment grade. The definition excludes
sovereign debt. Non-investment grade securities generally involve greater
risks than investment grade securities due to the issuer's creditworthiness
and the liquidity of the market for such securities. In addition, these
issuers have higher levels of indebtedness, resulting in an increased
sensitivity to adverse economic conditions. The Company recognizes these
risks and aims to reduce market and credit risk through the diversification
of its products and counterparties. High yield debt securities are carried
at market value, and unrealized gains or losses for these securities are
reflected in the Company's Consolidated Statement of Income. The Company's
portfolio of such securities at August 31, 1998 and November 30, 1997
included long positions with an aggregate market value of approximately $2.4
billion and $2.6 billion, respectively, and short positions with an
aggregate market value of approximately $351 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 August 31, 1998, the Company
had no single net exposure to an issuer of high yield securities or loans
greater than $110 million.
Lending Activities
The Company, through its high yield sales and trading activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and participates a significant portion of
these commitments. These commitments, which are net of syndications and
participations, totaled $2.8 billion at August 31, 1998, are typically
secured against the borrower's assets and have fixed maturity dates. The
utilization of these facilities is generally contingent upon certain
representations, warranties and contractual conditions of the borrower.
Total commitments may not be indicative of actual funding requirements as
the Company intends to continue syndicating, selling, and/or participating
these commitments.
In addition, the Company had lending commitments to high grade borrowers of
$474 million at August 31, 1998. These commitments also are typically
secured against the borrower's assets, have fixed maturity dates, and are
generally contingent upon certain representatives, warranties and
contractual conditions of the borrower.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Merchant Banking and Related Lending Activities
The Company's merchant banking activities include investments in five
partnerships, for which the Company acts as general partner, as well as
direct investments. At August 31, 1998, the investment in merchant banking
partnerships was $22 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 $207 million in the
partnerships, which in turn will make direct merchant banking related
investments. These commitments will be funded as required through the end of
the respective partnerships' investment periods, principally expiring in
2004.
In June 1998, the Company, together with a consortium of other financial
services companies, sponsored a $5 billion interim loan fund, designed to
extend financing to clients in connection with a wide range of domestic and
international leveraged transactions, including acquisitions, corporate
recapitalizations and refinancings of existing debt. In connection
therewith, the Company intends to provide up to $400 million to be used by
the fund. Any drawdowns under the facility are expected to be repaid within
a short-term period. At August 31, 1998, the fund had no outstanding loans.
<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.
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
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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):
August 31, 1998 November 30, 1997
--------------- -----------------
Interest rate risk $10.8 $9.8
Equity price risk 8.7 4.7
Foreign exchange risk 1.1 1.3
Diversification benefit (5.9) (4.8)
----- ----
Total Company $14.7 $11.0
==== ====
Value at risk increased at August 31, 1998 because of dramatic increases in
volatility across a broad spectrum of asset classes.
The Company utilizes a wide variety of market risk management methods,
including stress and scenario analysis, limits for each trading activity;
marking all positions to market on a daily basis; daily profit and loss
analyses; position reports; aged inventory position analyses; and
independent verification of all inventory pricing. The Company believes that
these procedures, which stress timely communication between the risk and
trading areas and senior management, are critical elements of the risk
management process.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Impact of EMU
As of January 1, 1999, 11 European countries will enter into the European
economic and monetary union ("EMU") and replace their local currencies with
a single currency, the Euro. During a three-year transition period, the
national currencies will continue to circulate but only as fixed
denominations of the Euro. Commencing on January 1, 1999, the settlement of
non-cash transactions previously denominated in the participating national
currencies will predominately be effected in Euros.
To date, the Council of Ministers of the European Union has approved the
following states for entry into EMU: Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
In order to have all areas of the Company prepared for EMU before the
scheduled start date of January 1, 1999, the Company has implemented a
worldwide EMU conversion and testing plan. A full-time team has been
assigned to assess the impact on the Company's global infrastructure and to
perform all required systems changes. The Company has also been reviewing
and planning for the impact of the conversion in its various business areas.
The Company has completed the analysis, design, and build phases of the
conversion and will focus on testing throughout the next several months. In
addition, the Company will be directing its efforts toward the detailed
planning of the conversion weekend (December 31, 1998 to January 3, 1999).
The Company's plan is currently on schedule, and integrated systems testing
has commenced.
Dress rehearsals of conversion weekend are planned. These rehearsals will
simulate the actual conversion weekend as closely as possible. High volume
tests are being run with production volumes to ensure that systems can
handle the conversion volume within acceptable time-frames. The Company's
test programs are designed to establish its ability to process all
transactions in the new environment. The Company is also participating in
industry testing where practicable, as organized by regulatory and market
agencies.
Many areas of the Company will be affected by the introduction of the single
currency. As with the Year 2000 issue, EMU poses various operating risks.
EMU will require many changes to the Company's operations and technology,
including currency conversions, modifications of trading payment and
settlement systems, and the redenomination of securities. This will require
the conversion of exceptionally large amounts of data in the Company's
systems.
The Company has incurred and expects to continue to incur expenses for the
internal technology and operations staff, as well as costs for outside
consultants, in order to implement its EMU conversion plan. Management
currently estimates that the cost of its EMU conversion program will be
approximately $7.5 million, of which $3 million has been incurred to date
and expensed.
The changes to the Company's data and computer systems will affect its
clearance, settlement and financial reporting activities, along with other
key operations of the Company. If not properly implemented, these changes
could lead to failed settlements, inability to reconcile trading positions
and funding disruptions. In addition, the Company is dependent for proper
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
transactions clearance and reporting on many third parties, including
counterparties, clearing agents, banks, exchanges, clearing houses and
providers of information. Errors arising in the Company's or third parties'
systems could also lead to erroneous entries in the Company's books and
records. These events could result in misstatement of the Company's
financial condition and results of operations, could impair its ability to
manage its risks, and result in a material loss, regulatory actions,
reputational harm and legal liability.
While convergence to the Euro has reduced client demand for certain
transactions, which has impacted the Company's foreign exchange and fixed
income activities in Europe, the Company anticipates that new opportunities
in Europe will be created through an expansion of activities in mergers and
acquisitions, investment grade and high yield debt capital markets, and
equity issuance and asset allocation. Overall, management anticipates that
implementation of EMU will not, by itself, materially affect the financial
results of the Company in an adverse manner.
Although all key suppliers have committed that they will be Euro
compliant, the Company can give no assurance that third parties on whom it
depends, will have the systems necessary to process Euro-denominated
transactions. Moreover, disruption in the activity in the European markets
because of the conversion to the Euro could hurt the Company's businesses in
those markets, resulting in lost revenues and increased costs. Management
cannot predict the magnitude of any such reduction or its impact on the
Company's financial results.
As part of the conversion process, the Company is establishing
detailed contingency plans. The contingency plans will provide mechanisms
to assess and communicate the impact of any delays. These plans also
address likely problems in the aftermath of conversion with a view to
maximizing the Company's ability to avoid disruption.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Impact of the Year 2000
The Year 2000 issue is the result of many computer programs and imbedded
chips being written using two digits rather than four to define the
applicable year. Many of the Company's computer programs that have
date-sensitive software may recognize a date using "00"as the year 1900
rather than the year 2000.
If not addressed and completed on a timely basis, failure of the Company's
computer systems to process Year 2000 related data correctly could have a
material adverse effect. Failures of this kind could, for example, lead to
incomplete or inaccurate accounting, settlement failures, trade processing
or recording errors in securities, currencies, commodities or other assets.
It could also lead to uncertainty regarding risk, exposures and liquidity.
If not addressed, the potential risks to the Company include financial loss,
legal liability, interruption to business and regulatory actions.
The Company established a team in 1996 to modify or replace and then test
the appropriate software and equipment to ensure that Year 2000 issues are
addressed. The Company presently believes that with modifications to
existing software and conversions to new software, the Year 2000 issue will
be resolved for all the Company's own systems worldwide.
However, even if these changes are successful, the Company remains at risk
from Year 2000 failures caused by third parties. The Company has therefore
initiated efforts with key counterparties, exchanges, agencies, utilities
and suppliers, among others, to assess and wherever possible remediate Year
2000 issues. To date, the Company has not received sufficient information
from certain vendors and international markets to complete its assessment of
Year 2000 awareness.
Examples of problems that could result from the failure by third parties
with whom the Company interacts to remediate Year 2000 bugs include: (i) in
the case of exchanges and clearing agents, funding disruptions, failure to
trade in certain markets and settlement failures; (ii) in the case of
counterparties and clients, accounting and financial difficulties to those
parties that may expose the Company to increased credit risk and lost
business; (iii) in the case of vendors, service failures such as power,
telecommunications, elevator operations and loss of security access control;
(iv) in the case of banks and other lenders, the potential for liquidity
stress due to disruptions in funding flows; and, (v) in the case of data
providers, inaccurate or out of date information that would impair the
Company's ability to perform critical functions such as pricing securities
and currencies. Additionally, general uncertainty regarding the success of
remediation may cause many market participants to reduce their market
activities temporarily as they address and assess their Year 2000 efforts in
1999. This could result in a general reduction in market activities and
revenue opportunities in late 1999 and early 2000. Management cannot predict
the magnitude of any such reduction or its impact on the Company's financial
results. However, the Company's Risk Management Department has undertaken a
comprehensive review of third party and credit risks posed by Year 2000.
Additionally, recognizing the uncertainty of external dependencies, the
Company is preparing a contingency plan that identifies potential problems,
actions to minimize the likelihood of their occurrence and action plans to
be invoked should they occur. These plans will include backup processes that
do not rely on computer systems, where appropriate.
<PAGE>
LEHMAN BROTHERS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The Company has taken a lead in industry efforts to deal with the Year 2000
issue by actively participating, and in some cases leading, industry-wide
testing in 1998 and 1999. The Company has already successfully participated
in a July industry-wide Beta test conducted by the Securities Industry
Association. This industry-wide testing is the forum in which firms within
the financial industry test the applications that transfer data between
them. However, as stated above, there can be no guarantee or assurance that
the systems of other companies on which the Company's systems rely will be
timely converted in a timely fashion, or that a failure to convert by
another company, or a conversion that is incompatible with the Company's
systems, would not have a material adverse effect on the Company.
The Company plans to complete the Year 2000 project, including industry-wide
testing, no later than August 1999. The Company has established an internal
auditing plan to record results and ensure ongoing compliance of tested
applications. It should be noted that efforts focused on addressing EMU have
delayed the finalization of internal and industry-wide testing in Europe.
The Company's total Year 2000 project cost is based on presently available
information. The total remaining cost of the Year 2000 project is estimated
at approximately $4.5 million which will be funded through operating cash
flows and expensed as incurred over the next one and one-half years. The
Company has incurred and expensed approximately $2 million in 1997, and $2.7
million through August 31, 1998, related to the Year 2000 project.
The costs of the Year 2000 testing, modifications and/or replacements, and
the date on which the Company plans to complete the project are based on
management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1 Legal Proceedings
The Company is involved in a number of judicial, regulatory and
arbitration proceedings concerning matters arising in connection with the
conduct of its business. Such proceedings include actions brought against
the Company and others with respect to transactions in which LBI acted as
an underwriter or financial advisor, actions arising out of the Company's
activities as a broker or dealer in securities and commodities and actions
brought on behalf of various classes of claimants against many securities
and commodities firms, including the Company.
Although there can be no assurance as to the ultimate outcome, the
Company has denied, or believes it has meritorious defenses and will deny,
liability in all significant cases pending against it including the
matters described below, and intends to defend vigorously each such case.
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 and Second Quarter Reports on Form
10-Q)
The Virginia Commissioner of Insurance Action. On July 7, 1998, the
Commissioner filed a Notice of Appeal to the United States Court of Appeals
for the Fourth Circuit from the Order filed on May 21, 1998.
Actions relating to National Association of Securities Dealers
Automated Quotations System ("NASDAQ") Market Maker Antitrust and
Securities Litigation. (Reported in LBI's Annual Report on Form 10-K) The
Stipulation and Order were approved by the United States District Court for
the Southern District of New York, which decision has been affirmed on
appeal by the Second Circuit Court of Appeals.
AIA Holding SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co.,
Inc. (Reported in LBI's Annual Report on Form 10-K and First and Second
Quarter Reports on Form 10-Q). The plaintiffs filed a First Amended
Complaint on July 3, 1998 which LBI answered on August 12, 1998. Discovery
is proceeding.
Actions relating to Sales and Marketing of Limited Partnerships
Klein, et al. v. Lehman Brothers Inc., et al. (Reported in LBI's
Annual Report on Form 10-K). On September 24, 1998, the Court filed an
opinion dismissing the complaint.
<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: October 15, 1998 By /s/David Goldfarb
------------------
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
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 Nine Months
Ended Ended Ended Ended Ended Ended
December 31 November 30 November 30 November 30 November 30 August 31
1993 1994 1995 1996 1997 1998
---- ---- ---- ---- ---- ----
Fixed Charges:
Interest expense:
<S> <C> <C> <C> <C> <C> <C>
Subordinated indebtedness $ 192 $ 184 $ 204 $ 221 $ 236 $ 179
Bank loans and other
borrowings* 4,393 5,661 9,750 9,900 11,980 10,888
Interest component of rentals
of office and equipment 62 27 25 18 16 12
Other adjustments** 101 53 2 7 3 4
----------- ---------- ---------- -------- ----------- --------
TOTAL (A) $4,748 $5,925 $ 9,981 $ 10,146 $12,235 $11,083
====== ========= ======= ======= ======== =======
Earnings:
Pretax income (loss) from
continuing operations $ (146) $ 1 $ 78 $ 309 $ 593 $ 830
Fixed charges 4,748 5,925 9,981 10,146 12,235 11,083
Other adjustments*** (68) (52) (1) (6) (2) (3)
---------- ------- -------- -------- ---------- ----------
TOTAL (B) $4,534 $5,874 $10,058 $ 10,449 $12,826 $11,910
====== ====== ======= ======= ======= =======
(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.
<TABLE> <S> <C>
<ARTICLE> BD
<LEGEND>
This schedule contains summary financial information extracted from
the Company's Consolidated Statement of Financial Condition at August 31,
1998 (Unaudited) and the Consolidated Statement of Income for the nine
months ended August 31, 1998 (Unaudited) and is qualified in its entirety
by reference to such financial statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> NOV-30-1998
<PERIOD-START> DEC-01-1998
<PERIOD-END> AUG-31-1998
<CASH> 2,191
<RECEIVABLES> 12,451
<SECURITIES-RESALE> 57,940
<SECURITIES-BORROWED> 18,167
<INSTRUMENTS-OWNED> 56,641
<PP&E> 263
<TOTAL-ASSETS> 148,058
<SHORT-TERM> 1,067
<PAYABLES> 13,567
<REPOS-SOLD> 67,555
<SECURITIES-LOANED> 8,447
<INSTRUMENTS-SOLD> 23,185
<LONG-TERM> 4,476
0
0
<COMMON> 0
<OTHER-SE> 2,469
<TOTAL-LIABILITY-AND-EQUITY> 148,058
<TRADING-REVENUE> 752
<INTEREST-DIVIDENDS> 11,486
<COMMISSIONS> 300
<INVESTMENT-BANKING-REVENUES> 1,088
<FEE-REVENUE> 0
<INTEREST-EXPENSE> 11,067
<COMPENSATION> 1,251
<INCOME-PRETAX> 830
<INCOME-PRE-EXTRAORDINARY> 518
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 518
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
