SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended August 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ____________ to ____________
Commission file number 1-9466
Lehman Brothers Holdings Inc.
(Exact Name of Registrant As Specified In Its Charter)
Delaware 13-3216325
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
3 World Financial Center
New York, New York 10285
(Address of principal (Zip Code)
executive offices)
Registrant's telephone number, including area code: (212) 526-7000
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ______
As of September 30, 1998, 115,980,030 shares of the Registrant's Common Stock,
par value $.10 per share, were outstanding.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
FORM 10-Q
FOR THE QUARTER ENDED AUGUST 31, 1998
INDEX
Part I. FINANCIAL INFORMATION Page Number
Item 1. Financial Statements - (unaudited)
Consolidated Statement of Income -
Three and Nine Months Ended
August 31, 1998 and 1997 ........................... 3
Consolidated Statement of Financial Condition -
August 31, 1998 and November 30, 1997 .............. 5
Consolidated Statement of Cash Flows -
Nine Months Ended
August 31, 1998 and November 30, 1997............... 7
Notes to Consolidated Financial Statements............ 9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations............ 16
Part II. OTHER INFORMATION
Item 1. Legal Proceedings ..................................... 39
Item 5. Other Information ..................................... 40
Item 6. Exhibits and Reports on Form 8-K ................. 40
Signatures............................................................ 41
EXHIBIT INDEX .................................................. 42
Exhibits
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of INCOME
(Unaudited)
(In millions, except per share data)
Three months ended
August 31 August 31
1998 1997
--------------- ----------
Revenues
Investment banking $ 493 $ 396
Principal transactions 131 389
Commissions 137 111
Interest and dividends 5,254 3,554
Other (52) 19
------ ------
Total revenues 5,963 4,469
Interest expense 5,033 3,398
----- -----
Net revenues 930 1,071
------ -----
Non-interest expenses
Compensation and benefits 472 543
Brokerage, commissions and
clearance fees 61 54
Professional services 49 43
Communications 37 35
Occupancy and Equipment 34 35
Business development 29 25
Depreciation and amortization 23 22
Other 18 33
----- ------
Total non-interest expenses 723 790
----- ------
Income before taxes 207 281
Provision for income taxes 56 84
----- ------
Net income $151 $197
==== =====
Net income applicable to common stock $139 $160
==== =====
Weighted average shares
Basic 121.5 118.7
===== =====
Diluted 126.2 122.4
===== =====
Earnings per common share
Basic $1.15 $1.34
===== =====
Diluted $1.10 $1.30
===== =====
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT of INCOME
(Unaudited)
(In millions, except per share data)
Nine months ended
August 31 August 31
1998 1997
--------------- ---------
Revenues
Investment banking $1,336 $ 910
Principal transactions 1,142 1,061
Commissions 378 299
Interest and dividends 13,235 9,931
Other 6 73
------ ------
Total revenues 16,097 12,274
Interest expense 12,649 9,424
------ ------
Net revenues 3,448 2,850
----- ------
Non-interest expenses
Compensation and benefits 1,749 1,445
Brokerage, commissions and
clearance fees 175 172
Professional services 134 131
Communications 111 105
Occupancy and equipment 102 104
Business development 84 76
Depreciation and amortization 67 65
Other 68 80
----- -------
Total non-interest expenses 2,490 2,178
----- -----
Income before taxes 958 672
Provision for income taxes 296 210
------ ------
Net income $ 662 $ 462
===== =====
Net income applicable to common stock $ 587 $ 412
===== =====
Weighted average shares
Basic 120.9 117.9
===== =====
Diluted 125.8 120.6
===== =====
Earnings per common share
Basic $4.86 $3.49
===== =====
Diluted $4.67 $3.41
===== =====
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
(Unaudited)
(In millions)
August 31 November 30
ASSETS 1998 1997
------ ----- --------
Cash and cash equivalents $ 4,732 $ 1,685
Cash and securities segregated and on deposit
for regulatory and other purposes 1,605 1,149
Securities and other financial instruments owned:
Governments and agencies 29,762 33,037
Corporate equities 15,161 10,877
Corporate debt and other 11,400 10,892
Mortgages and mortgage-backed 20,244 11,455
Derivatives and other contractual agreements 10,712 8,353
Certificates of deposit and other money market
instruments 3,430 2,248
------- -------
90,709 76,862
------ ------
Collateralized short-term agreements:
Securities purchased under agreements to resell 57,287 43,606
Securities borrowed 21,815 14,146
Receivables:
Brokers, dealers and clearing organizations 2,651 2,193
Customers 9,106 9,105
Others 1,478 1,540
Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization
of $790 in 1998 and $735 in 1997) 483 468
Other assets 1,043 787
Excess of cost over fair value of net assets
acquired (net of accumulated amortization
of $118 in 1998 and $111 in 1997) 165 164
-------- --------
Total assets $191,074 $151,705
======== ========
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS HOLDINGS 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 STOCKHOLDERS' EQUITY
<S> <C> <C>
Commercial paper and short-term debt $12,703 $ 7,818
Securities and other financial instruments sold but not yet purchased:
Governments and agencies 16,058 16,201
Corporate equities 6,546 4,293
Corporate debt and other 2,712 2,219
Derivatives and other contractual agreements 8,502 7,367
------- --------
33,818 30,080
Collateralized short-term financings:
Securities sold under agreements to repurchase 84,496 63,204
Securities loaned 6,110 7,846
Payables:
Brokers, dealers and clearing organizations 5,265 2,155
Customers 10,776 11,702
Accrued liabilities and other payables 4,176 4,116
Long-term debt:
Senior notes 24,711 17,049
Subordinated indebtedness 3,670 3,212
--------- ---------
Total liabilities 185,725 147,182
------- -------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock, $1.00 par value; 38,000,000 shares authorized: 5% Cumulative
Convertible Voting, 13,000,000 shares Authorized; $39.10 liquidation
preference per share
Series A - shares issued and outstanding:12,800, in 1998 and 33,050 in 1997 1 1
Series B - shares issued and outstanding:12,987,200 in 1998 and 12,966,950 in 1997 507 507
5.94% Cumulative, Series C - 500,000 shares issued and outstanding; $500 liquidation 250
preference per share
5.67% Cumulative, Series D - 40,000 shares issued and outstanding; $5,000 liquidation 200
preference per share
Redeemable Voting, 1,000 shares issued and outstanding; $1.00 liquidation
preference per share
Common stock, $0.10 par value; 300,000,000 shares authorized;
Shares issued: 121,782,299 in 1998 and 119,513,337 in 1997;
Shares outstanding: 116,673,240 in 1998 and 116,612,074 in 1997 12 12
Common stock issuable 150 155
Additional paid-in capital 3,503 3,436
Foreign currency translation adjustment 5 12
Retained earnings 1,053 498
Common stock in treasury, at cost: 5,109,059 shares in 1998 and 2,901,263 shares in 1997 (332) (98)
---------- ----------
Total stockholders' equity 5,349 4,523
---------- ----------
Total liabilities and stockholders' equity $191,074 $151,705
========== ========
</TABLE>
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS HOLDINGS 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 $ 662 $ 462
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 67 65
Provisions for losses and other reserves 107 41
Deferred tax benefit (60) (33)
Other adjustments 51 (262)
Net change in:
Cash and securities segregated (456) (239)
Securities and other financial instruments owned (13,847) (10,230)
Securities purchased under agreements to resell (13,680) (10,928)
Securities borrowed (7,670) 4,369
Receivables from brokers, dealers and clearing organizations (458) (1,208)
Receivables from customers (1) (1,656)
Securities and other financial instruments sold but
not yet purchased 3,738 5,948
Securities sold under agreements to repurchase 21,292 1,683
Securities loaned (1,736) 2,438
Payables to brokers, dealers and clearing organizations 3,110 2,649
Payables to customers (926) 2,363
Accrued liabilities and other payables (97) 330
Other operating assets and liabilities, net (166) (244)
-------- -------
Net cash used in operating activities $(10,070) $(4,452)
--------- --------
</TABLE>
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS (Continued)
(Unaudited)
(In millions)
<TABLE>
<CAPTION>
Nine months ended
August 31 August 31
1998 1997
--------- --------
<S> <C> <C>
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from issuance of senior notes $10,042 $5,503
Principal payments of senior notes (2,321) (2,071)
Proceeds from issuance of subordinated indebtedness 600 395
Principal payments of subordinated indebtedness (150) (550)
Net proceeds from commercial paper and short-term debt 4,885 404
Payments for treasury stock purchases (315)
Dividends paid (49) (45)
Issuances of common stock 57 20
Issuances of preferred stock 444
-------- ------
Net cash provided by financing activities 13,193 3,656
-------- ------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements (76) (53)
--------- -------
Net cash used in investing activities (76) (53)
---------- -------
Net change in cash and cash equivalents 3,047 (849)
------- -------
Cash and cash equivalents, beginning of period 1,685 2,149
------- -------
Cash and cash equivalents, end of period $ 4,732 $1,300
======= =======
</TABLE>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions)
Interest paid totaled $12,501 and $9,541 for the nine months ended
August 31, 1998 and 1997, respectively. Income taxes paid totaled $323 and $127
for the nine months ended August 31, 1998 and 1997, respectively.
See notes to consolidated financial statements.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation:
The consolidated financial statements include the accounts of Lehman
Brothers Holdings Inc. ("Holdings") and subsidiaries (collectively, the
"Company" or "Lehman Brothers"). Lehman Brothers is one of the leading
global investment banks serving institutional, corporate, government and
high-net- worth individual clients and customers. The Company's worldwide
headquarters in New York and regional headquarters in London and Tokyo are
complemented by offices in additional locations in North America, Europe,
the Middle East, Latin America and the Asia Pacific Region. The Company is
engaged primarily in providing financial services. The principal U.S.
subsidiary of Holdings is Lehman Brothers Inc. ("LBI"), a registered
broker-dealer. All material intercompany accounts and transactions have been
eliminated in consolidation. The Company's financial statements have been
prepared in accordance with the rules and regulations of the Securities and
Exchange Commission (the "SEC") with respect to the Form 10-Q and reflect
all normal recurring adjustments which are, in the opinion of management,
necessary for a fair presentation of the results for the interim periods
presented. Pursuant to such rules and regulations, certain footnote
disclosures which are normally required under generally accepted accounting
principles have been omitted. It is recommended that these consolidated
financial statements be read in conjunction with the audited consolidated
financial statements included in the Company's Annual Report on Form 10-K
for the twelve months ended November 30, 1997 (the "Form 10-K"). The
Consolidated Statement of Financial Condition at November 30, 1997 was
derived from the audited financial statements.
The nature of the Company's business is such that the results of any
interim period may vary significantly from quarter to quarter and may not be
indicative of the results to be expected for the fiscal year. Certain prior
period amounts reflect reclassifications to conform to the current period's
presentation.
2. Accounting Policies:
In 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share," which is effective for fiscal periods ending after December 15,
1997. SFAS No. 128 replaced the presentation of primary and fully diluted
earnings per common share ("EPS") with basic and diluted EPS. The Company
adopted SFAS No. 128 during the first quarter of 1998 and restated EPS data
for the prior periods to conform with the provisions of the Statement.
On January 1, 1998, SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities" became
fully effective. Previously, the FASB had deferred until that date certain
provisions of SFAS No. 125 pertaining to repurchase agreements, securities
lending and similar financing transactions. As a result of adopting the
deferred provisions of SFAS No. 125, the Company has recognized on its
August 31, 1998 Consolidated Statement of Financial Condition, approximately
$1 billion of collateral controlled on certain financing transactions and a
corresponding obligation to return such collateral at the termination of
such transactions.
In March 1998, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of
Position 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use" (the "SOP"). The SOP requires that certain costs
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
incurred in connection with developing or obtaining software for internal
use be capitalized. The SOP requires prospective application as of the
beginning of an entity's fiscal year without adjustment for costs that would
have been capitalized had the SOP been in effect in prior periods. The
Company has elected early adoption of this accounting pronouncement
effective as of the beginning of its 1998 fiscal year and capitalized
approximately $8.7 million of purchased software and other internal use
software costs during the nine months of fiscal 1998.
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, Accounting for Derivative Instruments and for Hedging Activities, which
requires all derivatives to be recorded on the balance sheet at fair value.
SFAS No. 133 is effective for years beginning after June 15, 1999. The
expected impact of adoption on the Company's results of operations has not
yet been determined, however it is not likely to be material since most of
the Company's derivatives are carried at fair value.
3. Long-Term Debt:
During the nine months ended August 31, 1998, the Company issued
$10,642 million of long-term debt (comprised of $10,042 million of senior
notes and $600 million of subordinated debt). Of the total issuances during
the period, $3,569 million were U.S. dollar fixed rate, $5,335 million were
U.S. dollar floating rate, $545 million were foreign currency denominated
fixed rate, and $1,193 million were foreign currency denominated floating
rate. These issuances were primarily utilized to refinance maturities of
long-term debt in 1998 and to increase total capital (stockholders' equity
plus long-term debt).
The Company's floating rate new issuances contain contractual interest
rates based primarily on London Interbank Offered Rates ("LIBOR"). All of
the Company's fixed rate new issuances were effectively converted to
floating rate obligations through the use of interest rate swaps. Of the
foreign currency denominated new issuances totaling $1,738 million, $1,061
million were effectively swapped to U.S. dollars with the remainder match
funding foreign currency denominated capital needs.
The Company had $2,471 million of long-term debt mature during the nine
months ended August 31, 1998.
4. Capital Requirements:
The Company operates globally through a network of subsidiaries with
several being subject to regulatory requirements. In the United States, LBI,
as a registered broker-dealer, is subject to SEC Rule 15c3-1, the Net
Capital Rule, which requires LBI to maintain net capital of not less than
the greater of 2% of aggregate debit items arising from customer
transactions, as defined, or 4% of funds required to be segregated for
customers' regulated commodity accounts, as defined. At August 31, 1998,
LBI's regulatory net capital, as defined, of $1,376 million exceeded the
minimum requirement by $1,247 million.
Lehman Brothers International (Europe) ("LBIE"), a United Kingdom
registered broker-dealer and subsidiary of Holdings, is subject to the
capital requirements of the Securities and Futures Authority ("SFA") of the
United Kingdom. Financial resources, as defined, must exceed the total
financial resources requirement of the SFA. At August 31, 1998, LBIE's
financial resources of approximately $2.4 billion exceeded the minimum
requirement by approximately $650 million. Lehman Brothers Japan Inc.'s
Tokyo branch, a regulated broker-dealer, is subject to the capital
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
requirements of the Japanese Ministry of Finance and, at August 31, 1998,
had net capital of approximately $500 million which was approximately $200
million in excess of the specified levels required. Certain other non-U.S.
subsidiaries are subject to various securities, commodities and banking
regulations and capital adequacy requirements promulgated by the regulatory
and exchange authorities of the countries in which they operate. At August
31, 1998, these other subsidiaries were in compliance with their applicable
local capital adequacy requirements. The Company's "AAA" rated derivatives
subsidiary, Lehman Brothers Financial Products Inc. ("LBFP"), has
established certain capital and operating restrictions which are reviewed by
various rating agencies. At August 31, 1998, LBFP had capital which exceeded
the requirement of the most stringent rating agency by approximately $140
million.
The regulatory rules referred to above, and certain covenants contained
in various debt agreements may restrict Holdings' ability to withdraw
capital from its regulated subsidiaries, which in turn could limit its
ability to pay dividends to shareholders.
5. Derivative Financial Instruments:
In the normal course of business, the Company enters into derivative
transactions to satisfy the needs of its clients and to manage the Company's
own exposure to market and credit risks resulting from its trading
activities in cash instruments (collectively, "Trading-Related Derivative
Activities").
The Company records its Trading-Related Derivative Activities on a
mark-to-market basis with realized and unrealized gains and losses
recognized currently in Principal transactions in the Consolidated Statement
of Income. Unrealized gains and losses on derivative contracts are recorded
on a net basis in the Consolidated Statement of Financial Condition for
those transactions with counterparties executed under a legally enforceable
master netting agreement and are netted across products and against cash
collateral when such provisions are stated in the master netting agreement.
Listed in the following table is the fair value and average fair value of
the Company's Trading-Related Derivative Activities. Average fair values of
these instruments were calculated based upon month-end statement of
financial condition values, which the Company believes do not vary
significantly from the average fair value calculated on a more frequent
basis. Variances between average fair values and period-end values are due
to changes in the volume of activities in these instruments and changes in
the valuation of these instruments due to variations in market and credit
conditions.
<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) $ 6,871 $3,905 $5,124 $3,262
Foreign exchange forward contracts and options 2,247 1,866 1,581 1,523
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 388 378 516 555
Equity contracts (including equity swaps, warrants
and options) 1,084 2,217 2,929 3,767
Commodity contracts (including swaps, forwards,
and options) 122 136 166 166
-------------------------------------------------------
Total $10,712 $8,502 $10,316 $9,273
--------------------------------------------------------
</TABLE>
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
<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) $4,704 $3,303 $4,306 $3,224
Foreign exchange forward contracts and options 1,840 1,885 1,236 1,532
Options on other fixed income securities,
mortgage-backed securities forward contracts
and options 310 297 275 246
Equity contracts (including equity swaps, warrants
and options) 1,304 1,696 2,134 1,681
Commodity contracts (including swaps, forwards,
and options) 195 186 304 465
--------------------------------------------------------
Total $8,353 $7,367 $8,255 $7,148
-------------------------------------------------------
</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 and on the previous page represent
the Company's unrealized gains, net of unrealized losses for situations in
which the Company has a master netting agreement. Similarly, liabilities
represent net amounts owed to counterparties. Therefore, the fair value of
assets/liabilities related to derivative contracts at August 31, 1998
represents the Company's net receivable/payable for derivative financial
instruments before consideration of collateral. Included within the $10,712
million fair value of assets at August 31, 1998 was $10,265 million related
to swaps and OTC contracts and $447 million related to exchange-traded
option and warrant contracts. Included within the $8,353 million fair value
of assets at November 30, 1997 was $8,016 million related to swaps and OTC
contracts and $337 million related to exchange-traded option and warrant
contracts.
With respect to OTC contracts, including swaps, the Company views its
net credit exposure to be $6,730 million at August 31, 1998, representing
the fair value of the Company's OTC contracts in an unrealized gain
position, after consideration of collateral of $3,535 million. Presented
below is an analysis of the Company's net credit exposure (after allocation
of collateral) at August 31, 1998 for OTC contracts based upon actual
ratings made by external rating agencies or by equivalent ratings
established and utilized by the Company's Corporate Credit Department.
Counterparty S&P/Moody's
Risk Rating Equivalent Net Credit Exposure
------------ ------------------------- -------------------
1 AAA/Aaa 18%
2 AA-/Aa3 or higher 23%
3 A-/A3 or higher 35%
4 BBB-/Baa3 or higher 11%
5 BB-/Ba3 or higher 6%
6 B+/B1 or lower 7%
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
The Company is also subject to credit risk related to its
exchange-traded derivative contracts. Exchange-traded contracts, including
futures and certain options, are transacted directly on the exchange. To
protect against the potential for a default, all exchange clearing houses
impose net capital requirements for their membership. Additionally, the
exchange clearing house requires counterparties to futures contracts to post
margin upon the origination of the contract and for any changes in the
market value of the contract on a daily basis (certain foreign exchanges
provide for settlement within three days). Therefore, the potential for
losses from exchange-traded products is limited.
For a further discussion of the Company's derivative related
activities, refer to "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Off-Balance Sheet Financial
Instruments and Derivatives" and Notes 1 and 11 to the Consolidated
Financial Statements, included in the Form 10-K.
6. Other Commitments and Contingencies:
In connection with its financing activities, the Company has
outstanding commitments under certain lending arrangements of approximately
$4.8 billion at August 31, 1998 and $2.4 billion at November 30, 1997. These
commitments require borrowers to provide acceptable collateral, as defined
in the agreements, when amounts are drawn under the lending facilities.
Advances made under the above lending arrangements are typically at variable
interest rates and generally provide for over-collateralization based upon
the borrowers' creditworthiness.
The Company, through its high yield sales and trading activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and then participates a significant portion
of these commitments. These commitments, net of syndications and
participations, totaled $2.8 billion and $1.6 billion at August 31, 1998 and
November 30, 1997, respectively, are typically secured against the
borrower's assets and have fixed maturity dates. The draw down of these
facilities is generally contingent upon certain representations, warranties
and contractual conditions of the borrower. Total commitments may not be
indicative of actual funding requirements as the Company intends to continue
syndicating, selling, and/or participating these commitments.
In addition, the Company had lending commitments to high grade
borrowers of $474 million at August 31, 1998. These commitments are
typically secured against the borrower's assets, have fixed maturity dates,
and are generally contingent upon certain representations, warranties and
contractual conditions of the borrower.
The Company has commitments to invest up to $353 million in
partnerships, which in turn will make direct merchant banking related
investments. These commitments will be funded as required through the end of
the respective partnerships' investment periods, principally expiring in
2004.
In June 1998, the Company, together with a consortium of other
financial services companies, sponsored a $5 billion interim loan fund,
designed to extend financing to clients in connection with a wide range of
domestic and international leveraged transactions, including acquisitions,
corporate recapitalization and refinancing of existing debt. In connection
therewith, the Company intends to provide up to $400 million to be used by
the fund. Any drawdowns under the facility are expected to be repaid within
a short-term period. At August 31, 1998, the fund had no outstanding loans.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
NOTES to CONSOLIDATED FINANCIAL STATEMENTS
In the normal course of its business, the Company has been named a
defendant in a number of lawsuits and other legal proceedings. After
considering all relevant facts, available insurance coverage and the advice
of outside counsel, in the opinion of the Company such litigation will not,
in the aggregate, have a material adverse effect on the Company's
consolidated financial position or results of operations.
As a leading global investment bank, risk is an inherent part of all of
the Company's businesses and activities. The extent to which the Company
properly and effectively identifies, assesses, monitors and manages each of
the various types of risks involved in its trading (including derivatives),
brokerage, and investment banking activities is critical to the success and
profitability of the Company. The principal types of risks involved in the
Company's activities are market risk, credit or counterparty risk and
transaction risk. Management has developed a control infrastructure
throughout the Company to monitor and manage these risks on a global basis.
For further discussion of these matters, refer to Note 13 to the
Consolidated Financial Statements, in the Form 10-K.
7. Capital Stock:
On July 21, 1998, the Company issued 4,000,000 Depository Shares (each
representing 1/100th of a share) of 5.67% Cumulative Preferred Stock, Series
D ("Series D Preferred Stock"), $1.00 par value. The Series D Preferred
Stock has a redemption price of $5,000 per share, together with accrued and
unpaid dividends. Redemption of the Series D Preferred Stock is at the
option of the Company for any or all of the outstanding shares after August
31, 2008. The $200 million redemption value of the shares outstanding at
August 31, 1998 is classified on the Company's Consolidated Statement of
Financial Condition as 5.67% Cumulative Series D Preferred Stock.
<PAGE>
8. Earnings Per Share
Earnings per share was calculated as follows (in millions, except for
per share data):
<TABLE>
<CAPTION>
Three months Nine months
Ended ended
August 31 August 31
---------------------------- ----------------------------
Numerator: 1998 1997 1998 1997
---------- -------------- ------------ ------------
<S> <C> <C> <C> <C>
Net income $ 151 $197 $ 662 $462
Preferred stock dividends (12) (37) (75) (50)
------ ----- ------ -----
Numerator for basic and diluted earnings
per share - income available to common
stockholders $ 139 $160 $587 $412
==== ==== ==== ====
Denominator:
Denominator for basic earnings
per share - weighted-average shares 121 119 121 118
Effect of dilutive securities:
Employee stock options 3 2 3 2
Common stock equivalents 2 1 2 1
------- ------ ------ -----
Dilutive potential common shares 5 3 5 3
------- ------ ------ -----
Denominator for diluted
Earnings per share - adjusted
Weighted-average shares 126 122 126 121
===== ===== ===== =====
Basic earnings per share $1.15 $1.34 $4.86 $3.49
===== ===== ===== =====
Diluted earnings per share $1.10 $1.30 $4.67 $3.41
===== ===== ===== =====
</TABLE>
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Business Environment
The principal business activities of the Company are investment
banking and securities trading and sales, which by their nature are subject
to volatility, primarily due to changes in interest and foreign exchange
rates, and security valuations, global economic and political trends and
industry competition. As a result, the Company's revenues and earnings
may vary significantly from quarter to quarter and from year to year.
The generally favorable market and economic conditions that
characterized fiscal 1997 continued into the first eight months of the
Company's current fiscal year ("fiscal 1998"). During the first eight
months of fiscal 1998, investor demand in the worldwide debt and equity
markets remained strong led by continued growth in the U.S. economy and the
favorable interest-rate environment. The pace of underwriting for combined
fixed income and equity securities accelerated to record levels. The pace
of global merger and acquisition activity fueled financing of all types.
Investors were focused on worldwide market conditions, particularly with
respect to the potential effects of the Asian crisis, as well as any signs
of potential weakening in the U.S. economy.
Following this period of relative stability, the turmoil in various
emerging markets erupted in mid-August particularily with respect to Russia.
Events in Russia drove all emerging market bond yields sharply higher. As
investors sought safe havens, U.S. Treasury and European government bond
yields moved sharply lower while spreads on other fixed income products
widened. Ten-year U.S. Treasury yields fell by over 50 basis points (bp) to
just under 5%, while yields on ten-year German Bunds fell by just over 60bp
to 4.2%, both representing new global lows. The yields on bonds of lower
rated corporations also rose abruptly. Deleveraging and reduced risk-taking
disrupted the flow of funds throughout the financial markets and new
issuances of debt and equity securities slowed.
Since reaching record levels in the middle of July, the U.S. equity
market is in the midst of the most serious correction of the 1990's with
the S&P 500 index down almost 20% from its peak to the trough on August 31.
The marketplace continues to reflect concerns over the lingering Asian
economic troubles, which spread to Russia and threaten Latin America, as
well as political uncertainty in Washington. This increased risk aversion
has resulted in a reduction in the availability of credit and lower equity
prices. After providing an annual return of about 24% from the beginning of
the fiscal year to the July peak, equity returns have fallen to almost zero
for the first nine months of the fiscal year.
Over the nine months to August, European equities have returned 16% in
dollar terms alongside healthy trading volumes, although this overall
performance masks an extremely strong 40% gain for the FT/S&P European Index
through the July peak, followed by a 17% fall to the end of August. While
the bond environment was supportive throughout, the impact of the crisis
sweeping emerging markets, including Russia's devaluation and debt
restructuring, sparked a severe correction amid highly volatile market
conditions. Far Eastern and Latin American stock markets became the focus of
the turmoil and lost a substantial proportion of their value over this
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
period with total returns of minus 23% and 40% as measured by the FT/S&P
Pacific Basin Index and IFC Latin America Investable Index, respectively.
Worldwide underwriting volumes, which had been running at an
unprecedented rate for the first seven months of fiscal 1998, saw a
significant slowdown in the last two months of the third quarter. While
volumes for the entire year will be record setting, the Company is not
anticipating a return to the flow of issuance volume it experienced earlier
this year due to the extreme volatility in the credit markets. Similarly,
equity and equity-related underwriting activity has mirrored the market as a
whole, with record new issuance in the first eight months of fiscal year
1998 followed by significantly reduced activity as a result of less
favorable market conditions.
Corporate Finance Advisory activities continued at record levels during
the first nine months of fiscal 1998. Coming off a strong pace in 1997, the
volume of announced transactions during the first nine months of 1998
continued to reflect the trend of consolidation, deregulation and
globalization across industry sectors. However, as a direct result of global
market turmoil caused by economic uncertainties throughout the world, the
volume of announced transactions has recently slowed.
Although strong financial markets characterized the first eight months
of fiscal 1998, recent events have highlighted the cyclicality of the
financial services industry. The current adverse market conditions impact
competitors and counterparties throughout the industry to varying degrees,
including the Company and all aspects of the Company's activities.
Management is responding to the changes and risks inherent in this
environment by reducing the Company's risk exposure, shifting the mix of
its balance sheet and reducing certain positions.
Note:Except for the historical information contained herein, this Management's
Discussion and Analysis of Financial Condition and Results of Operations
contains forward-looking statements that are based on current expectations,
estimates and projections about the industries in which the Company
operates. These statements are not guarantees of future performance and
involve certain risks, uncertainties and assumptions which are difficult to
predict. The Company undertakes no obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Results of Operations
For the Three Months Ended August 31, 1998 and 1997
The Company reported net income of $151 million for the third quarter
ended August 31, 1998 representing a decrease of 23% from net income of $197
million for the third quarter ended August 31, 1997. The Company enjoyed
strong results during June and July across its businesses. However, results
in August were affected by several unfavorable economic factors, including
the impact of significant volatility in Russia and other emerging markets
and the related widening of spreads across U.S. and European core fixed
income markets. Earnings per common share (diluted) decreased to $1.10 for
the third quarter of 1998 from $1.30 for the third quarter of 1997. Included
in the 1997 earnings per common share computation was the recognition of $31
million in dividends on the Company's Redeemable Voting Preferred Stock.
American Express Company and Nippon Life Insurance Company are entitled to
receive an annual non-cumulative preferred dividend equal to 50 percent of
the amount by which the company's net income for the full fiscal year
exceeds $400 million, up to a maximum of $50 million per year, through 2002.
In 1998, the Redeemable Voting Preferred Stock dividend was recognized in
the second quarter, when the Company's year to date net income exceeded the
$400 million threshold.
Net revenues decreased to $930 million for the third quarter of 1998
from $1,071 million for the third quarter of 1997. The decrease in net
revenues from the third quarter of 1997 was driven by widening of spreads in
U.S. fixed income markets, trading and credit losses in Russia and other
emerging markets, the reduced contribution from risk arbitrage strategies,
and reduced customer flow activity during August in certain U.S. cash equity
products. This negative impact was mitigated by strong performances in the
advisory, debt and equity origination businesses and equity derivatives,
demonstrating the revenue diversity of the company.
Compensation and benefits expense as a percentage of net revenues was
50.7% for both fiscal 1998 and 1997, reflecting the fourteenth successive
quarter of consistent compensation levels relative to net revenues.
Nonpersonnel expenses were $251 million in the third quarter of fiscal 1998,
essentially unchanged from the $247 million in the third quarter of fiscal
1997. Decreased net revenues and unchanged expense levels led to a decline
in the Company's pretax operating margin to 22.3% in the third quarter of
fiscal 1998 from 26.2% in the third quarter of fiscal 1997.
The Company, through its subsidiaries, is a market-maker of equity and
fixed income products in major domestic and international markets. As part
of its market-making activities, the Company maintains inventory positions
of varying amounts across a broad range of financial instruments that are
marked-to-market on a daily basis and, along with the Company's proprietary
trading positions, give rise to principal transactions revenues. The Company
utilizes various hedging strategies to minimize its exposure to significant
movements in interest and foreign exchange rates and the equity markets.
Net revenues from the Company's market-making and trading activities in
fixed income and equity products are recognized as either principal
transactions or net interest revenues depending upon the method of financing
and/or hedging related to specific inventory positions. The Company
evaluates its trading strategies on an overall profitability basis which
includes both principal transactions revenues and net interest. Therefore,
changes in net interest should not be viewed in isolation but should be
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
viewed in conjunction with revenues from principal transactions. Principal
transactions and net interest revenues decreased 35% to $352 million in the
third quarter of 1998 from $545 million in the third quarter of 1997 as a
result of events described above. Net interest revenues increased as a
result of an increase in inventory, and a shift in the composition of the
Company's fixed income portfolio.
The following table of net revenues by business unit and the
accompanying discussion have been prepared in order to present the Company's
net revenues in a format that reflects the manner in which the Company
manages its businesses. For internal management purposes, the Company has
been segregated into four major business units: fixed income, equity,
corporate finance advisory, and merchant banking. Each business unit
represents a grouping of financial activities and products with similar
characteristics. These business activities result in revenues that are
recognized in multiple revenue categories contained in the Company's
Consolidated Statement of Income. Net revenues by business unit contain
certain internal allocations, including funding costs, which are centrally
managed.
Three Months Ended August 31, 1998
<TABLE>
<CAPTION>
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $301 $ 11 $181 $(79) $414
Equity 39 121 117 277
Corporate Finance Advisory (2) 155 153
Merchant Banking (11) 40 29
Other 25 5 27 57
- ---------------------------------------------------------------------------------------------------------------------------------
$352 $137 $493 $(52) $930
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Three Months Ended August 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $400 $ 8 $ 97 $ 5 $ 510
Equity 141 99 101 1 342
Corporate Finance Advisory (1) 81 80
Merchant Banking 117 117
Other 5 4 13 22
- ---------------------------------------------------------------------------------------------------------------------------------
$545 $111 $396 $19 $1,071
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Fixed Income. The Company's fixed income net revenues reflect customer
flow activities (both institutional and high-net-worth retail), secondary
trading, debt underwriting, syndicate and financing activities related to
fixed income products. Fixed income products include dollar- and non-dollar
government securities, mortgage- and asset-backed securities, money market
products, dollar- and non-dollar corporate debt securities, emerging market
securities, municipal securities, financing (global access to debt financing
sources including repurchase and reverse repurchase agreements), foreign
exchange and fixed income derivative products. Fixed income net revenues
decreased 19% to $414 million for the third quarter of 1998 from $510
million for the third quarter of 1997. Results in the third quarter of 1998
were negatively impacted by the widening of spreads in credit sensitive
fixed income products as a result of investors' "flight to quality" into
U.S. Treasury securities. This translated into lower revenues in mortgages,
emerging markets, high yield and high grade corporates partially offset by
strong results in fixed income derivatives, foreign exchange and municipals.
Also negatively affecting these results were market and credit losses
relating to the volatility in Russia and other emerging markets during
August which reduced revenues by approximately $165 million. Investment
banking revenues, as a component of fixed income revenues, increased to $181
million for the third quarter of 1998 from $97 million for the third quarter
of 1997 due to significantly increased underwriting fees.
Equity. Equity net revenues reflect customer flow activities (both
institutional and high-net-worth retail), secondary trading, equity
underwriting, equity finance, equity derivatives and equity arbitrage
activities. The Company's equity net revenues decreased 19% to $277 million
for the third quarter of 1998 from $342 million for the third quarter of
1997. Lower revenues resulted from reduced customer flow activity during
August in certain U.S. cash products and decreased revenues from risk
arbitrage activities due to the widening of spreads and the cancellation of
several anticipated mergers. Investment Banking revenues, as a component of
equity revenues, increased to $117 million for the third quarter of 1998
from $101 million for the third quarter of 1997 due to increased
underwriting volumes in U.S. listed and convertible securities.
Corporate Finance Advisory. Corporate finance advisory net revenues,
classified in the Consolidated Statement of Income as a component of
investment banking revenues, result primarily from fees earned by the
Company in its role as strategic advisor to its clients. This role consists
of advising clients on mergers and acquisitions, divestitures, leveraged
buyouts, financial restructurings, and a variety of cross-border
transactions. Net revenues from corporate finance advisory activities
increased to $153 million for the third quarter of 1998, reflecting a 91%
increase from the $80 million recognized in the third quarter of 1997. This
increase reflected the closing of several large transactions in the third
quarter of 1998.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Merchant Banking. The Company is the general partner for nine active
merchant banking partnerships. Current merchant banking investments held by
the partnerships include both publicly traded and privately held companies.
Merchant banking net revenues represent the Company's proportionate share of
net unrealized gains and losses from the revaluation of investments held by
the partnerships. Such amounts are classified in the Consolidated Statement
of Income as a component of investment banking revenues. Merchant banking
net revenues also reflect the net interest expense relating to the financing
of the Company's investment in the partnerships. Merchant banking net
revenues were $29 million for the third quarter of 1998 down from $117
million in the third quarter of 1997. Net revenues in the third quarter of
1997 reflects the realized gains on the sale of the Company's remaining
positions in certain publicly traded investments held by the partnerships.
Non-Interest Expenses. Non-interest expenses were $723 million for the
third quarter of 1998 and $790 million for the third quarter of 1997.
Compensation and benefits expense as a percentage of net revenues remained
unchanged from the prior year quarter at 50.7%. Nonpersonnel expenses were
$251 million in the third quarter of 1998 compared to $247 million in the
third quarter of 1997.
Income Taxes. The Company's income tax provision was $56 million for
the third quarter of 1998 compared to $84 million for the third quarter of
1997. The effective tax rate was 27% for the third quarter of 1998 and 30%
for the third quarter of 1997. The 1998 effective tax rate reflects a
reduction in state taxes and a higher level of tax benefits attributable to
income and transactions subject to preferential tax treatment, which are
further magnified in the effective rate due to a lower level of pretax
earnings for the quarter.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Results of Operations
For the Nine Months Ended August 31, 1998 and 1997
The Company reported net income of $662 million for the nine months
ended August 31, 1998, representing an increase of 43% from net income of
$462 million for the nine months ended August 31, 1997. Earnings per common
share (diluted) increased to $4.67 for the nine months of 1998 from $3.41
for the nine months of 1997. Included in the 1998 and 1997 earnings per
common share computation was the recognition of $50 million and $31 million,
respectively, in dividends on the Company's Redeemable Voting Preferred
Stock. American Express Company and Nippon Life Insurance Company are
entitled to receive an annual non-cumulative preferred dividend equal to 50
percent of the amount by which the company's net income for the full fiscal
year exceeds $400 million, up to a maximum of $50 million per year, through
2002.
Net revenues increased to $3,448 million for the nine months of 1998
from $2,850 million for the nine months of 1997. The increase in net
revenues for the nine months of 1998 resulted from strong performances in
the global merger and acquisition advisory, fixed income and equity
businesses.
Compensation and benefits expense as a percentage of net revenues was
50.7% for both the first nine months of 1998 and 1997. Nonpersonnel expenses
increased slightly to $741 million in the nine months of 1998 from $733
million in the nine months of 1997; however, nonpersonnel expenses declined
as a percentage of net revenues to 21.5% for the nine months of 1998 from
25.7% for the comparable period in 1997. Increased net revenues and
essentially unchanged expense levels led to an improvement in the
Company's pretax operating margin to 27.8% in the first nine months of 1998
from 23.6% in the first nine months of 1997.
Principal transactions and net interest revenues increased to $1,728
million for the nine months of 1998 from $1,568 million for the nine months
of 1997. Principal transactions revenues increased as favorable market
conditions characterized by low interest rates and low inflation supported
debt markets and helped to spur growth in the equity markets in both the
U.S. and Europe. Net interest revenues increased as a result of an increase
in inventory and a shift in the composition of the Company's fixed income
portfolio.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following table of net revenues by business unit and the
accompanying discussion have been prepared in order to present the Company's
net revenues in a format that reflects the manner in which the Company
manages its businesses. Net revenues by business unit contain certain
internal allocations, including funding costs, which are centrally managed.
<TABLE>
<CAPTION>
Nine Months Ended August 31, 1998
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $1,421 $ 28 $ 558 $ (74) $1,933
Equity 302 336 299 4 941
Corporate Finance Advisory (4) 355 351
Merchant Banking (17) 125 108
Other 26 14 (1) 76 115
- ---------------------------------------------------------------------------------------------------------------------------------
$1,728 $378 $1,336 $6 $3,448
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Nine Months Ended August 31, 1997
Principal
Transactions and Investment
Net Interest Commissions Banking Other Total
- ---------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Income $1,226 $ 28 $270 $13 $1,537
Equity 346 259 207 4 816
Corporate Finance Advisory (4) 231 227
Merchant Banking (8) 200 192
Other 8 12 2 56 78
- ---------------------------------------------------------------------------------------------------------------------------------
$1,568 $299 $910 $73 $2,850
- ---------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Fixed Income. Fixed income net revenues increased to $1,933 million for
the nine months of 1998 from $1,537 million for the nine months of 1997. The
increase in the nine months of 1998 versus the prior year nine months
reflected increased revenues from a number of fixed income products
including improved performance in both sales and trading and syndicate
activities in high yield corporates as well as increased contributions from
fixed income derivatives, foreign exchange and mortgages partially offset by
decreased results in emerging markets and governments. Investment banking
revenues, as a component of fixed income revenues, increased to $558 million
for the nine months of 1998 from $270 million for the nine months of 1997
due to increased underwriting fees, particularly in high yield corporates.
Equity. The Company's equity net revenues increased to $941 million for
the nine months of 1998 from $816 million for the nine months of 1997.
Higher revenues resulted from increased levels of customer flow activities
in U.S. listed securities, increased underwriting volumes and improved
contributions from equity derivatives. Investment banking revenues, as a
component of equity revenues, increased to $299 million for the nine months
of 1998 from $207 million for the nine months of 1997 due to increased
underwriting volumes in U.S. listed and convertible securities.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Corporate Finance Advisory. Net revenues from corporate finance advisory
activities increased to $351 million for the nine months of 1998 reflecting
a 55% increase from the $227 million recognized in the nine months of 1997.
This increase reflected improved market share and continued strength in the
overall merger and acquisition market environment. For completed M&A
transactions, Lehman has improved its worldwide ranking from #8 to #4,
increasing its market share from 6.5% to 15.4%, in part through
participation in 3 of the 5 largest deals in the first nine months of the
1998 calendar year based on data supplied by Securities Data Company.
Merchant Banking. Merchant banking net revenues were $108 million for
the nine months of 1998 and $192 million in the nine months of 1997. 1998
net revenues reflect the unrealized gains recognized on the publicly traded
investments as well as realized gains on the sales of other investments.
1997 net revenues reflect the realized gains on the sales of the
partnerships' interest in certain publicly traded investments.
Non-Interest Expenses. Non-interest expenses were $2,490 million for
the nine months of 1998 and $2,178 million for the nine months of 1997.
Compensation and benefits expense as a percentage of net revenues remained
unchanged from the comparable prior year period at 50.7%. Nonpersonnel
expenses increased slightly to $741 million in the nine months of 1998 from
$733 million in the nine months of 1997, however, nonpersonnel expenses
declined as a percentage of net revenues to 21.5% for the nine months of
1998 from 25.7% for the comparable period in 1997.
Income Taxes. The Company's income tax provision was $296 million for
the nine months of 1998 compared to $210 million for the nine months of
1997. The effective tax rate was 31% for the nine months of 1998 and 1997.
The 1998 effective tax rate, although the same as that of 1997, reflects a
higher level of tax benefits attributable to income and transactions subject
to preferential tax treatment, which are minimized by a higher level of
pretax earnings for the year.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Liquidity and Capital Resources
Overview
As a leading global investment bank that actively participates in the global
capital markets, the Company has large and diverse capital requirements.
Many of the businesses in which the Company operates are capital intensive.
Capital is required to finance, among other things, the portion of the
Company's securities inventories not funded on a secured basis, merchant
banking activities and investments in fixed assets. The Company's primary
activities are based on the execution of customer-related transactions. This
flow of customer business supports the rapid asset turnover rate of the
Company's inventory.
The Company's balance sheet consists primarily of cash and cash
equivalents, securities and other financial instruments owned, and
collateralized short-term financing agreements. The liquid nature of these
assets provides the Company with flexibility in financing and managing its
business. The vast majority of these assets are funded on a secured basis
through collateralized short-term financing agreements with the remaining
assets being funded through unsecured financing and capital.
The Company's total assets increased to $191.1 billion at August 31, 1998
from $151.7 billion at November 30, 1997, reflecting an increase in secured
customer financing activities and the expansion of certain higher margin
business lines in strategic growth areas (i.e., equity derivatives and
mortgages).
Funding and Capital Policies
The Company's Finance Committee is responsible for establishing and managing
the funding and liquidity policies of the Company. These policies include
recommendations for capital and balance sheet size as well as the allocation
of capital and balance sheet to product areas. Members of the Company's
treasury department and business unit financing groups work with the Finance
Committee to ensure coordination of global funding efforts and
implementation of the funding and liquidity policies. Regional asset and
liability committees, aligned with the Company's geographic funding centers,
are responsible for implementing funding strategies for their respective
regions.
The primary goal of the Company's funding policies is to provide sufficient
liquidity and availability of funding sources to meet the needs of the
Company's businesses. The key elements of these policies are to:
(1) Maintain a Total Capital structure that supports the business
activities in which the Company is engaged. Total Capital is defined as
long-term debt, preferred stock and common stockholders' equity.
(2) Minimize liquidity and refinancing risk by funding the Company's assets
primarily on a secured basis.
(3) Obtain diversified funding through a global investor base which
increases liquidity and reduces concentration risk.
(4) Maintain funding availability in excess of actual utilization.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
(5) Maintain sufficient financial resources to enable the Company to meet
its obligations in periods of financial stress through a
combination of collaterized short term financings and Total Capital,
as well as the implementation of a contingency funding plan.
Short-Term Funding
The Company strives to maximize the portion of the Company's balance sheet
that is funded through collateralized borrowing sources, which in turn
minimizes the reliance placed upon unsecured short-term debt. Collateralized
borrowing sources include cash market securities and other financial
instruments sold but not yet purchased, as well as collateralized short-term
financings, defined as securities sold under agreements to repurchase
("repos") and securities loaned. Because of their secured nature, OECD
government repos and other investment grade types of collateralized
borrowings are less credit-sensitive and have historically been a stable
financing source irrespective of market conditions.
The amount of the Company's collateralized borrowing activities will vary
reflecting changes in the mix and overall levels of securities and other
financial instruments owned which are driven by strategic business
objectives and global market conditions. The majority of the Company's
assets are funded with collateralized borrowing sources. At August 31, 1998
and November 30, 1997, $116 billion and $94 billion, respectively, of the
Company's total balance sheet of $191 billion and $151 billion at August 31,
1998 and November 30, 1997, respectively, were financed using collateralized
borrowing sources.
As of August 31, 1998 and November 30, 1997, commercial paper and short-term
debt outstanding were $12.7 billion and $7.8 billion, respectively. At
October 9, 1998, commercial paper and short-term debt outstanding was $10.6
billion. Of this amount, commercial paper outstanding was $6.4 billion with
an average maturity of 74 days.
Holdings maintains a Revolving Credit Agreement (the "Credit Agreement")
with a syndicate of banks. Under the terms of the Credit Agreement, the
banks have committed to provide up to $2 billion for up to 364 days. Any
loans outstanding on the commitment termination date may be extended for up
to an additional year at the option of Holdings. The Credit Agreement
contains covenants which require, among other things, that the Company
maintain specified levels of liquidity and tangible net worth, as defined.
In July 1998, the Company entered into a new $1 billion Committed Securities
Repurchase Facility (the "Facility") for LBIE, the Company's major operating
entity in Europe. The Facility provides secured multi-currency financing for
a broader range of collateral types than LBIE's previous committed secured
credit facility. Under the terms of the Facility, the bank group will agree
to provide funding for up to one year on a secured basis. Any loans
outstanding on the commitment termination date may be extended for up to an
additional year at the option of Holdings.
There have been no borrowings outstanding under either the Credit Agreement
or the Facility. The Company may use the Credit Agreement and the Facility
for general corporate purposes from time to time. The Company has maintained
compliance with the applicable covenants for both the Credit Agreement and
the Facility at all times.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Total Capital
As part of the Company's liquidity plan, the Company increased its Total
Capital base in 1998 to $33.7 billion at August 31, 1998 from $24.8 billion
at November 30, 1997 primarily due to an increase in long-term debt and the
retention of earnings.
August 31 November 30
(in millions) 1998 1997
- -------------------------------------------------------------+-----------------
Long-term Debt
Senior Notes $24,711 $17,049
Subordinated Indebtedness 3,670 3,212
------- -------
28,381 20,261
Stockholders' Equity
Preferred Equity 958 508
Common Equity 4,391 4,015
------ -------
5,349 4,523
- -------------------------------------------------------------------------------
Total Capital $33,730 $24,784
- -------------------------------------------------------------------------------
During the first nine months of 1998, the Company issued $10.6 billion in
long-term debt, which was $8.2 billion in excess of its maturing debt.
Long-term debt increased to $28.4 billion at August 31, 1998 from $20.3
billion at November 30, 1997 with a weighted average maturity of 3.7 years
at August 31, 1998 and 4.1 years at November 30, 1997.
On September 23, 1998, the Board of Directors authorized the repurchase of
up to an additional 7.5 million shares of Holdings common stock, as part of
the Company's program to actively manage its capital position and common
shares outstanding. Earlier this year the Board authorized, and the Company
has since completed, the repurchase of 4.5 million shares.
Capital Resources and Capital Adequacy
Balance sheet leverage ratios are one measure used to evaluate the capital
adequacy of a company. Leverage ratios are commonly calculated using either
total assets or adjusted total assets divided by total stockholders' equity.
The Company believes that the adjusted leverage ratio, rather than the gross
leverage ratio, is a more effective measure of financial risk when comparing
companies in the securities industry. Adjusted total assets represent total
assets less the lower of securities purchased under agreements to resell or
securities sold under agreements to repurchase.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Due to the nature of the Company's sales and trading activities, the overall
size of the Company's assets and liabilities fluctuates from time to time
and at specific points in time may be higher than the fiscal quarter ends or
the quarterly average. The Company's average gross leverage ratio and
average adjusted leverage ratio for the quarter ended August 31, 1998 were
38.4x and 26.3x, respectively and for the quarter ended November 30, 1997
were 38.5x and 25.9x, respectively.
[OBJECT OMITTED]
[OBJECT OMITTED]
In early 1997, the Company implemented a business performance measurement
system. This system is a management reporting tool which charges for capital
utilization across the Company's products. It provides detailed
profitability and return on equity information for each of the Company's
lines of business. The results of charging each of the respective businesses
for its capital utilization are that businesses optimize their use of
balance sheet and capital resources, resulting in an improved return on
assets and overall decreased levels of both quarterly average gross and
adjusted leverage.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Credit Ratings
The Company, like other companies in the securities industry, relies on
external sources to finance a significant portion of its day-to-day
operations. The Company's access to and cost of funding is generally
dependent upon its short- and long- term debt ratings. In September 1998,
Moody's reaffirmed the "stable" long-term debt ratings of Holdings and
changed its outlook on the Company from positive to stable. Also in
September, Standard & Poor's, as part of its change in outlook for firms
throughout the securities industry, put the Company's debt rating on Credit
Watch with negative implications. As of August 31, 1998, the short- and
long-term senior debt ratings of Holdings and LBI were as follows:
Holdings LBI
-------- ---
Short-term Long-term Short-term Long-term**
- -------------------------------------------------------------------------------
Duff & Phelps Credit Rating Co. D-1 A D-1 A/A-
Fitch IBCA, Inc. F-1 A F-1 A/A-
Moody's P2 Baa1 P2 A3*/Baa1
S&P A-1 A A-1 A+*/A
Thomson BankWatch TBW-1 A TBW-1 A+/A
* Provisional ratings on shelf registration
** Senior/subordinated
Insurance Subsidiary
The Company has established a new subsidiary to underwrite and accumulate
insurance and reinsurance risks. The new subsidiary, Lehman Re Ltd., is a
Bermuda licensed Class 4 and Long-Term insurance company and is expected to
operate with capital of $500 million. Lehman Re Ltd. intends to underwrite
property and casualty, as well as life and annuity insurance risks. It
expects to focus its business initially in four areas: finite and structured
financial products; political risk and trade credit insurance; property
catastrophe reinsurance; and life and annuity reinsurance.
Lehman Brothers Derivative Products
On July 16, 1998, the Company announced that it had established a special
purpose subsidiary that will provide counterparties around the world with a
wide variety of derivative products and services. The new company, Lehman
Brothers Derivative Products Inc. ("LBDP") has been assigned Aaa and AAAt
credit ratings by Moody's Investor Services Inc. and Standard & Poor's
Corporation, respectively. LBDP was created to provide clients with the most
efficient delivery of a broad range of derivative product opportunities. Its
termination structure compliments the continuation structure of LBFP.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
High Yield Securities
The Company underwrites, trades, invests and makes markets in high yield
corporate debt securities. The Company also syndicates, trades and invests
in loans to below investment grade-rated companies. For purposes of this
discussion, high yield debt securities are defined as securities or loans to
companies rated BB+ or lower, or equivalent ratings by recognized credit
rating agencies, as well as non-rated securities or loans which, in the
opinion of management, are non-investment grade. The definition excludes
sovereign debt. Non-investment grade securities generally involve greater
risks than investment grade securities due to the issuer's creditworthiness
and the liquidity of the market for such securities. In addition, these
issuers have higher levels of indebtedness, resulting in an increased
sensitivity to adverse economic conditions. The Company recognizes these
risks and aims to reduce market and credit risk through the diversification
of its products and counterparties. High yield debt securities are carried
at market value, and unrealized gains or losses for these securities are
reflected in the Company's Consolidated Statement of Income. The Company's
portfolio of such securities at August 31, 1998 and November 30, 1997
included long positions with an aggregate market value of approximately $2.9
billion and $3.2 billion, respectively, and short positions with an
aggregate market value of approximately $506 million and $172 million,
respectively. The portfolio may, from time to time, contain concentrated
holdings of selected issues. The Company may also, from time to time,
mitigate its net exposure to any single issuer through the use of
derivatives and other financial instruments. At August 31, 1998, the Company
had no single net exposure to an issuer of high yield securities or loans
greater than $110 million.
Lending Activities
The Company, through its high yield sales and trading activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and participates a significant portion of
these commitments. These commitments, which are net of syndications and
participations, totaled $2.8 billion at August 31, 1998, are typically
secured against the borrower's assets and have fixed maturity dates. The
utilization of these facilities is generally contingent upon certain
representations, warranties and contractual conditions of the borrower.
Total commitments may not be indicative of actual funding requirements as
the Company intends to continue syndicating, selling, and/or participating
these commitments.
In addition, the Company had lending commitments to high grade borrowers of
$474 million at August 31, 1998. These commitments are typically secured
against the borrower's assets, have fixed maturity dates, and are generally
contingent upon certain representations, warranties and contractual
conditions of the borrower.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Merchant Banking and Related Lending Activities
The Company's merchant banking activities include investments in nine
partnerships, for which the Company acts as general partner, as well as
direct investments. At August 31, 1998, the investment in merchant banking
partnerships was $170 million and direct investments were $157 million. The
Company's policy is to carry its investments, including its partnership
interests, at fair value based upon the Company's assessment of the
underlying investments.
The Company has commitments to invest up to $353 million in the
partnerships, which in turn will make direct merchant banking related
investments. These commitments will be funded as required through the end of
the respective partnerships' investment periods, principally expiring in
2004.
In June 1998, the Company, together with a consortium of other financial
services companies, sponsored a $5 billion interim loan fund, designed to
extend financing to clients in connection with a wide range of domestic and
international leveraged transactions, including acquisitions, corporate
recapitalizations and refinancings of existing debt. In connection
therewith, the Company intends to provide up to $400 million to be used by
the fund. Any drawdowns under the facility are expected to be repaid within
a short-term period. At August 31, 1998, the fund had no outstanding loans.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Risk Management
As a leading global investment banking company, risk is an inherent part of
the Company's businesses. Global markets, by their nature, are prone to
uncertainty and subject participants to a variety of risks. The Company has
developed policies and procedures to identify, measure and monitor each of
the risks involved in its trading, brokerage and investment banking
activities on a global basis. The principal risks of Lehman Brothers are
market, credit, liquidity, legal and operational risks. Risk management is
considered to be of paramount importance. The Company devotes significant
resources across all of its worldwide trading operations to the measurement,
management and analysis of risk, including investments in personnel,
information technology infrastructure and systems.
Market Risk
Market risk represents the potential change in value of a portfolio of
financial instruments due to changes in market rates, prices, and
volatilities. Market risk is present in cash products, derivatives, and
contingent claim structures that exhibit linear as well as non-linear profit
and loss sensitivity. The Company's exposure to market risk varies in
accordance with the volume of client driven market-making transactions, the
size of the Company's proprietary and arbitrage positions, and the
volatility of financial instruments traded. The Company seeks to mitigate,
whenever possible, excess market risk exposures through the use of futures
and option contracts and offsetting cash market instruments.
The Company participates globally in interest rate, equity, and foreign
exchange markets. The Company's fixed income division has a broadly
diversified market presence in U.S. and foreign government bond trading,
emerging market securities, corporate debt (investment and non-investment
grade), money market instruments, mortgages and mortgage-backed securities,
asset-backed securities, municipal bonds, and interest rate derivatives. The
Company's equity division facilitates domestic and foreign trading in equity
instruments, indices, and related derivatives. The Company's foreign
exchange businesses are involved in trading currencies on a spot and forward
basis as well as through derivative products and contracts.
Value at Risk
For purposes of Securities and Exchange Commission disclosure requirements,
the Company has elected to disclose an entity-wide value at risk analysis of
virtually all of the Company's trading activities. The value at risk related
to non-trading financial instruments has been excluded from this analysis
and not reported separately because the amounts were not material. The value
at risk calculation measures potential losses in expected revenues and is
based on a methodology which uses a one-day holding period and a 95%
confidence level. Value at risk as of each date presented below was measured
by analyzing the distribution of actual trading revenues during the
preceding one year period and assumed a relatively consistent portfolio mix.
Value at risk is one measurement of potential losses in revenues that may
result from adverse market movements over a specified period of time with a
selected likelihood of occurrence. Value at risk has substantial
limitations, including its reliance on historical performance and data as
valid predictors of the future. Consequently, value at risk is only one of a
number of tools the Company utilizes in its daily risk management
activities.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The Company's value at risk for each component of market risk,
and in total was as follows (in millions):
August 31, 1998 November 30, 1997
--------------- -----------------
Interest rate risk $18.5 $12.2
Equity price risk 15.3 7.1
Foreign exchange risk 2.4 4.5
Diversification benefit (12.9) (9.0)
------ ----
Total Company $23.3 $14.8
===== =====
Value at risk increased at August 31, 1998 because of dramatic increases
in volatility across a broad spectrum of asset classes.
On October 5, 1998, the Company issued a press release disclosing its
exposures to hedge funds and emerging markets.
Hedge Fund Exposures. The Company's exposure to hedge funds arises when the
Company has mark-to-market gains on transactions with these counterparties.
This exposure is offset by the value of collateral held against those gains.
The Company was over-collateralized across its overall business with hedge
funds. The Company held $583 million of collateral, primarily in the form of
cash, U.S. Treasuries and U.S. agency securities, against total credit
exposure to active hedge fund counterparties of $447 million on a
mark-to-market basis across all products. The Company has adequately
reserved for credit exposures to inactive hedge funds. Within its overall
portfolio, the Company may have small uncollateralized exposures to reduce
the frequency of small transfers of funds and facilitate operational
efficiency. The Company's total uncollateralized exposure to active hedge
funds was $72 million across 54 counterparties. The Company's largest single
active hedge fund credit exposure was $10 million. The Company's gross
mark-to-market exposure to Long-Term Capital Management was $32 million
which is over-collateralized with $41 million of U.S. Treasuries. In
connection with the recapitalization of Long Term Capital by a consortium of
financial institutions, the Company made an equity investment of $100
million.
The Company manages these fund relationships closely and mark-to-market
exposures and collateral are reviewed on a daily basis.
Emerging Markets Exposures. The Company carries positions in emerging market
securities primarily to meet the needs of its customers and clients. The
Company's total net emerging markets position on a mark-to-market basis
amounted to $305 million, inclusive of hedges. The composition of this net
emerging market position was $49 million from Asian countries, $99 million
from European emerging markets and $157 million from Latin America.
The Company also conducts business with counterparties in emerging markets
countries. Across its entire client base and all products, the Company held
collateral of $266 million, primarily in the form of cash, U.S. Treasuries
and U.S. agency securities, against its mark-to-market exposure to emerging
market counterparties of $337 million. Within this overall portfolio, the
Company had a net credit exposure to
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
66 counterparties, totaling $164 million. This exposure was spread across 34
different countries. The Company's largest net credit exposure to any one
counterparty was $25 million. In any one country, the Company's largest
total exposure to all counterparties combined was $33 million.
All exposures are monitored actively, and are consistent with the Company's
risk limits and are included in the Company's credit reserve calculation.
The Company utilizes a wide variety of market risk management methods,
including stress and scenario analysis, limits for each trading activity;
marking all positions to market on a daily basis; daily profit and loss
analyses; position reports; aged inventory position analyses; and
independent verification of all inventory pricing. The Company believes that
these procedures, which stress timely communication between the risk and
trading areas and senior management, are critical elements of the risk
management process.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Impact of EMU
As of January 1, 1999, 11 European countries will enter into the European
economic and monetary union ("EMU") and replace their local currencies with
a single currency, the Euro. During a three-year transition period, the
national currencies will continue to circulate but only as fixed
denominations of the Euro. Commencing on January 1, 1999, the settlement of
non-cash transactions previously denominated in the participating national
currencies will predominately be effected in Euros.
To date, the Council of Ministers of the European Union has approved the
following states for entry into EMU: Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.
In order to have all areas of the Company prepared for EMU before the
scheduled start date of January 1, 1999, the Company has implemented a
worldwide EMU conversion and testing plan. A full-time team has been
assigned to assess the impact on the Company's global infrastructure and to
perform all required systems changes. The Company has also been reviewing
and planning for the impact of the conversion in its various business areas.
The Company has completed the analysis, design, and build phases of the
conversion and will focus on testing throughout the next several months. In
addition, the Company will be directing its efforts toward the detailed
planning of the conversion weekend (December 31, 1998 to January 3, 1999).
The Company's plan is currently on schedule, and integrated systems testing
has commenced.
Dress rehearsals of the conversion weekend are planned. These rehearsals
will simulate the actual conversion weekend as closely as possible. High
volume tests are being run with production volumes to ensure that systems
can handle the conversion volume within acceptable time-frames. The
Company's test programs are designed to establish its ability to process all
transactions in the new environment. The Company is also participating in
industry testing where practicable, as organized by regulatory and market
agencies.
Many areas of the Company will be affected by the introduction of the single
currency. As with the Year 2000 issue, EMU poses various operating risks.
EMU will require many changes to the Company's operations and technology,
including currency conversions, modifications of trading payment and
settlement systems, and the redenomination of securities. This will require
the conversion of exceptionally large amounts of data in the Company's
systems
The Company has incurred and expects to continue to incur expenses for the
internal technology and operations staff, as well as costs for outside
consultants, in order to implement its EMU conversion plan. Management
currently estimates that the cost of its EMU conversion program will be
approximately $30 million, of which $12 million has been incurred to date
and expensed.
The changes to the Company's data and computer systems will affect its
clearance, settlement and financial reporting activities, along with other
key operations of the Company. If not properly implemented, these changes
could lead to failed settlements, inability to reconcile trading positions
and funding disruptions. In addition, the Company is dependent for proper
transactions clearance and reporting on many third parties, including
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
counterparties, clearing agents, banks, exchanges, clearing houses and
providers of information. Errors arising in the Company's or third parties'
systems could also lead to erroneous entries in the Company's books and
records. These events could result in misstatement of the Company's
financial condition and results of operations, could impair its ability to
manage its risks, and result in a material loss, regulatory actions,
reputational harm and legal liability.
While convergence to the Euro has reduced client demand for certain
transactions, which has impacted the Company's foreign exchange and fixed
income activities in Europe, the Company anticipates that new opportunities
in Europe will be created through an expansion of activities in mergers and
acquisitions, investment grade and high yield debt capital markets, and
equity issuance and asset allocation. Overall, management anticipates that
implementation of EMU will not, by itself, materially affect the financial
results of the Company in an adverse manner.
Although all key suppliers have committed that they will be Euro compliant,
the Company can give no assurance that third parties on whom it depends,
will have the systems necessary to process Euro-denominated transactions.
Moreover, disruption in the activity in the European markets because of the
conversion to the Euro could hurt the Company's businesses in those markets,
resulting in lost revenues and increased costs. Management cannot predict
the magnitude of any such reduction or its impact on the Company's financial
results.
As part of the conversion process, the Company is establishing detailed
contingency plans. The contingency plans will provide mechanisms to assess
and communicate the impact of any delays. These plans also address likely
problems in the aftermath of conversion with a view to maximizing the
Company's ability to avoid disruption.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Impact of the Year 2000
The Year 2000 issue is the result of many computer programs and imbedded
chips being written using two digits rather than four to define the
applicable year. Many of the Company's computer programs that have
date-sensitive software may recognize a date using "00"as the year 1900
rather than the year 2000.
If not addressed and completed on a timely basis, failure of the Company's
computer systems to process Year 2000 related data correctly could have a
material adverse effect. Failures of this kind could, for example, lead to
incomplete or inaccurate accounting, settlement failures, trade processing
or recording errors in securities, currencies, commodities or other assets.
It could also lead to uncertainty regarding risk, exposures and liquidity.
If not addressed, the potential risks to the Company include financial loss,
legal liability, interruption to business and regulatory actions.
The Company established a team in 1996 to modify or replace and then test
the appropriate software and equipment to ensure that Year 2000 issues are
addressed. The Company presently believes that with modifications to
existing software and conversions to new software, the Year 2000 issue will
be resolved for all the Company's own systems worldwide.
However, even if these changes are successful, the Company remains at risk
from Year 2000 failures caused by third parties. The Company has therefore
initiated efforts with key counterparties, exchanges, agencies, utilities
and suppliers, among others, to assess and wherever possible remediate Year
2000 issues. To date, the Company has not received sufficient information
from certain vendors and international markets to complete its assessment of
Year 2000 awareness.
Examples of problems that could result from the failure by third parties
with whom the Company interacts to remediate Year 2000 bugs include: (i) in
the case of exchanges and clearing agents, funding disruptions, failure to
trade in certain markets and settlement failures; (ii) in the case of
counterparties and clients, accounting and financial difficulties to those
parties that may expose the Company to increased credit risk and lost
business; (iii) in the case of vendors, service failures such as power,
telecommunications, elevator operations and loss of security access control;
(iv) in the case of banks and other lenders, the potential for liquidity
stress due to disruptions in funding flows; and, (v) in the case of data
providers, inaccurate or out of date information that would impair the
Company's ability to perform critical functions such as pricing securities
and currencies. Additionally, general uncertainty regarding the success of
remediation may cause many market participants to reduce their market
activities temporarily as they address and assess their Year 2000 efforts in
1999. This could result in a general reduction in market activities and
revenue opportunities in late 1999 and early 2000. Management cannot predict
the magnitude of any such reduction or its impact on the Company's financial
results. However, the Company's Risk Management Department has undertaken a
comprehensive review of third party and credit risks posed by Year 2000.
Additionally, recognizing the uncertainty of external dependencies, the
Company is preparing a contingency plan that identifies potential problems,
actions to minimize the likelihood of their occurrence and action plans to
be invoked should they occur. These plans will include backup processes that
do not rely on computer systems, where appropriate.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The Company has taken a lead in industry efforts to deal with the Year 2000
issue by actively participating, and in some cases leading, industry-wide
testing in 1998 and 1999. The Company has already successfully participated
in a July industry-wide Beta test conducted by the Securities Industry
Association. This industry-wide testing is the forum in which firms within
the financial industry test the applications that transfer data between
them. However, as stated above, there can be no guarantee or assurance that
the systems of other companies on which the Company's systems rely will be
timely converted in a timely fashion, or that a failure to convert by
another company, or a conversion that is incompatible with the Company's
systems, would not have a material adverse effect on the Company.
The Company plans to complete the Year 2000 project, including industry-wide
testing, no later than August 1999. The Company has established an internal
auditing plan to record results and ensures ongoing compliance of tested
applications. It should be noted that efforts focused on addressing EMU have
delayed the finalization of internal and industry-wide testing in Europe.
The Company's total Year 2000 project cost is based on presently available
information. The total remaining cost of the Year 2000 project is estimated
at approximately $38 million which will be funded through operating cash
flows and expensed as incurred over the next one and one-half years. The
Company has incurred and expensed approximately $16 million in 1997, and
$22.5 million through August 31, 1998, related to the Year 2000 project.
The costs of Year 2000 testing, modifications and/or replacements and the
date on which the Company plans to complete the project are based on
management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors.
<PAGE>
LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1 Legal Proceedings
Lehman Brothers is involved in a number of judicial, regulatory and
arbitration proceedings concerning matters arising in connection with the
conduct of its business. Such proceedings include actions brought against
LBI and others with respect to transactions in which LBI acted as an
underwriter or financial advisor, actions arising out of LBI's activities
as a broker or dealer in securities and commodities and actions brought on
behalf of various classes of claimants against many securities and
commodities firms of which LBI is one.
Although there can be no assurance as to the ultimate outcome, Lehman
Brothers has denied, or believes it has meritorious defenses and will
deny, liability in all significant cases pending against it including the
matters described below, and intends to defend vigorously each such case.
Although there can be no assurance as to the ultimate outcome, based on
information currently available and established reserves, the Company
believes that the eventual outcome of the actions against it, including
the matters described below, will not, in the aggregate, have a material
adverse effect on its business or consolidated financial condition.
Actions Relating to First Capital Holdings Inc. (Reported in Holdings'
Annual Report on Form 10-K and First and Second Quarter Reports on Form
10-Q)
The Virginia Commissioner of Insurance Action. On July 7, 1998, the
Commissioner filed a Notice of Appeal to the United States Court of
Appeals for the Fourth Circuit from the Order filed on May 21, 1998.
Actions relating to National Association of Securities Dealers Automated
Quotations System ("NASDAQ") Market Maker Antitrust and Securities
Litigation. The Stipulation and Order were approved by the United States
District Court for the Southern District of New York, which decision has
been affirmed on appeal by the Second Circuit Court of Appeals.
AIA Holding SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co.,
Inc. (Reported in Holdings' Annual Report on Form 10-K and First and
Second Quarter Reports on Form 10-Q). The plaintiffs filed a First
Amended Complaint on July 3, 1998 which LBI answered on August 12, 1998.
Discovery is proceeding
Actions relating to Sales and Marketing of Limited Partnerships
Klein, et al. v. Lehman Brothers Inc., et al. (Reported in
Holdings' Annual Report on Form 10-K) On September 24, 1998,
the Court filed an opinion dismissing the complaint.
<PAGE>
ITEM 5 Other Information
Pursuant to the Securities and Exchange Commission Proxy Rule 14a-8,
Stockholder proposals intended to be presented at the Company's 1999
annual meeting of stockholders must be delivered to the Secretary of the
Company, 3 World Financial Center, 24th Floor, New York, New York 10285 on
or before October 23, 1998, in order to be included in the proxy statement
and proxy card relating to that meeting.
ITEM 6 Exhibits and Reports on Form 8-K
The following exhibits and reports on Form 8-K are filed as part of this
Quarterly Report, or where indicated, were heretofore filed and are hereby
incorporated by reference:
(a)Exhibits:
11 Computation of Per Share Earnings
12.1 Computation in Support of Ratio of Earnings to Fixed Charges
12.2 Computation in Support of Ratio of Earnings to Combined Fixed
Charges and Preferred Dividends
27 Financial Data Schedule
(b) Reports on Form 8-K:
1. Form 8-K dated September 3, 1998, Item 5 and 7.
2. Form 8-K dated September 23, 1998, Item 5 and 7.
3. Form 8-K dated September 25, 1998, Item 5 and 7.
4. Form 8-K dated October 5, 1998, Item 5 and 7.
<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 HOLDINGS INC.
(Registrant)
Date: October 15, 1998 By /s/ John Cecil
-----------------------
Chief Financial and
Administrative Officer
(Principal Financial Officer)
<PAGE>
EXHIBIT INDEX
Exhibit No. Exhibit
Exhibit 11 Computation of Per Share Earnings
Exhibit 12.1 Computation in Support of Ratio of Earnings to Fixed Charges
Exhibit 12.2 Computation in Support of Ratio of Earnings to Combined
Fixed Charges and Preferred Dividends
Exhibit 27 Financial Data Schedule
<PAGE>
Exhibit 11
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
COMPUTATION of PER SHARE EARNINGS
(Unaudited)
(In millions, except share data)
<TABLE>
<CAPTION>
Three months Nine months
Ended Ended
August 31 August 31
--------------------------------------------------------------------------
1998 1997 1998 1997
---------------- ---------------- ----------------- -----------------
Numerator:
<S> <C> <C> <C> <C>
Net income $151 $197 $662 $462
Preferred stock dividends (12) (37) (75) (50)
---------------- ---------------- -------------- -----------------
Numerator for basic and diluted
earnings per share - income
available to common stockholders $139 $160 $587 $412
================ ================ =============== =================
Denominator:
Denominator for basic earnings
per share - weighted-average
shares 121,523,227 118,722,434 120,908,771 117,901,989
Effect of dilutive securities
Employee stock options 2,609,299 2,458,397 2,881,356 1,867,283
Common stock equivalents 2,089,957 1,182,397 1,960,663 858,362
---------------- --------------- ---------------- -----------------
Dilutive potential common shares 4,699,256 3,640,794 4,842,019 2,725,645
---------------- --------------- ----------------- ----------------
Denominator for diluted
earnings per share - adjusted
weighted-average shares 126,222,483 122,363,228 125,750,790 120,627,634
================ ============== ================== ==================
Basic earnings per share $1.15 $1.34 $4.86 $3.49
================ ============== ================== ==================
Diluted earnings per share $1.10 $1.30 $4.67 $3.41
================ ============== ================== ==================
</TABLE>
<PAGE>
Exhibit 12.1
LEHMAN BROTHERS HOLDINGS 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 $ 144 $ 158 $ 206 $ 220 $ 240 $ 184
Bank loans and other
borrowings* 5,224 6,294 10,199 10,596 12,770 12,465
Interest component of rentals
of office and equipment 76 42 44 34 32 24
Other adjustments** 7 4 28 16 9 15
--------- --------- --------- --------- ----------- ---------
TOTAL (A) $5,451 $6,498 $10,477 $10,866 $13,051 $12,688
====== ========= ======== ======= ======== =======
Earnings:
Pretax income (loss) from
continuing operations $ 27 $ 193 $ 369 $ 637 $ 937 $ 958
Fixed charges 5,451 6,498 10,477 10,866 13,051 12,688
Other adjustments*** (6) (4) (28) (14) (8) (14)
-------------------- --- --- ---- ---- --- ----
TOTAL (B) $5,472 $6,687 $10,818 $11,489 $13,980 $13,632
====== ====== ======= ======= ======= =======
(B / A) 1.00 1.03 1.03 1.06 1.07 1.07
</TABLE>
* Includes amortization of long-term debt discount.
** Other adjustments include capitalized interest and debt issuance costs
and amortization of capitalized interest.
*** Other adjustments include adding the net loss of affiliates accounted
for at equity whose debt is not guaranteed by the Company and
subtracting capitalized interest and debt issuance costs and
undistributed net income of affiliates accounted for at equity.
<PAGE>
Exhibit 12.2
LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES
COMPUTATION in SUPPORT of RATIO of EARNINGS to COMBINED
FIXED CHARGES and PREFERRED DIVIDENDS
(Dollars in millions)
(Unaudited)
<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
---- ---- ---- ---- ---- ----
Combined Fixed Charges
and Preferred Dividends:
Interest expense:
<S> <C> <C> <C> <C> <C> <C>
Subordinated indebtedness $ 144 $ 158 $ 206 $ 220 $ 240 $ 184
Bank loans and other
borrowings* 5,224 6,294 10,199 10,596 12,770 12,465
Interest component of rentals
of office and equipment 76 42 44 34 32 24
Other adjustments** 7 4 28 16 9 15
--------- --------- --------- --------- ----------- --------
Total fixed charges 5,451 6,498 10,477 10,866 13,051 12,688
Preferred dividends (tax
equivalent basis) 48 58 64 58 109 110
-------- -------- --------- --------- -------- ---------
TOTAL (A) $5,499 $6,556 $10,541 $10,924 $13,160 $12,798
====== ====== ======= ======= ======= =======
Earnings:
Pretax income (loss) from
continuing operations $ 27 $ 193 $ 369 $ 637 $ 937 $ 958
Fixed charges 5,451 6,498 10,477 10,866 13,051 12,688
Other adjustments*** (6) (4) (28) (14) (8) (14)
-------------------- --- --- ---- ---- --- -------
TOTAL (B) $5,472 $6,687 $10,818 $11,489 $13,980 $13,632
====== ====== ======= ======= ======= =======
(B / A) **** 1.02 1.03 1.05 1.06 1.07
</TABLE>
* Includes amortization of long-term debt discount.
** Other adjustments include capitalized interest and debt issuance costs
and amortization of capitalized interest.
*** Other adjustments include adding the net loss of affiliates accounted
for at equity whose debt is not guaranteed by the Company and
subtracting capitalized interest and debt issuance costs and
undistributed net income of affiliates accounted for at equity.
**** Earnings were inadequate to cover fixed charges and preferred
dividends and would have had to increase $27 million in 1993 in order
to cover the deficiency.
<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-01-1997
<PERIOD-END> AUG-31-1998
<CASH> 6,337
<RECEIVABLES> 13,235
<SECURITIES-RESALE> 57,287
<SECURITIES-BORROWED> 21,815
<INSTRUMENTS-OWNED> 90,709
<PP&E> 483
<TOTAL-ASSETS> 191,074
<SHORT-TERM> 12,703
<PAYABLES> 16,041
<REPOS-SOLD> 84,496
<SECURITIES-LOANED> 6,110
<INSTRUMENTS-SOLD> 33,818
<LONG-TERM> 28,381
0
958
<COMMON> 12
<OTHER-SE> 4,379
<TOTAL-LIABILITY-AND-EQUITY> 191,074
<TRADING-REVENUE> 1,142
<INTEREST-DIVIDENDS> 13,235
<COMMISSIONS> 378
<INVESTMENT-BANKING-REVENUES> 1,336
<FEE-REVENUE> 0
<INTEREST-EXPENSE> 12,649
<COMPENSATION> 1,749
<INCOME-PRETAX> 958
<INCOME-PRE-EXTRAORDINARY> 662
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 662
<EPS-PRIMARY> 4.86
<EPS-DILUTED> 4.67
</TABLE>
