10-K 1 a2167455z10-k.htm 10-K
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


Form 10-K


ý

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended November 30, 2005

OR

o 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
(State or other jurisdiction of
incorporation or organization)
13-3216325
(I.R.S. Employer Identification No.)

745 Seventh Avenue
New York, New York

(Address of principal executive offices)


10019
(Zip Code)

Registrant's telephone number, including area code: (212) 526-7000

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

  Name of each exchange
on which registered

Common Stock, $.10 par value   New York Stock Exchange
Pacific Exchange
Depositary Shares representing 5.94% Cumulative Preferred Stock, Series C   New York Stock Exchange
Depositary Shares representing 5.67% Cumulative Preferred Stock, Series D   New York Stock Exchange
Depositary Shares representing 6.50% Cumulative Preferred Stock, Series F   New York Stock Exchange
Depositary Shares representing Floating Rate Cumulative Preferred Stock, Series G   New York Stock Exchange
6.375% Trust Preferred Securities, Series K, of Subsidiary Trust (and Registrant's guarantee thereof)   New York Stock Exchange
6.375% Trust Preferred Securities, Series L, of Subsidiary Trust (and Registrant's guarantee thereof)   New York Stock Exchange
6.00% Trust Preferred Securities, Series M, of Subsidiary Trust (and Registrant's guarantee thereof)   New York Stock Exchange
6.24% Trust Preferred Securities, Series N, of Subsidiary Trust (and Registrant's guarantee thereof)   New York Stock Exchange
Guarantee by Registrant of 75/8% Notes due 2006 of Lehman Brothers Inc.   New York Stock Exchange
61/4% Exchangeable Notes Due October 15, 2007 (subject to exchange into shares of common stock of General Mills, Inc.)   New York Stock Exchange
Absolute Buffer Notes Due July 29, 2008, Linked to the Dow Jones EURO STOXX50SM Index (SX5E)   American Stock Exchange
Absolute Buffer Notes Due July 7, 2008, Linked to the Dow Jones EURO STOXX 50SM Index (SX5E)   American Stock Exchange
Dow Jones Industrial Average 112.5% Minimum Redemption PrincipalPlus Stock Upside Note Securities® Due August 5, 2007   American Stock Exchange
Dow Jones Industrial Average Stock Upside Note Securities® Due April 29, 2010   American Stock Exchange
Index-Plus Notes Due December 23, 2009, Performance Linked to the Russell 2000® INDEX (RTY)   American Stock Exchange
Index-Plus Notes Due March 3, 2010, Linked to the S&P 500® Index (SPX)   American Stock Exchange
Index-Plus Notes Due November 15, 2009, Linked to the Dow Jones STOXX 50SM Index (SX5P)   American Stock Exchange
Index-Plus Notes Due September 28, 2009, Performance Linked to S&P 500® Index (SPX)   American Stock Exchange
Nasdaq-100® Index Rebound Risk AdjustiNG Equity Range SecuritiesSM Notes Due May 20, 2007   American Stock Exchange
Nasdaq-100® Index Rebound Risk AdjustiNG Equity Range SecuritiesSM Notes Due June 7, 2008   American Stock Exchange
Nikkei 225SM Index Call Warrants Expiring May 8, 2007   American Stock Exchange
Nikkei 225SM Index Stock Upside Note Securities® Due June 10, 2010   American Stock Exchange
Prudential Research Universe Diversified Equity Notes Due July 2, 2006, Linked to a Basket of Healthcare Stocks   American Stock Exchange
Return Accelerated PortfolIo Debt Securities Due September 3, 2006, Linked to the S&P® 500 Index (SPX)   American Stock Exchange
S&P 500® Index Callable Stock Upside Note Securities® Due November 6, 2009   American Stock Exchange
S&P 500® Index Stock Upside Note Securities® Due August 5, 2008   American Stock Exchange
S&P 500® Index Stock Upside Note Securities® Due December 26, 2006   American Stock Exchange
S&P 500® Index Stock Upside Note Securities® Due February 5, 2007   American Stock Exchange
S&P 500® Index Stock Upside Note Securities® Due September 27, 2007   American Stock Exchange
The Dow Jones Global TitansSM 50 Index Stock Upside Note Securities Due February 9, 2010   American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý    No o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o    No ý

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 ý    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer' in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ý Accelerated filer o Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

The aggregate market value of the voting and nonvoting common equity held by non-affiliates of the Registrant at May 31, 2005 (the last business day of the Registrant's most recently completed second fiscal quarter) was approximately $24,370,000,000. As of that date, 264,317,470 shares of the Registrant's common stock, $0.10 par value per share, were held by non-affiliates. For purposes of this information, the outstanding shares of common stock that were and that may be deemed to have been beneficially owned by directors and executive officers of the Registrant were deemed to be shares of common stock held by affiliates at that date.

As of January 31, 2006, 270,408,498 shares of the Registrant's common stock, $.10 par value per share, were issued and outstanding.


DOCUMENTS INCORPORATED BY REFERENCE:

Portions of Lehman Brothers Holdings Inc.'s Definitive Proxy Statement for its 2006 Annual Meeting of Stockholders (the "Proxy Statement") are incorporated in Part III.




LEHMAN BROTHERS HOLDINGS INC.

TABLE OF CONTENTS

 
   
  Page
Available Information   2

Part I

 

 
 
Item 1.

 

Business

 

3
  Item 1A.   Risk Factors   12
  Item 1B.   Unresolved Staff Comments   16
  Item 2.   Properties   16
  Item 3.   Legal Proceedings   17
  Item 4.   Submission of Matters to a Vote of Security Holders   23

Part II

 

 
 
Item 5.

 

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

24
  Item 6.   Selected Financial Data   26
  Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations   28
  Item 7A.   Quantitative and Qualitative Disclosures About Market Risk   66
  Item 8.   Financial Statements and Supplementary Data   67
  Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   114
  Item 9A.   Controls and Procedures   114
  Item 9B.   Other Information   114

Part III

 

 
 
Item 10.

 

Directors and Executive Officers of the Registrant

 

114
  Item 11.   Executive Compensation   115
  Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   115
  Item 13.   Certain Relationships and Related Transactions   116
  Item 14.   Principal Accountant Fees and Services   116

Part IV

 

 
 
Item 15.

 

Exhibits and Financial Statement Schedules

 

117

Signatures

 

121

Index to Consolidated Financial Statements and Schedule

 

F-1

Schedule I—Condensed Financial Information of Registrant

 

F-2

Exhibit Index

 

 

Exhibits

 

 

LEHMAN BROTHERS HOLDINGS INC.

AVAILABLE INFORMATION

Lehman Brothers Holdings Inc. ("Holdings") files annual, quarterly and current reports, proxy statements and other information with the United States Securities and Exchange Commission ("SEC"). You may read and copy any document Holdings files with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549, U.S.A. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330 (or 1-202-551-8090). The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Holdings' electronic SEC filings are available to the public at http://www.sec.gov.

Holdings' public internet site is http://www.lehman.com. Holdings makes available free of charge through its internet site, via a link to the SEC's internet site at http://www.sec.gov, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as soon as reasonably practicable after it electronically files such material with, or furnishes it to, the SEC. Holdings also makes available through its internet site, via a link to the SEC's internet site, statements of beneficial ownership of Holdings' equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

In addition, Holdings currently makes available on http://www.lehman.com its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q for the current fiscal year, its most recent proxy statement and its most recent annual report to stockholders, although in some cases these documents are not available on that site as soon as they are available on the SEC's site.

Holdings also makes available on http://www.lehman.com (i) its Corporate Governance Guidelines, (ii) its Code of Ethics (including any waivers therefrom granted to executive officers or directors) and (iii) the charters of the Audit, Compensation and Benefits, and Nominating and Corporate Governance Committees of its Board of Directors. These documents are also available in print without charge to any person who requests them by writing or telephoning:

Lehman Brothers Holdings Inc.
Office of the Corporate Secretary
1301 Avenue of the Americas
5th Floor
New York, New York 10019, U.S.A.
1-212-526-0858

In order to view and print the documents referred to above (which are in the.PDF format) on Holdings' internet site, you will need to have installed on your computer the Adobe® Acrobat® Reader® software. If you do not have Adobe Acrobat, a link to Adobe Systems Incorporated's internet site, from which you can download the software, is provided.

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LEHMAN BROTHERS HOLDINGS INC.


PART I


ITEM 1. BUSINESS

As used herein, "Holdings" or the "Registrant" means Lehman Brothers Holdings Inc., a Delaware corporation, incorporated on December 29, 1983. Holdings and its subsidiaries are collectively referred to as the "Company," "Lehman Brothers," the "Firm," "we," "us" or "our". Our executive offices are located at 745 Seventh Avenue, New York, New York 10019, U.S.A., and our telephone number is 1-212-526-7000.

FORWARD-LOOKING STATEMENTS

Some of the statements contained or incorporated by reference in this Report, including those relating to the Company's strategy and other statements that are predictive in nature, that depend upon or refer to future events or conditions or that include words such as "expects," "anticipates," "intends," "plans," "believes," "estimates" and similar expressions, are forward-looking statements within the meaning of Section 21E of the Exchange Act. These statements are not historical facts but instead represent only management's expectations, estimates and projections regarding future events. Similarly, these statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict, which may include, but are not limited to, the risk factors discussed in Item 1A below and the factors listed in Management's Discussion and Analysis of Financial Condition and Results of Operations—Certain Factors Affecting Results of Operations in Part II, Item 7, of this Report.

As a global investment bank, our results of operations have varied significantly in response to global economic and market trends and geopolitical events. The nature of our business makes predicting the future trends of revenues difficult. Caution should be used when extrapolating historical results to future periods. Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any forward-looking statements and, accordingly, readers are cautioned not to place undue reliance on such statements, which speak only as of the date on which they are made. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

LEHMAN BROTHERS

Lehman Brothers, an innovator in global finance, serves the financial needs of corporations, governments and municipalities, institutional clients and high-net-worth individuals worldwide. We provide a full array of equities and fixed income sales, trading and research, investment banking services and investment management and advisory services. Our 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 Firm, through predecessor entities, was founded in 1850.

Through our subsidiaries, we are a global market-maker in all major equity and fixed income products. To facilitate our market-making activities, we are a member of all principal securities and commodities exchanges in the United States, as well as NASD, Inc., and we hold memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Australian stock exchanges.

Our principal business activities are investment banking, capital markets and investment management. Through our investment banking, trading, research, structuring and distribution capabilities in equity and fixed income products, we continue to build on our client-flow business model, which is based on our principal focus of facilitating client transactions in all major global capital markets products and services. We generate client-flow revenues from institutional, corporate, government and high-net-worth clients by (i) advising on and structuring transactions specifically suited to meet client needs; (ii) serving as a market maker and/or intermediary in the global marketplace, including having securities and other financial instrument products available to allow clients to adjust their portfolios and risks across different market cycles; (iii) providing investment management and advisory services; and (iv) acting as an underwriter to clients. As part of our client-flow activities, we maintain inventory positions of varying amounts across a broad range of financial instruments. In addition, we also take proprietary trading and investment positions. The financial services industry is significantly influenced by worldwide economic conditions as well as other factors inherent in the global financial markets. As a result, revenues and earnings may vary from quarter to quarter and from year to year. We believe our client-flow orientation and the diversity of our business helps to mitigate overall

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LEHMAN BROTHERS HOLDINGS INC.

revenue volatility. See Part I, Item 1A, Risk Factors, in this Report for a discussion of certain material risks to our business, financial condition and results of operations.

We operate in three business segments (each of which is described below): Investment Banking, Capital Markets and Investment Management. Financial information concerning the Company for the fiscal years ended November 30, 2005, 2004 and 2003, including the amount of net revenues contributed by each segment in such periods, is set forth in the Consolidated Financial Statements and Notes thereto in Part II, Item 8, of this Report. Information with respect to our operations by business segment and net revenues by geographic area is set forth under the captions Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Segments and —Geographic Revenues in Part II, Item 7, of this Report, and in Note 18 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

We are engaged primarily in providing financial services. Other businesses in which we are engaged represent less than 10 percent of each of consolidated assets, revenues and pre-tax income.

Investment Banking

The Investment Banking business segment provides advice to corporate, institutional and government clients throughout the world on mergers, acquisitions and other financial matters. Investment Banking also raises capital for clients by underwriting public and private offerings of debt and equity securities. Our Investment Banking professionals are responsible for developing and maintaining relationships with issuer clients, gaining a thorough understanding of their specific needs and bringing together the full resources of Lehman Brothers to accomplish their financial and strategic objectives.

Investment Banking is made up of Advisory Services and Global Finance activities that serve our corporate, institutional and government clients. The segment is organized into global industry groups—Communications, Consumer/Retailing, Financial Institutions, Financial Sponsors, Healthcare, Industrial, Media, Natural Resources, Power, Real Estate and Technology—that include bankers who deliver industry knowledge and expertise to meet clients' objectives. Specialized product groups within Advisory Services include mergers and acquisitions ("M&A") and restructuring. Global Finance serves our clients' capital-raising needs through specialized product groups in underwriting, private placements, leveraged finance and other activities associated with debt and equity products. Product groups are partnered with relationship managers in the global industry groups to provide comprehensive financial solutions for clients.

Lehman Brothers maintains investment banking offices in North America, Europe, the Middle East, Latin America and the Asia Pacific region.

The high degree of integration among our industry, product and geographic groups has allowed us to become a leading source of one-stop financial solutions for our global clients.

Mergers & Acquisitions.    Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, spin-offs, targeted stock transactions, share repurchase strategies, government privatization programs, takeover defenses and other strategic advice.

Restructuring.    Our Restructuring group provides full-service restructuring expertise on a global basis. The group provides advisory services to distressed companies, their creditors and potential purchasers, including providing out-of-court options for companies to avoid bankruptcy, helping companies and creditors move efficiently through the bankruptcy process and advising strategic and financial buyers on the unique challenges of buying distressed and bankrupt companies.

Underwriting.    We are a leading underwriter of initial and other public offerings of equity and fixed income securities, including listed and over-the-counter securities, government and agency securities and mortgage- and asset-backed securities.

Leveraged Finance.    Our global Leveraged Finance group provides comprehensive financing solutions for below-investment-grade clients across many industries through our high-yield bond, leveraged loan, bridge financing and mezzanine debt products.

Private Placements.    We have a dedicated Private Placement group focused on capital raising in the private equity and debt markets. Clients range from pre-initial public offering ("IPO") companies to well-established corporations that span many industries. The Private Placement group has experience in identifying sources, establishing structures

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LEHMAN BROTHERS HOLDINGS INC.

and placing common stock, convertible preferred stock, subordinated debt and senior debt, as well as utilizing a variety of financing techniques, including mezzanine debt, securitizations, project financings and sale-leasebacks.

Capital Markets

The Capital Markets business segment primarily represents institutional client-flow activities including prime brokerage, research, mortgage origination and securitization, secondary-trading and financing activities in fixed income and equity products. These products include a wide range of cash, derivative, secured financing and structured instruments and investments. We are a leading global market-maker in numerous equity and fixed income products, including U.S., European and Asian equities, government and agency securities, money market products, corporate high-grade, high-yield and emerging market securities, mortgage- and asset-backed securities, preferred stock, municipal securities, bank loans, foreign exchange, financing and derivative products. We are one of the largest investment banks in terms of U.S. and pan-European listed equities trading volume and maintain a major presence in over-the-counter U.S. stocks, major Asian large capitalization stocks, warrants, convertible debentures and preferred issues. In addition, the secured financing business manages our equity and fixed income matched book activities, supplies secured financing to institutional clients and provides secured funding for our inventory of equity and fixed income products. The Capital Markets segment also includes proprietary activities as well as principal investing in real estate and private equity. Lehman Brothers combines the skills from the sales, trading and research areas of our Equities and Fixed Income Capital Markets businesses to serve the financial needs of our clients. This integrated approach enables us to structure and execute global transactions for clients and to provide worldwide liquidity in marketable securities.

Equities Capital Markets

The Equities Capital Markets business is responsible for our equities and equity-related operations and products worldwide. These products include listed and over-the-counter securities, American Depositary Receipts, convertibles, options, warrants and derivatives. We make markets in equity and equity-related securities and execute block trades on behalf of clients. We participate in the global equity and equity-related markets in all major currencies through our worldwide presence and membership in major stock exchanges. Equities Capital Markets is composed of Liquid Markets and Leveraged Businesses.

Liquid Markets.    Liquid Markets consists of our Single Stock cash trading, Flow Volatility and Program Trading businesses, which also includes Connectivity services. Single Stock trades are executed for clients in a conventional (calls to a sales person) or electronic fashion through external systems as well as our own LINKS platform. These trades can be executed manually or via algorithmic trading strategies based on client needs. Program Trading specializes in execution of trades on baskets of stocks, which can be executed on an agency or risk basis, as well as "riskless" arbitrage, in which we seek to benefit from temporary price discrepancies that occur when a security or index is traded in two or more markets. We deliver global electronic connectivity services to our clients, offering seamless electronic access to our trading desks and sources of liquidity around the world. Our flow volatility business facilitates client orders in listed options markets.

Leveraged Businesses.    Leveraged Businesses include Structured Volatility, Convertibles and Relative Value. Our global Structured Volatility business offers equity derivative capabilities across a wide spectrum of products and currencies, including over-the-counter options and other derivatives, to assist our clients in managing risk. The Convertibles business trades and makes markets in conventional and highly structured convertible securities. The Relative Value business includes our proprietary "risk" arbitrage activities, which involve the purchase of securities at discounts from the expected values that would be realized if certain proposed or anticipated corporate transactions (such as mergers, acquisitions, recapitalizations, exchange offers, reorganizations, bankruptcies, liquidations or spin-offs) were to occur, as well as facilitation of trades for clients who engage in these type of trading strategies.

Fixed Income Capital Markets

Lehman Brothers actively participates in key fixed income markets worldwide and maintains a 24-hour trading presence in global fixed income securities. We are a market-maker and participant in the new issue and secondary markets for a broad variety of fixed income securities. Fixed Income businesses include the following:

Government and Agency Obligations.    Lehman Brothers is one of the leading primary dealers in U.S. government securities, participating in the underwriting of and market-making in U.S. Treasury bills, notes and bonds, and securities

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LEHMAN BROTHERS HOLDINGS INC.

of federal agencies. We are also a market-maker in the government securities of all G7 countries, and participate in other major European and Asian government bond markets.

Corporate Debt Securities and Loans.    We make markets in fixed and floating rate investment grade debt worldwide. We are also a major participant in the preferred stock market, managing numerous offerings of long-term and perpetual preferreds and auction rate securities.

High-Yield Securities and Leveraged Bank Loans.    We also make markets in non-investment grade debt securities and bank loans. Lehman Brothers provides "one-stop" leveraged financing solutions for corporate and financial acquirers and high-yield issuers, including multi-tranche, multi-product acquisition financing. We are one of the leading investment banks in the syndication of leveraged loans.

Through our high grade and high yield sales, trading and underwriting activities, we make commitments to extend credit in loan syndication transactions. We also provide contingent commitments to investment and non-investment grade counterparties related to acquisition financings.

Money Market Products.    We hold leading market positions in the origination and distribution of medium-term notes and commercial paper. We are an appointed dealer or agent for numerous active commercial paper and medium-term note programs on behalf of companies and government agencies worldwide.

Mortgage Origination, Secured Lending and Mortgage- and Asset-Backed Securities. Lehman Brothers Bank, FSB, offers traditional and online mortgage banking services to individuals as well as institutions and their customers. Lehman Brothers Bankhaus AG, a German bank, offers lending and real estate financing to corporate and institutional borrowers worldwide. We originate commercial and residential mortgage loans through Lehman Brothers Bank, Lehman Brothers Bankhaus and other subsidiaries in the U.S., Europe and Asia. We are a leading underwriter of and market-maker in residential and commercial mortgage- and asset-backed securities and are active in all areas of secured lending, structured finance and securitized products. We underwrite and make markets in the full range of U.S. agency-backed mortgage products, mortgage-backed securities, asset-backed securities and whole loan products. We are also a leader in the global market for residential and commercial mortgages (including multi-family financing) and leases. In 2005, we established Lehman Brothers Commercial Bank, a Utah-chartered industrial loan company, in order to issue certificates of deposit to institutions and conduct certain lending activities.

Real Estate Investment.    In addition to our lending activities, we invest in commercial real estate in the form of debt, joint venture equity investments and direct ownership interests. We have interests in properties throughout the world.

Municipal and Tax-Exempt Securities.    Lehman Brothers is a major dealer in municipal and tax-exempt securities, including general obligation and revenue bonds, notes issued by states, counties, cities and state and local governmental agencies, municipal leases, tax-exempt commercial paper and put bonds.

Fixed Income Derivatives.    We offer a broad range of interest rate- and credit-based derivative products and related services. Derivatives professionals are integrated into all of our Fixed Income areas in response to the worldwide convergence of the cash and derivative markets. In 2005, Lehman Brothers established an energy trading business with global capability in power, natural gas and oil. The business will include futures, swaps, options and other structured products, as well as physical trading.

Foreign Exchange.    Our global foreign exchange operations provide market access and liquidity in all currencies for spot, forward and over-the-counter options markets around the clock. We offer our clients execution, analysis and hedging capabilities, utilizing foreign exchange as well as foreign exchange options and other foreign exchange derivatives. We also provide advisory services to central banks, corporations and investors worldwide, structuring innovative products to fit their specific needs. We make extensive use of our global macroeconomics research to advise clients on the appropriate strategies to minimize interest rate and currency risk.

Global Client Services

The Global Client Services group includes our Secured Financing, Prime Broker, Futures and Correspondent and Clearing businesses.

The Secured Financing business within Capital Markets engages in three primary functions: managing our equity and fixed income matched book activities, supplying secured financing to institutional clients and obtaining secured funding for our inventory of equity and fixed income products. Matched book funding involves borrowing and lending cash on a short-term basis to institutional clients collateralized by marketable securities, typically government or government

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LEHMAN BROTHERS HOLDINGS INC.

agency securities. We enter into these agreements in various currencies and seek to generate profits from the difference between interest earned and interest paid. Secured Financing works with our institutional sales force to identify clients that have cash to invest and/or securities to pledge to meet our financing and investment objectives and those of our clients. Secured Financing also coordinates with our Treasury group to provide collateralized financing for a large portion of our securities and other financial instruments owned. In addition to our activities on behalf of our U.S. clients, we are a major participant in the European and Asian repurchase agreement ("repo") markets, providing secured financing for our clients in those regions. Secured Financing provides margin loans in all markets for client purchases of securities, as well as securities lending and short-selling facilitation.

The Prime Broker business engages in full operations, clearing and processing services for its hedge fund and other clients. We offer a full suite of prime brokerage products and services, including margin financing and yield enhancement through synthetic and traditional products, global securities lending (including eBorrow, our online securities lending tool), full-service global execution platforms and research teams, customized risk management solutions, introduction of clients to suitable institutional investors, portfolio accounting and reporting solutions and personalized client service.

Our Futures business executes and clears futures transactions for clients on an agency basis. The Correspondent and Clearing business provides these services to broker-dealers that do not have the capacity themselves.

Global Distribution

Our institutional sales organizations encompass distinct global sales forces that have been integrated into the Capital Markets businesses to provide investors with the full array of products offered by Lehman Brothers.

Equities Sales.    Our Equities Capital Markets sales force provides an extensive range of services to institutional investors, focusing on developing long-term relationships though a comprehensive understanding of clients' investment objectives, while providing proficient execution and consistent liquidity in a wide range of global equity securities and derivatives.

Fixed Income Sales.    Our Fixed Income Capital Markets sales force is one of the most productive in the industry, serving the investing and liquidity needs of major institutional investors by employing a relationship management approach that provides superior information flow and product opportunities for our clients.

Research

Research at Lehman Brothers encompasses the full range of research disciplines, including quantitative, economic, strategic, credit, relative value and market-specific analysis. To ensure in-depth expertise within various markets, Equity Research has established regional teams on a worldwide basis that are staffed with industry and strategy specialists. Fixed Income Research provides expertise in U.S., European and Asian government and agency securities, derivatives, sovereign issues, corporate securities, high yield, asset- and mortgage-backed securities, indices, emerging market debt and municipal securities.

Investment Management

The Investment Management business segment consists of our Asset Management and Private Investment Management businesses.

Asset Management

Asset Management provides proprietary asset management products across traditional and alternative asset classes, through a variety of distribution channels, to individuals and institutions. It includes both the Neuberger Berman and Lehman Brothers Asset Management brands as well as our Private Equity business.

Neuberger Berman.    Neuberger Berman has provided money management products and services to individuals and families since 1939. We acquired Neuberger Berman in October 2003.

Neuberger Berman Private Asset Management. Neuberger Berman's Private Asset Management business provides discretionary, customized portfolio management across equity and fixed income asset classes for high-net-worth clients.

Neuberger Berman Family of Funds. The Neuberger Berman family of funds spans asset classes, investment styles and capitalization ranges. Its open-end mutual funds are available directly to investors or through distributors, and its

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LEHMAN BROTHERS HOLDINGS INC.

closed-end funds trade on major stock exchanges. Neuberger Berman is also a leading sub-advisor of funds for institutional clients, including insurance companies, banks and other financial services firms. Neuberger Berman also provides mutual fund asset allocation services to individuals and institutions through its Fund Advisory Service business.

Lehman Brothers Asset Management.    Lehman Brothers Asset Management specializes in investment strategies for institutional and qualified individual investors. While our strategies are numerous and diverse, our managers share a dedication to investment discipline that includes quantitative screening, fundamental analysis and risk management.

Institutional Asset Management. Lehman Brothers Institutional Asset Management provides a full range of asset management products for pensions, foundations, endowments and other institutions. It offers strategies across the risk/return spectrum, in cash, fixed income, equity and hybrid asset classes.

Absolute Return Strategies. Lehman Brothers' Absolute Return Strategies platform provides a wide range of hedge fund products to institutions and qualified individual clients. It offers proprietary single-manager funds, proprietary multiple-manager funds of funds and third-party single-manager funds.

Private Equity.    Private Equity provides opportunities in privately negotiated transactions across a variety of asset classes for institutional and high-net-worth individual investors. Our investment partnerships manage a number of private equity portfolios, with the Company's capital invested alongside that of our clients. Lehman Brothers creates funds and invests in asset classes in which we have strong capabilities, proprietary deal flow and an excellent reputation. Areas of specialty include Merchant Banking, Venture Capital, Real Estate, Fixed Income-Related Investments and Private Funds Investments. We also make other non-fund-related direct private equity investments.

Private Investment Management

Private Investment Management provides comprehensive investment, wealth advisory and capital markets execution services to high-net-worth individuals and middle-market businesses, leveraging all the resources of Lehman Brothers.

Investment Services.    Lehman Brothers investment professionals manage client relationships with high-net-worth individuals and businesses.

Portfolio Advisory.    Our Portfolio Advisory group supports our investment professionals with asset allocation, portfolio strategy and manager selection advice. The group creates customized portfolio recommendations, monitors client portfolios and analyzes both proprietary and third-party managers to ensure our clients' access to appropriate investment managers.

Wealth Advisory.    Our Wealth Advisory group supports our investment professionals by working with our clients and their advisors to recommend plans for preserving and enhancing wealth across generations.

The Lehman Brothers Trust Company.    The Lehman Brothers Trust Company offers a full suite of services, including fiduciary, investment planning and financial planning services. For businesses and institutional clients, the Trust Company structures and manages defined benefit and defined contribution plans, master trust/custody arrangements, employee stock ownership plans and nonqualified plans. The Trust Company includes a nationally chartered trust company as well as a Delaware state chartered trust company.

Capital Advisory.    Our Capital Advisory group works with investment professionals to provide integrated wealth management and corporate finance solutions for executives, small to mid-sized companies, private equity firms and professional sports franchise owners.

Institutional Client.    The Institutional Client group leverages the Lehman Brothers Capital Markets franchise to provide brokerage and market-making services to small and mid-sized institutional clients in the fixed income and equities capital markets. The group also leads our effort to establish business relationships with minority and women-owned financial firms, through our Partnership Solutions program.

Corporate

Our Corporate division provides support to our businesses through the processing of certain securities and commodities transactions; receipt, identification and delivery of funds and securities; safeguarding of clients' securities; risk management; and compliance with regulatory and legal requirements. In addition, the Corporate Division is responsible for technology infrastructure and systems development, treasury operations, financial control and analysis, tax planning and compliance, internal audit, expense management, career development and recruiting and other support functions.

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LEHMAN BROTHERS HOLDINGS INC.

Risk Management

A description of our Risk Management infrastructure and procedures is contained in Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Management in Part II, Item 7, of this Report. Information regarding our use of derivative financial instruments to hedge interest rate, currency, security and commodity price and other market risks is contained in Notes 1, 2, 3, 8, 9 and 10 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

Competition

All aspects of our business are highly competitive. Lehman Brothers competes in U.S. and international markets directly with numerous other firms in the areas of securities underwriting and placement, corporate finance and strategic advisory services, securities sales and trading, prime brokerage, research, foreign exchange and derivative products, asset management and private equity, including investment banking firms, traditional and online securities brokerage firms, mutual fund companies and other asset managers, investment advisers, venture capital firms and certain commercial banks and, indirectly for investment funds, with insurance companies and others. Our competitive ability depends on many factors, including our reputation, the quality of our services and advice, product innovation, execution ability, pricing, advertising and sales efforts and the talent of our personnel. See Part I, Item 1A, Risk Factors, for a further discussion of the competitive risks to which we are exposed.

Regulation

The securities industry in the United States is subject to extensive regulation under both federal and state laws.

Holdings and its subsidiaries are regulated by the SEC as a Consolidated Supervised Entity. See Capital Requirements below and Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources—Liquidity Risk Management in Part II, Item 7, of this Report. Lehman Brothers Inc. ("LBI"), Neuberger Berman, LLC ("NB LLC") and Neuberger Berman Management Inc. ("NBMI") are registered with the SEC as broker-dealers; Lehman Brothers OTC Derivatives Inc. ("LOTC") is registered with the SEC as an OTC derivatives dealer; and LBI, NB LLC, NBMI, Lehman Brothers Asset Management LLC ("LBAM") and certain other of our subsidiaries are registered with the SEC as investment advisers. As such these entities are subject to regulation by the SEC and by self-regulatory organizations, principally the NASD (which has been designated by the SEC as NBMI's primary regulator), national securities exchanges such as the New York Stock Exchange ("NYSE") (which has been designated by the SEC as LBI's and NB LLC's primary regulator) and the Municipal Securities Rulemaking Board, among others. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. Various of our subsidiaries are registered as broker-dealers in all 50 states, the District of Columbia and the Commonwealth of Puerto Rico.

Broker-dealers are subject to regulations that cover all aspects of the securities business, including sales practices, market making and trading among broker-dealers, publication of research, margin lending, use and safekeeping of clients' funds and securities, capital structure, recordkeeping and the conduct of directors, officers and employees.

Registered investment advisers are subject to regulations under the Investment Advisers Act of 1940. Such requirements relate to, among other things, recordkeeping and reporting requirements, disclosure requirements, limitations on agency cross and principal transactions between an adviser and advisory clients, as well as general anti-fraud prohibitions.

Certain investment funds that we manage are registered investment companies under the Investment Company Act of 1940. Those funds and the Lehman Brothers entities that serve as the funds' investment advisers are subject to that act and the rules thereunder, which, among other things, regulate the relationship between a registered investment company and its investment adviser and prohibit or severely restrict principal transactions and joint transactions.

Violation of applicable regulations can result in legal and/or administrative proceedings, which may impose censures, fines, cease-and-desist orders or suspension or expulsion of a broker-dealer or an investment adviser, its officers or employees.

LBI and NB LLC are also registered with the Commodity Futures Trading Commission (the "CFTC") as futures commission merchants; and NB LLC, LBAM and other subsidiaries are registered as commodity pool operators and/or commodity trading advisers. These entities are subject to regulation by the CFTC and various domestic boards of trade and other commodity exchanges. Our U.S. commodity futures and options business is also regulated

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LEHMAN BROTHERS HOLDINGS INC.

by the National Futures Association, a not-for-profit membership corporation that has been designated as a registered futures association by the CFTC.

The Sarbanes-Oxley Act of 2002 and rules promulgated by the SEC and the NYSE thereunder have imposed substantial new or enhanced regulations and disclosure requirements in the areas of corporate governance (including director independence, director selection and audit, corporate governance and compensation committee responsibilities), equity compensation plans, auditor independence, pre-approval of auditor fees and services and disclosure and internal control procedures. We are committed to industry best practices in these areas and believe we are in compliance with the relevant rules and regulations.

The USA PATRIOT Act of 2001 contains anti-money laundering and anti-terrorism laws that mandate the implementation of various regulations applicable to banks, broker-dealers, futures commission merchants and other financial services companies, including standards for verifying client identity at account opening, standards for conducting enhanced due diligence and obligations to monitor client transactions and report suspicious activities. Through these and other provisions, the PATRIOT Act seeks to promote cooperation among financial institutions, regulators and law enforcement in identifying parties that may be involved in terrorism or money laundering. Anti-money laundering laws outside of the U.S. contain similar provisions. We have established appropriate policies, procedures and internal controls that are designed to comply with these rules and regulations.

We do business in the international fixed income and equity markets and undertake international investment banking activities, principally through our regional headquarters in London and Tokyo. Lehman Brothers International (Europe) ("LBIE") is an authorized investment firm in the United Kingdom and is a member of the London, Frankfurt, Paris and Milan exchanges, among others. The U.K. Financial Services and Markets Act 2000 (the "FSMA") and rules promulgated thereunder govern all aspects of the United Kingdom investment business, including regulatory capital, sales, research and trading practices, use and safekeeping of client funds and securities, record keeping, margin practices and procedures, approval standards for individuals, periodic reporting and settlement procedures. Pursuant to the FSMA, certain of our subsidiaries are subject to regulations promulgated and administered by the Financial Services Authority. The European Union ("E.U.") Market Abuse Directive establishes a common regulatory framework for policing market manipulation and insider dealing in Europe, with offenses of dealing on the basis of inside information and manipulating the market, obligations on issuers to disclose inside information to the market and to maintain lists of all those with access to inside information and obligations on investment firms to report suspicious transactions and disclose information about research sources and methods and conflicts of interest. U.K. regulations implementing the Directive came into effect on July 1, 2005. Other member states in which we do business have largely completed implementation of the directive as well. In the U.K., regulated firms are bound by a number of other laws and regulations, namely the First and Second E.U. Money Laundering Directives, the Proceeds of Crime Act 2002, the Terrorism Act 2000, the Money Laundering Regulations 2003 and the FSA's Money Laundering sourcebook. Collectively, these require firms to have policies and controls around the identification of clients, reporting suspicious activity, staff training and awareness, record keeping and making use of international findings. We have established appropriate policies, procedures and internal controls that are designed to comply with these rules and regulations.

Lehman Brothers Japan Inc. ("LBJ") is a registered securities company in Japan and a member of the Tokyo Stock Exchange Inc., the Osaka Securities Exchange Co., Ltd., the Jasdaq Securities Exchange Inc., the Tokyo Financial Exchange Inc., and, as such, is regulated by the Financial Services Agency, the Securities Exchange Surveillance Commission, the Japan Securities Dealers Association, the Financial Futures Association of Japan, the Tokyo Metropolitan Government and those exchanges.

Lehman Brothers Bank, a federally chartered savings bank incorporated in Delaware, is regulated by the Office of Thrift Supervision and the Federal Deposit Insurance Corporation ("FDIC"). Lehman Brothers Commercial Bank is subject to regulation by the FDIC and the Utah Commissioner of Financial Institutions. Lehman Brothers Bankhaus is regulated by the German Federal Supervisory Authority for the Financial Service Industry. Lehman Brothers Trust Company, N.A., which holds a national bank charter, is regulated by the Office of the Comptroller of the Currency of the United States. Lehman Brothers Trust Company of Delaware, a non-depository limited purpose trust company, is subject to oversight by the State Bank Commissioner of the State of Delaware. These bodies regulate such matters as policies and procedures on conflicts of interest, account administration and overall governance and supervisory procedures.

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LEHMAN BROTHERS HOLDINGS INC.

LBI, LBIE, LBJ and many of our other subsidiaries are also subject to regulation by securities, banking and finance regulatory authorities, securities exchanges and other self-regulatory organizations in numerous other countries in which they do business.

We believe that we are in material compliance with applicable regulations.

We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our business. See Part I, Item 3, Legal Proceedings, in this Report for information about certain pending proceedings.

Capital Requirements

LBI, LOTC, NB LLC, NBMI, LBIE, the Tokyo branch of LBJ, Lehman Brothers Bank, our "AAA" rated derivatives subsidiaries (Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc.), Lehman Brothers Trust Company, N.A., Lehman Brothers Trust Company of Delaware and other subsidiaries of Holdings are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate and/or to capital targets established by various ratings agencies. The regulatory rules referred to above, and certain covenants contained in various debt agreements, may restrict Holdings' ability to withdraw capital from certain subsidiaries, which in turn could limit its ability to commit capital to other businesses, meet obligations or pay dividends to shareholders. Further information about these requirements and restrictions is contained in Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources in Part II, Item 7, of this Report and in Note 12 to the Consolidated Financial Statements in Part II, Item 8, of this Report.

In June 2004, the SEC approved a rule establishing a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies. We applied for permission to operate under the rule and received approval effective December 1, 2005. The rule allows LBI to use an alternative method, based on internal models, to calculate net capital charges for market and derivative-related credit risk. Under this rule, Lehman Brothers is subject to group-wide supervision and examination by the SEC and is subject to minimum capital requirements on a consolidated basis generally consistent with the International Convergence of Capital Measurement and Capital Standards published by the Basel Committee on Banking Supervision. See Management's Discussion and Analysis of Financial Condition and Results of Operations—Accounting and Regulatory Developments—Consolidated Supervised Entity in Part II, Item 7, of this Report for more information.

Client Protection

LBI and NB LLC are members of the Securities Investor Protection Corporation ("SIPC"). Clients of LBI and NB LLC are protected by SIPC against some losses. SIPC provides protection against lost, stolen or missing securities (except loss in value due to a rise or fall in market prices) for clients in the event of the failure of the broker-dealer. Accounts are protected up to $500,000 per client with a limit of $100,000 for cash balances. In addition to being members of SIPC, LBI and NB LLC carry excess SIPC protection, which increases each client's protection up to the net equity of the account, subject to terms and conditions similar to SIPC. Like SIPC, the excess coverage does not apply to loss in value due to a rise or fall in market prices. Certain of our non-U.S. broker-dealer subsidiaries participate in programs similar to SIPC in certain jurisdictions.

Deposits in Lehman Brothers Bank and Lehman Brothers Commercial Bank are insured by the FDIC, subject to applicable limits per depositor. Lehman Brothers Bankhaus participates in the German Depositors Protection Fund, which insures deposits from non-bank clients, with applicable limits per depositor.

Insurance

We maintain insurance coverage in types and amounts and with deductibles that management believes are customary for companies of similar size and engaged in similar businesses. However, the insurance market is volatile, and there can be no assurance that any particular coverages will be available in the future on terms acceptable to us.

Employees

As of November 30, 2005, we employed approximately 22,900 persons. We consider our relationship with our employees to be good.

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ITEM 1A. RISK FACTORS

You should carefully consider the following risks and all of the other information set forth in this Report, including the Consolidated Financial Statements and the Notes thereto. If any of the events or developments described below were actually to occur, our business, financial condition or results of operations could be adversely affected.

Market Risk

As a global investment bank, risk is an inherent part of our business. Our businesses are materially affected by conditions in the financial markets, and economic conditions generally, around the world. A favorable business environment is characterized by many factors, including a stable geopolitical climate, transparent financial markets, low inflation, low unemployment, strong business profitability and high business and investor confidence. Concerns about geopolitical developments, oil prices and natural disasters, among other things, can affect the global financial markets. In addition, economic or political pressures in a country or region may cause local market disruptions and currency devaluations, which may also affect markets generally. In the event of changes in market conditions, such as interest or foreign exchange rates, stock or real estate valuations or volatility, our businesses could be adversely affected in many ways, including those described below. See Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Market Risk for a further discussion of the market risks to which we are exposed.

Our Client-Flow Revenues May Decline in Adverse Market Conditions. We have been operating in a low interest rate market for the past several years (though, recently, central banks have been raising rates). Increasing or high interest rates and/or widening credit spreads, especially if such changes are rapid, may create a less favorable environment for certain of our businesses. In particular, in our mortgage origination and securitization businesses, rising interest rates may cause a decline in the volume of mortgage origination activity, and therefore may also decrease the volume of securitizations. Declining real estate values could also reduce our level of new mortgage loan originations and securitizations.

Our Investment Banking revenues, in the form of financial advisory and debt and equity underwriting fees, are directly related to the number and size of the transactions in which we participate and would therefore be adversely affected by a sustained market downturn.

A market downturn would likely lead to a decline in the volume of transactions that we execute for our clients and, therefore, to a decline in the revenues we receive from commissions and spreads earned from the trades we execute for our clients. In addition, because the fees that we charge for managing our clients' portfolios are in many cases based on the value of those portfolios, a market downturn that reduces the value of our clients' portfolios would reduce the revenue we receive from our asset management business. Even in the absence of a market downturn, below-market investment performance could reduce Investment Management revenues and assets under management.

We May Incur Losses in Our Capital Markets Business Segment Due to Fluctuations in Market Rates, Prices and Volatility. Market risk is inherent in our client-driven market-making transactions in equity and fixed income securities and derivatives and our mortgage origination and loan syndication activities. Fluctuations in market rates, prices and volatility can adversely affect the market value of our long or short inventory positions and, to the extent that such positions are not hedged, cause the Firm to incur losses. In our client-driven market-making transactions, we maintain substantial inventory positions from time to time, acting as a financial intermediary for our clients, and we hold inventory positions in the normal course of business to allow clients to rebalance their portfolios and diversify risks across market cycles. To the extent that we hold long inventory positions, a downturn in the market could result in losses from a decline in the value of those positions. On the other hand, to the extent that we have sold inventory short, an upturn in those markets could expose us to losses as we attempt to cover our short positions by acquiring assets in a rising market.

In our mortgage origination and securitization businesses, we are also subject to risks from decreasing interest rates. Most residential mortgages provide that the borrower may repay them early. Borrowers often exercise this right when interest rates decline. As prepayments increase, the value of mortgages held in inventory prior to securitization generally will decrease, and to the extent that prepayment risk has not been hedged, prepayments may result in a loss.

We also maintain long and short positions through our proprietary trading activities, and make principal investments in real estate and private equity, which are also subject to market risks. The value of these positions can be adversely

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affected by changes in market rates, prices and volatility.

Holding Large and Concentrated Positions May Expose Us to Losses. Concentration of risk may reduce revenues or result in losses in our market-making, block trading, underwriting, proprietary trading and lending businesses in the event of unfavorable market movements. We have committed substantial amounts of capital to these businesses, which often require us to take large positions in the securities of, or make large loans to, a particular issuer or issuers in a particular industry, country or region. Moreover, the trend in all major capital markets is towards larger and more frequent commitments of capital in many of these activities, and we expect this trend to continue.

Market Risk May Increase the Other Risks That We Face. In addition to the potentially adverse effects on our businesses described above, market risk could exacerbate other risks that we face. For example, if we were to incur substantial market risk losses, our need for liquidity could rise significantly, while our access to liquidity could be impaired. In addition, in conjunction with a market downturn, our clients and counterparties could incur substantial losses of their own, thereby weakening their financial condition and increasing our credit risk to them.

Credit Risk

We May Incur Losses Associated with Our Credit Exposures. Credit risk represents the possibility a counterparty or an issuer of securities or other financial instruments we hold or a borrower of funds from us will be unable to honor its contractual obligations to us. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Default risk may also arise from events or circumstances that are difficult to foresee or detect, such as fraud. Credit risk may arise, for example, from holding securities of third parties; entering into swap or other derivative contracts under which counterparties have obligations to make payments to us; executing securities, futures, currency or commodity trades that fail to settle at the required time due to non-delivery by the counterparty or systems failure by clearing agents, exchanges, clearing houses or other financial intermediaries; and extending credit to our clients through bridge or margin loans or other arrangements. See Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk for a further discussion of the credit risks to which we are exposed. Our principal focus has been acting as an intermediary of credit. In recent years, we have expanded our activities associated with providing our clients access to credit and liquidity and have significantly expanded our swaps and other derivatives businesses. As a result, our credit exposures have increased in amount and in duration.

Defaults by Another Large Financial Institution Could Adversely Affect Financial Markets Generally. The commercial soundness of many financial institutions may be closely interrelated as a result of credit, trading, clearing or other relationships between the institutions. As a result, concerns about, or a default by, one institution could lead to significant market-wide liquidity problems, losses or defaults by other institutions. This is sometimes referred to as "systemic risk" and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which we interact on a daily basis, and therefore could adversely affect Lehman Brothers.

Liquidity Risk

Liquidity, that is, ready access to funds, is essential to our businesses. Financial institutions rely on external borrowings for the vast majority of their funding, and failures in our industry are typically the result of insufficient liquidity.

An Inability to Access the Debt Markets Could Impair Our Liquidity. We maintain a liquidity pool available to Holdings that is intended to cover all expected cash outflows for one year in a stressed liquidity environment, which assumes, among other things, that during that year we cannot issue unsecured debt. See Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Liquidity Risk Management, for a discussion of our liquidity needs and liquidity management.

To the extent that a liquidity event lasts for more than one year, or our expectations concerning the market conditions that exist during a liquidity event, or our access to funds, prove to be inaccurate (e.g., the level of secured financing "haircuts" (the difference between the market and pledge value of the assets) required to fund our assets in a stressed market event is greater than expected, or the amount of drawdowns under our commitments to extend credit in a stressed market environment exceeds our expectations), our ability to fund operations could be significantly impaired. Even within the one-year time frame contemplated by our liquidity pool, we depend on continuous access to secured financing in the repurchase and securities lending markets, which could be impaired by factors that are not

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LEHMAN BROTHERS HOLDINGS INC.

specific to Lehman Brothers, such as a severe disruption of the financial markets.

We Are a Holding Company and Are Dependent on Our Subsidiaries for Funds. Since Holdings is primarily a holding company, our cash flow and consequent ability to pay dividends and satisfy our obligations under securities we issue are dependent upon the earnings of our subsidiaries and the distribution of those earnings as dividends or loans or other payments by those subsidiaries to us. Several of our principal subsidiaries are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate and/or to capital targets established by various ratings agencies. These regulatory rules, and certain covenants contained in various debt agreements, may restrict our ability to withdraw capital from our subsidiaries by dividends, loans or other payments. Further information about these requirements and restrictions is set forth in Note 12 to the Consolidated Financial Statements in Part II, Item 8, of this Report. Additionally, our ability to participate as an equity holder in any distribution of assets of any subsidiary upon liquidation is generally subordinate to the claims of creditors of the subsidiary.

Credit Ratings

Our borrowing costs and our access to the debt capital markets depend significantly on our credit ratings. A reduction in our credit ratings could increase our borrowing costs, limit our access to the capital markets and trigger additional collateral requirements in derivative contracts and other secured funding arrangements. Credit ratings are also important to us when competing in certain markets, such as longer-term over-the-counter derivatives. Therefore, a substantial reduction in our credit ratings would reduce our earnings and adversely affect our liquidity and competitive position. See Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Liquidity Risk Management and—Credit Ratings, for additional information concerning our credit ratings.

Operational Risk

Operational Risks May Disrupt Our Businesses, Result in Regulatory Action Against Us or Limit Our Growth. We face operational risk arising from errors made in the execution, confirmation or settlement of transactions or from transactions not being properly recorded, evaluated or accounted for. Derivative contracts, particularly credit derivatives, are not always confirmed by the counterparties on a timely basis; while the transaction remains unconfirmed, we are subject to heightened credit and operational risk and in the event of a default may find it more difficult to enforce the contract. Our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies, and the transactions we process have become increasingly complex. Consequently, we rely heavily on our financial, accounting and other data processing systems. If any of these systems do not operate properly or are disabled, we could suffer financial loss, a disruption of our businesses, liability to clients, regulatory intervention or reputational damage. The inability of our systems to accommodate an increasing volume of transactions could also constrain our ability to expand our businesses. In recent years, we have substantially upgraded and expanded the capabilities of our data processing systems and other operating technology, and we expect that we will need to continue to upgrade and expand in the future to avoid disruption of, or constraints on, our operations.

In addition, despite the contingency plans we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located. This may include a disruption involving electrical, communications, transportation or other services used by Lehman Brothers or third parties with which we conduct business, terrorist activities or disease pandemics. See Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Management in Part II, Item 7, of this Report for a description of our Risk Management infrastructure and procedures.

Acquisitions or Joint Ventures Could Present Unforeseen Integration Obstacles or Costs. Acquisitions and joint ventures involve a number of risks and present financial, managerial and operational challenges, including difficulty with integrating personnel and financial and other systems, hiring additional management and other critical personnel and increasing the scope, geographic diversity and complexity of our operations. In addition, we may not realize the anticipated benefits from an acquisition, and we may be exposed to additional liabilities of any acquired business.

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LEHMAN BROTHERS HOLDINGS INC.

Legal, Regulatory and Reputational Risk

We Face Significant Litigation Risks in Our Businesses. The volume of litigation against financial services firms and the amount of damages claimed has increased over the past several years. We are exposed to potential liability under securities or other laws for materially false or misleading statements made in connection with securities and other transactions, potential liability for the "fairness opinions" and other advice we provide to participants in corporate transactions and disputes over the terms and conditions of complex trading arrangements. We also face the possibility that counterparties in complex or risky trading transactions will claim that we improperly failed to tell them of the risks or that they were not authorized or permitted to enter into these transactions with us and that their obligations to Lehman Brothers are not enforceable. In our Investment Management segment, we are exposed to claims against us for recommending investments that are not consistent with a client's investment objectives or engaging in unauthorized or excessive trading. During a prolonged market downturn, we would expect these types of claims to increase. We are also subject to claims arising from disputes with employees for alleged discrimination or harassment, among other things. These risks often may be difficult to assess or quantify, and their existence and magnitude often remain unknown for substantial periods of time. We incur significant legal expenses every year in defending against litigation, and we expect to continue to do so in the future. See Part I, Item 3, Legal Proceedings, for a discussion of some of the legal and regulatory matters in which we are currently involved.

Extensive Regulation of Our Businesses Limits Our Activities and May Subject Us to Significant Penalties. Lehman Brothers, as a participant in the financial services industry, is subject to extensive regulation under both federal and state laws in the U.S. and under the laws of the many global jurisdictions in which we do business. We are also regulated by a number of self-regulatory organizations. The industry has experienced increased scrutiny from a variety of regulators, including the SEC, NYSE, NASD and state attorneys general. Penalties and fines sought by regulatory authorities in our industry have increased substantially over the last several years. The requirements imposed by our regulators are designed to ensure the integrity of the financial markets and to protect customers and other third parties who deal with Lehman Brothers. Consequently, these regulations often serve to limit our activities, including through net capital, customer protection and market conduct requirements. If we were found to have breached certain of these rules or regulations, we could face the risk of significant intervention by regulatory authorities, including extended investigation and surveillance activity, adoption of costly or restrictive new regulations and judicial or administrative proceedings that may result in substantial penalties. Among other things, we could be fined or prohibited from engaging in some of our business activities. See Part I, Item 1, Business—Regulation" for a further discussion of the regulatory environment in which we conduct our businesses.

Additional legislation and regulations, changes in rules imposed by regulatory authorities, self-regulatory organizations and exchanges or changes in the interpretation or enforcement of existing laws and rules may adversely affect our business and profitability. Our business may be materially affected not only by regulations applicable to us as an investment bank, but also by regulations of general application, including existing and proposed tax legislation and other governmental regulations and policies (including the interest rate and monetary policies of the Federal Reserve Board and other central banks) and changes in the interpretation or enforcement of existing laws and rules that affect the business and financial communities.

Exposure to Reputational Risks Could Impact the Value of our Brand. Our reputation is critical in maintaining our relationships with clients, investors, regulators and the general public, and is a key focus in our risk management efforts. In recent years there have been a number of highly publicized cases involving fraud, conflicts of interest or other misconduct by employees in the financial services industry, and we run the risk that misconduct by our employees could occur. Misconduct by employees could include binding Lehman Brothers to transactions that exceed authorized limits or present unacceptable risks, or hiding from Lehman Brothers unauthorized or unsuccessful activities, which, in either case, may result in unknown and unmanaged risks or losses. Employee misconduct could also involve the improper use or disclosure of confidential information, which could result in regulatory sanctions and serious reputational or financial harm. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. In addition, in certain circumstances our reputation could be damaged by activities of our clients in which we participate, over which we have little or no control.

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Competitive Environment

All aspects of our business are highly competitive. Our competitive success depends on many factors, including our reputation, the quality of our services and advice, intellectual capital, product innovation, execution ability, pricing, sales efforts, and the talent of our personnel.

We Face Increased Competition Due to a Trend Toward Consolidation.    In recent years, there has been substantial consolidation and convergence among companies in the financial services industry. In particular, a number of large commercial banks, insurance companies and other broad-based financial services firms have established or acquired broker-dealers or have merged with other financial institutions. Many of these firms have the ability to offer a wide range of products, from loans, deposit-taking and insurance to brokerage, asset management and investment banking services, which may enhance their competitive position. They also have the ability to support investment banking and securities products with commercial banking, insurance and other financial services revenues in an effort to gain market share, which has resulted in pricing pressure in our businesses. We have experienced intense price competition in some of our businesses in recent years. For example, equity and debt underwriting and trading spreads and fees for lending and other activities have been under competitive pressures for a number of years.

Our Revenues May Decline Due to Competition from Alternative Trading Systems.    Securities and futures transactions are now being conducted through the internet and other alternative, non-traditional trading systems, and it appears that the trend toward alternative trading systems will continue and probably accelerate. A dramatic increase in computer-based or other electronic trading may adversely affect our commission and trading revenues.

Our Ability to Retain Our Key Employees is Critical to the Success of Our Business. Our people are our most important resource. Our ability to continue to compete effectively in our businesses will depend upon our ability to attract top talent and retain and motivate our existing employees while managing compensation costs.

Risk Management

We have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future. Nonetheless, our hedging strategies and other risk management techniques may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk, including risks that are unidentified or unanticipated. Some of our methods of managing risk are based upon our use of observed historical market behavior. As a result, these methods may not predict future risk exposures, which could be significantly greater than the historical measures indicate. Management of operational, legal and regulatory risk requires, among other things, policies and procedures to record properly and verify a large number of transactions and events, and these policies and procedures may not be fully effective. See Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Management, for a discussion of the policies and procedures we use to identify, monitor and manage the risks we assume in conducting our businesses.


ITEM 1B. UNRESOLVED STAFF COMMENTS


None.


ITEM 2. PROPERTIES

Our world headquarters is a 1,000,000 square-foot owned office tower at 745 Seventh Avenue in New York City. In addition, we lease approximately 1,500,000 square feet of office space in the New York metropolitan area.

In addition to our offices in the New York area, we have offices in over 115 locations in the Americas. We also have offices in Europe and Asia.

Our European headquarters is an 820,000 square foot leased facility in the Canary Wharf development, east of the City of London. In addition to our European headquarters, we have an additional fifteen locations in Europe.

Our Asian headquarters is located in approximately 190,000 square feet of leased office space in the Roppongi Hills area of central Tokyo, Japan. We lease office space in eight other locations in Asia.

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All three of our business segments (as described herein) use the occupied facilities described above. We believe that the facilities we occupy are adequate for the purposes for which they are used, and the occupied facilities are well maintained.

Additional information with respect to facilities and lease commitments is set forth under the caption Lease Commitments in Note 10 to the Consolidated Financial Statements in Part II, Item 8, of this Report.


ITEM 3. LEGAL PROCEEDINGS

We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our business. Such proceedings include actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms, including us.

Although there can be no assurance as to the ultimate outcome, we generally have denied, or believe we have a meritorious defense and will deny, liability in all significant cases pending against us, including the matters described below, and we intend to defend vigorously each such case. Based on information currently available, we believe the amount, or range, of reasonably possible losses in connection with the actions against us, including the matters described below, in excess of established reserves, in the aggregate, not to be material to the Company's consolidated financial condition or cash flows. However, losses may be material to our operating results for any particular future period, depending on the level of our income for such period.

Actions Regarding Enron Corporation

Enron Securities Purchaser Actions.    In April 2002, a Consolidated Complaint for Violation of the Securities Laws was filed in the United States District Court for the Southern District of Texas (the "Texas District Court"), captioned In re Enron Corporation Securities Litigation (the "Enron Litigation"), alleging claims for violation of Sections 11 and 15 of the Securities Act of 1933 (the "Securities Act"), Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 thereunder, and the Texas Securities Act. The case was brought on behalf of a purported class of purchasers of Enron Corporation's publicly traded equity and debt securities between October 19, 1998 and November 27, 2001, against Holdings and eight other commercial or investment banks, 38 current or former Enron officers and directors, Enron's accountants, Arthur Andersen LLP (and affiliated entities and partners) and two law firms. The complaint sought unspecified compensatory and injunctive relief based on the theory that defendants engaged or participated in manipulative devices to inflate Enron's reported profits and financial condition, made false or misleading statements and participated in a scheme or course of business to defraud Enron's shareholders. Ultimately, after motion practice, on February 4, 2004, the Texas District Court entered an order dismissing the claims against Holdings and LBI under Section 10(b) and 20(a) of the Exchange Act. Subsequently, Holdings and LBI reached an agreement to settle this case, as well as the Washington State Investment Board action, discussed below, for $222.5 million. On October 19, 2005, the settlement was approved by the Texas District Court. That settlement did not resolve certain claims discussed below.

In May 2002, American National Insurance Company and certain of its affiliates filed a complaint against LBI, Holdings, Lehman Commercial Paper Inc. ("LCPI") and a broker formerly employed by Lehman. The amended complaint, filed in October 2003, is based on allegations similar to those in the Enron Litigation and asserts that plaintiffs relied on defendants' allegedly false and misleading statements in purchasing and continuing to hold Enron debt and equities in their LBI accounts. The amended complaint alleges violations of the Texas Securities Act, violations of the Texas Business and Commerce Code, fraud, breach of fiduciary duty, negligence and professional malpractice, and seeks unspecified compensatory and punitive damages. This action has been coordinated for pretrial purposes with the Enron Litigation in the Texas District Court.

In August 2002, a complaint was filed against Holdings and four other commercial or investment banks, among other defendants, by the Public Employees Retirement System of Ohio and three other state employee retirement plans, containing allegations similar to those in the Enron Litigation. Against Holdings, the complaint alleges claims for common law fraud and deceit, aiding and abetting common law fraud, conspiracy to commit fraud, negligent misrepresentation and violation of the Texas Securities Act, and seeks unspecified compensatory and punitive damages. This action has been consolidated with the Enron Litigation in the Texas District Court.

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LEHMAN BROTHERS HOLDINGS INC.

In September 2002, the Washington State Investment Board, which is a named plaintiff in the Enron Litigation, filed a new purported class action. This action mirrored the Enron Litigation but alleges a longer class action period of September 9, 1997 to October 18, 1998. The amended complaint alleged claims against Holdings and LBI for violations of Sections 11 and 15 of the Securities Act. Plaintiffs sought unspecified compensatory damages, an accounting and disgorgement of certain defendants' alleged insider-trading proceeds, restitution and rescission. This action had been consolidated with the Enron Litigation in the Texas District Court. As indicated above, Holdings and LBI have settled this case and that settlement has been approved by the Texas District Court.

In April 2003, Westboro Properties LLC and Stonehurst Capital, Inc. filed a complaint against LBI, Holdings and other commercial or investment banks. Plaintiffs alleged that defendants engaged in violations of the Texas Securities Act, statutory fraud in stock transactions, fraud, negligence and professional malpractice, and violations Sections 12 and 15 of the Securities Act in inducing plaintiffs to purchase certain certificates, or investments, in two special purpose entities ("SPEs"), Osprey I and Osprey II. Plaintiffs also alleged that defendants aided and abetted Enron's fraud in setting up SPEs, allegedly falsifying Enron's books and records and in continuing to recommend Enron's stock. Plaintiffs sought unspecified actual, special and punitive damages and equitable relief. This action had been consolidated with the Enron Litigation in the Texas District Court. LBI and Holdings have settled this case and are awaiting final dismissal from the Texas District Court.

In September 2003, a purported class action complaint was filed against Holdings and seven other commercial or investment banks, among other defendants, by Sara McMurray on behalf of purchasers of Enron common stock between October 16, 1998 and November 27, 2001, making similar allegations as the Enron Litigation. Plaintiff alleges negligent misrepresentation, common law fraud, breach of fiduciary duty and aiding and abetting breach of fiduciary duty, and seeks unspecified damages for lost investment opportunities and lost benefit of the bargain. This action has been consolidated with the Enron Litigation in the Texas District Court. Plaintiff has filed a motion to voluntarily dismiss Holdings from the action without prejudice. The motion is pending before the Texas District Court. Similarly, in January 2004, a purported class action complaint was filed against Holdings and other commercial or investment banks, among other defendants, by William Young and Frank Conway on behalf of all persons who held Enron shares from April 13, 1999 through November 8, 2001. Making allegations similar to those in the Enron Litigation, plaintiffs allege claims for negligent misrepresentation and common law fraud and seek unspecified compensatory damages. This action has been coordinated for pretrial purposes with the Enron Litigation in the Texas District Court. Plaintiffs have filed a motion to voluntarily dismiss Holdings from the action without prejudice. The motion is pending before the Texas District Court.

Other Actions.    In August 2003, Al Rajhi Investment Corporation BV filed a petition against rating agencies, law firms, commercial and investment banks, including LBI and Holdings, and others. Plaintiff claims to have engaged in a commodities trade with Enron and to have effectively extended over $101 million of credit to Enron in reliance on misrepresentations. The amended complaint alleged that LBI and Holdings were involved in funding the LJM2 and the Osprey Trust transactions, that they were involved in Enron transactions used to inflate Enron's net worth and creditworthiness and that they made false and misleading statements in analysts' reports. The claims against LBI and Holdings were for conspiracy and for participation in a joint or common enterprise and seek actual and exemplary damages. This action had been coordinated for pretrial purposes with the Enron Litigation in the Texas District Court. In December 2005, plaintiff voluntarily dismissed its claims with prejudice as to all defendants, including LBI and Holdings.

In November 2003, a complaint was filed by Enron in the United States Bankruptcy Court for the Southern District of New York (the "New York Bankruptcy Court") against Lehman Brothers Finance S.A. ("LBF"), LBI, Holdings and LCPI. Among other things, the complaint seeks to avoid as preferential transfers and/or fraudulent conveyances approximately $236 million in payments made by Enron in the year prior to Enron's bankruptcy filing. These payments were made pursuant to transactions under a swap contract between LBF and Enron relating to Enron common stock. The parties have entered into a settlement agreement that will be presented to the Bankruptcy Court for approval.

Also in November 2003, Enron filed two nearly identical lawsuits against LCPI, LBIE and other commercial paper dealers and investors in the New York Bankruptcy Court. The complaints allege that monies paid by Enron in October and November 2002 to repurchase its outstanding commercial paper shortly before its maturity were preferential payments and/or fraudulent conveyances under the Bankruptcy Code. Among other things, the complaints seek to avoid and recover these payments from the defendants. In total, approximately $500 million is

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LEHMAN BROTHERS HOLDINGS INC.

sought from LCPI and LBIE, nearly all of which relates to LCPI's role as intermediary between Enron and several co-defendant holders of the commercial paper.

In March 2004, LJM2 Liquidation Statutory Trust B and its managing trustee filed a complaint against the limited partners in LJM2 Co-Investment L.P., including LB I Group Inc., alleging that the limited partners improperly rescinded a capital call. The complaint asserts claims against the LB I Group Inc. for violations of the Delaware Revised Uniform Limited Partnership Act, for breach of the partnership and subscription agreements, for breach of the credit agreement, for tortious interference, for aiding and abetting a breach of fiduciary duty, for avoidable transfer, for breach of the covenant of good faith and fair dealing, for unjust enrichment, for breach of the partnership agreement and for conspiracy to engage in fraudulent transfer. Plaintiffs seek monetary damages of approximately $75 million in the aggregate from the limited partners, plus interest and costs, as well as specific enforcement of the obligation to make capital contributions. The action is currently pending in Delaware Chancery Court. This case has been settled in principle subject to final documentation.

In April 2004, LJM2 Liquidation Statutory Trust B and its managing trustee filed an amended complaint against the limited partners of LJM2 Co-Investment, L.P., including LB I Group Inc., alleging that the distributions to the limited partners were fraudulent transfers and violated the Delaware Revised Uniform Limited Partnership Act. Plaintiffs seek monetary damages of approximately $75 million in the aggregate from the limited partners, plus interest and costs. The action is currently pending in the United States Bankruptcy Court for the Northern District of Texas. This case has been settled in principle subject to final documentation.

First Alliance Mortgage Company Matters

During 1999 and the first quarter of 2000, LCPI provided a warehouse line of credit to First Alliance Mortgage Company ("FAMCO"), a subprime mortgage lender, and LBI underwrote the securitizations of mortgages originated by FAMCO. In March 2000, FAMCO filed for bankruptcy protection in the United States Bankruptcy Court for the Central District of California (the "California Bankruptcy Court"). In August 2001, a purported adversary class action (the "Class Action") was filed in the California Bankruptcy Court, allegedly on behalf of a class of FAMCO borrowers seeking equitable subordination of LCPI's (among other creditors') liens and claims. In October 2001, the complaint was amended to add LBI as a defendant and to add claims for aiding and abetting alleged fraudulent lending activities by FAMCO and for unfair competition under the California Business and Professions Code. In August 2002, a Second Amended Complaint was filed, which added a claim for punitive damages and extended the class period from May 1, 1996, until FAMCO's bankruptcy filing. The complaint sought actual and punitive damages, the imposition of a constructive trust on all proceeds paid by FAMCO to LCPI and LBI, disgorgement of profits and attorneys' fees and costs.

In November 2001, the Official Joint Borrowers Committee (the "Committee") initiated an adversary proceeding, allegedly on behalf of the FAMCO-related debtors, in the California Bankruptcy Court by filing a complaint against LCPI, LBI, Holdings and several individual officers and directors of FAMCO and its affiliates. As to the Lehman defendants, the Committee asserted various bankruptcy claims for avoidance of liens, aiding and abetting and breach of fiduciary duty. In December 2001, the Committee amended its complaint, dropping Holdings as a defendant.

The United States District Court for the Central District of California (the "California District Court") withdrew the reference to the California Bankruptcy Court in both of these cases and in February 2002 consolidated them before the California District Court. In November 2002, the California District Court entered an order defining the class in the Class Action as all persons who acquired mortgage loans from FAMCO from May 1, 1996 through March 31, 2000, which were used as collateral for FAMCO's warehouse credit line with LCPI or were securitized in transactions underwritten by LBI. The class claims were subsequently limited to the period 1999 forward. Trial began in February 2003.

In June 2003, the California District Court dismissed plaintiffs' claim for punitive damages. Also in June 2003, the jury rendered its verdict, finding LBI and LCPI liable for aiding and abetting FAMCO's fraud. The jury found damages of $50.9 million and held the Lehman defendants responsible for 10% of those damages. In July 2003, the California District Court entered findings of fact and conclusions of law relating to all claims still pending and holding that any transfers to LCPI were not fraudulent and its liens were not avoidable, nor was equitable subordination of amounts owed by FAMCO to LCPI at the time of the Chapter 11 filing warranted. Judgment was entered in November 2003 on the jury verdict. LBI and LCPI are appealing the jury verdict to the United States Court of Appeals for the Ninth Circuit and both sets of plaintiffs are appealing various rulings of the California District Court.

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LEHMAN BROTHERS HOLDINGS INC.

In June 2003, the Attorney General of the State of Florida filed a civil complaint against LCPI in the Circuit Court of the 17th Judicial Circuit in and for Broward County, Florida, alleging violations of the Florida Unfair and Deceptive Trade Practices Act and common law fraud. The allegations arise out of LCPI's relationship with FAMCO insofar as FAMCO did business with Florida borrowers. The Florida Attorney General alleges in the complaint that, among other things, LCPI provided financing to FAMCO, despite LCPI's purported knowledge that FAMCO was engaged in "predatory lending" practices. The Complaint seeks a permanent injunction, compensatory and punitive damages, civil penalties, attorney's fees and costs.

In re Fleming Securities Litigation

In February 2003, a lawsuit captioned Massachusetts State Carpenters Pension Fund v. Fleming Companies, Inc., et al. was filed in the 160th District Court of Dallas County, Texas, asserting claims arising under Sections 11, 12(a) (2), and 15 of the Securities Act. The action was brought on behalf of a purported class of investors who purchased in two simultaneous Fleming securities offerings in June 2002 that raised approximately $378 million. LBI's share of these offerings as underwriter was 27.5%. The complaint alleged that the prospectus and registration statement for the offerings contained false and misleading statements or omitted material facts concerning, among other things, deductions Fleming took on vendor invoices, its accounting for recognition of income, amortization of long term assets and use of capitalized interest and the performance of Fleming's retail operations. The complaint sought unspecified damages and costs. In addition to Fleming, the suit named as defendants ten officers and/or directors of Fleming, Fleming's auditor, and the underwriters of the offerings, including LBI.

The case was removed to the United States District Court for the Northern District of Texas. The underwriters were contractually entitled to customary indemnification from Fleming, but in April 2003, Fleming filed for bankruptcy protection. Also in April 2003, plaintiffs filed a virtually identical second lawsuit in the United States District Court for the Eastern District of Texas.

In June 2003, the Judicial Panel on Multidistrict Litigation consolidated the securities litigations concerning Fleming to which LBI was not a party in the United States District Court for the Eastern District of Texas. Subsequently, in September 2003, plaintiffs in the two Massachusetts State Carpenters Pension Fund cases to which LBI is a party, and plaintiffs in the consolidated actions, jointly filed a Third Consolidated Amended Class Action Complaint, which, as to LBI, in substance re-alleged the claims set forth in the original Massachusetts State Carpenters Pension Fund cases. Thereafter, in June 2004, plaintiffs filed a Fourth Consolidated Amended Class Action Complaint adding details to the allegations in the prior complaint concerning lead plaintiffs' purchases in the offerings, and a Fifth Complaint was filed in December 2004, which added no new allegations or claims against LBI.

The parties agreed to a settlement of this action as to which the Court granted final approval on November 29, 2005.

IPO Allocation Cases

LBI was named as a defendant in approximately 192 purported securities class actions that were filed between March and December 2001 in the United States District Court for the Southern District of New York (the "New York District Court"). The actions, which allege improper IPO allocation practices, were brought by persons who, either directly or in the aftermarket, purchased IPO securities during the period between March 1997 and December 2000. The plaintiffs allege that Lehman and other IPO underwriters required persons receiving allocations of IPO shares to pay excessive commissions on unrelated trades and to purchase shares in the aftermarket at specified escalating prices. The plaintiffs, who seek unspecified compensatory damages, claim that these alleged practices violated various provisions of the federal securities laws, specifically sections 11, 12(a)(2) and 15 of the Securities Act, sections 10(b) and 20(a) of the Exchange Act. The 192 actions in which LBI was named a defendant have been consolidated into 83 cases, each involving a distinct offering. Those 83 consolidated cases, and approximately 226 others in which LBI is not named as a defendant, have been coordinated for pretrial purposes before a single judge.

In January 2002, a separate consolidated class action, entitled In re Initial Public Offering Antitrust Litigation, was filed in the New York District Court against LBI, among other underwriters, alleging violations of federal and state antitrust laws. The complaint alleges that the underwriter defendants conspired to require customers who wanted IPO allocations to pay the underwriters a percentage of their IPO profits in the form of commissions on unrelated trades to purchase other, less attractive securities and to buy shares in the aftermarket at predetermined escalating prices. In November 2003, the court dismissed the antitrust action on the grounds that the conduct alleged was impliedly immune from the antitrust laws. On appeal, the United States Court of Appeals for the Second Circuit reversed the New York District Court's decision in September 2005.

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LEHMAN BROTHERS HOLDINGS INC.

In April 2002, a suit was filed in Delaware Chancery Court by Breakaway Solutions Inc. ("Breakaway"), which names LBI and two other underwriters as defendants (the "Delaware Action"). The complaint purports to be brought on behalf of a class of issuers who issued securities in IPOs through at least one of the defendants during the period January 1998 through October 2000 and whose securities increased in value 15% or more above the original price within 30 days after the IPO. It alleges that defendants underpriced IPO securities and allocated those underpriced securities to certain favored customers in return for alleged arrangements with the customers for increased commissions on other transactions and alleged tie-in arrangements. The complaint asserts claims for breaches of contract, of the implied covenant of good faith and fair dealing and of fiduciary duty, and for indemnification or contribution and unjust enrichment or restitution. Breakaway seeks, among other relief, class certification, injunctive relief, an accounting, declarations requiring defendants to indemnify Breakaway in the pending consolidated IPO securities class actions and determining that Breakaway has no indemnification obligation to defendants in those actions, and compensatory damages. In August 2004, the court denied defendants' motion to dismiss. On motion by defendants, the court reconsidered its prior decision and by order dated December 8, 2005, dismissed all but Breakaway's claim for breach of fiduciary duty.

In September 2005, Breakaway commenced an action in the New York State Supreme Court, New York County, naming the same defendants (the "New York Action"). This action alleges that LBI, as a co-manager of Breakaway's initial public offering and in conjunction with the other underwriter defendants, breached a fiduciary duty to Breakaway and breached the covenant of good faith and fair dealing implied in the underwriting agreement among Breakaway and the underwriters by allegedly underpricing Breakaway's shares in the IPO. Unlike the Delaware Action, which Breakaway purports to bring on behalf of a class of issuers, the New York Action concerns claims brought only on behalf of Breakaway.

IPO Fee Litigation

Harold Gillet, et al. v. Goldman Sachs & Co., et al.; Yakov Prager, et al. v. Goldman, Sachs & Co., et al.; David Holzman, et al. v. Goldman, Sachs & Co., et al.    Beginning in November 1998, four purported class actions were filed in the New York District Court against in excess of 25 underwriters of IPO securities, including LBI. The cases were subsequently consolidated into In re Public Offering Antitrust Litigation. Plaintiffs, alleged purchasers of securities issued in certain IPOs, seek compensatory and injunctive relief for alleged violations of the antitrust laws based on the theory that the defendants fixed and maintained fees for underwriting certain IPO securities at supra-competitive levels. In February 2001, the New York District Court granted defendants' motion to dismiss the Consolidated Amended Complaint, concluding that the purchaser plaintiffs lacked standing under the antitrust laws to assert the claims. On appeal, the United States Court of Appeals for the Second Circuit reversed and remanded the case to the New York District Court for further proceedings, including potential dismissal of the claims based on additional arguments raised in the motion to dismiss. The New York District Court, in an order dated February 24, 2004, dismissed plaintiffs' claims for monetary damages allowing only their claims for injunctive relief to proceed.

In re Issuer Plaintiff Initial Public Offering Fee Antitrust Litigation.    In April 2001, the New York District Court consolidated four actions pending before the court brought by bankrupt issuers of IPO securities against more than 20 underwriter defendants (including LBI). In July 2001, the plaintiffs filed a consolidated class action complaint seeking unspecified compensatory damages and injunctive relief for alleged violations of the antitrust laws based on the theory that the defendant underwriters fixed and maintained fees for underwriting certain IPO securities at supra-competitive levels. Two of the four original plaintiffs subsequently withdrew their claims.

Metricom Securities Litigation

In August 2002, an amended complaint was filed in the United States District Court for the Northern District of California captioned In re Metricom Securities Litigation. The action is brought on behalf of a purported class of investors who purchased the common stock of Metricom, Inc., during the period from June 21, 1999, to July 2, 2001. Plaintiffs name various officers, directors and selling shareholders of Metricom, along with LBI as lead underwriter and the four other co-managing underwriters of an offering of Metricom common stock in February 2000. The underwriters are contractually entitled to customary indemnification from Metricom in connection with the offering, but prior to the commencement of this action, Metricom filed for bankruptcy protection. The February 2000 offering raised approximately $500 million, of which Lehman's underwriting share was 28.5%. Against the underwriters, plaintiffs allege violations of Sections 11 and 12(2) of the Securities Act and of Section 10(b) of the Exchange Act. The complaint alleges that the prospectus and registration statement for the offering failed to disclose material facts concerning, among other things, Metricom's flawed business plan and marketing strategy. The complaint seeks class

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LEHMAN BROTHERS HOLDINGS INC.

action status, unspecified damages and costs.

In May 2003, the court dismissed that complaint. In July 2003, plaintiffs filed a second amended complaint that drops claims against the underwriters under the Exchange Act but realleges claims against them under the Securities Act. On April 29, 2004, the United States District Court for the Northern District of California dismissed the second amended complaint with prejudice, and the plaintiffs are appealing that decision to the United States Court of Appeals for the Ninth Circuit.

Mirant Securities Litigation

In November 2002, an amended complaint was filed in the United States District Court for the Northern District of Georgia, Atlanta Division, captioned In re Mirant Corporation Securities Litigation. The action is brought on behalf of a purported class of investors who purchased the securities of Mirant Corporation during the period from September 26, 2000 and September 5, 2002. Plaintiffs name Mirant, various officers and directors, Mirant's former parent, The Southern Company, along with its officers and directors, LBI, as a member of the underwriting syndicate, and eleven other underwriters of Mirant's IPO of common stock in September, 2000. The underwriters are contractually entitled to customary indemnification from Mirant, but Mirant filed for bankruptcy protection in July 2003. The IPO raised approximately $1.467 billion, of which Lehman's underwriting share was 9%. Against the underwriters, plaintiffs allege violations of Section 11 of the Securities Act. The complaint alleges that the prospectus and registration statement for the offering contained false and misleading statements or failed to disclose material facts concerning, among other things, Mirant's alleged misconduct in energy markets in the State of California, the accounting for Mirant's interest in a United Kingdom-based company, Western Power Distribution, and other accounting issues. The complaint seeks class action certification, unspecified damages and costs.

Mutual Fund Related Litigation

In re Mutual Funds Investment Litigation.    In September 2004, LBI and two LBI employees were added as defendants to a consolidated class action pending in the United States District Court for the District of Maryland (the "Maryland District Court") purportedly brought by a class of investors against Federated Investors, Inc. ("Federated") and numerous of its subsidiaries, directors, trustees and employees, together with certain traders and broker-dealers, and others. The action had been consolidated before the United States District Court for the Western District of Pennsylvania and transferred to the Maryland District Court in March 2004 pursuant to an order of the Judicial Panel on Multidistrict Litigation. The consolidated amended class action complaint alleged that LBI and two LBI employees violated the securities laws, including Section 10 of the Exchange Act and Section 36(b) and 48(a) of the Investment Company Act of 1940, aided and abetted a breach of fiduciary duty, and were unjustly enriched as a result of trading in the Federated family of mutual funds allegedly conducted by LBI customers through LBI. The consolidated amended class action complaint sought unspecified damages. On March 7, 2005, the defendants, including LBI and its two employees, filed motions to dismiss the complaint. On November 3, 2005, United States District Court Judge Catherine C. Blake rendered a decision dismissing, as against, among others, LBI and the two LBI employees, (1) the federal securities law claims with prejudice, and (2) the state law claims without prejudice, on the basis that they are preempted under the Securities Litigation Uniform Standards Act of 1998.

In re Excelsior, Federated and Scudder.    In September 2004, Holdings and LBI were added as defendants to a consolidated shareholder derivative action pending in the Maryland District Court against Federated and numerous of its subsidiaries and directors, together with certain financial institutions and individuals. The action had been consolidated before the United States District Court for the Western District of Pennsylvania and transferred to the Maryland District Court in March 2004 pursuant to an order of the Judicial Panel on Multidistrict Litigation. The consolidated amended complaint contained allegations that LBI aided and abetted a breach of fiduciary duty, interfered with contracts, engaged in a civil conspiracy, and were unjustly enriched, in connection with trading of the Federated family of mutual funds allegedly conducted by LBI customers through LBI. The consolidated amended complaint seeks unspecified damages. After plaintiffs agreed to voluntarily dismiss Holdings from the action, on March 4, 2005, United States District Court Judge Catherine C. Blake rendered a decision dismissing the complaint as against Holdings. On March 7, 2005, the defendants, including LBI, filed motions to dismiss the complaint. On November 3, 2005, Judge Blake entered an order dismissing the complaint as against, among other defendants, LBI.

Research Analyst Independence Litigations

Since the announcement of the final global regulatory settlement regarding alleged research analyst conflicts of interest at various investment banking firms in the United States, including LBI, and various federal and state regulators and

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LEHMAN BROTHERS HOLDINGS INC.

self-regulatory organizations in April 2003 (the "Final Global Settlement"), a number of purported class actions were filed, resulting in three consolidated actions, against LBI in federal court, which are specific to LBI's research of particular companies (Razorfish, Inc., RealNetworks, Inc. and RSL Communications, Inc.): Swack, et al. v. Lehman Brothers Inc, in the United States District Court for the District of Massachusetts ("Massachusetts District Court") (Razorfish); DeMarco v. Lehman Brothers Inc., et al., in the New York District Court (RealNetworks); and Fogarazzo v. Lehman Brothers Inc., in the New York District Court (RSL Communications). All the actions allege conflicts of interest between LBI's investment banking business and research activities and seek to assert claims pursuant to Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 thereunder. In the purported class action relating to RSL Communications, plaintiffs have filed an amended consolidated complaint, containing essentially the same allegations as the original complaints, but adding two other investment banks as defendants (Fogarazzo, et al. v. Lehman Brothers Inc., et al.).

In DeMarco, which relates to Real Networks, the New York District Court issued an order in 2004 granting LBI's motion for summary judgment and dismissing the claims. In Swack, which relates to LBI's research on Razorfish, Inc., the Massachusetts District Court issued an order in August 2005 dismissing the action.

In June 2003, a purported derivative action, Bader and Yakaitis P.S.P. and Trust, et al. v. Michael L. Ainslie, et al., relating to the Final Global Settlement was filed in New York State Supreme Court, New York County. The suit names Holdings and its Board of Directors as defendants and contends that the Board should have been aware of and prevented the alleged misconduct that resulted in the settlement with regulators. In December 2003, plaintiffs filed an amended complaint, reiterating the allegations concerning the alleged failure to detect and prevent conduct resulting in the Final Global Settlement and adding allegations concerning the alleged failure to detect and prevent conduct relating to purportedly improper IPO allocation practices, discussed more fully above under the heading IPO Allocation Cases.

WorldCom Bondholders Litigation

Holdings and LBI (together, the "Lehman Defendants"), along with other underwriters of WorldCom, Inc. bonds, were named as defendants in certain securities class and individual actions commenced beginning on or about July 19, 2002 alleging that the offering materials issued in connection with certain securities offerings were false and misleading. Certain of the lawsuits (some of which were originally filed in various state courts and removed to federal court) were transferred by order of the Judicial Panel on Multidistrict Litigation to the New York District Court..

All defendants, including the Lehman Defendants, have settled the class action claims. That settlement was approved by the District Court by decision dated September 21, 2005. The Lehman Defendants contributed $62.7 million to that settlement. That settlement did not resolve claims brought by certain investors who opted out of the class action and filed separate actions.

On June 22, 2005, the underwriter defendants agreed to settle Public Employees' Retirement System of Ohio, et al. v. Bernard J. Ebbers, et al., and the Lehman Defendants contributed $787,500 toward that settlement. On August 8, 2005, the underwriter defendants agreed to settle New York City Employees' Retirement System,, et al. v. Bernard J. Ebbers, et al., and the Lehman Defendants contributed $1.6 million toward that settlement. On October 8, 2005, the underwriter defendants agreed to settle the various actions filed on behalf of plaintiffs represented by Lerach Coughlin Stoia Geller Rudman & Robbins, LLP in various courts throughout the United States. The Lehman Defendants contributed $10.7 million toward the Lerach settlement. On December 31, 2005, the underwriter defendants agreed to settle SunTrust Bank, et al. v. Ebbers, et al., and the Lehman Defendants contributed $40,012 toward that settlement.

Several individual actions remain pending against the underwriter defendants, including the Lehman Defendants. These remaining cases are Adcock, et al. v. Ebbers, et al., Escude v. Ebbers, et al., Kemp v. Ebbers, et al., Pacific Life Ins., et al., v. J.P. Morgan Chase & Co., et al., Utah State Retirement Board v. Ebbers, et al., and Shriners Hospital for Children v. Alexander, et al. Court-supervised negotiations are ongoing in the latter three actions. The Lehman Defendants' total exposure for these actions is not material.


ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS


None.

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PART II


ITEM 5.    MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
                   AND ISSUER PURCHASES OF EQUITY SECURITIES

Holdings' common stock, par value $0.10 per share, is listed on the New York Stock Exchange and on the Pacific Exchange. As of January 31, 2006, there were 270,408,498 shares of our common stock outstanding and approximately 22,450 holders of record. On February 10, 2006, the last reported sales price of our common stock was $137.50. The table below shows the high and low sales prices for the common stock for each fiscal quarter within the two most recent fiscal years:

Price Range of Common Stock

Three months ended 2005
  November 30
  August 31
  May 31
  February 28

High   $ 133.16   $ 108.00   $ 96.93   $ 94.70
Low   $ 103.72   $ 91.05   $ 85.92   $ 83.25
Three months ended 2004
  November 30
  August 31
  May 31
  February 29

High   $ 85.50   $ 79.04   $ 89.72   $ 88.22
Low   $ 73.32   $ 67.25   $ 69.50   $ 70.50

In January 2006, our Board of Directors increased the fiscal 2006 annual common stock dividend rate to $0.96 per share from an annual dividend rate of $0.80 per share in fiscal 2005 and $0.64 per share in fiscal 2004. Dividends on the common stock are generally payable, following declaration by the Board of Directors, in February, May, August and November.

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LEHMAN BROTHERS HOLDINGS INC.

The table below sets forth information with respect to purchases made by or on behalf of Holdings or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended), of our common stock during the quarter ended November 30, 2005.

 
  Issuer Purchases of Equity Securities
 
  Total Number
of Shares
Purchased(1)

  Average Price
Paid per Share

  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans
or Programs(2)

  Maximum Number
of Shares that May
Yet Be Purchased
Under the Plans or
Programs(2)


Month #1 (September 1—September 30, 2005):        
  Common stock
    repurchases(1)
  2,639,400       2,639,400    
  Employee transactions(2)   255,783       255,783    
  Total   2,895,183   $111.10   2,895,183   35,945,615
Month #2 (October 1—October 31, 2005):        
  Common stock
    repurchases(1)
  3,037,700       3,037,700    
  Employee transactions(2)   407,252       407,252    
  Total   3,444,952   $113.54   3,444,952   32,500,663
Month #3 (November 1—November 30, 2005):        
  Common stock
    repurchases(1)
  2,322,900       2,322,900    
  Employee transactions(2)   5,471,428       5,471,428    
  Total   7,794,328   $125.16   7,794,328   24,706,335
Total, September 1, 2005—November 30, 2005:        
  Common stock
    repurchases(1)
  8,000,000       8,000,000    
  Employee transactions(2)   6,134,463       6,134,463    
  Total   14,134,463   $119.45   14,134,463   24,706,335

(1)
We have an ongoing common stock repurchase program, pursuant to which we repurchase shares in the open market on a regular basis. As previously announced, in January 2005 our Board of Directors authorized the repurchase of up to approximately 65 million shares of our common stock in fiscal 2005. Of this amount, approximately 35 million shares were authorized for repurchase to offset dilution due to employee stock plans in 2005, and up to an additional 30 million shares were authorized for repurchase in fiscal 2005, subject to market conditions, for the possible acceleration of 2006 requirements to offset dilution due to employee stock plans. The number of shares authorized to be repurchased in the open market is reduced by the actual number of Employee Offset Shares (as defined below) received.

(2)
Represents shares of common stock withheld in satisfaction of the exercise price of stock options and tax withholding obligations upon option exercises and conversion of restricted stock units (collectively, "Employee Offset Shares").

Our Board of Directors has authorized the repurchase in 2006, subject to market conditions, of up to 40 million shares of Holdings common stock in 2006, for the management of the Firm's equity capital, including offsetting 2006 dilution due to employee stock plans. Our Board also authorized the repurchase in 2006, subject to market conditions, of up to an additional 15 million shares, for the possible acceleration of repurchases to offset a portion of 2007 dilution due to employee stock plans. This authorization supersedes the stock repurchase program authorized in January 2005. For more information about the repurchase program and employee stock plans, see Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity, Funding and Capital Resources—Stock Repurchase Program in Part II, Item 7, Notes 11 and 14 to the Consolidated Financial Statements in Part II, Item 8, and Security Ownership of Certain Beneficial Owners and Management in Part III, Item 12, in this Report.

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LEHMAN BROTHERS HOLDINGS INC.


ITEM 6. SELECTED FINANCIAL DATA

The following table summarizes certain consolidated financial information.

Selected Financial Data

In millions, except per common share and selected data and financial ratios



Year ended November 30

  2005
  2004
  2003
  2002
  2001

Consolidated Statement of Income                              
Total revenues   $ 32,420   $ 21,250   $ 17,287   $ 16,781   $ 22,392
Interest expense     17,790     9,674     8,640     10,626     15,656

Net revenues     14,630     11,576     8,647     6,155     6,736
Non-interest expenses:                              
  Compensation and benefits     7,213     5,730     4,318     3,139     3,437
  Non-personnel expenses(1)     2,588     2,309     1,716     1,517     1,424
  Real estate reconfiguration charge         19     77     128    
  September 11th related (recoveries)/expenses, net                 (108 )   127
  Regulatory settlement                 80    

Total non-interest expenses     9,801     8,058     6,111     4,756     4,988

Income before taxes and dividends on trust
    preferred securities
    4,829     3,518     2,536     1,399     1,748
Provision for income taxes     1,569     1,125     765     368     437
Dividends on trust preferred securities(2)         24     72     56     56

Net income   $ 3,260   $ 2,369   $ 1,699   $ 975   $ 1,255
Net income applicable to common stock   $ 3,191   $ 2,297   $ 1,649   $ 906   $ 1,161

Consolidated Statement of Financial Condition (at November 30)
  Total assets   $ 410,063   $ 357,168   $ 312,061   $ 260,336   $ 247,816
  Net assets(3)     211,424     175,221     163,182     140,488     141,354
  Long-term borrowings(2)     62,309     56,486     43,529     38,678     38,301
  Preferred securities subject to mandatory
    redemption(2)
            1,310     710     710
  Total stockholders' equity     16,794     14,920     13,174     8,942     8,459
  Tangible equity capital(4)     15,564     12,636     10,681     9,439     9,002
  Total capital (2)(5)     79,103     71,406     58,013     48,330     47,470

Per Common Share Data                              
  Net income (basic)   $ 11.47   $ 8.36   $ 6.71   $ 3.69   $ 4.77
  Net income (diluted)   $ 10.87   $ 7.90   $ 6.35   $ 3.47   $ 4.38
  Weighted average common shares (basic)
    (in millions)
    278.2     274.7     245.7     245.4     243.1
  Weighted average common shares (diluted) (in
    millions)
    293.6     290.7     259.9     261.2     265.3
Dividends declared per common share   $ 0.80   $ 0.64   $ 0.48   $ 0.36   $ 0.28
Book value per common share (at November 30)(6)   $ 57.50   $ 49.32   $ 44.17   $ 34.15   $ 31.81

Selected Data (at November 30)                              
  Gross leverage ratio(7)     24.4x     23.9x     23.7x     29.1x     29.3x
  Net leverage ratio(8)     13.6x     13.9x     15.3x     14.9x     15.7x
  Employees     22,919     19,579     16,188     12,343     13,090
  Assets under management (in billions)(9)   $ 175   $ 137   $ 120   $ 9   $ 12
Financial Ratios (%)                              
  Compensation and benefits/net revenues     49.3     49.5     49.9     51.0     51.0
  Pre-tax margin     33.0     30.4     29.3     22.7     26.0
  Return on average common stockholders'
    equity(10)
    21.6     17.9     18.2     11.2     15.9
  Return on average tangible common
    stockholders' equity(11)
    27.8     24.7     19.2     11.5     16.3

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LEHMAN BROTHERS HOLDINGS INC.

Notes to Selected Financial Data:

(1)
Non-personnel expenses exclude the following items: 1) real estate reconfiguration charges of $19 million, $77 million and $128 million for the years ended November 2004, 2003 and 2002, respectively, September 11th related (recoveries)/expenses of $(108) million and $127 million for the years ended November 30, 2002 and 2001, respectively, and 3) regulatory settlement of $80 million for the year ended November 30, 2002.
(2)
We adopted FIN 46R effective February 29, 2004, which required us to deconsolidate the trusts that issued the preferred securities. Accordingly, at and subsequent to February 29, 2004, preferred securities subject to mandatory redemption were reclassified to Junior Subordinated notes. Dividends on preferred securities subject to mandatory redemption, which were presented as Dividends on trust preferred securities in the Consolidated Statement of Income through February 29, 2004, are included in Interest expense in periods subsequent to February 29, 2004.
(3)
Net assets represent total assets excluding: 1) cash and securities segregated and on deposit for regulatory and other purposes, 2) securities received as collateral, 3) securities purchased under agreements to resell, 4) securities borrowed and 5) identifiable intangible assets and goodwill. We believe net assets is a measure more useful to investors than total assets when comparing companies in the securities industry because it excludes certain assets considered to have a low-risk profile and identifiable intangible assets and goodwill. Net assets as presented are not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of calculation.(a)
(4)
Tangible equity capital represents total stockholders' equity plus junior subordinated notes (and at November 30, 2003, 2002 and 2001, preferred securities subject to mandatory redemption), less identifiable intangible assets and goodwill.(b) See "MD&A—Liquidity, Funding and Capital Resources—Balance Sheet and Financial Leverage" for additional information about tangible equity capital. We believe total stockholders' equity plus junior subordinated notes to be a more meaningful measure of our equity because the junior subordinated notes are subordinated and have maturities at issuance from 30 to 49 years. In addition, a leading rating agency views these securities as equity capital for purposes of calculating net leverage. Further, we do not view the amount of equity used to support identifiable intangible assets and goodwill as available to support our remaining net assets. Tangible equity capital as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of calculation.
(5)
Total capital includes long-term borrowings (including junior subordinated notes) and total stockholders' equity and, at November 30, 2003 and prior year-ends, preferred securities subject to mandatory redemption. We believe total capital is useful to investors as a measure of our financial strength.
(6)
The book value per common share calculation includes amortized restricted stock units granted under employee stock award programs, which have been included in total stockholders' equity.
(7)
Gross leverage ratio is defined as total assets divided by total stockholders' equity.
(8)
Net leverage ratio is defined as net assets (see note 3 above) divided by tangible equity capital (see note 4 above). We believe net leverage is a more meaningful measure of leverage to evaluate companies in the securities industry. In addition, many of our creditors and a leading rating agency use the same definition of net leverage. Net leverage as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of calculation.
(9)
Assets under management at November 30, 2003 have been restated to include $3.9 billion of discretionary brokerage cash management assets.
(10)
Average common stockholders' equity in 2003 was appropriately weighted for the effect of the equity issued in connection with the Neuberger Berman acquisition on October 31, 2003. Return on average common stockholders' equity is computed by dividing net income applicable to common stock for the period by average common stockholders' equity. Average common stockholders' equity for the years ended November 2005, 2004, 2003, 2002 and 2001 was $14.7 billion, $12.8 billion, $9.1 billion, $8.1 billion and $7.3 billion, respectively.
(11)
Average tangible common stockholders' equity in 2003 was appropriately weighted for the effect of the equity issued in connection with the Neuberger Berman acquisition on October 31, 2003. Return on average tangible common stockholders' equity is computed by dividing net income applicable to common stock for the period by average tangible common stockholders' equity. Average tangible common stockholders' equity equals average total common stockholders' equity less average identifiable intangible assets and goodwill. Average identifiable intangible assets and goodwill for the years ended November 2005, 2004, 2003, 2002 and 2001 was $3.3 billion, $3.5 billion, $471 million, $191 million and $174 million, respectively. Management believes tangible common stockholders' equity is a meaningful measure because it reflects the common stockholders' equity deployed in our businesses.

(a)
Net Assets calculation:
November 30 (in millions)
  2005
  2004
  2003
  2002
  2001
 

 
Total assets   $ 410,063   $ 357,168   $ 312,061   $ 260,336   $ 247,816  
Cash and securities segregated and on
    deposit for regulatory
    and other purposes
    (5,744 )   (4,085 )   (3,100 )   (2,803 )   (3,289 )
Securities received as collateral     (4,975 )   (4,749 )   (3,406 )   (1,994 )   (1,734 )
Securities purchased under agreement to
    resell
    (106,209 )   (95,535 )   (87,416 )   (94,341 )   (83,278 )
Securities borrowed     (78,455 )   (74,294 )   (51,396 )   (20,497 )   (17,994 )
Identifiable intangible assets and
    goodwill
    (3,256 )   (3,284 )   (3,561 )   (213 )   (167 )

 
Net assets   $ 211,424   $ 175,221   $ 163,182   $ 140,488   $ 141,354  

 
(b)
Tangible equity capital calculation:
November 30 (in millions)
  2005
  2004
  2003
  2002
  2001
 

 
Total stockholders' equity   $ 16,794   $ 14,920   $ 13,174   $ 8,942   $ 8,459  
Junior subordinated notes (subject to limitation)(i)     2,026     1,000     1,068     710     710  
Identifiable intangible assets and goodwill     (3,256 )   (3,284 )   (3,561 )   (213 )   (167 )

 
Tangible equity capital   $ 15,564   $ 12,636   $ 10,681   $ 9,439   $ 9,002  

 
    (i)
    Preferred securities subject to mandatory redemption at November 30, 2003, 2002 and 2001.

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LEHMAN BROTHERS HOLDINGS INC.


ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
                   OF OPERATIONS

   

Contents

 
  Page
Number

Management's Discussion and Analysis of Financial Condition and Results of Operations    
 
Introduction

 

29
 
Forward-Looking Statements

 

29
 
Certain Factors Affecting Results of Operations

 

30
 
Executive Overview

 

31
 
Consolidated Results of Operations

 

33
 
Business Segments

 

38
 
Geographic Revenues

 

44
 
Liquidity, Funding and Capital Resources

 

44
 
Summary of Contractual Obligations and Commitments

 

51
 
Off-Balance-Sheet Arrangements

 

53
 
Risk Management

 

54
 
Critical Accounting Policies and Estimates

 

59
 
Accounting and Regulatory Developments

 

64
 
Effects of Inflation

 

66

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations


Introduction

Lehman Brothers Holdings Inc. ("Holdings") and subsidiaries (collectively, the "Company", "Lehman Brothers", "we", "us" or "our") is one of the leading global investment banks, serving institutional, corporate, government and high-net-worth individual clients. Our 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. Through our subsidiaries, we are a global market-maker in all major equity and fixed income products. To facilitate our market-making activities, we are a member of all principal securities and commodities exchanges in the U.S. and we hold memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Australian stock exchanges.

Our principal businesses are investment banking, capital markets and investment management, which, by their nature, are subject to volatility primarily due to changes in interest and foreign exchange rates, valuation of financial instruments and real estate, global economic and political trends and industry competition. Through our investment banking, trading, research, structuring and distribution capabilities in equity and fixed income products, we continue to build on our client-flow business model. The client-flow business model is based on our principal focus of facilitating client transactions in all major global capital markets products and services. We generate client-flow revenues from institutional, corporate, government and high-net-worth clients by (i) advising on and structuring transactions specifically suited to meet client needs; (ii) serving as a market-maker and/or intermediary in the global marketplace, including having securities and other financial instrument products available to allow clients to adjust their portfolios and risks across different market cycles; (iii) providing investment management and advisory services; and (iv) acting as an underwriter to clients. As part of our client-flow activities, we maintain inventory positions of varying amounts across a broad range of financial instruments that are marked to market daily and give rise to principal transactions and net interest revenue. In addition, we also maintain inventory positions (long and short) through our proprietary trading activities, and make principal investments in real estate and private equity. The financial services industry is significantly influenced by worldwide economic conditions as well as other factors inherent in the global financial markets. As a result, revenues and earnings may vary from quarter to quarter and from year to year.

All references to the years 2005, 2004 and 2003 in this Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") refer to our fiscal years ended November 30, 2005, 2004 and 2003, or the last day of such fiscal years, as the context requires, unless specifically stated otherwise.


Forward-Looking Statements

Some of the statements contained in this MD&A, including those relating to our strategy and other statements that are predictive in nature, that depend on or refer to future events or conditions or that include words such as "expects", "anticipates", "intends", "plans", "believes", "estimates" and similar expressions, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These statements are not historical facts but instead represent only management's expectations, estimates and projections regarding future events. Similarly, these statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict, which may include, but are not limited to, the factors discussed under "Certain Factors Affecting Results of Operations" below and in Part I, Item 1A, Risk Factors, in this Form 10-K.

As a global investment bank, our results of operations have varied significantly in response to global economic and market trends and geopolitical events. The nature of our business makes predicting the future trends of net revenues difficult. Caution should be used when extrapolating historical results to future periods. Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, accordingly, readers are cautioned not to place undue reliance on such statements, which speak only as of the date on which they are made. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations


Certain Factors Affecting Results of Operations

Our financial condition and results of operations may be affected by uncertain or unfavorable economic, market, legal and other conditions. These conditions include but are not limited to:

Market Risk

Changes in interest and foreign exchange rates, financial instruments and real estate valuations and increases in volatility can increase credit and market risks and may also affect client-flow-related revenues and proprietary trading revenues as well as affect the volume of debt and equity underwritings and merger and acquisition transactions. See Risk Management—Market Risk in this MD&A for more information.

Competitive Environment

All aspects of our business are highly competitive. Our competitive ability depends on many factors, including our reputation, the quality of our services and advice, intellectual capital, product innovation, execution ability, pricing, sales efforts and the talent of our employees. See Part I, Item 1—Business—Competition in this Form 10-K for more information about competitive matters.

Business Environment

Concerns about geopolitical developments, oil prices and natural disasters, among other things, can affect the global financial markets. Accounting and corporate governance scandals in recent years have had a significant effect on investor confidence. See Executive Overview—Business Environment and—Economic Outlook in this MD&A for additional information.

Liquidity

Liquidity and liquidity management are of critical importance in our industry. Liquidity could be affected by the inability to access the long-term or short-term debt, repurchase or securities-lending markets or to draw under credit facilities, whether due to factors specific to us or to general market conditions. In addition, the amount and timing of contingent events, such as unfunded commitments and guarantees, could adversely affect cash requirements and liquidity. To mitigate these risks, our liquidity and funding policies have been conservatively designed to maintain sufficient liquid financial resources to continually fund our balance sheet and to meet all expected cash outflows, for one year in a stressed liquidity environment. See Liquidity, Funding and Capital Resources—Liquidity Risk Management in this MD&A for more information.

Credit Ratings

Our access to the unsecured funding markets is dependent on our credit ratings. A reduction in our credit ratings could adversely affect our access to liquidity alternatives and our competitive position, and could increase the cost of funding or trigger additional collateral requirements. See Liquidity, Funding and Capital Resources—Credit Ratings in this MD&A for more information.

Credit Exposure

Credit exposure represents the possibility that a counterparty will be unable to honor its contractual obligations. Although we actively manage credit exposure daily as part of our risk management framework, counterparty default risk may arise from unforeseen events or circumstances. See Risk Management—Credit Risk in this MD&A for more information.

Operational Risk

Operational risk is the risk of loss resulting from inadequate or failed internal or outsourced processes, people, infrastructure and technology, or from external events. We seek to minimize these risks through an effective internal control environment. See Risk Management—Operational Risk in this MD&A for more information.

Legal, Regulatory and Reputational Risk

The securities and financial services industries are subject to extensive regulation under both federal and state laws in the U.S. and under the laws of the many other jurisdictions in which we do business. We also are regulated by a number of

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

self-regulatory organizations such as the National Association of Securities Dealers, the Municipal Securities Rulemaking Board and the National Futures Association, and by national securities and commodities exchanges, including the New York Stock Exchange. As of December 1, 2005, Holdings became regulated by the SEC as a consolidated supervised entity ("CSE"), and as such, we are subject to group-wide supervision and examination by the SEC, and accordingly, we are subject to minimum capital requirements on a consolidated basis. Violation of applicable regulations could result in legal and/or administrative proceedings, which may impose censures, fines, cease-and-desist orders or suspension of a firm, its officers or employees. The scrutiny of the financial services industry has increased over the past several years, which has led to increased regulatory investigations and litigation against financial services firms.

Legislation and rules adopted both in the U.S. and around the world have imposed substantial new or more stringent regulations, internal practices, capital requirements, procedures and controls and disclosure requirements in such areas as financial reporting, corporate governance, auditor independence, equity compensation plans, restrictions on the interaction between equity research analysts and investment banking employees and money laundering.

The trend and scope of increased compliance requirements has increased costs necessary to ensure compliance. Our reputation is critical in maintaining our relationships with clients, investors, regulators and the general public, and is a key focus in our risk management efforts.

We are involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of our business, including actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and actions brought on behalf of various classes of claimants against many securities firms and lending institutions, including us. See Part I, Item 1—Business—Regulation and Part I, Item 3—Legal Proceedings in this Form 10-K for more information about legal and regulatory matters.

See Part I, Item 1A, Risk Factors, in this Form 10-K for additional information about these and other risks inherent in our business.


Executive Overview2

Summary of Results

Net income totaled $3.3 billion, $2.4 billion and $1.7 billion in 2005, 2004 and 2003, respectively, increasing 38% in 2005 and 39% in 2004 from the corresponding 2004 and 2003 periods, respectively. Diluted earnings per share were $10.87, $7.90 and $6.35 in 2005, 2004 and 2003, respectively, up 38% in 2005 and 24% in 2004 from the corresponding 2004 and 2003 periods, respectively. Net revenues were $14.6 billion, $11.6 billion and $8.6 billion in 2005, 2004 and 2003, respectively, up 26% and 34% from the corresponding 2004 and 2003 periods.

These record results in fiscal 2005 reflect the enhanced scale we have built and the geographic and product diversification we have achieved, and our continued discipline around managing expenses, risk and capital.

During 2005, we continued to strengthen and grow our firm. We achieved record net revenues, net income and diluted earnings per share in 2005 for the second consecutive fiscal year. These results were driven by record net revenues in each business segment and in each geographic region.

Net revenues grew 26% in 2005 compared with 2004. Investment Banking business segment revenues increased 32% compared with 2004, propelled by record revenues in Global Finance—Debt, and Global Finance—Equity, and the second highest revenues ever in Advisory Services. Capital Markets business segment net revenues rose 27% in 2005 compared with 2004, reflecting a record performance in Fixed Income and second highest Equities net revenues. Investment Management business segment net revenues rose 14% in 2005 compared with 2004 on record levels of both Private Investment Management and Asset Management revenues, and assets under management grew to $175 billion. Non-U.S. net revenues increased to a record $5.4 billion, representing 37% of total net revenues in 2005, up from 29% in 2004, as both the Europe and Asia Pacific and other regions achieved double-digit net revenue growth.


(2)
Market share, volume and ranking statistics in this MD&A were obtained from Thomson Financial.

-31-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Net revenues grew 34% in 2004 compared with 2003, reflecting increases in each of our three business segments and in each geographic region. Investment Banking business segment revenues rose 27% in 2004 compared with 2003 propelled by improvements in Global Finance—Equity and Advisory Services. Capital Markets net revenues rose 28% in 2004 compared with 2003, reflecting robust Fixed Income net revenues and improved Equities net revenues. Investment Management business segment net revenues rose 87% in 2004 compared with 2003, primarily due to increased Asset Management revenues associated with business acquisitions, complemented by improved results in the Private Investment Management component of this business segment.

Business Environment

As a global investment bank, our results of operations can vary in response to global economic and market trends and geopolitical events. A favorable business environment is characterized by many factors, including a stable geopolitical climate, transparent financial markets, low inflation, low unemployment, strong business profitability and high business and investor confidence. These factors can influence (i) levels of debt and equity security issuance and M&A activity, which can affect our Investment Banking business, (ii) trading volumes, financial instrument and real estate valuations and client activity in secondary financial markets, which can affect our Capital Markets businesses and (iii) wealth creation, which can affect both our Capital Markets and Investment Management businesses.

The global market environment during 2005 was generally favorable for our businesses due to a combination of factors—positive economic growth, improved corporate profitability, strong equity markets, and low long-term interest rates by historical standards. The global equity markets rose, driven by strong earnings reports and positive economic data, notwithstanding record high oil prices and continued geopolitical and inflationary concerns. Global yield curves continued to flatten and corporate credit spreads remained generally tight. The economies of Asia (excluding Japan) continued their strong growth in 2005, while the European and Japanese economies grew more slowly. At various points in 2005, market conditions became more challenging due to higher energy prices, the aftermath of the hurricanes in the southeast U.S. and concerns that these factors could translate into higher core inflation. Oil prices reaching $70 a barrel and higher than expected producer and consumer price indices also added uncertainty, volatility and a higher risk premium to the capital markets. However, both the consumer and the markets generally proved to be remarkably resilient.

Equity markets.    The global equity markets reported broad gains during 2005, due primarily to positive economic data and strong earnings reports. Higher valuations served to fuel the equity origination calendar, such that industry-wide volumes were very strong and pipelines continued to build. In 2005, the New York Stock Exchange, Dow Jones Industrial Average, S&P 500 and NASDAQ indices rose 9%, 4%, 6%, and 6%, respectively, when compared to 2004. In the European equity markets, the FTSE and DAX rose 15% and 26%, respectively, in 2005 when compared to 2004. In Asia, the Nikkei and Hang Seng indices rose 36% and 6%, respectively, in 2005 when compared to 2004.

Global trading volumes improved in 2005 compared to 2004. In the U.S., trading volumes for all major indices increased in 2005 compared with 2004, as continued low interest rates and improved corporate profitability created a more favorable environment for equity products. Average daily trading volumes of FTSE 100 stocks declined 6% compared with 2004, while the trading volumes of DAX composite stocks rose 7% compared with 2004. Volumes on the Nikkei and Hang Seng exchanges rose 30% and 6%, respectively, in 2005 compared with 2004.

Fixed income markets.    Throughout 2005 interest rates continued to remain low and the yield curve continued to flatten, as longer term yields were little affected by the Federal Funds Rate increases which totaled 200 basis points. Credit and swap spreads while generally tight, widened slightly in response to the flatter treasury curve. Conditions in Europe were somewhat less favorable than the U.S., as growth remained slow and the Euro weakened. Japan continued on its recovery path, with the Bank of Japan providing favorable monetary policies which continued to support liquidity and growth. Total global debt origination rose 13% in 2005 compared with 2004 on higher levels of investment-grade debt issuances partially offset by a decline in high-yield origination volumes.

Mergers and acquisitions.    Stronger stock valuations and the favorable interest rate environment during 2005 kept both strategic buyers and financial sponsors very active in M&A. Announced M&A volumes rose 56% in 2005 compared with 2004, while completed M&A volumes rose 31% in the period.

Economic Outlook

The financial services industry is significantly influenced by worldwide economic conditions in both banking and capital markets. We expect global GDP growth of 2.6% for 2006, a level that continues to provide a favorable underpinning for

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

this industry. We expect the Fed to continue raising rates to 5% by mid-2006 and then keeping interest rates steady. The end of the Fed's rising interest rate cycle in the past has been positive for our sector. We expect that corporate profitability will remain resilient, and we are looking for corporate earnings to increase by 8% to 10% in 2006. Additionally, U.S. corporate balance sheets remain strong and operating cash flows solid, with cash on hand amounting to approximately 10% of total balance sheets, giving corporations a higher degree of flexibility for mergers and acquisitions, buybacks and dividends. Although we remain wary of geopolitical risk, the growing deficits in the U.S., and China's efforts to rein in growth, we see resiliency in the global economy as a whole.

Equity markets.    The environment for the equity markets became more positive in 2005 compared with 2004. Liquidity remained available and industry-wide equity-offering pipelines continued to grow. We expect the equity offering calendar to remain robust through 2006, as reasonably strong corporate profitability and a low inflation outlook are expected to increase confidence in the marketplace.

Fixed income markets.    We see a continued constructive environment for fixed income origination, given low absolute interest rates, credit spreads remaining in line with historical averages, refinancings of debt maturing in calendar 2006 and the expected increase in M&A and financial-sponsor-related financings. We expect both fixed-income-related products and the fixed income investor base to continue to grow with a continuing global trend of more liquidity requirements being sourced from the capital markets. We also believe a reasonably strong primary debt market should have a positive impact on secondary market flows.

Fixed income activity is driven in part by the absolute level of interest rates, but also is highly correlated with the degree of volatility, the shape of the yield curve and credit quality, which in the aggregate, impact the overall business environment. The fixed income investor base has changed dramatically from long-only investors of a few years ago to a rapidly-growing hedge fund and an expanding international investor base. Investors now employ far more developed risk mitigation tools to manage their portfolios. In addition, in recent years the Fed has become more transparent in communicating its intentions, as evidenced by the market's ability to successfully absorb twelve consecutive 25 basis-point Fed Funds rate hikes from June 1, 2004 through November 30, 2005, to bring the Fed Funds rate to 4%. We believe that the Fed will continue its pattern of raising rates until it reaches 5% in 2006. In addition, the size and diversity of the global fixed income marketplace has become significantly larger and broader over the last several years. We expect approximately $8.5 trillion of global fixed income origination in calendar 2006, staying constant with 2005 issuance levels, but almost double the $4.3 trillion issued in calendar 2000.

Mergers and acquisitions.    During fiscal 2005, M&A activity increased significantly, and we expect this to continue. Companies are still looking to grow, and strategic M&A is an increasingly viable option to achieve these growth objectives, particularly for companies with liquid and strong balance sheets and stronger stock valuations.

During fiscal 2004 and 2005, activity from strategic buyers increased, and we expect the M&A fee pool in fiscal 2006 to continue to grow compared with fiscal 2005. Financial sponsor M&A also has been an important factor driving the increase in activity.

Asset management and high net worth.    Capital markets continued to be resilient in 2005, and growing economies translate into wealth. We aspire to be a provider of choice among the high-net-worth client base, given our growing product breadth and strong performance. Our outlook for asset management and services to high-net-worth individuals is positive, given favorable demographics, higher savings rates globally and intergenerational wealth transfer. The high-net-worth client increasingly seeks multiple providers and greater asset diversification along with a high service component. We believe the significant expansion of our asset management business and the strong investment-return performance of our asset managers, coupled with our cross-selling initiatives, position us well for continued growth in 2006.


Consolidated Results of Operations

Overview

We achieved record net revenues, net income and diluted earnings per share in 2005 for the second consecutive fiscal year. Net revenues were $14.6 billion, $11.6 billion and $8.6 billion in 2005, 2004 and 2003, respectively, up 26% and 34% from the corresponding 2004 and 2003 periods. Net income totaled $3.3 billion, $2.4 billion and $1.7 billion in 2005, 2004 and 2003, respectively, up 38% and 39% from the corresponding 2004 and 2003 periods.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Diluted earnings per share were $10.87, $7.90 and $6.35 in 2005, 2004 and 2003, respectively, up 38% in 2005 and 24% in 2004 from the corresponding 2004 and 2003 periods, respectively.

Return on average common stockholders' equity3 was 21.6%, 17.9% and 18.2% in 2005, 2004 and 2003, respectively. Return on average tangible common stockholders' equity was 27.8%, 24.7% and 19.2% in 2005, 2004 and 2003, respectively.

Compensation and benefits expense as a percentage of net revenues was 49.3%, 49.5% and 49.9% in 2005, 2004 and 2003, respectively. Non-personnel expenses as a percentage of net revenues were 17.7%, 20.1% and 20.7% in 2005, 2004 and 2003, respectively. Pre-tax margin was 33.0%, 30.4% and 29.3% in 2005, 2004 and 2003, respectively.

Net Revenues

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Principal transactions   $ 7,811   $ 5,699   $ 4,272   37 % 33 %
Investment banking     2,894     2,188     1,722   32   27  
Commissions     1,728     1,537     1,210   12   27  
Interest and dividends     19,043     11,032     9,942   73   11  
Asset management and other     944     794     141   19   463  

 
Total revenues     32,420     21,250     17,287   53   23  
Interest expense     17,790     9,674     8,640   84   12  

 
Net revenues   $ 14,630   $ 11,576   $ 8,647   26 % 34 %

 
Principal transactions, commissions and net
    interest revenue
  $ 10,792   $ 8,594   $ 6,784   26 % 27 %

 
Net interest revenue   $ 1,253   $ 1,358   $ 1,302   (8 )% 4 %

 

Net revenues totaled $14.6 billion, $11.6 billion and $8.6 billion in 2005, 2004 and 2003, respectively, representing three consecutive years of record net revenues. Net revenues grew 26% in 2005 compared with 2004, reflecting the highest ever net revenues in each of our three business segments and in each geographic region.

Principal Transactions, Commissions and Net Interest Revenues

In both the Capital Markets and Investment Management business segments, we evaluate net revenue performance based on the aggregate of Principal transactions, Commissions and Interest and dividends revenue net of Interest expense ("Net interest revenue"). These revenue categories include realized and unrealized gains and losses, commissions associated with client transactions and the interest and dividend revenue or interest expense associated with financing or hedging positions. Caution should be used when analyzing these revenue categories individually because they may not be indicative of the overall performance of the Capital Markets and Investment Management business segments. Principal transactions, Commissions and Net interest revenue in the aggregate rose 26% in 2005 compared with 2004 and 27% in 2004 compared with 2003.

Principal transactions revenue improved 37% in 2005 compared with 2004, driven by improvements across both fixed income and equity products, including a higher contribution from non-U.S. regions. In Fixed Income Capital Markets the notable increases were in commercial mortgages and real estate, residential mortgages and interest rate products. The


(3)
Return on average common stockholders' equity and return on average tangible common stockholders' equity are computed by dividing net income applicable to common stock for the period by average common stockholders' equity and average tangible common stockholders' equity, respectively. We believe average tangible common stockholders' equity is a meaningful measure because it reflects the common stockholders' equity deployed in our businesses. Average tangible common stockholders' equity equals average common stockholders' equity less average identifiable intangible assets and goodwill and is computed as follows:


Year ended November 30 (in millions)

  2005
  2004
  2003
 

 
Average common stockholders' equity   $ 14,741   $ 12,843   $ 9,061  
Average identifiable intangible assets and goodwill     (3,272 )   (3,547 )   (471 )

 
Average tangible common stockholders' equity   $ 11,469   $ 9,296   $ 8,590  

 

-34-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

2005 increase in net revenues from equity capital market products was driven by higher trading volumes and improved equity valuations globally as well as increases in financing and derivative activities. Principal transactions revenue improved 33% in 2004 compared with 2003. Then-record fixed income revenues in 2004, with notable improvements in mortgage and interest rate products over the prior year, contributed to the principal transactions revenue increase, together with stronger equity net revenues, particularly in equity derivatives.

Commission revenues rose 12% in 2005 compared with 2004 on higher global trading volumes. Commission revenues increased 27% in 2004 compared with 2003, reflecting commission revenue attributable to the acquisition of Neuberger Berman Inc. and its subsidiaries ("Neuberger") complemented by growth in our trading volumes, despite generally lower market volumes.

Interest and dividends revenue and Interest expense are a function of the level and mix of total assets and liabilities (primarily financial instruments owned and sold but not yet purchased, and collateralized borrowing and lending activities), the prevailing level of interest rates and the term structure of our financings. Interest and dividends revenue and Interest expense are integral components of our evaluation of our overall Capital Markets activities. Net interest revenue in 2005 declined 8% compared with 2004, due to higher short-term interest rates and a flatter yield curve, partially offset by higher levels of interest and dividend earning assets. Interest and dividends revenue and Interest expense rose 73% and 84%, respectively, in 2005 compared with 2004, attributable to higher short-term interest rates coupled with higher levels of interest- and dividend-earning assets and interest-bearing liabilities. Net interest revenue in 2004 rose 4% compared with 2003 principally due to an increase in interest-earning assets. Interest and dividends revenue and Interest expense rose 11% and 12%, respectively, in 2004 compared with 2003 attributable to higher levels of interest- and dividend-earning assets and interest-bearing liabilities coupled with a modest upward shift in interest rates.

Investment Banking

Investment banking revenues result from fees and commissions received for underwriting public and private offerings of fixed income and equity securities, fees and other revenues associated with advising clients on M&A activities, as well as other corporate financing activities. Investment banking revenues rose to record levels in 2005, increasing 32% compared with 2004. The 2005 results reflected our highest levels of revenues in Global Finance—Debt and Global Finance—Equity, and the highest level of Advisory Services revenues since fiscal 2000. Investment banking revenues increased 27% in 2004 compared with 2003, reflecting substantial revenue increases in Global Finance—Equity and Advisory Services and continued strength from our Global Finance—Debt business. See Business Segments—Investment Banking in this MD&A for a discussion and analysis of our Investment Banking business segment.

Asset Management and Other

Asset management and other revenues primarily result from asset management activities in the Investment Management business segment. Asset management and other revenues rose 19% in 2005 compared with 2004. The growth in 2005 primarily reflects higher asset management fees attributable to the growth in assets under management. The significant increase in 2004 compared with 2003 is attributable primarily to the October 31, 2003 acquisition of Neuberger, complemented by higher private equity management and incentive fees.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Non-Interest Expenses

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Compensation and benefits   $ 7,213   $ 5,730   $ 4,318   26 % 33 %
Non-personnel expenses:                            
  Technology and communications     834     764     598   9   28  
  Brokerage and clearance fees     503     453     367   11   23  
  Occupancy     490     421     319   16   32  
  Professional fees     282     252     158   12   59  
  Business Development     234     211     149   11   42  
  Other     245     208     125   18   66  
  Real estate reconfiguration charge         19     77   (100 ) (75 )

 
  Total non-personnel expenses   $ 2,588   $ 2,328   $ 1,793   11 % 30 %

 
Total non-interest expenses   $ 9,801   $ 8,058   $ 6,111   22 % 32 %

 
Compensation and benefits/Net revenues     49.3%     49.5%     49.9%          
Non-personnel expenses/Net revenues     17.7%     20.1%     20.7%          

Non-interest expenses were $9.8 billion, $8.1 billion, and $6.1 billion in 2005, 2004 and 2003, respectively. Non-interest expenses in 2004 and 2003 include a real estate reconfiguration charge discussed further below. Significant portions of certain expense categories are variable, including compensation and benefits, brokerage and clearance, and business development. We expect these variable expenses as a percentage of net revenues to remain in approximately the same proportions for future periods. We continue to maintain a strict discipline in managing expenses.

Compensation and benefits.    Compensation and benefits totaled $7.2 billion, $5.7 billion and $4.3 billion in 2005, 2004, and 2003, respectively. Compensation and benefits expense as a percentage of net revenues continued to decrease and was 49.3%, 49.5%, and 49.9% in 2005, 2004 and 2003, respectively. Employees totaled approximately 22,900, 19,600 and 16,200 at November 30, 2005, 2004 and 2003, respectively. The growth in employees in 2005 is primarily attributable to higher levels of business activity across the firm, as well as investments in the continued growth of the franchise. The increase in employees in 2004 reflects a combination of business acquisitions and organic growth. Compensation and benefits expense includes both fixed and variable components. Fixed compensation, consisting primarily of salaries, benefits and amortization of previous years' deferred equity awards, totaled $3.2 billion, $2.6 billion and $2.0 billion in 2005, 2004 and 2003, respectively, up 21% in 2005 from 2004 and 30% in 2004 from 2003. The growth of fixed compensation in both comparison periods was due primarily to increases in employees. Variable compensation, consisting primarily of incentive compensation, commissions and severance, totaled $4.0 billion, $3.1 billion and $2.3 billion in 2005, 2004 and 2003, respectively, up 30% in 2005 compared to 2004 and 35% in 2004 from 2003, as higher net revenues resulted in higher incentive compensation. Amortization of deferred stock compensation awards was $1,055 million, $800 million and $625 million in 2005, 2004 and 2003, respectively.

Non-personnel expenses.    Non-personnel expenses totaled $2.6 billion, $2.3 billion and $1.8 billion in 2005, 2004 and 2003, respectively. Non-personnel expenses as a percentage of net revenues were 17.7%, 20.1%, and 20.7% in 2005, 2004, and 2003, respectively. The increase in non-personnel expenses in 2005 compared with 2004 is primarily attributable to increased technology, occupancy and costs associated with higher levels of business activity.

Technology and communications expenses rose 9% in 2005 compared with 2004 reflecting increased costs associated with the continued expansion and development of our Capital Markets platforms and infrastructure, and increased technology costs to create further efficiencies in our mortgage origination businesses. Occupancy expenses increased 16% in 2005 compared with 2004 primarily attributable to growth in our global space requirements due to higher levels of employees. Brokerage and clearance expenses rose 11% in 2005 compared with 2004, due primarily to higher transaction volumes in certain Capital Markets products. Professional fees and business development expenses increased 12% and 11%, respectively, in 2005 compared with 2004 due primarily to the higher levels of business activity. Other expenses increased 18% in 2005 compared with 2004 due to a number of factors, including an increase in mutual fund distribution and administration costs related to the growth in assets under management, as well as an increase in charitable contributions.

-36-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

The increase in non-personnel expenses in 2004 is attributable to a number of factors, including business acquisitions coupled with increased technology initiatives, higher occupancy costs and higher levels of business activity. Technology and communications expenses rose 28% in 2004 compared with 2003 reflecting the business acquisitions, the depreciation of technology assets at new facilities, and increased costs associated with the continued build-out of Capital Markets platforms and infrastructure. Brokerage and clearance expenses rose 23% in 2004 compared with 2003, due primarily to higher volumes in Capital Markets products and expansion in equities-related businesses. Occupancy expenses increased 32% in 2004 compared with 2003 primarily attributable to the business acquisitions and the increased cost of our new facilities in London and Tokyo. Professional fees increased 59% in 2004 compared with 2003 due to the business acquisitions and higher recruiting and legal fees. Business development expenses increased 42% in 2004 compared with 2003 due to the higher level of business activity and the business acquisitions. Other expenses increased 66% in 2004 compared with 2003 attributable primarily to the business acquisitions, including mutual fund distribution costs and the amortization of intangible assets.

Real estate reconfiguration charge.    Non-interest expenses in 2004 and 2003 include pre-tax real estate charges of $19 million and $77 million, respectively ($11 million and $45 million after-tax, respectively), associated with our 2002 decision to dispose of certain excess real estate. In March 2004, we reached an agreement to exit virtually all of our remaining leased space at our downtown New York City location, which clarified the loss on the location and resulted in the $19 million charge. See Note 17 to the Consolidated Financial Statements for additional information about the real estate reconfiguration charge.

Insurance settlement.    During 2004, we entered into a settlement with our insurance carriers relating to several legal proceedings noticed to the carriers and initially occurring prior to January 2003. Under the terms of the insurance settlement, the insurance carriers agreed to pay us $280 million. During 2004, we also entered into a Memorandum of Understanding to settle the In re Enron Corporation Securities Litigation class action lawsuit for $223 million. The settlement with our insurance carriers and the settlement under the Memorandum of Understanding did not result in a net gain or loss in our Consolidated Statement of Income as the $280 million settlement with our insurance carriers represented an aggregate settlement associated with several matters, including Enron, Worldcom and other matters. See Part I, Item 3—Legal Proceedings in this Form 10-K for additional information about the Enron securities class action and related matters.

Income Taxes

The provisions for income taxes totaled $1.6 billion, $1.1 billion and $765 million in 2005, 2004 and 2003, respectively. These provisions resulted in effective tax rates of 32.5%, 32.0% and 30.2% for 2005, 2004 and 2003, respectively. The increases in the effective tax rates in 2005 and 2004 compared with the prior years were primarily due to higher levels of pre-tax income, which reduced the effect of certain permanent differences. See Note 16 to the Consolidated Financial Statements for additional information about income taxes.

Business Acquisitions and Dispositions

Capital Markets.    During 2004, we acquired three residential mortgage origination platforms for an aggregate cost of approximately $184 million. We believe these acquisitions add long-term value to our mortgage franchise by allowing further vertical integration of the business platform. Mortgage loans originated by the acquired companies are intended to provide a more cost-efficient source of loan product for our securitization pipeline. We sold our reverse mortgage originator in 2004 for approximately $42 million. During 2003, we acquired controlling interests in two mortgage loan originators for an aggregate cost of approximately $35 million. Net employees added as a result of these acquisitions and disposition totaled approximately 1,300 and 2,000 for 2004 and 2003, respectively.

Investment Management.    In October 2003, we purchased Neuberger as part of our strategic plan to build out our Investment Management business segment. The Neuberger acquisition increased our revenues from fee-based activities, allowing for reduced cross-cycle earnings volatility, while at the same time the acquisition has increased opportunities for revenue synergies across business segments. We purchased Neuberger for a net purchase price of approximately $2.5 billion, including equity consideration of $2.1 billion and cash consideration and incremental costs of $0.7 billion, and excluding cash and short-term investments acquired of $276 million.

In October 2003, we also acquired substantially all of the operating assets of Crossroads, a diversified private equity fund manager, which expanded our global private equity franchise. In January 2003, we acquired the fixed income asset

-37-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

management business of Lincoln Capital Management, a fixed income asset management platform. The cost of these acquisitions aggregated $137 million.

These acquisitions were made as part of our strategic plan to build out our Investment Management business segment. On the dates of acquisition, employees associated with these entities aggregated approximately 1,400.


Business Segments

We operate in three business segments: Investment Banking, Capital Markets and Investment Management. These business segments generate revenues from institutional, corporate, government and high-net-worth individual clients across each of the revenue categories in the Consolidated Statement of Income. Net revenues also contain certain internal allocations, including funding costs and regional transfer pricing which are centrally managed.

The following table summarizes the net revenues of our business segments:

Business Segments

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Net revenues:                            
  Investment Banking   $ 2,894   $ 2,188   $ 1,722   32 % 27 %
  Capital Markets     9,807     7,694     6,018   27   28  
  Investment Management     1,929     1,694     907   14   87  

 
Total net revenues     14,630     11,576     8,647   26   34  
Compensation and benefits     7,213     5,730     4,318   26   33  
Non-personnel expenses(1)     2,588     2,328     1,793   11   30  

 
Income before taxes(1)   $ 4,829   $ 3,518   $ 2,536   37 % 39 %

 
(1)
Includes the Real estate reconfiguration charge recognized in 2004 and 2003 which have not been allocated to our segments.

Investment Banking

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Investment banking revenues   $ 2,894   $ 2,188   $ 1,722   32 % 27 %
Non-interest expenses(1)     2,039     1,601     1,321   27   21  

 
Income before taxes(1)   $ 855   $ 587   $ 401   46 % 46 %

 
(1)
Excludes Real estate reconfiguration charges.

The Investment Banking business segment is made up of Advisory Services and Global Finance activities that serve our corporate and government clients. The segment is organized into global industry groups—Communications, Consumer/Retailing, Financial Institutions, Financial Sponsors, Healthcare, Industrial, Media, Natural Resources, Power, Real Estate and Technology—that include bankers who deliver industry knowledge and expertise to meet clients' objectives. Specialized product groups within Advisory Services include M&A and restructuring. Global Finance serves our clients' capital raising needs through underwriting, private placements, leveraged finance and other activities associated with debt and equity products. Product groups are partnered with relationship managers in the global industry groups to provide comprehensive financial solutions for clients.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Investment Banking Revenues4

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Global Finance—Debt   $ 1,304   $ 1,002   $ 980   30 % 2 %
Global Finance—Equity     824     560     363   47   54  
Advisory Services     766     626     379   22   65  

 
Investment banking revenues   $ 2,894   $ 2,188   $ 1,722   32 % 27 %

 

Investment Banking revenues totaled $2.9 billion, $2.2 billion and $1.7 billion in 2005, 2004 and 2003, respectively. Investment Banking revenues increased 32% in 2005 compared with 2004, reflecting record Global Finance—Debt and Global Finance—Equity revenues and the highest level of Advisory Services revenues since fiscal 2000. Investment Banking revenues increased 27% in 2004 compared with 2003, reflecting significant revenue increases in Global Finance—Equity and Advisory Services.

Global Finance—Debt revenues were a record $1,304 million in 2005, increasing 30% over 2004 with global debt origination market volumes and our volumes increasing 13% and 8%, respectively, over the same period. Revenues in 2005 reflect strong global investment-grade underwriting, which benefited from continued low interest rates, strong investor demand across a flattening yield curve and credit spreads at historic average levels. Revenues in 2005 also benefited from a higher level of client-driven derivative and other capital market-related transactions with our investment banking clients providing fees of $318 million in 2005, compared with fees of $140 million in 2004. Our global debt origination ranking improved to number two for calendar 2005, up from number four for calendar 2004 while our global market share for publicly-reported debt origination was 6.6% in calendar year 2005 compared with 6.8% in calendar year 2004. Our debt origination fee backlog at November 30, 2005 was a record $219 million on lead volumes of $51 billion, up 48% and 38%, respectively, from November 30, 2004. Debt origination backlog may not be indicative of the level of future business due to the frequent use of the shelf registration process. Global Finance—Debt revenues were $1,002 million in 2004, up 2% compared with robust 2003 revenue levels. Our global debt origination volumes in 2004 rose 6% compared with 2003, consistent with the 6% increase in industry-wide global debt origination volumes over the same period, as clients continued to take advantage of low interest rates and tight credit spreads. Improved leveraged finance revenues in 2004 essentially offset a decline in high grade revenues. Our global debt origination ranking improved to number four for calendar 2004, up from number five for calendar 2003, while our market share declined slightly to 6.8% in calendar 2004 compared with 7.0% in calendar 2003.

Global Finance—Equity revenues grew 47% in 2005 to a record $824 million compared with 2004. Our publicly reported equity underwriting volumes rose 7% in 2005 compared with 2004 while industry-wide global equity origination market volumes remained relatively flat over the same period. In addition to our increased volume, our 2005 revenues also reflect a change in the mix of underwriting revenues with particular strength in initial public offerings. Although overall 2005 equity underwriting volumes industry-wide remained relatively flat, IPO and follow-on activity increased. Common stock underwriting activity in 2005 benefited from increased monetization activity by financial sponsors. We substantially increased our market share for publicly reported global equity underwriting transactions for the second consecutive year to 4.8% in calendar 2005 compared with 4.3% for calendar year 2004 and 3.3% in calendar 2003. Our equity-related fee backlog (for both filed and unfiled transactions) at November 30, 2005 was approximately $305 million on lead volume of $19 billion, up 9% and 46%, respectively, over November 30, 2004. Global Finance—Equity revenues grew 54% in 2004 compared with 2003 as improved investor confidence and corporate profitability drove improved equity origination volumes. Industry-wide equity origination volumes rose 48% in 2004 compared with 2003, while our equity origination volumes rose 51% in the same period.


(4)
Debt and equity underwriting volumes are based on full credit for single-book managers and equal credit for joint-book managers. Debt underwriting volumes include both publicly registered and Rule 144A issues of high-grade and high-yield bonds, sovereign, agency and taxable municipal debt, non-convertible preferred stock and mortgage- and asset-backed securities. Equity underwriting volumes include both publicly registered and Rule 144A issues of common stock and convertibles. Because publicly reported debt and equity underwriting volumes do not necessarily correspond to the amount of securities actually underwritten and do not include certain private placements and other transactions, and because revenue rates vary among transactions, publicly reported debt and equity underwriting volumes may not be indicative of revenues in a given period. Additionally, because Advisory Services volumes are based on full credit to each of the advisors in a transaction, and because revenue rates vary among transactions, Advisory Services volumes may not be indicative of revenues in a given period.

-39-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Advisory Services revenues were at our second highest level ever at $766 million in 2005, up 22% compared with 2004. Industry-wide completed and announced transaction volumes increased 31% and 56%, respectively, in 2005 compared with 2004 while our completed and announced volumes increased 24% and 98%, respectively, for the period. Increased M&A volumes benefited from stable equity markets, increased financial sponsor activity as well as improved world economies in 2005. Our global market share for publicly reported completed transactions declined to 13.8% for calendar 2005 compared with 15.5% in calendar year 2004. Our M&A fee backlog at November 30, 2005 was $247 million on volume of $236 billion, up 83% and 225%, respectively, over November 30, 2004. M&A advisory fees rose 65% in 2004 compared with 2003, as we substantially improved our M&A market position for completed transactions in calendar 2004 with a 15.5% market share, up from a 9.0% market share for calendar 2003. M&A completed market transaction volumes increased 34% in fiscal 2004, driven by an improved economy and higher stock market valuation.

Non-interest expenses rose 27% in 2005 compared with 2004, attributable to an increase in compensation and benefits expense related to improved performance, and higher non-personnel expenses related to increased business activity. Non-interest expenses rose 21% in 2004 compared with 2003, attributable to an increase in compensation and benefits expense related to improved performance coupled with higher non-personnel expenses—principally business development expenses.

Income before taxes was $855 million, $587 million and $401 million in 2005, 2004 and 2003, respectively, up 46% in both the 2005 and 2004 comparison periods. Pre-tax margin increased to 30% in 2005, up from 27% in 2004 and 23% in 2003.

Capital Markets

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Principal transactions   $ 7,393   $ 5,255   $ 3,792   41 % 39 %
Commissions     1,132     1,033     911   10   13  
Interest and dividends     18,987     10,999     9,903   73   11  
Other     33     49     22   (33 ) 123  

 
Total revenues     27,545     17,336     14,628   59   19  
Interest expense     17,738     9,642     8,610   84   12  

 
Net revenues     9,807     7,694     6,018   27   28  
Non-interest expenses(1)     6,235     5,168     4,011   21   29  

 
Income before taxes(1)   $ 3,572   $ 2,526   $ 2,007   41 % 26 %

 
(1)
Excludes the Real estate reconfiguration charges.

The Capital Markets business segment includes institutional client-flow activities, prime brokerage, research, mortgage origination and securitization, and secondary-trading and financing activities in fixed income and equity products. These products include a wide range of cash, derivative, secured financing and structured instruments and investments. We are a leading global market-maker in numerous equity and fixed income products including U.S., European and Asian equities, government and agency securities, money market products, corporate high-grade, high-yield and emerging market securities, mortgage- and asset-backed securities, preferred stock, municipal securities, bank loans, foreign exchange, financing and derivative products. We are one of the largest investment banks in terms of U.S. and pan-European listed equities trading volume, and we maintain a major presence in over-the-counter ("OTC") U.S. stocks, major Asian large capitalization stocks, warrants, convertible debentures and preferred issues. In addition, the secured financing business manages our equity and fixed income matched book activities, supplies secured financing to institutional clients and provides secured funding for our inventory of equity and fixed income products. The Capital Markets segment also includes proprietary activities as well as principal investing in real estate and private equity.

See Consolidated Results of Operations—Business Acquisitions and Dispositions in this MD&A for information about Capital Markets-related business acquisitions and dispositions completed during 2004 and 2003.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Capital Markets Net Revenues

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Fixed Income   $ 7,334   $ 5,739   $ 4,391   28 % 31 %
Equities     2,473     1,955     1,627   26   20  

 
Capital markets net revenues   $ 9,807   $ 7,694   $ 6,018   27 % 28 %

 

Net revenues totaled $9.8 billion, $7.7 billion and $6.0 billion in 2005, 2004 and 2003, respectively. Capital Markets net revenues in 2005 represent the seventh consecutive year of record performance in Fixed Income and the second highest revenue level in Equities. Fixed Income revenues rose 28% in 2005 compared with 2004 on improved client-flow activities, an increased contribution from the non-US regions and record revenues across a number of products. Equities revenues rose 26% in 2005 compared with 2004, benefiting from higher global trading volumes and market indices, particularly in Europe and Asia, as well as increased prime broker activities. Fixed Income revenues improved in 2004 compared with 2003 as a favorable interest rate environment helped drive strength in mortgage originations and securitizations as well as interest rate products and the declining dollar drove higher foreign exchange activity. Equities delivered improved revenues in 2004 compared with 2003 on higher client-flow levels, particularly in equity derivatives and our prime broker business, as equity market valuations improved compared with 2003.

Fixed Income net revenues were a record $7.3 billion in 2005, increasing 28% compared with 2004 driven by double digit revenue increases from each geographic region and record revenues across a number of businesses including commercial mortgage and real estate, residential mortgage origination and securitization, and interest rate products. Revenues from our commercial mortgage and real estate businesses increased substantially in 2005 reaching record levels, as the strong demand for commercial real estate properties, the recovery in certain property markets and relatively low interest rates drove asset sales and robust levels of securitizations. Revenues from our residential mortgage origination and securitization businesses increased in 2005 from the robust levels in 2004, reflecting record volumes and the continued benefits associated with the vertical integration of our mortgage origination platforms. We originated approximately $85 billion and $65 billion of residential mortgage loans in 2005 and 2004, respectively. We securitized approximately $133 billion and $101 billion of residential mortgage loans in 2005 and 2004, respectively, including both originated loans and those we acquired in the secondary market. While the performance in our mortgage businesses reached record levels, these businesses were affected by somewhat lower levels of mortgage origination volumes and revenues in the U.S. in the latter half of 2005, partly offset by stronger volumes and revenues outside the U.S. We originated approximately $27 billion and $13 billion of commercial mortgage loans in 2005 and 2004, respectively, the majority of which has been sold through securitization or syndication activities during both 2005 and 2004. Interest rate product revenues increased in 2005 on higher activity levels, as clients repositioned portfolios in light of rising global interest rates and a flattening U.S. yield curve. Credit product revenues also increased in 2005 as compared to 2004 driven by strength in both high yield and high grade credit products. Fixed Income net revenues increased 31% in 2004 compared with 2003, reflecting generally favorable market conditions. The mortgage securitization business was notably strong, with revenues in mortgage products benefiting from the low rate environment as well as the continued vertical integration of our mortgage origination platforms. Interest rate products benefited from robust client-flow activity as investors sought derivative hedging solutions amid an environment of increased interest rate volatility in the first half of 2004. Foreign exchange revenues also rose as the U.S. dollar weakened in the latter half of 2004. Partially offsetting these increases were reduced contributions from high-grade and high-yield credit products in 2004 compared with 2003.

Equities net revenues rose 26% in 2005 compared with 2004, benefiting from increased client activity from rising global equity indices and higher trading volumes. Global equities indices advanced 16.5% in local currency terms in 2005 benefiting from positive economic data and strong earnings reports, despite volatile oil prices and concerns about inflation and rising interest rates. Equities net revenues in 2005 reflect improved client-flow activities across most products, higher net revenues in equity derivatives and the continued growth in our prime broker business. Equity derivatives business net revenues in 2005 were notably strong benefiting from higher volumes as well as improved market opportunities. Our prime broker business continued to benefit from an expanding client base and growth in client financing balances, as total balances increased 22% in 2005 compared with 2004. Equities net revenues grew 20% in 2004 compared with 2003 on higher client-flow levels, particularly in equity derivative products and our prime broker activities, as equity market valuations improved compared with 2003. Prime broker activity continued to benefit from growth in client financing balances and an expanding client base, as total balances increased 72% compared with

-41-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

November 30, 2003. Our 2004 results also reflect higher private equity gains compared with 2003. These improvements were partially offset by lower revenues from our convertibles business due to a lower level of origination activity and a sharp drop in market volatility globally, resulting in lower valuations on convertible debt.

Interest and dividends revenue and Interest expense are a function of the level and mix of total assets and liabilities (primarily financial instruments owned and collateralized activities), the prevailing level of interest rates and the term structure of our financings. Interest and dividends revenue and Interest expense are integral components of our evaluation of our overall Capital Markets activities. Net interest revenue in 2005 declined 8% compared with 2004, due to higher short-term interest rates and a flatter yield curve, partially offset by higher levels of interest and dividend-earning assets. Interest and dividends revenue and Interest expense rose 73% and 84%, respectively, in 2005 compared with 2004, attributable to higher short-term interest rates coupled with higher levels of interest- and dividend-earning assets and interest-bearing liabilities. Net interest revenue in 2004 rose 5% compared with 2003 primarily due to an increase in interest earning assets. Interest and dividends revenue and Interest expense rose 11% and 12%, respectively, in 2004 compared with 2003 attributable to higher levels of interest- and dividend-earning assets and interest-bearing liabilities coupled with a modest upward shift in interest rates.

Non-interest expenses increased to $6.2 billion in 2005 from $5.2 billion in 2004 and $4.0 billion in 2003. The growth in non-interest expenses in both periods reflects higher Compensation and benefits expense related to improved revenue performance coupled with higher non-personnel expenses. Non-personnel expenses in both periods grew primarily due to increased technology and communications expenses, attributable to the continued investments in our trading platforms as well as the integration of the business acquisitions, and higher brokerage and clearance costs and professional fees on increased business activities. Occupancy expenses also increased due to growth in the number of employees and our new facilities in London and Tokyo in 2004.

Income before taxes totaled $3,572 million, $2,526 million and $2,007 million in 2005, 2004 and 2003, respectively, up 41% in 2005 compared with 2004 and 26% in 2004 compared with 2003. Pre-tax margin was 36%, 33% and 33% in 2005, 2004 and 2003, respectively.

Investment Management

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Principal transactions   $ 418   $ 444   $ 480   (6 )% (8 )%
Commissions     596     504     299   18   69  
Interest and dividends     56     33     39   70   (15 )
Asset management and other     911     745     119   22   526  

 
Total revenues     1,981     1,726     937   15   84  
Interest expense     52     32     30   63   7  

 
Net revenues     1,929     1,694     907   14   87  
Non-interest expenses(1)     1,527     1,270     702   20   81  

 
Income before taxes(1)   $ 402   $ 424   $ 205   (5 )% 107 %

 
(1)
Excludes Real estate reconfiguration charges.

The Investment Management business segment consists of the Asset Management and Private Investment Management businesses. Asset Management generates fee-based revenues from customized investment management services for high-net-worth clients, as well as fees from mutual fund and other institutional investors. Asset Management also generates management and incentive fees from our role as general partner for private equity and other alternative investment partnerships. Private Investment Management provides comprehensive investment, wealth advisory and capital markets execution services to high-net-worth and middle market clients.

See Consolidated Results of Operations—Business Acquisitions and Dispositions in this MD&A and Note 5 to the Consolidated Financial Statements for information about Investment Management-related business acquisitions completed during 2003.

-42-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Investment Management Net Revenues

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Asset Management   $ 1,026   $ 840   $ 141   22 % 496 %
Private Investment Management     903     854     766   6   11  

 
Investment management net revenues   $ 1,929   $ 1,694   $ 907   14 % 87 %

 

Changes in Assets Under Management

 
   
   
   
  Percent Change
 

In billions
November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Opening balance   $ 137   $ 120   $ 9   14 % 1,233 %
Net additions     26     6     110   333   (95 )
Net market appreciation     12     11     1   9   1,000  

 
  Total increase     38     17     111   124   (85 )

 
Assets Under Management, November 30   $ 175   $ 137   $ 120   28 % 14 %

 

Composition of Assets Under Management

 
   
   
   
  Percent Change
 

In billions
November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Equity   $ 75   $ 54   $ 43   39 % 26 %
Fixed income     55     52     49   6   6  
Money markets     29     19     18   53   6  
Alternative investments     16     12     10   33   20  

 
Assets Under Management, November 30   $ 175   $ 137   $ 120   28 % 14 %

 

Net revenues totaled $1.9 billion, $1.7 billion and $0.9 billion in 2005, 2004 and 2003, respectively. Net revenues rose 14% in 2005 compared with 2004, as both Asset Management and Private Investment Management achieved record results in 2005. Net revenues increased 87% in 2004 compared with 2003, primarily due to business acquisitions completed during 2003, most notably the Neuberger acquisition completed in October 2003.

Asset Management net revenues in 2005 increased 22% compared with 2004, driven by a 28% increase in assets under management. Assets under management increased to a record $175 billion at November 30, 2005, up from $137 billion at November 30, 2004, with nearly 70% of the increase resulting from net inflows. Asset Management net revenues increased to $840 million in 2004 compared with $141 million in 2003, primarily as a result of business acquisitions as well as increased private equity fees. Total fees from private equity were $148 million, $117 million and $28 million in 2005, 2004 and 2003, respectively. Private equity fees increased in 2005 as a result of higher management fees from new fund offerings. Private equity fees increased in 2004 as a result of new fund offerings as well as higher incentive fees, which totaled $63 million and $2 million in 2004 and 2003, respectively.

Private Investment Management net revenues increased 6% in 2005 compared with 2004, primarily driven by an increase in equity-related activity, as investors shifted asset allocations. Fixed income-related activity declined 11% in 2005 compared to 2004 as a result of clients' asset reallocations into equity products. Private Investment Management net revenues rose 11% to $854 million in 2004 compared with 2003, driven by sales of equity products, which benefited from improved market conditions, partially offset by modestly lower sales of fixed income products attributable to rising interest rates.

Non-interest expenses totaled $1.5 billion, $1.3 billion and $0.7 billion in 2005, 2004 and 2003, respectively. The increase in non-interest expense in 2005 was principally driven by higher compensation and benefits associated with higher level of earnings, as well as increased non-personnel expenses, as we continue to build the business. The increase in non-interest expenses in 2004 compared with 2003 was primarily due to business acquisitions, including higher compensation and benefits, mutual fund distribution costs and the amortization of intangible assets.

-43-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Income before taxes totaled $402 million, $424 million and $205 million in 2005, 2004 and 2003, respectively. Income before taxes decreased 5% in 2005 compared with 2004. Income before taxes increased 107% in 2004 compared with 2003. Pre-tax margin was 21%, 25% and 23% in 2005, 2004 and 2003, respectively.


Geographic Revenues

Net Revenues by Geographic Region

 
   
   
   
  Percent Change
 

In millions
Year ended November 30

   
   
   
 
  2005
  2004
  2003
  2005/
2004

  2004/
2003

 

 
Europe   $ 3,601   $ 2,104   $ 1,864   71 % 13 %
Asia Pacific and other     1,759     1,247     875   41   43  

 
Total Non-U.S.     5,360     3,351     2,739   60   22  
U.S.     9,270     8,225     5,908   13   39  

 
Net revenues   $ 14,630   $ 11,576   $ 8,647   26 % 34 %

 

Non-U.S. net revenues rose 60% in 2005 compared with 2004 to a record $5.4 billion. Non-U.S. net revenues represented 37% of total net revenues in 2005, compared with 29% in 2004. The improved net revenues in 2005 compared with 2004 reflects significant growth in Capital Markets and Investment Banking in both the Europe and Asia Pacific and other regions. Non-U.S. net revenues grew 22% to a then-record $3.4 billion in 2004 compared with 2003. Revenues in 2004 compared with 2003 reflect improvements in both Capital Markets and Investment Banking and represent strength in revenues in both the Asia Pacific and other and Europe regions.

Net revenues in Europe rose 71% in 2005 compared with 2004 reflecting higher revenues in Investment Banking and Capital Markets, as well as a growing Investment Management presence. Investment Banking benefited from a significant increase in completed M&A transactions and increased client-driven derivative-solution transactions in 2005. In Fixed Income Capital Markets, our strong performance in 2005 was driven by commercial mortgages and real estate, interest rate products and residential mortgages. In Equities Capital Markets, higher net revenues reflect strong results in equity derivatives, cash products, and equity arbitrage activities. Net revenues in Europe increased 13% in 2004 compared with 2003, attributable to improvements in both Capital Markets and Investment Banking. The Capital Markets improvement reflects strong mortgage securitization and foreign exchange results as well as equity cash and derivatives results. These improvements were partially offset by lower results in real estate attributable to the further softening of certain sectors within the commercial real estate market and lower results in convertibles as the rising interest rate environment in the second half of 2004 negatively affected the convertible market. Investment Banking revenues were up significantly as we continued to gain market share in both equity and debt origination, although M&A market share declined.

Net revenues in Asia Pacific and other rose 41% in 2005 compared with 2004, reflecting strong Investment Banking and Capital Markets net revenues. Investment Banking benefited from several non-public structured equity transactions for clients in 2005. Capital Markets net revenues increased in 2005 primarily from strong performances in high yield and equity derivatives. Net revenues in Asia Pacific and other increased 43% in 2004 compared with 2003 due to strong revenue growth in both Capital Markets and Investment Banking. Fixed Income Capital Markets client activity increased in high yield and foreign exchange. Equities Capital Markets results improved in 2004 compared with 2003, reflecting higher volumes in the Asian equity markets.


Liquidity, Funding and Capital Resources

Management's Finance Committee is responsible for developing, implementing and enforcing our liquidity, funding and capital policies. These policies include recommendations for capital and balance sheet size as well as the allocation of capital and balance sheet to the business units. Management's Finance Committee oversees compliance with policies and limits with the goal of ensuring we are not exposed to undue liquidity, funding or capital risk.

-44-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Liquidity Risk Management

We view liquidity and liquidity management as critically important to the Company. Our liquidity strategy seeks to ensure that we maintain sufficient liquidity to meet all of our funding obligations in all market environments. Our liquidity strategy is centered on five principles:

    We maintain a liquidity pool available to Holdings that is of sufficient size to cover expected cash outflows over the next twelve months in a stressed liquidity environment.

    We rely on secured funding only to the extent that we believe it would be available in all market environments.

    We aim to diversify our funding sources to minimize reliance on any given providers.

    Liquidity is assessed at the entity level. For example, because our legal entity structure can constrain liquidity available to Holdings, our liquidity pool excludes liquidity that is restricted from availability to Holdings.

    We maintain a comprehensive Funding Action Plan that represents a detailed action plan to manage a stress liquidity event, including a communication plan for regulators, creditors, investors and clients.

Liquidity pool.    We maintain a liquidity pool available to Holdings that covers expected cash outflows for twelve months in a stressed liquidity environment. In assessing the required size of our liquidity pool, we assume that assets outside the liquidity pool cannot be sold to generate cash, unsecured debt cannot be issued, and any cash and unencumbered liquid collateral outside of the liquidity pool cannot be used to support the liquidity of Holdings. Our liquidity pool is sized to cover expected cash outflows associated with the following items:

    The repayment of all unsecured debt maturing in the next twelve months ($11.4 billion at November 30, 2005).

    The funding of commitments to extend credit made by Holdings and its unregulated subsidiaries based on a probabilistic analysis of these drawdowns. The funding of commitments to extend credit made by our regulated subsidiaries is covered by the liquidity pools maintained by these subsidiaries. (See Summary of Contractual Obligations and Commitments—Lending-Related Commitments in this MD&A and Note 10 to the Consolidated Financial Statements).

    The impact of adverse changes on secured funding—either in the form of wider "haircuts" (the difference between the market and pledge value of assets) or in the form of reduced borrowing availability.

    The anticipated funding requirements of equity repurchases as we manage our equity base (including offsetting the dilutive effect of our employee incentive plans) (See Liquidity, Funding and Capital Resources—Equity Management in this MD&A).

In addition, the liquidity pool is sized to cover the impact of a one notch downgrade of Holdings' long-term debt ratings, including the additional collateral required for our derivative contracts and other secured funding arrangements. (See Liquidity, Funding and Capital Resources—Credit Ratings in this MD&A).

The liquidity pool is primarily invested in highly liquid instruments including: money market funds, bank deposits, U.S., European and Japanese Government bonds, and U.S. agency securities, with the balance invested in liquid securities that we believe have a highly reliable pledge value. We calculate our liquidity pool on a daily basis.

At November 30, 2005, the estimated pledge value of the liquidity pool available to Holdings was $18.3 billion, which is in excess of the items discussed above. Additionally, our regulated subsidiaries, such as our broker-dealers and bank institutions maintain their own liquidity pools to cover their stand-alone one year expected cash funding needs in a stressed liquidity environment. The estimated pledge value of the liquidity pools held by our regulated subsidiaries totaled an additional $35.7 billion at November 30, 2005.

-45-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Funding of assets.    We fund assets based on their liquidity characteristics, and utilize cash capital for our long-term funding needs. Our funding strategy incorporates the following factors:

    Liquid assets (i.e., assets for which a reliable secured funding market exists across all market environments including government bonds, U.S. agency securities, corporate bonds, asset-backed securities and high quality equity securities) are primarily funded on a secured basis.

    Secured funding "haircuts" are funded with cash capital5.

    Illiquid assets (e.g., fixed assets, intangible assets, and margin postings) and less liquid inventory positions (e.g., derivatives, private equity investments, certain corporate loans, certain commercial mortgages and real estate positions) are funded with cash capital.

    Unencumbered assets, irrespective of asset quality, that are not part of the liquidity pool are also funded with cash capital. These assets are typically unencumbered because of operational and asset-specific factors (e.g., securities moving between depots). We do not assume a change in these factors during a stressed liquidity event.

As part of our funding strategy, we also take steps to mitigate our main sources of contingent liquidity risk as follows:

    Commitments to extend credit—Cash capital is utilized to cover expected funding of commitments to extend credit. See Summary of Contractual Obligations and Commitments—Lending-Related Commitments in this MD&A.

    Ratings downgrade—Cash capital is utilized to cover the liquidity impact of a one notch downgrade on Holdings. A rating downgrade would increase the amount of collateral to be posted against our derivative contracts and other secured funding arrangements. See Liquidity, Funding and Capital Resources—Credit Ratings in this MD&A.

    Customer financing—We provide secured financing to our clients typically through repurchase and prime broker agreements. These financing activities can create liquidity risk if the availability and terms of our secured borrowing agreements adversely change during a stressed liquidity event and we are unable to reflect these changes in our customer financing agreements. We mitigate this risk by entering into term secured borrowing agreements, in which we can fund different types of collateral at pre-determined collateralization levels, and by the liquidity pools maintained at our broker-dealers.

Our policy is to operate with an excess of long-term funding sources over our long-term funding requirements. We seek to maintain a cash capital surplus at Holdings of at least $2 billion. As of November 30, 2005 and November 30, 2004, our cash capital surplus at Holdings totaled $6.2 billion and $7.1 billion, respectively. Additionally, cash capital surpluses in regulated entities at November 30, 2005 and 2004 amounted to $8.1 billion and $2.8 billion, respectively.

Diversification of funding sources.    We seek to diversify our funding sources. We issue long-term debt in multiple currencies and across a wide range of maturities to tap many investor bases, thereby reducing our reliance on any one source.

    During 2005, we issued $23.7 billion of long-term borrowings. Long-term borrowings increased to $62.3 billion at November 30, 2005 from $56.5 billion at November 30, 2004, with weighted-average maturities of 5.9 years and 5.2 years, respectively—above our targeted minimum weighted-average maturity of four years.

    We diversify our issuances geographically to minimize refinancing risk and broaden our debt-holder base. As of November 30, 2005, 47% of our long-term debt was issued outside the United States.

    We typically issue in a single maturity in sufficient size to create a liquid benchmark issuance (i.e., sufficient size to be included in the Lehman Bond Index, a widely used index for fixed income asset managers).

    In order to minimize refinancing risk, we set limits for the amount of long-term borrowings maturing over any three, six and twelve month horizon at 10%, 15% and 25% of outstanding long-term borrowings, respectively—

(5)
Cash capital consists of stockholders' equity, core deposit liabilities at our bank subsidiaries, the undrawn portion of committed credit facilities with greater than one-year remaining life and liabilities with remaining terms of over one year.

-46-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

that is, $6.2 billion, $9.3 billion and $15.6 billion, respectively, at November 30, 2005. If we were to operate with debt above these levels, we would not include the additional amount as a source of cash capital.

Extendible issuances (in which, unless debt holders instruct us to redeem their debt instruments at least one year prior to stated maturity, the maturity date of these instruments is automatically extended) are included in these limits at their earliest maturity date. Based on experience, we expect the majority of these extendibles to remain outstanding beyond their earliest maturity date in a normal market environment and "roll" through the long-term-borrowings maturity profile.

The quarterly long-term borrowings maturity schedule over the next five years at November 30, 2005 is as follows:

Long-Term Borrowings Maturity Profile Chart

GRAPHIC

    We use both committed and uncommitted bilateral and syndicated long-term bank facilities to complement our long-term debt issuance. In particular, Holdings maintains an unsecured revolving credit agreement (the "Credit Agreement") with a syndicate of banks under which the banks have committed to provide up to $1.5 billion to Holdings through April 2007. We also maintain a $1.0 billion multi-currency unsecured committed revolving credit facility with a syndicate of banks for Lehman Brothers Bankhaus (the "Facility"). The Facility has a term of three and a half years expiring in April 2008. There were no borrowings outstanding under either the Credit Agreement or the Facility at November 30, 2005.

    Bank facilities provide us with further diversification and flexibility. For example, we draw on our committed syndicated credit facilities described above on a regular basis (typically 25% to 30% of the time on a weighted- average basis) to provide us with additional sources of cash capital on an as-needed basis.

    We own three bank entities: Lehman Brothers Bank, a U.S.-based thrift institution, Lehman Brothers Commercial Bank, a U.S.-based industrial bank, and Lehman Brothers Bankhaus, a German bank. These regulated bank entities operate in a deposit-protected environment and are able to source low-cost unsecured funds that are primarily term deposits. These are generally insulated from a Company-specific or market liquidity event, thereby providing a reliable funding source for our mortgage products and selected loan assets and increasing our funding diversification. Overall, these bank institutions have raised $14.8 billion and $10.2 billion of customer deposit liabilities as of November 30, 2005 and 2004, respectively.

-47-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Legal Entity Structure.    Our legal entity structure can constrain liquidity available to Holdings. Some of our legal entities, particularly our regulated broker-dealers and bank institutions, are restricted in the amount of funds that they can distribute or lend to Holdings.

    As of November 30, 2005, Holdings' Total Equity Capital (defined as total stockholders' equity of $16.8 billion plus $2.0 billion of junior subordinated notes) amounted to $18.8 billion. We believe Total Equity Capital to be a more meaningful measure of our equity than stockholders' equity because junior subordinated notes are deeply subordinated and have maturities of at least 30 years at issuance. Leading rating agencies view these securities as equity capital for purposes of calculating net leverage. (See Note 8 to the Consolidated Financial Statements). We aim to maintain a primary equity double leverage ratio (the ratio of equity investments in Holdings' subsidiaries to its Total Equity Capital) of 1.0x or below. Our primary equity double leverage ratio was 0.85x as of November 30, 2005 and 2004.

    Certain regulated subsidiaries are funded with subordinated debt issuances and/or subordinated loans from Holdings, which are counted as regulatory capital for those subsidiaries. Our policy is to fund subordinated debt advances by Holdings to subsidiaries for use as regulatory capital with long-term debt issued by Holdings having a maturity at least one year greater than the maturity of the subordinated debt advance.

Funding Action Plan.    We have developed and regularly update a Funding Action Plan, which represents a detailed action plan to manage a stress liquidity event, including a communication plan for regulators, creditors, investors and clients. The Funding Action Plan considers two types of liquidity stress events—a Company-specific event, where there are no issues with the overall market liquidity; and a broader market-wide event, which affects not just our Company but the entire market.

In a Company-specific event, we assume we would lose access to the unsecured funding market for a full year and have to rely on the liquidity pool available to Holdings to continue to fund our balance sheet.

In a market liquidity event, in addition to the pressure of a Company-specific event, we also assume that, because the event is market wide, some counterparties to whom we have extended liquidity facilities draw on these facilities. To mitigate the effect of a market liquidity event, we have developed access to additional liquidity sources beyond the liquidity pool at Holdings. These sources include unutilized funding capacity in our bank entities, a conduit pre-funded with short-term liquid instruments, and unutilized capacity in our bank facilities. (See Liquidity Risk Management—Funding of Assets in this MD&A.)

We perform regular assessments of our funding requirements in stress liquidity scenarios to best ensure we can meet all our funding obligations in all market environments.

Cash Flows

Cash and cash equivalents declined $0.5 billion at November 30, 2005 compared with November 30, 2004, as net cash used in operating activities of $7.5 billion—attributable primarily to growth in financial instruments and other inventory positions owned—coupled with net cash used in investing activities of $447 million exceeded net cash provided by financing activities of $7.4 billion. Cash and cash equivalents declined $2.5 billion at November 30, 2004 compared with November 30, 2003, as net cash used in operating activities of $11.5 billion—attributable primarily to growth in secured financing activities—coupled with net cash used in investing activities of $531 million exceeded net cash provided by financing activities of $9.5 billion.

Balance Sheet and Financial Leverage

Assets.    Our balance sheet consists primarily of Cash and cash equivalents, Financial instruments and other inventory positions owned, and collateralized financing agreements. The liquid nature of these assets provides us with flexibility in financing and managing our business. The majority of these assets are funded on a secured basis through collateralized financing agreements.

Our total assets at November 30, 2005 increased 15% to $410 billion at November 30, 2005 compared with $357 billion at November 30, 2004, primarily due to an increase in secured financing transactions and net assets. Net assets at November 30, 2005 increased $36 billion primarily due to increases in mortgages and mortgage-backed inventory positions, equities and corporate debt. We believe net assets is a more useful measure than total assets when comparing companies in the securities industry because it excludes certain assets considered to have a low risk profile (including

-48-


LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Cash and securities segregated and on deposit for regulatory and other purposes, Securities received as collateral, Securities purchased under agreements to resell and Securities borrowed) and Identifiable intangible assets and goodwill. This definition of net assets is used by many of our creditors and a leading rating agency to evaluate companies in the securities industry. Under this definition, net assets were $211 billion and $175 billion at November 30, 2005 and November 30, 2004, respectively, as follows:

Net Assets


In millions
November 30

  2005
  2004
 

 
Total assets   $ 410,063   $ 357,168  
Cash and securities segregated and on deposit for regulatory and other purposes     (5,744 )   (4,085 )
Securities received as collateral     (4,975 )   (4,749 )
Securities purchased under agreements to resell     (106,209 )   (95,535 )
Securities borrowed     (78,455 )   (74,294 )
Identifiable intangible assets and goodwill     (3,256 )   (3,284 )

 
Net assets   $ 211,424   $ 175,221  

 

Our net assets consist of inventory necessary to facilitate client flow activities and, to a lesser degree, proprietary activities. As such, our mix of net assets is subject to change depending primarily on client demand. In addition, due to the nature of our client flow activities and based on our business outlook, the overall size of our balance sheet will fluctuate from time to time and, at specific points in time, may be higher than the year-end or quarter-end amounts. Our total assets at quarter-ends were, on average, approximately 5% lower than amounts based on a monthly average over both the four and eight quarters ended November 30, 2005. Our net assets at quarter-ends were, on average, approximately 7% lower than amounts based on a monthly average over both the four and eight quarters ended November 30, 2005.

Leverage Ratios.    Balance sheet leverage ratios are one measure used to evaluate the capital adequacy of a company. The gross leverage ratio is calculated as total assets divided by total stockholders' equity. Our gross leverage ratios were 24.4x and 23.9x at November 30, 2005 and 2004, respectively. However, we believe net leverage based on net assets as defined above (which excludes certain assets considered to have a low risk profile and Identifiable intangible assets and goodwill) divided by tangible equity capital (Total stockholders' equity plus Junior subordinated notes less Identifiable intangible assets and goodwill), to be a more meaningful measure of leverage in evaluating companies in the securities industry. Our net leverage ratio of 13.6x at November 30, 2005 declined from 13.9x at November 30, 2004 as we increased our tangible equity capital proportionately more than we increased our net assets. We believe tangible equity capital to be a more representative measure of our equity for purposes of calculating net leverage because Junior subordinated notes are subordinated and have maturities at issuance from 30 to 49 years and we do not view the amount of equity used to support Identifiable intangible assets and goodwill as available to support our remaining net assets. This definition of net leverage is used by many of our creditors and a leading rating agency. Tangible equity capital and net leverage are computed as follows at November 30, 2005 and 2004:

Tangible Equity Capital and Net Leverage


In millions
November 30

  2005
  2004
 

 
Total stockholders' equity   $ 16,794   $ 14,920  
Junior subordinated notes(1)     2,026     1,000  
Identifiable intangible assets and goodwill     (3,256 )   (3,284 )

 
Tangible equity capital   $ 15,564   $ 12,636  

 
Gross leverage     24.4 x   23.9 x
Net leverage     13.6 x   13.9 x

 
(1)
See Note 8 to the Consolidated Financial Statements.

Net assets, tangible equity capital and net leverage as presented above are not necessarily comparable to similarly titled measures provided by other companies in the securities industry because of different methods of calculation.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Equity Management

The management of equity is a critical aspect of our capital management. The determination of the appropriate amount of equity is affected by a number of factors, including the amount of "risk equity" needed, the capital required by our regulators, balance sheet leverage and the dilutive effects of equity-based employee awards. Equity requirements constantly are changing, and we actively monitor risk requirements and potential investment opportunities. We continuously look at investment alternatives for our equity with the objective of maximizing shareholder value. In addition, in managing our capital, returning capital to shareholders by repurchasing shares is among the alternatives considered.

We maintain a stock repurchase program to manage our equity capital. Our stock repurchase program is effected through regular open-market purchases, as well as through employee transactions where employees tender shares of common stock to pay for the exercise price of stock options, and the required tax withholding obligations upon option exercises and conversion of restricted stock units to freely-tradable common stock. During 2005, we repurchased approximately 30 million shares of our common stock through open-market purchases at an aggregate cost of $3.0 billion, or $99.98 per share. In addition, we withheld approximately 10.3 million shares of common stock from employees at an equivalent cost of $1.2 billion, principally done in the last quarter of 2005.

For 2006, our Board of Directors has authorized the repurchase, subject to market conditions, of up to 40 million shares of Holdings common stock for the management of our equity capital, including offsetting 2006 dilution due to equity-based award plans. Our Board also authorized the repurchase in 2006, subject to market conditions, of up to an additional 15 million shares, for the possible acceleration of repurchases to offset a portion of 2007 dilution due to equity-based award plans. This authorization supersedes the stock repurchase program authorized in January 2005.

Included below are the changes in our Tangible Equity Capital during the years ended November 30, 2005 and November 30, 2004:

Tangible Equity Capital


In millions
Year Ended November 30

  2005
  2004
 

 
Beginning tangible equity capital   $ 12,636   $ 10,681  
Net income     3,260     2,369  
Dividends on common stock     (233 )   (186 )
Dividends on preferred stock     (69 )   (72 )
Common stock open-market repurchases     (2,994 )   (1,693 )
Common stock withheld from employees(1)     (1,163 )   (574 )
Equity-based award plans(2)     3,305     1,894  
Net change in preferred stock     (250 )   300  
Net change in junior subordinated notes included in tangible equity(3)     1,026     (68 )
Other, net     46     (15 )

 
Ending tangible equity capital     15,564     12,636  

 
(1)
Represents shares of common stock withheld in satisfaction of the exercise price of stock options and tax withholding obligations upon option exercises and conversion of restricted stock units.

(2)
This represents the sum of (i) proceeds received from employees upon the exercise of stock options, (ii) the incremental tax benefits from the issuance of stock-based awards and (iii) the value of employee services received—as represented by the amortization of deferred stock compensation.

(3)
Junior subordinated notes are subordinated and have maturities at issuance from 30 to 49 years and are utilized in calculating equity capital by a leading rating agency.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Credit Ratings

Like other companies in the securities industry, we rely on external sources to finance a significant portion of our day-to-day operations. The cost and availability of unsecured financing are affected by our short-term and long-term credit ratings. Factors that may be significant to the determination of our credit ratings or otherwise affect our ability to raise short-term and long-term financing include our profit margin, our earnings trend and volatility, our cash liquidity and liquidity management, our capital structure, our risk level and risk management, our geographic and business diversification, and our relative positions in the markets in which we operate. A deterioration in any of these factors or combination of these factors may lead rating agencies to downgrade our credit ratings. This may increase the cost of, or possibly limit our access to, certain types of unsecured financings and trigger additional collateral requirements in derivative contracts and other secured funding arrangements. In addition, our debt ratings can affect certain capital markets revenues, particularly in those businesses where longer-term counterparty performance is critical, such as OTC derivative transactions, including credit derivatives and interest rate swaps.

In October 2005, Standard & Poor's Ratings Services ("S&P") raised its long-term counterparty credit rating on Holdings to A+ with a stable outlook from A with a positive outlook, and also raised Lehman Brothers Inc.'s ("LBI") short- and long-term ratings by one notch. In July 2005, Fitch Ratings upgraded Holdings' and LBI's short-term debt ratings from F-1 to F-1+, Fitch's highest short-term rating.

At November 30, 2005, the short- and long-term borrowings ratings of Holdings and LBI were as follows:

 
  Credit Ratings
 
  Holdings
  LBI
 
  Short-
term

  Long-
term

  Short-
term

  Long-
term(1)


Standard & Poor's Ratings Services   A-1   A+   A-1+   AA-
Moody's Investors Service   P-1   A1   P-1   Aa3
Fitch Ratings   F-1+   A+   F-1+   A+
Dominion Bond Rating Service Limited   R-1 (middle)   A (high)   R-1 (middle)   AA (low)/A (high)

(1)
Senior/subordinated.

At November 30, 2005, counterparties had the right to require us to post additional collateral pursuant to derivative contracts and other secured funding arrangements of approximately $0.8 billion. Additionally, at that date we would have been required to post additional collateral pursuant to such arrangements of approximately $0.2 billion in the event we were to experience a downgrade of our senior debt rating of one notch and $1.6 billion in the event we were to experience a downgrade of our senior debt rating of two notches.


Summary of Contractual Obligations and Commitments

In the normal course of business, we enter into various commitments and guarantees, including lending commitments to high grade and high yield borrowers, private equity investment commitments, liquidity commitments and other guarantees. In all instances, we mark to market these commitments and guarantees, with changes in fair value recognized in Principal transactions in the Consolidated Statement of Income.

Lending-Related Commitments

Through our high grade and high yield sales, trading, underwriting and mortgage origination activities, we make commitments to extend credit in loan syndication transactions. We use various hedging and funding strategies to actively manage our market, credit and liquidity exposures on these commitments. We do not believe total commitments necessarily are indicative of actual risk or funding requirements because the commitments may not be drawn or fully used and such amounts are reported before consideration of hedges. These commitments and any related drawdowns of these facilities typically have fixed maturity dates and are contingent on certain representations, warranties and contractual conditions applicable to the borrower. We define high yield (non-investment grade) exposures as securities of or loans to companies rated BB+ or lower or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans that, in management's opinion, are non-investment grade. In addition, our residential and commercial mortgage platforms in our Capital Markets business make commitments to extend mortgage loans. From

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

time to time, we may also provide contingent commitments to investment and non-investment grade counterparties related to acquisition financing. Our expectation is, and our past practice has been, to distribute through loan syndications to investors substantially all the credit risk associated with these acquisition financing loans, if closed, consistent with our credit facilitation framework. We do not believe these commitments are necessarily indicative of our actual risk because the borrower may not complete a contemplated acquisition or, if the borrower completes the acquisition, often will raise funds in the capital markets instead of drawing on our commitment. In addition, our Capital Markets businesses enter into secured financing commitments.

Lending-related commitments at November 30, 2005 and 2004 were as follows:

 
  Amount of Commitment Expiration per Period
  Total
Contractual Amount


In millions

  2006
  2007
  2008-
2009

  2010-
2011

  2012 and
Later

  November
30, 2005

  November
30, 2004


High grade(1)   $ 2,405   $ 1,624   $ 3,270   $ 6,169   $ 571   $ 14,039   $ 10,677
High yield(2)     1,289     1,159     645     1,448     631     5,172     4,438
Mortgage commitments     9,024     176     209     8         9,417     12,835
Investment-grade contingent
    acquisition facilities
    3,915                     3,915     1,475
Non-investment-grade contingent
    acquisition facilities
    4,738                     4,738     4,244
Secured lending transactions,
    including forward starting
    resale and repurchase
    agreements
    62,470     1,124     320     873     995     65,782     105,879

(1)
We view our net credit exposure for high grade commitments, after consideration of hedges, to be $5.4 billion and $4.1 billion at November 30, 2005 and 2004, respectively.

(2)
We view our net credit exposure for high yield commitments, after consideration of hedges, to be $4.4 billion and $3.5 billion at November 30, 2005 and 2004, respectively.

See Note 10 to the Consolidated Financial Statements for additional information about our lending-related commitments.

Contractual obligations

Contractual obligations at November 30, 2005 and 2004 were as follows:

 
  Amount of Obligation Expiration per Period
  Total Contractual Amount

In millions

  2006
  2007
  2008-
2009

  2010 and
Later

  November
30, 2005

  November
30, 2004


Long-term borrowings maturities   $ 8,410   $ 13,503   $ 13,939   $ 26,457   $ 62,309   $ 56,486
Operating lease obligations     173     165     308     1,069     1,715     1,740
Capital lease obligations     61     61     154     2,497     2,773     2,900
Purchase obligations     366     148     107     43     664     604

See Note 8 to the Consolidated Financial Statements for additional information about long-term borrowings maturities. See Note 10 to the Consolidated Financial Statements for additional information about operating and capital lease obligations. Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations with variable pricing provisions are included in the table based on the minimum contractual amounts. Certain purchase obligations contain termination or renewal provisions. The table reflects the minimum contractual amounts likely to be paid under these agreements assuming the contracts are not terminated. Excluded from the table are a number of obligations recorded in the Consolidated Statement of Financial Condition that generally are short-term in nature, including securities financing transactions, trading liabilities, deposits, commercial paper and other short-term borrowings and other payables and accrued liabilities.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations


Off-Balance-Sheet Arrangements

In the normal course of business we engage in a variety of off-balance-sheet arrangements, including derivative contracts.

Derivatives

Derivatives often are referred to as off-balance-sheet instruments because neither their notional amounts nor the underlying instruments are reflected as assets or liabilities in our Consolidated Statement of Financial Condition. Instead, the market or fair values related to the derivative transactions are reported in the Consolidated Statement of Financial Condition as assets or liabilities in Derivatives and other contractual agreements, as applicable.

In the normal course of business, we enter into derivative transactions both in a trading capacity and as an end-user. We use derivative products in a trading capacity as a dealer to satisfy the financial needs of clients and to manage our own exposure to market and credit risks resulting from our trading activities (collectively, "Trading-Related Derivative Activities"). In this capacity, we transact extensively in derivatives including interest rate, credit (both single name and portfolio), foreign exchange and equity derivatives. Additionally, in 2005 the Company began trading in commodity derivatives. The use of derivative products in our trading businesses is combined with transactions in cash instruments to allow for the execution of various trading strategies. Derivatives are recorded at market or fair value in the Consolidated Statement of Financial Condition on a net-by-counterparty basis when a legal right of set-off exists and are netted across products when such provisions are stated in the master netting agreement. As an end-user, we use derivative products to adjust the interest rate nature of our funding sources from fixed to floating interest rates and to change the index on which floating interest rates are based (e.g., Prime to LIBOR).

We conduct our derivative activities through a number of wholly-owned subsidiaries. Our fixed income derivative products business is principally conducted through our subsidiary Lehman Brothers Special Financing Inc., and separately capitalized "AAA" rated subsidiaries, Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc. Our equity derivative products business is conducted through Lehman Brothers Finance S.A. and Lehman Brothers OTC Derivatives Inc. In addition, as a global investment bank, we also are a market maker in a number of foreign currencies. Counterparties to our derivative product transactions primarily are U.S. and foreign banks, securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds. We manage the risks associated with derivatives on an aggregate basis, along with the risks associated with our non-derivative trading and market-making activities in cash instruments, as part of our firmwide risk management policies. We use industry standard derivative contracts whenever appropriate.

See Notes 1 and 2 to the Consolidated Financial Statements for additional information about our accounting policies and our Trading-Related Derivative Activities.

Special Purpose Entities

In the normal course of business, we establish special purpose entities ("SPEs"), sell assets to SPEs, transact derivatives with SPEs, own securities or residual interests in SPEs and provide liquidity or other guarantees for SPEs. SPEs are corporations, trusts or partnerships that are established for a limited purpose. There are two types of SPEs—qualifying special purpose entities ("QSPEs") and variable interest entities ("VIEs"). SPEs, by their nature, generally are not controlled by their equity owners, because the establishing documents govern all material decisions. Our primary involvement with SPEs relates to securitization transactions through QSPEs, in which transferred assets are sold to an SPE that issues securities supported by the cash flows generated by the assets (i.e., securitized). A QSPE can generally be described as an entity with significantly limited powers that are intended to limit it to passively holding financial assets and distributing cash flows to investors on pre-set terms. Under SFAS 140, we are not required to, and do not, consolidate QSPEs. Rather, we account for our involvement with QSPEs under a financial components approach in which we recognize any interest we retain after securitization at fair value, with changes in fair value reported in Principal transactions in the Consolidated Statement of Income.

We are a market leader in mortgage (both residential and commercial), municipal and other asset-backed securitizations that are principally transacted through QSPEs. See Note 3 to the Consolidated Financial Statements for additional information about our securitization activities.

In addition, we transact extensively with VIEs which do not meet the QSPE criteria due to their permitted activities not being sufficiently limited, or because the assets are not deemed qualifying financial instruments (e.g., real estate). Under

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

FIN 46R, we consolidate such VIEs if we are deemed to be the primary beneficiary of such entity. The primary beneficiary is the party that has either a majority of the expected losses or a majority of the expected residual returns of such entity, as defined. Examples of our involvement with VIEs include collateralized debt obligations, synthetic credit transactions, real estate investments through VIEs, and other structured financing transactions. For additional information about our involvement with VIEs, see Note 3 to the Consolidated Financial Statements.

Other Commitments and Guarantees

Other commitments and guarantees at November 30, 2005 and 2004 were as follows:

 
  Amount of Commitment Expiration per Period
  Notional/
Maximum Amount


In millions

  2006
  2007
  2008-
2009

  2010-
2011

  2012 and
Later

  November
30, 2005

  November
30, 2004


Derivative contracts(1)   $ 120,805   $ 68,171   $ 97,075   $ 89,813   $ 163,597   $ 539,461   $ 470,641
Municipal-securities-related
    commitments
    680     16     34     744     2,631     4,105     7,179
Other commitments with special
    purpose entities
    3,257     248     606     485     1,725     6,321     5,261
Standby letters of credit     2,608                     2,608     1,703
Private equity and other
    principal investment
    commitments
    328     243     316     40         927     695

(1)
We believe the fair value of these derivative contracts is a more relevant measure of the obligations because we believe the notional amount overstates the expected payout. At November 30, 2005 and 2004 the fair value of these derivative contracts approximated $9.4 billion and $9.0 billion, respectively.

See Note 10 to the Consolidated Financial Statements for additional information about our other commitments and guarantees.

Other Off-Balance-Sheet Activities

In the ordinary course of business we enter into various other types of off-balance-sheet arrangements. For additional information about our lending-related commitments and guarantees and our contractual obligations see "Summary of Contractual Obligations and Commitments" in this MD&A.


Risk Management

As a leading global investment bank, risk is an inherent part of our business. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The principal risks we face are credit, market, liquidity, legal, reputation and operational risks. Risk management is considered to be of paramount importance in our day-to-day operations. Consequently, we devote significant resources (including investments in employees and technology) to the measurement, analysis and management of risk.

While risk cannot be eliminated, it can be mitigated to the greatest extent possible through a strong internal control environment. Essential in our approach to risk management is a strong internal control environment with multiple overlapping and reinforcing elements. We have developed policies and procedures to identify, measure and monitor the risks involved in our global trading, brokerage and investment banking activities. Our approach applies analytical procedures overlaid with sound practical judgment working proactively with the business areas before transactions occur to ensure that appropriate risk mitigants are in place.

We also seek to reduce risk through the diversification of our businesses, counterparties and activities in geographic regions. We accomplish this objective by allocating the usage of capital to each of our businesses, establishing trading limits and setting credit limits for individual counterparties. Our focus is balancing risk versus return. We seek to achieve adequate returns from each of our businesses commensurate with the risks they assume. Nonetheless, the effectiveness of our approach to managing risks can never be completely assured. For example, unexpected large or rapid movements or disruptions in one or more markets or other unforeseen developments could have an adverse effect on our results of operations and financial condition. The consequences of these developments can include losses due to adverse changes in inventory values, decreases in the liquidity of trading positions, increases in our credit exposure to clients and counterparties and increases in general systemic risk.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Our overall risk limits and risk management policies are established by the Executive Committee. On a weekly basis, our Risk Committee, which consists of the Executive Committee, the Chief Risk Officer and the Chief Financial Officer, reviews all risk exposures, position concentrations and risk-taking activities. The Global Risk Management Division (the "Division") is independent of the trading areas and reports directly to the Firm's Chief Administrative Officer. The Division includes credit risk management, market risk management, quantitative risk management, sovereign risk management and operational risk management. Combining these disciplines facilitates a fully integrated approach to risk management. The Division maintains staff in each of our regional trading centers as well as in key sales offices. Risk management personnel have multiple levels of daily contact with trading staff and senior management at all levels within the Company. These discussions include reviews of trading positions and risk exposures.

Credit Risk

Credit risk represents the possibility that a counterparty or an issuer of securities or other financial instruments we hold will be unable to honor its contractual obligations to us. Credit risk management is therefore an integral component of our overall risk management framework. The Credit Risk Management Department (the "CRM Department") has global responsibility for implementing our overall credit risk management framework.

The CRM Department manages the credit exposure related to trading activities by giving credit approval for counterparties, assigning internal risk ratings, establishing credit limits by counterparty, country and industry group and requiring master netting agreements and collateral in appropriate circumstances. The CRM Department considers the transaction size, the duration of a transaction and the potential credit exposure for complex derivative transactions in making our credit decisions. The CRM Department is responsible for the continuous monitoring and review of counterparty risk ratings, current credit exposures and potential credit exposures across all products and recommending valuation adjustments, when appropriate. Credit limits are reviewed periodically to ensure that they remain appropriate in light of market events or the counterparty's financial condition.

The CRM Department also has responsibility for portfolio management of counterparty credit risks. This includes monitoring and reporting large exposures (current credit exposure and maximum potential exposure) and concentrations across countries, industries and products, as well as ensuring risk ratings are current and performing asset quality portfolio trend analyses.

Our Chief Risk Officer is a member of the Investment Banking Commitment, Investment and Bridge Loan Approval Committees. Members of Credit and Market Risk Management participate in committee meetings, vetting and reviewing transactions. Decisions on approving transactions not only take into account the creditworthiness of the transaction on a stand-alone basis, but they also consider our aggregate obligor risk, portfolio concentrations, reputation risk and, importantly, the impact any particular transaction under consideration would have on our overall risk appetite. Exceptional transactions and/or situations are addressed and discussed with senior management including, when appropriate, the Executive Committee.

See Critical Accounting Policies and Estimates—Derivatives and other contractual agreements in this MD&A and Note 2 to the Consolidated Financial Statements for additional information about net credit exposure on OTC derivative contracts.

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 management also is an essential component of our overall risk management framework. The Market Risk Management Department (the "MRM Department") has global responsibility for developing and implementing our overall market risk management framework. To that end, it is responsible for developing the policies and procedures of the market risk management process; determining the market risk measurement methodology in conjunction with the Quantitative Risk Management Department (the "QRM Department"); monitoring, reporting and analyzing the aggregate market risk of trading exposures; administering market risk limits and the escalation process; and communicating large or unusual risks as appropriate. Market risks inherent in positions include, but are not limited to, interest rate, equity and foreign exchange exposures.

The MRM Department uses qualitative as well as quantitative information in managing trading risk, believing a combination of the two approaches results in a more robust and complete approach to the management of trading risk. Quantitative information is developed from a variety of risk methodologies based on established statistical principles. To

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

ensure high standards of analysis, the MRM Department has retained seasoned risk managers with the requisite experience and academic and professional credentials.

Market risk is present in cash products, derivatives and contingent claim structures that exhibit linear as well as non-linear price behavior. Our exposure to market risk varies in accordance with the volume of client-driven market-making transactions, the size of our proprietary positions and the volatility of financial instruments traded. We seek to mitigate, whenever possible, excess market risk exposures through appropriate hedging strategies.

We participate globally in interest rate, equity and foreign exchange markets and, beginning in 2005, commodity markets. Our 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- and asset-backed securities, real estate, municipal bonds and interest rate derivatives. Our Equities Division facilitates domestic and foreign trading in equity instruments, indices and related derivatives. Our foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts.

We incur short-term interest rate risk in the course of facilitating the orderly flow of client transactions through the maintenance of government and other bond inventories. Market-making in high-grade corporate bonds and high-yield instruments exposes us to additional risk due to potential variations in credit spreads. Trading in international markets exposes us to spread risk between the term structure of interest rates in different countries. Mortgages and mortgage-related securities are subject to prepayment risk. Trading in derivatives and structured products exposes us to changes in the volatility of interest rates. We actively manage interest rate risk through the use of interest rate futures, options, swaps, forwards and offsetting cash-market instruments. Inventory holdings, concentrations and agings are monitored closely and used by management to selectively hedge or liquidate undesirable exposures.

We are a significant intermediary in the global equity markets through our market making in U.S. and non-U.S. equity securities and derivatives, including common stock, convertible debt, exchange-traded and OTC equity options, equity swaps and warrants. These activities expose us to market risk as a result of equity price and volatility changes. Inventory holdings also are subject to market risk resulting from concentrations and changes in liquidity conditions that may adversely affect market valuations. Equity market risk is actively managed through the use of index futures, exchange-traded and OTC options, swaps and cash instruments.

We enter into foreign exchange transactions through our market-making activities. We are exposed to foreign exchange risk on our holdings of non-dollar assets and liabilities. We are active in many foreign exchange markets and have exposure to the Euro, Japanese yen, British pound, Swiss franc and Canadian dollar, as well as a variety of developed and emerging market currencies. We hedge our risk exposures primarily through the use of currency forwards, swaps, futures and options.

If any of the strategies used to hedge or otherwise mitigate exposures to the various types of risks described above are not effective, we could incur losses. See Notes 1 and 2 to the Consolidated Financial Statements for additional information about our use of derivative financial instruments to hedge interest rate, currency, equity and other market risks.

Operational Risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. We face operational risk arising from mistakes made in the execution, confirmation or settlement of transactions or from transactions not being properly recorded, evaluated or accounted for. Our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies, and the transactions we process have become increasingly complex. Consequently, we rely heavily on our financial, accounting and other data processing systems. In recent years, we have substantially upgraded and expanded the capabilities of our data processing systems and other operating technology, and we expect that we will need to continue to upgrade and expand in the future to avoid disruption of, or constraints on, our operations.

Operational Risk Management (the "ORM Department") is responsible for implementing and maintaining our overall global operational risk management framework, which seeks to minimize these risks through assessing, reporting, monitoring and mitigating operational risks.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

We have a company-wide business continuity plan ("BCP Plan"). The BCP Plan objective is to ensure that we can continue critical operations with limited processing interruption in the event of a business disruption. The BCP group manages our internal incident response process and develops and maintains continuity plans for critical business functions and infrastructure. This includes determining how vital business activities will be performed until normal processing capabilities can be restored. The BCP group is also responsible for facilitating disaster recovery and business continuity training and preparedness for our employees.

Reputational Risk

We recognize that maintaining our reputation among clients, investors, regulators and the general public is an important aspect of minimizing legal and operational risks. Maintaining our reputation depends on a large number of factors, including the selection of our clients and the conduct of our business activities. We seek to maintain our reputation by screening potential clients and by conducting our business activities in accordance with high ethical standards.

Potential clients are screened through a multi-step process that begins with the individual business units and product groups. In screening clients, these groups undertake a comprehensive review of the client and its background and the potential transaction to determine, among other things, whether they pose any risks to our reputation. Potential transactions are screened by independent committees in the Firm, which are composed of senior members from various corporate divisions of the Company including members of the Global Risk Management Division. These committees review the nature of the client and its business, the due diligence conducted by the business units and product groups and the proposed terms of the transaction to determine overall acceptability of the proposed transaction. In doing so, the committees evaluate the appropriateness of the transaction, including a consideration of ethical and social responsibility issues and the potential effect of the transaction on our reputation.

Value At Risk

Value-at-risk (VaR) measures the potential mark-to-market loss over a specified time horizon and is expressed at a given confidence level. We report an "empirical" VaR calculated based upon the distribution of actual trading revenue. We consider VaR based on net revenue volatility to be a comprehensive risk measurement tool because it incorporates virtually all of our trading activities and types of risk including market, credit and event risks. The table below presents VaR for each component of risk using historical daily net trading revenues. Under this method, we estimate a reporting daily VaR using actual daily net trading revenues over the previous 250 trading days. Such VaR is measured as the loss, relative to the median daily trading net revenue, at a 95% confidence level. This means there is a 1-in-20 chance that such loss on a particular day could exceed the reported VaR number.

Value At Risk—Revenue Volatility

 
   
   
  Year ended November 30
 
  VaR At
November 30

 
  2005
  2004

In millions

  2005
  2004
  Average
  High
  Low
  Average
  High
  Low

Interest rate risk   $ 24.5   $ 22.0   $ 24.0   $ 26.2   $ 21.9   $ 21.5   $ 24.2   $ 18.2
Equity price risk     14.0     11.0     11.7     14.2     11.0     9.6     11.0     6.7
Foreign exchange risk     2.5     2.8     2.5     3.0     2.2     3.4     3.8     2.7
Diversification benefit     (5.2 )   (7.9 )   (6.8 )               (7.7 )          

    $ 35.8   $ 27.9   $ 31.4   $ 36.1   $ 27.9   $ 26.8   $ 30.0   $ 21.7

Average VaR for 2005 of $31.4 million increased from $26.8 million for the comparable 2004 period reflecting the increased scale of our fixed income and equity capital markets businesses, as well as a lower diversification benefit across these businesses.

VaR based on net revenue volatility is just one tool we use in evaluating firmwide risk. Another risk measurement tool is a model-based approach, using end-of-day positions, and modeling market risk, counterparty credit risk and event risk. Using this model-based approach, our average firmwide risk for 2005 declined compared with 2004, primarily due to reduced event risk, partially offset by slightly higher market risk.

The market risk component of the model-based risk measurement approach is based on a historical simulation VaR using end-of-day positions to determine the revenue loss at a 95% confidence level over a one-day time horizon. Specifically, the historical simulation approach involves constructing a distribution of hypothetical daily changes in the

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

value of our financial instruments based on risk factors embedded in the current portfolio and historical observations of daily changes in these risk factors. Our method uses four years of historical data weighted to give greater impact to more recent time periods in simulating potential changes in market risk factors.

It is implicit in a historical simulation VaR methodology that positions will have offsetting risk characteristics, referred to as diversification benefit. We measure the diversification benefit within our portfolio of financial instruments by historically simulating how the positions in our current portfolio would have behaved in relation to each other (as opposed to using a static estimate of a diversification benefit, which remains relatively constant from period to period). Thus, from time to time there will be changes in our historical simulation VaR due to changes in the diversification benefit across our portfolio of financial instruments.

Historical simulation VaR was $38.4 million at November 30, 2005, up from $29.6 million at November 30, 2004 primarily attributable to higher equity price risk and a lower diversification benefit. Average historical simulation VaR was $38.7 million for 2005, up from $29.3 million in 2004 reflecting the increased scale of our fixed income and equity capital markets businesses as well as a lower diversification benefit in relative terms.

As with any predictive model, VaR measures have inherent limitations, and we could incur losses greater than the VaR reported above. These limitations include: historical market conditions and historical changes in market risk factors may not be accurate predictors of future market conditions or future market risk factors and VaR measurements are based on current positions, while future risk depends on future positions. In addition, a one day historical simulation VaR does not fully capture the market risk of positions that cannot be liquidated or hedged within one day.

In addition, because there is no uniform industry methodology for estimating VaR, different assumptions and methodologies could produce materially different results and therefore caution should be used when comparing such risk measures across firms. We believe our methods and assumptions used in these calculations are reasonable and prudent.

Distribution of Daily Net Revenues

Substantially all of the Company's inventory positions are marked-to-market daily with changes recorded in net revenues. The following chart sets forth the frequency distribution for daily net revenues for our Capital Markets and Investment Management business segments (excluding asset management fees) for the years ended November 30, 2005 and 2004.

As discussed throughout this MD&A, we seek to reduce risk through the diversification of our businesses and a focus on client-flow activities. This diversification and focus, combined with our risk management controls and processes, helps mitigate the net revenue volatility inherent in our trading activities. Although historical performance is not necessarily indicative of future performance, we believe our focus on business diversification and client-flow activities should continue to reduce the volatility of future net trading revenues.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Daily Trading Net Revenues

GRAPHIC

In both 2004 and 2005, daily trading net revenues did not exceed losses of $30 million on any single day.


Critical Accounting Policies and Estimates

Generally accepted accounting principles require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management estimates are required in determining the valuation of inventory positions, particularly over-the-counter ("OTC") derivatives, certain commercial mortgage loans and investments in real estate, certain high-yield positions, private equity and other principal investments, and non-investment-grade retained interests. Additionally, significant management estimates are required in assessing the realizability of deferred tax assets, the fair value of assets and liabilities acquired in a business acquisition, the accounting treatment of QSPEs and VIEs, the outcome of litigation, the fair value of equity-based compensation awards and determining the allocation of the cost of acquired businesses to identifiable intangible assets and goodwill and determining the amount of the real estate reconfiguration charges. Management believes the estimates used in preparing the financial statements are reasonable and prudent. Actual results could differ from these estimates.

The following is a summary of our critical accounting policies and estimates. See Note 1 to the Consolidated Financial Statements for a full description of these and other accounting policies.

Fair Value

The determination of fair value is a critical accounting policy that is fundamental to our financial condition and results of operations. We record financial instruments classified as Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased at market or fair value, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. In all instances, we believe we have established rigorous internal control processes to ensure we use reasonable and prudent measurements of fair value on a consistent basis.

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When evaluating the extent to which estimates may be required in determining the fair values of assets and liabilities reflected in our financial statements, we believe it is useful to analyze the balance sheet as shown in the following table:

LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

Summary Balance Sheet


In millions

  November 30, 2005
 

 
Assets            
Financial instruments and other inventory positions owned   $ 177,438   43 %
Securities received as collateral     4,975   1 %
Collateralized agreements     184,664   45 %
Cash, Receivables and PP&E     35,172   9 %
Other assets     4,558   1 %
Identifiable intangible assets and goodwill     3,256   1 %

 
Total assets   $ 410,063   100 %

 

Liabilities and Equity

 

 

 

 

 

 
Financial instruments and other inventory positions sold but not yet purchased   $ 110,577   27 %
Obligation to return securities received as collateral     4,975   1 %
Collateralized financing     152,425   37 %
Payables and other accrued liabilities     62,983   16 %
Total capital(1)     79,103   19 %

 
Total liabilities and equity   $ 410,063   100 %

 
(1)
Total capital includes long-term borrowings (including junior subordinated notes) and total stockholders' equity, and at November 30, 2003 and prior year ends, preferred securities subject to mandatory redemption. We adopted FIN 46R effective February 29, 2004, which required us to deconsolidate trusts that issue preferred securities subject to mandatory redemption. Accordingly, at February 29, 2004 and subsequent period ends, Long-term borrowings include junior subordinated notes that at November 30, 2003 and prior period ends, were classified as preferred securities subject to mandatory redemption. We believe Total capital is useful to investors as a measure of our financial strength because it aggregates our long-term funding sources.

The majority of our assets and liabilities are recorded at amounts for which significant management estimates are not used. The following balance sheet categories, comprising 54% of total assets and 72% of total liabilities and equity, are valued either at historical cost or at contract value (including accrued interest) which, by their nature, do not require the use of significant estimates: Collateralized agreements, Cash, Receivables and PP&E, Collateralized financing, Payables and other accrued liabilities and Total capital. Securities received as collateral and Obligation to return securities received as collateral are recorded at fair value, but due to their offsetting nature do not result in fair value estimates affecting the Consolidated Statement of Income. Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased (long and short inventory positions, respectively), are recorded at market or fair value, the components of which may require, to varying degrees, the use of estimates in determining fair value.

When evaluating the extent to which management estimates may be used in determining the fair value for long and short inventory, we believe it is useful to consider separately derivatives and cash instruments.

Derivatives and other contractual agreements.    The fair values of derivative assets and liabilities at November 30, 2005 were $18.0 billion and $15.6 billion, respectively (See Note 2 to the Consolidated Financial Statements). Included within these amounts were exchange-traded derivative assets and liabilities of $2.6 billion and $2.4 billion, respectively, for which fair value is determined based on quoted market prices. The fair values of our OTC derivative assets and liabilities at November 30, 2005 were $15.4 billion and $13.2 billion, respectively.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

The following table sets forth the fair value of OTC derivatives by contract type and by remaining contractual maturity:

Fair Value of OTC Derivative Contracts by Maturity


In millions
November 30, 2005

  Less
than
1 Year

  1 to 5
Years

  5 to 10
Years

  Greater
than
10 Years

  Cross
Maturity
and Cash
Collateral
Netting(1)

  OTC
Derivatives

  Net
Credit
Exposure


Assets                                          
Interest rate, currency and credit default swaps and options   $ 1,677   $ 6,794   $ 7,907   $ 5,620   $ (13,725 ) $ 8,273   $ 6,261
Foreign exchange forward contracts and options     6,828     1,497     303     45     (6,703 )   1,970     1,447
Other fixed income securities contracts     3,415     139             (1,313 )   2,241     1,876
Equity contracts     1,548     2,201     446     216     (1,453 )   2,958     878

    $ 13,468   $ 10,631   $ 8,656   $ 5,881   $ (23,194 ) $ 15,442   $ 10,462

Liabilities                                          
Interest rate, currency and credit default swaps and options   $ 1,194   $ 4,939   $ 4,636   $ 4,025   $ (7,666 ) $ 7,128      
Foreign exchange forward contracts and options     7,068     2,131     498     181     (7,874 )   2,004      
Other fixed income securities contracts     2,230     13             (1,347 )   896      
Equity contracts     1,634     2,404     686     273     (1,847 )   3,150      

     
    $ 12,126   $ 9,487   $ 5,820   $ 4,479   $ (18,734 ) $ 13,178      

     
(1)
Cross-maturity netting represents the netting of receivable balances with payable balances for the same counterparty across maturity and product categories. Receivable and payable balances with the same counterparty in the same maturity category are netted within the maturity category when appropriate. Cash collateral received or paid is netted on a counterparty basis, provided legal right of offset exists. Assets and liabilities at November 30, 2005 were netted down for cash collateral of approximately $10.5 billion and $6.1 billion, respectively.

Presented below is an analysis of net credit exposure at November 30, 2005 for OTC contracts based on actual ratings made by external rating agencies or by equivalent ratings established and used by our Credit Risk Management Department.

Net Credit Exposure


Counterparty
Risk Rating

   
  Less
than
1 Year

   
   
  Greater
than
10 Years

  Total
 
  S&P/Moody's
Equivalent

  1 to 5
Years

  5 to 10
Years

 
  2005
  2004
 

 
iAAA   AAA/Aaa   8 % 4 % 3 % 4 % 19 % 15 %
iAA   AA/Aa   11   7   5   6   29   37  
iA   A/A   10   7   5   10   32   31  
iBBB   BBB/Baa   5   3   1   6   15   12  
iBB   BB/Ba   1     1   1   3   4  
iB or lower   B/B1 or lower   1   1       2   1  

 
        36 % 22 % 15 % 27 % 100 % 100 %

 

The majority of our OTC derivatives are transacted in liquid trading markets for which fair value is determined using pricing models with readily observable market inputs. Examples of such derivatives include interest rate swap contracts, TBAs, foreign exchange forward and option contracts in G-7 currencies and equity swap and option contracts on listed securities. However, the determination of fair value of certain less liquid derivatives required the use of significant estimates. Such derivatives include certain credit derivatives, equity option contracts with terms greater than five years, and certain other complex derivatives we provide to clients. We strive to limit the use of significant estimates by using

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

consistent pricing assumptions between reporting periods and using observed market data for model inputs whenever possible. As the market for complex products develops, we refine our pricing models based on market experience to use the most current indicators of fair value.

Cash instruments.    The majority of our non-derivative long and short inventory (i.e., cash instruments) is recorded at market value based on listed market prices or using third-party broker quotes and therefore does not incorporate significant estimates. Examples of inventory valued in this manner include government securities, agency mortgage-backed securities, listed equities, money market instruments, municipal securities and corporate bonds. However, in certain instances we may deem such quotations to be unrealizable (e.g., when the instruments are thinly traded or when we hold a substantial block of a particular security such that the listed price is not deemed to be readily realizable). In such instances, we determine fair value based on, among other factors, management's best estimate giving appropriate consideration to reported prices and the extent of public trading in similar securities, the discount from the listed price associated with the cost at date of acquisition and the size of the position held in relation to the liquidity in the market. When the size of our holding of a listed security is likely to impair our ability to realize the quoted market price, we record the position at a discount to the quoted price reflecting our best estimate of fair value.

When quoted prices are not available, fair value is determined based on pricing models or other valuation techniques, including the use of implied pricing from similar instruments. Pricing models typically are used to derive fair value based on the net present value of estimated future cash flows including adjustments, when appropriate, for liquidity, credit and/or other factors. For the vast majority of instruments valued through pricing models, significant estimates are not required because the market inputs to such models are readily observable and liquid trading markets provide clear evidence to support the valuations derived from such pricing models. Examples of inventory valued using pricing models or other valuation techniques for which the use of management estimates are necessary include certain mortgages and mortgage-backed positions, real estate inventory, non-investment-grade retained interests, certain derivative and other contractual agreements, as well as certain high yield and certain private equity and other principal investments.

Mortgages, mortgage-backed and real estate inventory positions.    Mortgages and mortgage-backed positions include mortgage loans (both residential and commercial), non-agency mortgage-backed securities and real estate investments. We are a market leader in mortgage-backed securities trading. We originate residential and commercial mortgage loans as part of our mortgage trading and securitization activities. We originated approximately $85 billion and $65 billion of residential mortgage loans in 2005 and 2004, respectively. We securitized approximately $133 billion and $101 billion of residential mortgage loans in 2005 and 2004, respectively, including both originated loans and those we acquired in the secondary market. In addition, we originated approximately $27 billion and $13 billion of commercial mortgage loans in 2005 and 2004, respectively, the majority of which has been sold through securitization or syndicate activities during both 2005 and 2004. See Note 3 to the Consolidated Financial Statements for additional information about our securitization activities. We record mortgage loans at fair value, with related mark-to-market gains and losses recognized in Principal transactions in the Consolidated Statement of Income.

Management estimates are generally not required in determining the fair value of residential mortgage loans because these positions are securitized frequently. Certain commercial mortgage loans and investments, due to their less liquid nature, may require management estimates in determining fair value. Fair value for these positions is generally based on analyses of both cash flow projections and underlying property values. We use independent appraisals to support our assessment of the property in determining fair value for these positions. Fair value for approximately $3.6 billion and $3.8 billion at November 30, 2005 and 2004, respectively, of our total mortgage loan inventory is determined using the above valuation methodologies, which may involve the use of significant estimates. Because a portion of these assets have been financed on a non-recourse basis, our net investment position is limited to $3.5 billion and $2.9 billion at November 30, 2005 and 2004, respectively.

We invest in real estate through direct investments in equity and debt. We record real estate held for sale at the lower of cost or fair value. The assessment of fair value generally requires the use of management estimates and generally is based on property appraisals provided by third parties and also incorporates an analysis of the related property cash flow projections. We had real estate investments of approximately $7.9 billion and $10.7 billion at November 30, 2005 and 2004, respectively. Because significant portions of these assets have been financed on a non-recourse basis, our net investment position was limited to $4.8 billion and $4.1 billion at November 30, 2005 and 2004, respectively.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

High yield.    We underwrite, invest and make markets in high yield corporate debt securities. We also syndicate, trade and invest in loans to below-investment-grade-rated companies. For purposes of this discussion, high yield debt instruments are defined as securities of or loans to companies rated BB+ or lower or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans that, in management's opinion, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities due to the issuer's creditworthiness and the lower liquidity of the market for such securities. In addition, these issuers generally have relatively higher levels of indebtedness resulting in an increased sensitivity to adverse economic conditions. We recognize these risks and seek to reduce market and credit risk through the diversification of our products and counterparties. High yield debt instruments are carried at fair value, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. Such instruments at November 30, 2005 and 2004 included long positions with an aggregate fair value of approximately $4.5 billion at both periods. At November 30, 2005 and 2004, the largest industry concentrations were 22% and 17%, respectively, categorized within the finance and insurance and manufacturing industrial classifications, respectively. The largest geographic concentrations at November 30, 2005 and 2004 were 65% and 54%, respectively, in the United States. The majority of these positions are valued using broker quotes or listed market prices. However, at November 30, 2005 and November 30, 2004, approximately $610 million and $650 million, respectively, of these positions were valued using other valuation techniques because there was little or no trading activity. In such instances, we use prudent judgment in determining fair value, which may involve using analyses of credit spreads associated with pricing of similar instruments, or other valuation techniques. We mitigate our aggregate and single-issuer net exposure through the use of derivatives, non-recourse financing and other financial instruments.

Private equity and other principal investments.    Our Private Equity business operates in five major asset classes: Merchant Banking, Real Estate, Venture Capital, Fixed Income Related Investments and Private Funds Investments. We have raised privately-placed funds in all of these classes, for which we act as general partner and in which we have general and in some cases limited partner interests. In addition, we generally co-invest in the investments made by the funds or may make other non-fund-related direct investments. We carry our private equity investments, including our partnership interests, at fair value based on our assessment of each underlying investment. At November 30, 2005 and 2004, our private equity related investments totaled $1.6 billion and $1.5 billion, respectively. The real estate industry represented the highest concentrations at 27% and 25% at November 30, 2005 and November 30, 2004, respectively, and the largest single-investment exposures were $180 million and $101 million, at those respective dates.

The determination of fair value for these investments often requires the use of estimates and assumptions because these investments generally are less liquid and often contain trading restrictions. At November 30, 2005 and November 30, 2004, we estimate that approximately $172 million and $229 million, respectively, of these investments have readily determinable fair values because they are publicly-traded securities with limited remaining trading restrictions. For the remainder of these positions, fair value is based on our assessment of the underlying investments incorporating valuations that consider expected cash flows, earnings multiples and/or comparisons to similar market transactions. Valuation adjustments, which may involve the use of significant management estimates, are an integral part of pricing these instruments, reflecting consideration of credit quality, concentration risk, sale restrictions and other liquidity factors. Additional information about our private equity and other principal investment activities, including related commitments, can be found in Note 10 to the Consolidated Financial Statements.

Non-investment grade retained interests.    We held approximately $700 million and $900 million of non-investment grade retained interests at November 30, 2005 and 2004, respectively. Because these interests primarily represent the junior interests in securitizations for which there are not active trading markets, estimates generally are required in determining fair value. We value these instruments using prudent estimates of expected cash flows and consider the valuation of similar transactions in the market. See Note 3 to the Consolidated Financial Statements for additional information about the effect of adverse changes in assumptions on the fair value of these interests.

Identifiable Intangible Assets and Goodwill

In October 2003 we acquired Neuberger for a net purchase price of approximately $2.5 billion, including equity consideration of $2.1 billion and cash consideration and incremental costs of $0.7 billion, and excluding cash and short-term investments acquired of approximately $276 million. The excess of the purchase price over the fair values of the net assets acquired (which included certain intangible assets) was recorded as goodwill.

Determining the fair values and useful lives of certain assets acquired and liabilities assumed associated with business acquisitions—intangible assets in particular—requires significant judgment. In addition, we are required to assess for

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

impairment goodwill and other intangible assets with indefinite lives at least annually using fair value measurement techniques. Periodically estimating the fair value of a reporting unit and intangible assets with indefinite lives involves significant judgment and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant effect on whether or not an impairment charge is recognized and the magnitude of such a charge. We completed our last goodwill impairment test as of August 31, 2005, and no impairment was identified.

SPEs

The Company is a market leader in securitization transactions, including securitizations of residential and commercial loans, municipal bonds and other asset backed transactions. The vast majority of such securitization transactions are designed to be in conformity with the SFAS 140 requirements of a QSPE. Securitization transactions meeting the requirements of a QSPE are deemed to be off-balance-sheet. The assessment of whether a securitization vehicle meets the accounting requirements of a QSPE requires significant judgment, particularly in evaluating whether servicing agreements meet the conditions of a permitted activities under SFAS 140 and whether or not derivatives are considered to be passive.

In addition, the evaluation of whether an entity is subject to the requirements of FIN46R as a variable interest entity (VIE) and the determination of whether the Company is deemed to be the primary beneficiary of such VIE is a critical accounting policy that requires significant management judgment.

See Note 1 to the Consolidated Financial Statements for additional information about the Company's accounting policies.

Real Estate Reconfiguration Charges

In connection with our decision to reconfigure certain of our global real estate facilities, we recognized real estate reconfiguration charges in 2004 and 2003. The recognition of these charges required significant management estimates including estimates of the vacancy periods prior to subleasing, the anticipated rates of subleases and the amounts of incentives (e.g., free rent periods) that may be required to induce sub-lessees. See Note 17 to the Consolidated Financial Statements for additional information about the real estate reconfiguration charges.

Legal Reserves

In the normal course of business we have been named as a defendant in a number of lawsuits and other legal and regulatory proceedings. Such proceedings include actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities firms, including us. In addition, our business activities are reviewed by various taxing authorities around the world with regard to corporate income tax rules and regulations. We provide for potential losses that may arise out of legal, regulatory and tax proceedings to the extent such losses are probable and can be estimated.


Accounting and Regulatory Developments

FSP FAS 109-2.    In December 2004, the FASB issued FSP FAS 109-2 "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004", ("FSP FAS 109-2") which provides guidance on the accounting implications of the American Jobs Creation Act of 2004 (the "Act") related to the one-time tax benefit for the repatriation of foreign earnings. The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned outside the U.S. by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. We have reviewed the Act to determine the implications of repatriating all or a portion of our accumulated non-U.S. retained earnings pool and determined that we would not generate any material tax benefits associated with the Act, as any amounts able to be repatriated under the Act would not be material.

SFAS 123(R).    In December 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 123(R), "Share-Based Payment", ("SFAS 123(R)"), which we will adopt on December 1, 2005. SFAS 123(R) requires public companies to recognize expense in the income statement for the grant-date fair value of awards of equity instruments granted to employees. Expense is to be recognized over the period during which employees are required to provide service.

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

SFAS 123(R) also clarifies and expands the guidance in SFAS 123 in several areas, including measuring fair value and attributing compensation cost to reporting periods. Under the modified prospective transition method applied in the adoption of SFAS123(R), compensation cost will be recognized for the unamortized portion of outstanding awards granted prior to the adoption of SFAS 123. Upon adoption of SFAS 123(R) on December 1, 2005, we will recognize an after-tax gain of approximately $47 million as the cumulative effect of a change in accounting principle, primarily attributable to the requirement to estimate forfeitures at the date of grant instead of recognizing them as incurred. We do not expect adoption of SFAS 123(R) otherwise will have a material effect on our consolidated financial statements.

SFAS 123(R) generally requires equity-based awards granted to retirement-eligible employees, and those employees with non-substantive non-compete agreements to be expensed immediately. For stock-based awards granted prior to our adoption of SFAS123(R) compensation cost for retirement eligible employees and employees subject to non-compete agreements, is recognized over the service period specified in the award. We accelerate the recognition of compensation cost if and when a retirement-eligible employee or an employee subject to a non-compete agreement leaves the Company.

The following table sets forth the pro forma net income that would have been reported for the years ended November 30, 2005, 2004 and 2003 if equity-based awards granted to retirement-eligible employees, and those with non-substantive non-compete agreements had been expensed immediately as required by SFAS 123(R):

Pro Forma Net Income


In millions
Year ended November 30

  2005
  2004
  2003
 

 
Net income, as reported   $ 3,260   $ 2,369   $ 1,699  
Add: stock-based employee compensation expense included in reported net income,
    net of related tax effect
    611     464     362  
Deduct: stock-based employee compensation expense, net of related tax effect,
    determined under SFAS 123 (R)
    (867 )   (643 )   (447 )

 
Pro forma net income   $ 3,004   $ 2,190   $ 1,614  

 

EITF Issue No. 04-5.    In June 2005, the FASB ratified the consensus reached in EITF Issue No. 04-5, "Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights", ("EITF 04-5") which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with rights to remove the general partner or to terminate the partnership. As the general partner of numerous private equity, merchant banking and asset management partnerships, we adopted EITF 04-5 immediately for partnerships formed or modified after June 29, 2005. For partnerships formed on or before June 29, 2005 that have not been modified, we are required to adopt EITF 04-5 on December 1, 2006 in a manner similar to a cumulative-effect-type adjustment or by retrospective application. We do not expect adoption of EITF 04-5 for partnerships formed on or before June 29, 2005 that have not been modified will have a material effect on our consolidated financial statements.

Consolidated Supervised Entity.    In June 2004, the SEC approved a rule establishing a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies. The framework is designed to minimize the duplicative regulatory burdens on U.S. securities firms resulting from the European Union (the "EU") Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. The rule also allows companies to use an alternative method, based on internal risk models, to calculate net capital charges for market and derivative-related credit risk. Under this rule, the SEC will regulate the holding company and any unregulated affiliated registered broker-dealer pursuant to an undertaking to be provided by the holding company, including subjecting the holding company to capital requirements generally consistent with the International Convergence of Capital Measurement and Capital Standards published by the Basel Committee on Banking Supervision. On November 9, 2005 the SEC approved our application to become a consolidated supervised entity ("CSE") effective December 1, 2005.

As of December 1, 2005, Holdings became regulated by the SEC as a CSE. As such, Holdings is subject to group-wide supervision and examination by the SEC and, accordingly, we are subject to minimum capital requirements on a

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LEHMAN BROTHERS HOLDINGS INC.
Management's Discussion and Analysis of Financial Condition and Results of Operations

consolidated basis. LBI is authorized to calculate its net capital under provisions as specified by the SEC applicable rules.


Effects of Inflation

Because our assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects such expenses as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the prices of services we offer. To the extent inflation results in rising interest rates and has other adverse effects on the securities markets, it may adversely affect our consolidated financial condition and results of operations in certain businesses.


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information under the caption Management's Discussion and Analysis of Financial Condition and Results of Operations—Risk Management in Part II, Item 7, of this Report is incorporated herein by reference.

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LEHMAN BROTHERS HOLDINGS INC.


ITEM 8. Financial Statements and Supplementary Data
(a)
Financial Statements

 
  Page
Number

 
Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting

 

68
 
Management's Assessment of Internal Control over Financial Reporting

 

69
 
Report of Independent Registered Public Accounting Firm

 

70
 
Consolidated Financial Statements

 

 
     
Consolidated Statement of Income—
Years Ended November 30, 2005, 2004 and 2003

 

71
     
Consolidated Statement of Financial Condition—
November 30, 2005 and 2004

 

72
     
Consolidated Statement of Changes in Stockholders' Equity—
Years Ended November 30, 2005, 2004 and 2003

 

74
     
Consolidated Statement of Cash Flows—Years Ended November 30, 2005, 2004 and 2003

 

76
     
Notes to Consolidated Financial Statements

 

77
(b)
Condensed unconsolidated financial information of Holdings and notes thereto are set forth in Schedule I beginning on Page F-2 of this Report and are incorporated herein by reference. Holdings has issued a full and unconditional guarantee of certain outstanding and future debt securities of its wholly-owned subsidiary, LBI. Condensed consolidating financial information pursuant to Rule 3-10(c) of Regulation S-X is set forth in Note 8 of the notes to such condensed unconsolidated financial information in Schedule I.

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LEHMAN BROTHERS HOLDINGS INC.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Lehman Brothers Holdings Inc.

We have audited management's assessment, included in the accompanying Management's Assessment of Internal Control over Financial Reporting, that Lehman Brothers Holdings Inc. (the "Company") maintained effective internal control over financial reporting as of November 30, 2005, based on criteria established in Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (the "COSO criteria"). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management's assessment that Lehman Brothers Holdings Inc. maintained effective internal control over financial reporting as of November 30, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Lehman Brothers Holdings Inc. maintained, in all material respects, effective internal control over financial reporting as of November 30, 2005, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition of Lehman Brothers Holdings Inc. as of November 30, 2005 and 2004 and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the three years in the period ended November 30, 2005 of Lehman Brothers Holdings Inc. and our report dated February 13, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP
New York, New York
February 13, 2006

-68-


LEHMAN BROTHERS HOLDINGS INC.

Management's Assessment of Internal Control over Financial Reporting

The management of Lehman Brothers Holdings Inc. (the "Company") is responsible for establishing and maintaining adequate internal control over financial reporting. The Company's internal control system is designed to provide reasonable assurance to the Company's management and Board of Directors regarding the preparation and fair presentation of published financial statements. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

The Company's management assessed the effectiveness of the Company's internal control over financial reporting as of November 30, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control—Integrated Framework. Based on our assessment we believe that, as of November 30, 2005, the Company's internal control over financial reporting is effective based on those criteria.

The Company's independent registered public accounting firm that audited the accompanying Consolidated Financial Statements has issued an attestation report on our assessment of the Company's internal control over financial reporting. Their report appears on the preceding page.

-69-


LEHMAN BROTHERS HOLDINGS INC.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders of Lehman Brothers Holdings Inc.

We have audited the accompanying consolidated statement of financial condition of Lehman Brothers Holdings Inc. (the "Company") as of November 30, 2005 and 2004, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended November 30, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Holdings Inc. at November 30, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the period ended November 30, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Lehman Brothers Holdings Inc.'s internal control over financial reporting as of November 30, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 13, 2006 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP
New York, New York
February 13, 2006

-70-



LEHMAN BROTHERS HOLDINGS INC.
CONSOLIDATED STATEMENT OF INCOME


In millions, except per share data
Year ended November 30

  2005
  2004
  2003


Revenues                  
Principal transactions   $ 7,811   $ 5,699   $ 4,272
Investment banking     2,894     2,188     1,722
Commissions     1,728     1,537     1,210
Interest and dividends     19,043     11,032     9,942
Asset management and other     944     794     141

  Total revenues     32,420     21,250     17,287
Interest expense     17,790     9,674     8,640

  Net revenues     14,630     11,576     8,647

Non-Interest Expenses                  
Compensation and benefits     7,213     5,730     4,318
Technology and communications     834     764     598
Brokerage and clearance fees     503     453     367
Occupancy     490     421     319
Professional fees     282     252     158
Business development     234     211     149
Other     245     208     125
Real estate reconfiguration charge         19     77

  Total non-personnel expenses     2,588     2,328     1,793

  Total non-interest expenses     9,801     8,058     6,111

Income before taxes and dividends on trust preferred securities     4,829     3,518     2,536
Provision for income taxes     1,569     1,125     765
Dividends on trust preferred securities         24     72

Net income   $ 3,260   $ 2,369   $ 1,699

Net income applicable to common stock   $ 3,191   $ 2,297   $ 1,649

Earnings per share                  
Basic   $ 11.47   $ 8.36   $ 6.71
Diluted   $ 10.87   $ 7.90   $ 6.35

See Notes to Consolidated Financial Statements.

-71-



LEHMAN BROTHERS HOLDINGS INC.
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION


In millions
November 30

  2005
  2004


Assets            
Cash and cash equivalents   $ 4,900   $ 5,440
Cash and securities segregated and on deposit for regulatory and other purposes     5,744     4,085
Financial instruments and other inventory positions owned:
    (includes $36,369 in 2005 and $27,418 in 2004 pledged as collateral)
    177,438     144,468
Securities received as collateral     4,975     4,749
Collateralized agreements:            
  Securities purchased under agreements to resell     106,209     95,535
  Securities borrowed     78,455     74,294
Receivables:            
  Brokers, dealers and clearing organizations     7,454     3,400
  Customers     12,887     13,241
  Others     1,302     2,122
Property, equipment and leasehold improvements (net of accumulated depreciation and
    amortization of $1,448 in 2005 and $1,187 in 2004)
    2,885     2,988
Other assets     4,558     3,562
Identifiable intangible assets and goodwill (net of accumulated amortization of $257 in
    2005 and $212 in 2004)
    3,256     3,284

Total assets   $ 410,063   $ 357,168

See Notes to Consolidated Financial Statements.

-72-


LEHMAN BROTHERS HOLDINGS INC.
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Continued)


In millions, except per share data
November 30

  2005
  2004
 


 
Liabilities and Stockholders' Equity              
Short-term borrowings   $ 2,941   $ 2,857  
Financial instruments and other inventory positions sold but not yet purchased     110,577     96,281  
Obligation to return securities received as collateral     4,975     4,749  
Collateralized financings:              
  Securities sold under agreements to repurchase     116,155     105,956  
  Securities loaned     13,154     14,158  
  Other secured borrowings     23,116     11,621  
Payables:              
  Brokers, dealers and clearing organizations     1,870     1,705  
  Customers     47,210     37,824  
Accrued liabilities and other payables     10,962     10,611  
Long-term borrowings     62,309     56,486  

 
Total liabilities     393,269     342,248  
Commitments and contingencies              
Stockholders' Equity              
Preferred stock     1,095     1,345  
Common stock, $0.10 par value;
    Shares authorized: 600,000,000 in 2005 and 2004;
    Shares issued: 302,668,973 in 2005 and 297,796,197 in 2004;
    Shares outstanding: 271,437,103 in 2005 and 274,159,411 in 2004
    30     30  
Additional paid-in capital     6,314     5,865  
Accumulated other comprehensive income (net of tax)     (16 )   (19 )
Retained earnings     12,198     9,240  
Other stockholders' equity, net     765     741  
Common stock in treasury, at cost: 31,231,870 shares in 2005 and 23,636,786 shares in
    2004
    (3,592 )   (2,282 )

 
Total common stockholders' equity     15,699     13,575  

 
Total stockholders' equity     16,794     14,920  

 
Total liabilities and stockholders' equity   $ 410,063   $ 357,168  

 

See Notes to Consolidated Financial Statements.

-73-



LEHMAN BROTHERS HOLDINGS INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY


In millions
Year ended November 30

  2005
  2004
  2003
 


 
Preferred Stock                    
5.94% Cumulative, Series C:                    
  Beginning and ending balance   $ 250   $ 250   $ 250  

 
5.67% Cumulative, Series D:                    
  Beginning and ending balance     200     200     200  

 
7.115% Fixed/Adjustable Rate Cumulative, Series E:                    
  Beginning balance     250     250     250  
  Redemptions     (250 )        

 
  Ending balance         250     250  

 
6.50% Cumulative, Series F:                    
  Beginning balance     345     345      
  Issuances             345  

 
  Ending balance     345     345     345  

 
Floating Rate (3% Minimum) Cumulative, Series G:                    
  Beginning balance     300          
  Issuances         300      

 
  Ending balance     300     300      

 
Total preferred stock, ending balance     1,095     1,345     1,045  

 
Common Stock, Par Value $0.10 Per Share                    
  Beginning balance     30     29     25  
  Issuances in connection with Neuberger acquisition             3  
  Other Issuances         1     1  

 
  Ending balance     30     30     29  

 
Additional Paid-In Capital                    
  Beginning balance     5,865     6,164     3,628  
  RSUs exchanged for Common Stock     184     135     (36 )
  Employee stock-based awards     (760 )   (585 )   (352 )
  Tax benefit from the issuance of stock-based awards     1,005     468     543  
  Share issuances in connection with Neuberger acquisition             2,371  
  Neuberger final purchase price adjustment         (307 )    
  Other, net     20     (10 )   10  

 
  Ending balance     6,314     5,865     6,164  

 
Accumulated Other Comprehensive Income                    
  Beginning balance     (19 )   (16 )   (13 )
  Translation adjustment, net(1)     3     (3 )   (3 )

 
  Ending balance   $ (16 ) $ (19 ) $ (16 )

 
(1)
Net of income taxes of $1 in 2005, $(2) in 2004 and $(1) in 2003.

See Notes to Consolidated Financial Statements.

-74-



LEHMAN BROTHERS HOLDINGS INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY—(Continued)


In millions
Year ended November 30

  2005
  2004
  2003
 


 
Retained Earnings                    
  Beginning balance   $ 9,240   $ 7,129   $ 5,608  
  Net income     3,260     2,369     1,699  
  Dividends declared:                    
    5.94% Cumulative, Series C Preferred Stock     (15 )   (15 )   (15 )
    5.67% Cumulative, Series D Preferred Stock     (11 )   (11 )   (11 )
    7.115% Fixed/Adjustable Rate Cumulative, Series E Preferred Stock     (9 )   (18 )   (18 )
    6.50% Cumulative, Series F Preferred Stock     (22 )   (23 )   (6 )
    Floating Rate (3% Minimum) Cumulative, Series G Preferred Stock     (12 )   (5 )    
    Redeemable Voting Preferred Stock              
    Common Stock     (233 )   (186 )   (128 )

 
  Ending balance     12,198     9,240     7,129  

 
Common Stock Issuable                    
  Beginning balance     3,874     3,353     2,822  
  RSUs exchanged for Common Stock     (832 )   (585 )   (425 )
  Deferred stock awards granted     1,574     1,182     957  
  Other, net     (68 )   (76 )   (1 )

 
  Ending balance     4,548     3,874     3,353  

 
Common Stock Held in RSU Trust                    
  Beginning balance     (1,353 )   (852 )   (754 )
  Employee stock-based awards     (676 )   (876 )   (518 )
  RSUs exchanged for Common Stock     549     401     444  
  Other, net     (30 )   (26 )   (24 )

 
  Ending balance     (1,510 )   (1,353 )   (852 )

 
Deferred Stock Compensation                    
  Beginning balance     (1,780 )   (1,470 )   (1,119 )
  Deferred stock awards granted     (1,574 )   (1,182 )   (999 )
  Amortization of deferred compensation, net     988     773     625  
  Other, net     93     99     23  

 
  Ending balance     (2,273 )   (1,780 )   (1,470 )

 
Common Stock In Treasury, at Cost                    
  Beginning balance     (2,282 )   (2,208 )   (1,955 )
  Repurchases of Common Stock     (2,994 )   (1,693 )   (967 )
  Shares reacquired from employee transactions     (1,163 )   (574 )   (541 )
  RSUs exchanged for Common Stock     99     49     18  
  Employee stock-based awards     2,748     2,144     1,237  

 
  Ending balance     (3,592 )   (2,282 )   (2,208 )

 
Total stockholders' equity   $ 16,794   $ 14,920   $ 13,174  

 

See Notes to Consolidated Financial Statements.

-75-



LEHMAN BROTHERS HOLDINGS INC.
CONSOLIDATED STATEMENT OF CASH FLOWS


In millions
Year ended November 30

  2005
  2004
  2003
 


 
Cash Flows From Operating Activities                    
Net income   $ 3,260   $ 2,369   $ 1,699  
Adjustments to reconcile net income to net cash provided by (used in)
    operating activities:
                   
  Depreciation and amortization     426     428     315  
  Deferred tax benefit     (502 )   (74 )   (166 )
  Tax benefit from the issuance of stock-based awards     1,005     468     543  
  Amortization of deferred stock compensation     1,055     800     625  
  Real estate reconfiguration charge         19     77  
  Other adjustments     173     85     (26 )
Net change in:                    
    Cash and securities segregated and on deposit for regulatory and other
    purposes
    (1,659 )   (985 )   (297 )
    Financial instruments and other inventory positions owned     (36,652 )   (8,936 )   (14,736 )
    Resale agreements, net of repurchase agreements     (475 )   (9,467 )   19,504  
    Securities borrowed, net of securities loaned     (5,165 )   (22,728 )   (25,048 )
    Other secured borrowings     11,495     (2,923 )   2,700  
    Receivables from brokers, dealers and clearing organizations     (4,054 )   1,475     (1,100 )
    Receivables from customers     354     (4,432 )   (530 )
    Financial instruments and other inventory positions sold but not yet
    purchased
    14,156     23,471     5,326  
    Payables to brokers, dealers and clearing organizations     165     (1,362 )   1,280  
    Payables to customers     9,386     10,158     10,189  
    Accrued liabilities and other payables     (801 )   520     1,195  
    Other operating assets and liabilities, net     345     (370 )   346  

 
Net cash provided by (used in) operating activities     (7,488 )   (11,484 )   1,896  

 
Cash Flows From Financing Activities                    
Derivative contracts with a financing element     140     334     110  
Issuance (payments) of short-term borrowings, net     84     526     (38 )
Issuance of long-term borrowings     23,705     20,485     13,383  
Principal payments of long-term borrowings     (14,233 )   (10,820 )   (10,137 )
Issuance of preferred securities subject to mandatory redemption             600  
Issuance of common stock     230     108     57  
Issuance (retirement) of preferred stock     (250 )   300     345  
Issuance of treasury stock     1,015     551     260  
Purchase of treasury stock     (2,994 )   (1,693 )   (967 )
Dividends paid     (302 )   (258 )   (178 )

 
Net cash provided by financing activities     7,395     9,533     3,435  

 
Cash Flows From Investing Activities                    
Purchase of property, equipment and leasehold improvements, net     (409 )   (401 )   (451 )
Business acquisitions, net of cash acquired     (38 )   (130 )   (657 )

 
Net cash used in investing activities     (447 )   (531 )   (1,108 )

 
Net change in cash and cash equivalents     (540 )   (2,482 )   4,223  
Cash and cash equivalents, beginning of period     5,440     7,922     3,699  

 
Cash and cash equivalents, end of period   $ 4,900   $ 5,440   $ 7,922  

 
Supplemental Disclosure of Cash Flow Information (in millions):                    
Interest paid totaled $17,893, $9,534 and $8,654 in 2005, 2004 and 2003,
    respectively.
                   
Income taxes paid totaled $789, $638 and $717 in 2005, 2004 and 2003,
    respectively.
                   

 

See Notes to Consolidated Financial Statements.

-76-



LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Contents

 
   
  Page
Number

Note 1   Summary of Significant Accounting Policies   78

Note 2

 

Financial Instruments

 

85

Note 3

 

Securitizations and Other Off-Balance-Sheet Arrangements

 

87

Note 4

 

Securities Received and Pledged as Collateral

 

89

Note 5

 

Business Combinations

 

90

Note 6

 

Identifiable Intangible Assets and Goodwill

 

90

Note 7

 

Short-Term Borrowings

 

91

Note 8

 

Long-Term Borrowings

 

92

Note 9

 

Fair Value of Financial Instruments

 

94

Note 10

 

Commitments, Contingencies and Guarantees

 

95

Note 11

 

Stockholders' Equity

 

98

Note 12

 

Regulatory Requirements

 

100

Note 13

 

Earnings per Share

 

101

Note 14

 

Employee Incentive Plans

 

101

Note 15

 

Employee Benefit Plans

 

105

Note 16

 

Income Taxes

 

108

Note 17

 

Real Estate Reconfiguration Charge

 

110

Note 18

 

Business Segments and Geographic Information

 

110

Note 19

 

Quarterly Information (unaudited)

 

113

-77-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements


Note 1 Summary of Significant Accounting Policies

Description of Business

Lehman Brothers Holdings Inc. ("Holdings") and subsidiaries (collectively, the "Company," "Lehman Brothers," "we," "us" or "our") is one of the leading global investment banks serving institutional, corporate, government and high-net-worth individual clients. Our 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. We are engaged primarily in providing financial services. The principal U.S., European, and Asian subsidiaries of Holdings are Lehman Brothers Inc. ("LBI"), a U.S. registered broker-dealer, Lehman Brothers International (Europe) ("LBIE"), an authorized investment firm in the United Kingdom and Lehman Brothers Japan, a registered securities company in Japan, respectively.

Basis of Presentation

The Consolidated Financial Statements are prepared in conformity with generally accepted accounting principles, and include the accounts of Holdings, our subsidiaries, and all other entities in which we have a controlling financial interest or are considered to be the primary beneficiary. All material intercompany accounts and transactions have been eliminated in consolidation. Certain prior-period amounts reflect reclassifications to conform to the current year's presentation.

Use of Estimates

Generally accepted accounting principles require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management estimates are required in determining the valuation of inventory positions, particularly over-the-counter ("OTC") derivatives, certain commercial mortgage loans and investments in real estate, certain high-yield positions, private equity and other principal investments, and non-investment-grade retained interests. Additionally, significant management estimates are required in assessing the realizability of deferred tax assets, the fair value of assets and liabilities acquired in a business acquisition, the accounting treatment of QSPEs and VIEs, the outcome of litigation, the fair value of equity-based compensation awards and determining the allocation of the cost of acquired businesses to identifiable intangible assets and goodwill and determining the amount of the real estate reconfiguration charges. Management believes the estimates used in preparing the financial statements are reasonable and prudent. Actual results could differ from these estimates.

Consolidation Accounting Policies

Operating companies.    Financial Accounting Standards Board ("FASB") Interpretation No. 46(R), "Consolidation of Variable Interest Entities (revised December 2003)—an interpretation of ARB No. 51", ("FIN 46(R)"), defines the criteria necessary to be considered an operating company (i.e., a voting-interest entity) for which the consolidation accounting guidance of Statement of Financial Accounting Standards ("SFAS") No. 94, "Consolidation of All Majority-Owned Subsidiaries", ("SFAS 94") should be applied. As required by SFAS 94, we consolidate operating companies in which we have a controlling financial interest. The usual condition for a controlling financial interest is ownership of a majority of the voting interest. FIN 46(R) defines operating companies as businesses that have sufficient legal equity to absorb the entities' expected losses (presumed to require minimum 10% equity) and, in each case, for which the equity holders have substantive voting rights and participate substantively in the gains and losses of such entities. Operating companies in which we exercise significant influence but do not control are accounted for under the equity method. Significant influence generally is deemed to exist when we own 20% to 50% of the voting equity of a corporation, or when we hold at least 3% of a limited partnership interest.

Special purpose entities.    Special purpose entities ("SPEs") are corporations, trusts or partnerships that are established for a limited purpose. SPEs by their nature generally do not provide equity owners with significant voting powers because the SPE documents govern all material decisions. There are two types of SPEs: qualifying special purpose entities ("QSPEs") and variable interest entities ("VIEs").

A QSPE generally can be described as an entity whose permitted activities are limited to passively holding financial assets and distributing cash flows to investors based on pre-set terms. Our primary involvement with SPEs relates to securitization transactions in which transferred assets, including mortgages, loans, receivables and other assets, are sold to an SPE that qualifies as a QSPE under SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets

-78-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

and Extinguishments of Liabilities", ("SFAS 140"). In accordance with SFAS 140 we do not consolidate QSPEs. Rather, we recognize only our retained interests in the QSPEs, if any. We account for such retained interests at fair value.

Certain SPEs do not meet the QSPE criteria because their permitted activities are not sufficiently limited or because the assets are not deemed qualifying financial instruments (e.g., real estate). Such SPEs are referred to as VIEs and we typically use them to create securities with a unique risk profile desired by investors, as a means of intermediating financial risk or to make an investment in real estate. In the normal course of business we may establish VIEs, sell assets to VIEs, underwrite, distribute, and make a market in securities issued by VIEs, transact derivatives with VIEs, own securities or residual interests in VIEs, and provide liquidity or other guarantees to VIEs. Under FIN 46(R), we are required to consolidate a VIE if we are deemed to be the primary beneficiary of such entity. The primary beneficiary is the party that has either a majority of the expected losses or a majority of the expected residual returns of such entity, as defined. In 2004 we adopted FIN 46(R) for all VIEs in which we hold a variable interest. The effect of adopting FIN 46(R) in fiscal 2004 was not material to our financial condition or results of operations.

For a further discussion of our securitization activities and our involvement with VIEs see Note 3 to the Consolidated Financial Statements.

Revenue Recognition Policies

Principal transactions.    Financial instruments classified as Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased (both of which are recorded on a trade-date basis) are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income.

Investment banking.    Underwriting revenues, net of related underwriting expenses, and revenues for merger and acquisition advisory and other investment-banking-related services are recognized when services for the transactions are completed. Direct costs associated with advisory services are recorded as non-personnel expenses, net of client reimbursements.

Commissions.    Commissions primarily include fees from executing and clearing client transactions on stocks, options and futures markets worldwide. These fees are recognized on a trade-date basis.

Interest and dividends revenue and interest expense.    We recognize contractual interest on Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased on an accrual basis as a component of Interest and dividends revenue and Interest expense, respectively. Interest flows on derivative transactions are included as part of the mark-to-market valuation of these contracts in Principal transactions in the Consolidated Statement of Income and are not recognized as a component of interest revenue or expense. We account for our secured financing activities and short-and long-term borrowings on an accrual basis with related interest recorded as interest revenue or interest expense, as applicable.

Asset management and other.    Investment advisory fees are recorded as earned. Generally, high-net-worth and institutional clients are charged or billed quarterly based on the account's net asset value at the end of a quarter. Investment advisory and administrative fees earned from our mutual fund business (the "Funds") are charged monthly to the Funds based on average daily net assets under management. In certain circumstances, we receive asset management incentive fees when the return on assets under management exceeds specified benchmarks. Such incentive fees generally are based on investment performance over a twelve-month period and are not subject to adjustment after the measurement period ends. Accordingly, such incentive fees are recognized when the measurement period ends. We receive private equity incentive fees when the return on certain private equity funds' investments exceeds specified threshold returns. Such incentive fees typically are based on investment periods in excess of one year, and future investment underperformance could require amounts previously distributed to us to be returned to the funds. Accordingly, these incentive fees are recognized when all material contingencies have been substantially resolved.

Financial Instruments and Other Inventory Positions

Financial instruments classified as Financial instruments and other inventory positions owned, including loans, and Financial instruments and other inventory positions sold but not yet purchased are recognized on a trade-date basis and are carried at market or fair value, or amounts which approximate fair value, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. Lending commitments also are recorded at fair value, with unrealized gains or losses recognized in Principal transactions in the Consolidated Statement of Income.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

We follow the American Institute of Certified Public Accountants ("AICPA") Audit and Accounting Guide, "Brokers and Dealers in Securities", (the "Guide") when determining market or fair value for financial instruments. Market value generally is determined based on listed prices or broker quotes. In certain instances, such price quotations may be deemed unreliable when the instruments are thinly traded or when we hold a substantial block of a particular security and the listed price is not deemed to be readily realizable. In accordance with the Guide, in these instances we determine fair value based on management's best estimate, giving appropriate consideration to reported prices and the extent of public trading in similar securities, the discount from the listed price associated with the cost at the date of acquisition, and the size of the position held in relation to the liquidity in the market, among other factors. When listed prices or broker quotes are not available, we determine fair value based on pricing models or other valuation techniques, including the use of implied pricing from similar instruments. We typically use pricing models to derive fair value based on the net present value of estimated future cash flows including adjustments, when appropriate, for liquidity, credit and/or other factors. We account for real estate positions held for sale at the lower of cost or fair value with gains or losses recognized in Principal transactions in the Consolidated Statement of Income.

All firm-owned securities pledged to counterparties that have the right, by contract or custom, to sell or repledge the securities are classified as Financial instruments and other inventory positions owned, and are disclosed as pledged as collateral, as required by SFAS 140.

Derivative financial instruments.    Derivatives are financial instruments whose value is based on an underlying asset (e.g., Treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR), and include futures, forwards, swaps, option contracts, or other financial instruments with similar characteristics. A derivative contract generally represents a future commitment to exchange interest payment streams or currencies based on the contract or notional amount or to purchase or sell other financial instruments at specified terms on a specified date. OTC derivative products are privately-negotiated contractual agreements that can be tailored to meet individual client needs and include forwards, swaps and certain options including caps, collars and floors. Exchange-traded derivative products are standardized contracts transacted through regulated exchanges and include futures and certain option contracts listed on an exchange.

Derivatives are recorded at market or fair value in the Consolidated Statement of Financial Condition on a net-by-counterparty basis when a legal right of offset exists and are netted across products when such provisions are stated in the master netting agreement. Cash collateral received is netted on a counterparty basis, provided legal right of offset exists. Derivatives often are referred to as off-balance-sheet instruments because neither their notional amounts nor the underlying instruments are reflected as assets or liabilities of the Company. Instead, the market or fair values related to the derivative transactions are reported in the Consolidated Statement of Financial Condition as assets or liabilities, in Derivatives and other contractual agreements, as applicable. Margin on futures contracts is included in receivables and payables from/to brokers, dealers and clearing organizations, as applicable. Changes in fair values of derivatives are recorded in Principal transactions in the Consolidated Statement of Income. Market or fair value generally is determined either by quoted market prices (for exchange-traded futures and options) or pricing models (for swaps, forwards and options). Pricing models use a series of market inputs to determine the present value of future cash flows with adjustments, as required, for credit risk and liquidity risk. Credit-related valuation adjustments incorporate historical experience and estimates of expected losses. Additional valuation adjustments may be recorded, as deemed appropriate, for new or complex products or for positions with significant concentrations. These adjustments are integral components of the mark-to-market process.

We follow Emerging Issues Task Force ("EITF") Issue No. 02-3, "Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved In Energy Trading and Risk Management Activities", ("EITF 02-3") when marking to market our derivative contracts. Under EITF 02-3, recognition of a trading profit at inception of a derivative transaction is prohibited unless the fair value of that derivative is obtained from a quoted market price, supported by comparison to other observable market transactions or based on a valuation technique incorporating observable market data. Subsequent to the transaction date, we recognize trading profits deferred at inception of the derivative transaction in the period in which the valuation of such instrument becomes observable.

As an end user, we primarily use derivatives to modify the interest rate characteristics of our long-term debt and secured financing activities. We also use equity derivatives to hedge our exposure to equity price risk embedded in certain of our debt obligations and foreign exchange forwards to manage the currency exposure related to our net investment in non-U.S.-dollar functional currency operations (collectively, "End-User Derivative Activities"). In many hedging relationships both the derivative and the hedged item are marked to market through earnings ("fair value hedge"). In these instances, the

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

hedge relationship is highly effective and the mark to market on the derivative and the hedged item virtually offset. Certain derivatives embedded in long-term debt are bifurcated from the debt and marked to market through earnings.

We use fair value hedges primarily to convert a substantial portion of our fixed-rate debt and certain long-term secured financing activities to floating interest rates. Any hedge ineffectiveness in these relationships is recorded in Interest expense in the Consolidated Statement of Income. Gains or losses from revaluing foreign exchange contracts associated with hedging our net investments in non-U.S.-dollar functional currency operations are reported within Accumulated other comprehensive income in Stockholders' equity. Unrealized receivables/payables resulting from the mark to market of end-user derivatives are included in Financial instruments and other inventory positions owned or Financial instruments and other inventory positions sold but not yet purchased.

Private equity investments.    We carry our private equity investments, including our partnership interests, at fair value. Certain of our private equity positions are less liquid and often contain trading restrictions. Fair value is determined based upon our assessment of the underlying investments incorporating valuations that consider expected cash flows, earnings multiples and/or comparisons to similar market transactions. Valuation adjustments reflecting consideration of credit quality, concentration risk, sales restrictions and other liquidity factors are an integral part of pricing these instruments.

Securitization Activities.    In accordance with SFAS 140, we recognize transfers of financial assets as sales provided control has been relinquished. Control is deemed to be relinquished only when all of the following conditions have been met: (i) the assets have been isolated from the transferor, even in bankruptcy or other receivership (true-sale opinions are required); (ii) the transferee has the right to pledge or exchange the assets received and (iii) the transferor has not maintained effective control over the transferred assets (e.g., a unilateral ability to repurchase a unique or specific asset).

Securities Received as Collateral and Obligation to Return Securities Received as Collateral

When we act as the lender in a securities-lending agreement and we receive securities that can be pledged or sold as collateral, we recognize in the Consolidated Statement of Financial Condition an asset, representing the securities received (Securities received as collateral) and a liability, representing the obligation to return those securities (Obligation to return securities received as collateral).

Secured Financing Activities

Repurchase and resale agreements.    Securities purchased under agreements to resell and Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities subsequently will be resold or repurchased plus accrued interest. It is our policy to take possession of securities purchased under agreements to resell. We monitor the market value of the underlying positions on a daily basis compared with the related receivable or payable balances, including accrued interest. We require counterparties to deposit additional collateral or return collateral pledged, as necessary, to ensure the market value of the underlying collateral remains sufficient. Financial instruments and other inventory positions owned that are financed under repurchase agreements are carried at market value, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income.

We use interest rate swaps as an end-user to modify the interest rate exposure associated with certain fixed-rate resale and repurchase agreements. We adjust the carrying value of these secured financing transactions that have been designated as the hedged item.

Securities borrowed and loaned.    Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is our policy to value the securities borrowed and loaned on a daily basis and to obtain additional cash as necessary to ensure such transactions are adequately collateralized.

Other secured borrowings.    Other secured borrowings principally reflects non-recourse financing, and is recorded at contractual amounts plus accrued interest.

Long-Lived Assets

Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets. Buildings are depreciated up to a maximum of 40 years. Leasehold improvements are amortized over the lesser of their

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

useful lives or the terms of the underlying leases, ranging up to 30 years. Equipment, furniture and fixtures are depreciated over periods of up to 15 years. Internal-use software that qualifies for capitalization under AICPA Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use", is capitalized and subsequently amortized over the estimated useful life of the software, generally three years, with a maximum of seven years. We review long-lived assets for impairment periodically and whenever events or changes in circumstances indicate the carrying amounts of the assets may be impaired. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss would be recognized to the extent the carrying value of such asset exceeded its fair value.

Identifiable Intangible Assets and Goodwill

Identifiable intangible assets with finite lives are amortized over their expected useful lives. Identifiable intangible assets with indefinite lives and goodwill are not amortized. Instead, these assets are evaluated at least annually for impairment. Goodwill is reduced upon the recognition of certain acquired net operating loss carryforward benefits.

Equity-Based Compensation

SFAS No. 123, "Accounting for Stock-Based Compensation", ("SFAS 123") established financial accounting and reporting standards for equity-based employee and non-employee compensation. SFAS 123 permits companies to account for equity-based employee compensation using the intrinsic-value method prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", ("APB 25"), or using the fair-value method prescribed by SFAS 123. Through November 30, 2003, we followed APB 25 and its related interpretations to account for equity-based employee compensation. Accordingly, no compensation expense was recognized for stock option awards because the exercise price equaled or exceeded the market value of our common stock on the grant date.

In 2004, we adopted the fair value recognition provisions of SFAS 123 as amended by SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123", using the prospective adoption method. Under this method of adoption, compensation expense is recognized based on the fair value of stock options and RSUs granted for 2004 and future years over the related service periods. Stock options granted for the years ended November 30, 2003 and before continue to be accounted for under APB 25. Adoption of SFAS 123 also required us to change the fair value measurement method for RSUs. Under SFAS 123, the fair value measurement of an RSU must include a discount from the market value of an unrestricted share of common stock on the RSU grant date for selling restrictions subsequent to the vesting date. RSUs granted prior to 2004 continue to be measured in accordance with APB 25 and, accordingly, a discount from the market value of an unrestricted share of common stock on the RSU grant date is not recognized for selling restrictions subsequent to the vesting date. Under both APB 25 and SFAS 123, compensation expense for RSUs with future service requirements is recognized over the relevant stated vesting periods of the awards. See Accounting Developments below for a discussion of SFAS No. 123(R), "Share-Based Payment" ("SFAS 123(R)"), which we are required to adopt on December 1, 2005.

Our equity-based employee award plans provide for the accrual of non-cash dividend equivalents on outstanding RSUs. These dividend equivalents on RSUs are charged to retained earnings as declared.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

The following table illustrates the effect on net income and earnings per share for the years ended November 30, 2005, 2004, and 2003 if the fair-value-based retroactive method prescribed by SFAS 123 had been applied to all awards granted prior to fiscal year 2004:

Equity Based Compensation—Pro Forma Net Income and Earnings per Share


In millions, except per share data Year ended November 30

  2005
  2004
  2003
 

 
Net income, as reported   $ 3,260   $ 2,369   $ 1,699  
Add: stock-based employee compensation expense
    included in reported net income, net of related tax effect
    611     464     362  
Deduct: stock-based employee compensation expense
    determined under the fair-value-based method
    for all awards, net of related tax effect
    (694 )   (623 )   (534 )

 
Pro forma net income   $ 3,177   $ 2,210   $ 1,527  

 
Earnings per share:                    
    Basic, as reported   $ 11.47   $ 8.36   $ 6.71  
    Basic, pro forma   $ 11.17   $ 7.78   $ 6.01  
    Diluted, as reported   $ 10.87   $ 7.90   $ 6.35  
    Diluted, pro forma   $ 10.64   $ 7.42   $ 5.77  

 

We used the Black-Scholes option-pricing model to measure the fair value of the stock options granted during 2005 and 2004, as well as for the measurement of fair value utilized to quantify the pro forma effects on net income and earnings per share of the fair value of stock options outstanding during 2005, 2004 and 2003. Based on the results of the model, the weighted-average fair values of the stock options granted were $26.48, $19.26, and $22.02 for 2005, 2004 and 2003, respectively. The weighted-average assumptions used for 2005, 2004 and 2003 were as follows:

Weighted Average Black-Scholes Assumptions


Year ended November 30

  2005
  2004
  2003
 

 
Risk-free interest rate   3.97 % 3.04 % 3.10 %
Expected volatility   23.73 % 28.09 % 35.00 %
Dividends per share   $0.80   $0.64   $0.48  
Expected life   3.9 years   3.7 years   4.6 years  

 

The increase in the weighted-average fair value price of stock options granted in 2005 compared with 2004 resulted primarily from the higher price of the Company's stock on the grant dates. The expected volatility declined due to lower volatility in our stock over the historical and future periods the Company uses to determine volatility.

Earnings per Share

We compute earnings per share ("EPS") in accordance with SFAS No. 128, "Earnings per Share". Basic EPS is computed by dividing net income applicable to common stock by the weighted-average number of common shares outstanding, which includes restricted stock units for which service has been provided. Diluted EPS includes the components of basic EPS and also includes the dilutive effects of restricted stock units for which service has not yet been provided and employee stock options. See Notes 13 and 14 to the Consolidated Financial Statements for additional information about EPS.

Income Taxes

We account for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes", ("SFAS 109"). We recognize the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. Deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carry-forwards. We record a valuation allowance to reduce deferred tax assets to an amount that more likely than not will be realized. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in future years. Contingent liabilities related to income taxes are recorded when probable and reasonably estimable in accordance with SFAS No. 5, "Accounting for Contingencies".

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Cash Equivalents

Cash equivalents include highly liquid investments not held for resale with maturities of three months or less when we acquire them.

Foreign Currency Translation

Assets and liabilities of foreign subsidiaries having non-U.S.-dollar functional currencies are translated at exchange rates at the Consolidated Statement of Financial Condition date. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating foreign currency financial statements into U.S. dollars, net of hedging gains or losses and taxes, are included in Accumulated other comprehensive income, a component of Stockholders' equity. Gains or losses resulting from foreign currency transactions are included in the Consolidated Statement of Income.

Accounting Developments

FSP FAS 109-2.    In December 2004, the FASB issued FSP FAS 109-2 "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004", ("FSP FAS 109-2") which provides guidance on the accounting implications of the American Jobs Creation Act of 2004 (the "Act") related to the one-time tax benefit for the repatriation of foreign earnings. The Act creates a temporary incentive for U.S. corporations to repatriate accumulated income earned outside the U.S. by providing an 85 percent dividends received deduction for certain dividends from controlled foreign corporations. We have reviewed the Act to determine the implications of repatriating all or a portion of our accumulated non-U.S. retained earnings pool and determined that we would not generate any material tax benefits associated with the Act, as any amounts able to be repatriated under the Act would not be material.

SFAS 123(R).    In December 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment", ("SFAS 123(R)"), which we will adopt on December 1, 2005. SFAS 123(R) requires public companies to recognize expense in the income statement for the grant-date fair value of awards of equity instruments granted to employees. Expense is to be recognized over the period during which employees are required to provide service.

SFAS 123(R) also clarifies and expands the guidance in SFAS 123 in several areas, including measuring fair value and attributing compensation cost to reporting periods. Under the modified prospective transition method applied in the adoption of SFAS 123(R), compensation cost will be recognized for the unamortized portion of outstanding awards granted prior to the adoption of SFAS 123. Upon adoption of SFAS 123(R) on December 1, 2005, we will recognize an after-tax gain of approximately $47 million as the cumulative effect of a change in accounting principle, primarily attributable to the requirement to estimate forfeitures at the date of grant instead of recognizing them as incurred. We do not expect adoption of SFAS 123(R) otherwise will have a material effect on our consolidated financial statements.

SFAS 123(R) generally requires equity-based awards granted to retirement-eligible employees, and those employees with non-substantive non-compete agreements to be expensed immediately. For stock-based awards granted prior to our adoption of SFAS123(R), compensation cost for retirement eligible employees and employees subject to non-compete agreements, is recognized over the service period specified in the award. We accelerate the recognition of compensation cost if and when a retirement-eligible employee or an employee subject to a non-compete agreement, leaves the Company.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

The following table sets forth the pro forma net income that would have been reported for the years ended November 30, 2005, 2004 and 2003 if equity-based awards granted to retirement-eligible employees, and those with non-substantive non-compete agreements had been expensed immediately as required by SFAS 123(R):

Pro Forma Net Income


In millions
Year ended November 30

  2005
  2004
  2003
 

 
Net income, as reported   $ 3,260   $ 2,369   $ 1,699  
Add: stock-based employee compensation expense included in reported
    net income, net of related tax effect
    611     464     362  
Deduct: stock-based employee compensation expense, net of
    related tax effect, determined under SFAS 123 (R)
    (867 )   (643 )   (447 )

 
Pro forma net income   $ 3,004   $ 2,190   $ 1,614  

 

EITF Issue No. 04-5.    In June 2005, the FASB ratified the consensus reached in EITF Issue No. 04-5, "Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights", ("EITF 04-5") which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with rights to remove the general partner or to terminate the partnership. As the general partner of numerous private equity, merchant banking and asset management partnerships, we adopted EITF 04-5 immediately for partnerships formed or modified after June 29, 2005. For partnerships formed on or before June 29, 2005 that have not been modified, we are required to adopt EITF 04-5 on December 1, 2006 in a manner similar to a cumulative-effect-type adjustment or by retrospective application. We do not expect adoption of EITF 04-5 for partnerships formed on or before June 29, 2005 that have not been modified will have a material effect on our consolidated financial statements.


Note 2 Financial Instruments

Financial Instruments and Other Inventory Positions

Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased were comprised of the following:

 
   
   
  Sold But Not
Yet Purchased


In millions
November 30

  Owned
  2005
  2004
  2005
  2004

Mortgages, mortgage-backed and real estate inventory positions   $ 62,216   $ 43,831   $ 63   $ 246
Corporate equities     33,426     26,772     21,018     23,019
Corporate debt and other     30,182     24,948     8,997     10,988
Government and agencies     30,079     29,829     64,743     46,697
Derivatives and other contractual agreements     18,045     17,459     15,560     15,242
Certificates of deposit and other money market instruments     3,490     1,629     196     89

    $ 177,438   $ 144,468   $ 110,577   $ 96,281

Mortgages, Mortgage-backed and Real Estate Inventory Positions

Mortgages and mortgage-backed positions include mortgage loans (both residential and commercial), non-agency mortgage-backed securities and real estate investments held for sale. We originate residential and commercial mortgage loans as part of our mortgage trading and securitization activities and are a market leader in mortgage-backed securities trading. We securitized approximately $133 billion and $101 billion of residential mortgage loans in 2005 and 2004, respectively, including both originated loans and those we acquired in the secondary market. We originated approximately $85 billion and $65 billion of residential mortgage loans in 2005 and 2004, respectively. In addition, we originated approximately $27 billion and $13 billion of commercial mortgage loans in 2005 and 2004, respectively, the majority of which has been sold through securitization or syndication activities. See Note 3 to the Consolidated Financial Statements for additional information about our securitization activities. We record mortgage loans at fair

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

value, with related mark-to-market gains and losses recognized in Principal transactions in the Consolidated Statement of Income.

At November 30, 2005 and 2004, we owned approximately $7.9 billion and $10.7 billion, respectively, of real estate held for sale. Our net investment position after giving effect to non-recourse financing was $4.8 billion and $4.1 billion at November 30, 2005 and 2004, respectively.

Derivative Financial Instruments

In the normal course of business, we enter into derivative transactions both in a trading capacity and as an end-user. Our derivative activities (both trading and end-user) are recorded at fair value in the Consolidated Statement of Financial Condition. Acting in a trading capacity, we enter into derivative transactions to satisfy the needs of our clients and to manage our own exposure to market and credit risks resulting from our trading activities (collectively, "Trading-Related Derivative Activities"). As an end-user, we primarily enter into interest rate swap and option contracts to adjust the interest rate nature of our funding sources from fixed to floating rates and to change the index on which floating interest rates are based (e.g., Prime to LIBOR).

Derivatives are subject to various risks similar to other financial instruments, including market, credit and operational risks. In addition, we may be exposed to legal risks related to derivative activities, including the possibility a transaction may be unenforceable under applicable law. The risks of derivatives should not be viewed in isolation, but rather should be considered on an aggregate basis along with our other trading-related activities. We manage the risks associated with derivatives on an aggregate basis along with the risks associated with proprietary trading and market-making activities in cash instruments, as part of our firmwide risk management policies.

We record derivative contracts at fair value with realized and unrealized gains and losses recognized 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 when such provisions are stated in the master netting agreement. We offer equity, fixed income, commodity and foreign exchange derivative products to clients. Because of the integrated nature of the market for such products, each product area trades cash instruments as well as derivative products.

The following table presents the fair value of derivatives at November 30, 2005 and 2004. Assets included in the table represent unrealized gains, net of unrealized losses, for situations in which we have a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. The fair value of assets/liabilities related to derivative contracts at November 30, 2005 and 2004 represents our net receivable/payable for derivative financial instruments before consideration of securities collateral. At November 30, 2005 and 2004, the fair value of derivative assets included $2.6 billion and $3.4 billion, respectively, related to exchange-traded option and warrant contracts.

Fair Value of Derivatives and Other Contractual Agreements


In millions
November 30

  2005
  2004
  Assets
  Liabilities
  Assets
  Liabilities

Interest rate, currency and credit default swaps and options   $ 8,273   $ 7,128   $ 7,927   $ 6,664
Foreign exchange forward contracts and options     1,970     2,004     2,155     2,494
Other fixed income securities contracts (including
    TBAs and forwards)
    2,241     896     1,633     275
Equity contracts (including equity swaps, warrants
    and options)
    5,561     5,532     5,744     5,809

    $ 18,045   $ 15,560   $ 17,459   $ 15,242

The primary difference in risks between OTC and exchange-traded contracts is credit risk. OTC contracts contain credit risk for unrealized gains, net of collateral, from various counterparties for the duration of the contract. With respect to OTC contracts, we view our net credit exposure to be $10.5 billion and $11.3 billion at November 30, 2005 and 2004, respectively, representing the fair value of OTC contracts in an unrealized gain position, after consideration of collateral. Counterparties to our OTC derivative products primarily are U.S. and foreign banks, securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds. Collateral held related to OTC contracts generally includes U.S. government and federal agency securities.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

We also are subject to credit risk related to exchange-traded derivative contracts. Exchange-traded contracts, including futures and certain options, are transacted directly on exchanges. To protect against the potential for a default, all exchange clearinghouses impose net capital requirements for their membership. Additionally, exchange clearinghouses require counterparties to futures contracts to post margin upon the origination of the contracts and for any changes in the market value of the contracts on a daily basis (certain foreign exchanges provide for settlement within three days). Therefore, the potential for credit losses from exchange-traded products is limited.

Concentrations of Credit Risk

A substantial portion of our securities transactions are collateralized and are executed with, and on behalf of, commercial banks and other institutional investors, including other brokers and dealers. Our exposure to credit risk associated with the non-performance of these clients and counterparties in fulfilling their contractual obligations pursuant to securities transactions can be directly affected by volatile or illiquid trading markets, which may impair the ability of clients and counterparties to satisfy their obligations to us.

Financial instruments and other inventory positions owned include U.S. government and agency securities, and securities issued by non-U.S. governments, which in the aggregate, represented 7% of total assets at November 30, 2005. In addition, collateral held for resale agreements represented approximately 26% of total assets at November 30, 2005, and primarily consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. Our most significant industry concentration is financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of business.


Note 3 Securitizations and Other Off-Balance-Sheet Arrangements

We are a market leader in mortgage- and asset-backed securitizations and other structured financing arrangements. In connection with our securitization activities, we use SPEs primarily for the securitization of commercial and residential mortgages, home equity loans, municipal and corporate bonds, and lease and trade receivables. The majority of our involvement with SPEs relates to securitization transactions meeting the SFAS 140 definition of a QSPE. Based on the guidance in SFAS 140, we do not consolidate such QSPEs. We derecognize financial assets transferred in securitizations, provided we have relinquished control over such assets. We may retain an interest in the financial assets we securitize ("retained interests"), which may include assets in the form of residual interests in the SPEs established to facilitate the securitization. Retained interests are included in Financial instruments and other inventory positions owned (primarily Mortgages and mortgage-backed) in the Consolidated Statement of Financial Condition. For further information regarding the accounting for securitization transactions, refer to Note 1, Summary of Significant Accounting Policies—Consolidation Accounting Policies.

During 2005 and 2004, we securitized approximately $152 billion and $120 billion of financial assets, including approximately $133 billion and $101 billion of residential mortgages, $13 billion and $8 billion of commercial mortgages and $6 billion and $11 billion of municipal and other asset-backed financial instruments, respectively. At November 30, 2005 and 2004, we had approximately $700 million and $900 million, respectively, of non-investment grade retained interests from our securitization activities (primarily junior security interests in securitizations). We record inventory positions held prior to securitization, including residential and commercial loans, at fair value, as well as any retained interests post-securitization. Mark-to-market gains or losses are recorded in Principal transactions in the Consolidated Statement of Income. Fair value is determined based on listed market prices, if available. When market prices are not available, fair value is determined based on valuation pricing models that take into account relevant factors such as discount, credit and prepayment assumptions, and also considers comparisons to similar market transactions.

The following table presents the fair value of retained interests at November 30, 2005 and 2004, the key economic assumptions used in measuring the fair value of retained interests, and the sensitivity of the fair value of the retained interests to immediate 10% and 20% adverse changes in the valuation assumptions, as well as the cash flows received on such retained interests from securitization trusts for the years ended November 30, 2005 and 2004.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Securitization Activity

 
  2005
  2004
 
Dollars in millions
November 30

  Residential
Mortgages

  Commercial
Mortgages

  Municipal
and
Other
Asset-
Backed

  Residential
Mortgages

  Commercial
Mortgages

  Municipal
and
Other
Asset-
Backed

 

 
Non-investment grade                                      
  Retained interests (in billions)   $ 0.5   $   $ 0.2   $ 0.5   $ 0.1   $ 0.3  
Weighted-average
    life (years)
    5         16     5     1     7  
Average CPR (1)     28.2   $     5.2     33.0     0     3.5  
  Effect of 10% adverse change   $ 10   $   $   $ 4   $   $  
  Effect of 20% adverse change   $ 18   $   $   $ 11   $   $  
Credit loss assumption     0.1%-9.2 % $ %   0.1-4 %   0.5-9 %   0-1.2 %   1-4 %
  Effect of 10% adverse change   $ 23   $   $ 5   $ 13   $   $ 7  
  Effect of 20% adverse change   $ 44   $   $ 11   $ 28   $ 4   $ 14  
Weighted-average discount rate     15 % $ %   5 %   24 %   15 %   3 %
  Effect of 10% adverse change   $ 22   $   $ 21   $ 16   $ 2   $ 26  
  Effect of 20% adverse change   $ 41   $   $ 42   $ 28   $ 3   $ 52  

 
Year ended November 30,
  2005
  2004
 
Cash flows received on retained interests   $ 138   $   $ 75   $ 172   $ 8   $ 165  

 
(1)
Constant prepayment rate.

The sensitivity analysis is hypothetical and should be used with caution because the stresses are performed without considering the effect of hedges, which serve to reduce our actual risk. In addition, these results are calculated by stressing a particular economic assumption independent of changes in any other assumption (as required by U.S. GAAP); in reality, changes in one factor often result in changes in another factor (for example, changes in discount rates will often affect expected prepayment speeds). Further, changes in the fair value based on a 10% or 20% variation in an assumption should not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

Mortgage servicing rights.    Mortgage servicing rights ("MSRs") represent the Company's right to a future stream of cash flows based upon the contractual servicing fee associated with servicing mortgage loans and mortgage-backed securities. Our MSRs generally arise from the securitization of residential mortgage loans that we originate, and to a lesser extent from the purchase of MSRs from other servicers. MSRs are included in "Financial instruments and other inventory positions owned" on the Consolidated Statements of Financial Condition, and are reported at the lower of amortized cost or market value. At November 30, 2005 and 2004 the Company has MSRs of approximately $561 million and $400 million, respectively. MSRs are amortized in proportion to and over the period of estimated net servicing income. MSRs are periodically evaluated for impairment based on the fair value of those rights determined by using market-based models which discount anticipated future net cash flows considering loan prepayment predictions, interest rates, default rates, servicing costs and other economic factors. The excess of amortized cost over market value is reflected as a valuation allowance at the balance sheet dates. The Company's MSRs activities for the years ended November 30, 2005 and 2004 were as follows:

In millions
November 30

  2005
  2004
 

 
Balance, beginning of period   $ 400   $ 314  
  Additions     509     467  
  Sales     (237 )   (294 )
  Amortization     (151 )   (104 )
  Net change in valuation allowance     40     17  

 
Balance, end of period   $ 561   $ 400  

 

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Non-QSPE activities.    Substantially all of our securitization activities are transacted through QSPEs, including residential and commercial mortgage securitizations. However, we also are actively involved with SPEs that do not meet the QSPE criteria due to their permitted activities not being sufficiently limited or because the assets are not deemed qualifying financial instruments (e.g., real estate). Our involvement with such SPEs includes collateralized debt obligations ("CDOs"), credit-linked notes and other structured financing transactions designed to meet clients' investing or financing needs.

A CDO transaction involves the purchase by an SPE of a diversified portfolio of securities and/or loans that are then managed by an independent asset manager. Interests in the SPE (debt and equity) are sold to third party investors. Our primary role is limited to acting as structuring and placement agent, warehouse provider, underwriter and market maker in the related CDO securities. In a typical CDO, at the direction of a third party asset manager, we temporarily will warehouse securities or loans on our balance sheet pending the sale to the SPE once the permanent financing is completed in the capital markets. At November 30, 2005 and 2004, we owned approximately $42 million and $114 million of equity securities in CDOs, respectively. Because our investments do not represent a majority of any CDO equity class, we are not deemed the primary beneficiary of the CDOs and therefore we do not consolidate such SPEs.

We are a dealer in credit default swaps and, as such, we make a market in buying and selling credit protection on single issuers as well as on portfolios of credit exposures. One of the mechanisms we use to mitigate credit risk is to enter into default swaps with SPEs, in which we purchase default protection. In these transactions, the SPE issues credit-linked notes to investors and uses the proceeds to invest in high quality collateral. We pay a premium to the SPE for assuming credit risk under the default swap. Third-party investors in these SPEs are subject to default risk associated with the referenced obligations under the default swap as well as the credit risk of the assets held by the SPE. Our maximum loss associated with our involvement with such credit-linked note transactions is the fair value of our credit default swaps with such SPEs, which amounted to $156 million and $110 million at November 30, 2005 and 2004, respectively. In addition, our default swaps are secured by the value of the underlying investment-grade collateral held by the SPEs which was $5.7 billion and $4.4 billion at November 30, 2005 and 2004, respectively. Because the results of our expected loss calculations generally demonstrate the investors in the SPE bear a majority of the entity's expected losses (because the investors assume default risk associated with both the reference portfolio and the SPE's assets), we generally are not deemed to be the primary beneficiary of these transactions and therefore do not consolidate such SPEs. However, in certain credit default transactions, generally when we participate in the fixed interest rate risk associated with the underlying collateral through an interest rate swap, we are deemed to be the primary beneficiary of such transaction and therefore have consolidated the SPEs. At November 30, 2005 and 2004 we consolidated approximately $0.6 billion and $0.7 billion of such credit default transactions, respectively. We record the assets associated with such consolidated credit default transactions as a component of long inventory for which principally all of such assets are financed on a non-recourse basis.

We also invest in real estate directly through controlled subsidiaries and through variable interest entities. We consolidate our investments in variable interest real estate entities when we are deemed to be the primary beneficiary. At November 30, 2005 and 2004, we consolidated approximately $4.6 billion and $4.8 billion, respectively, of real estate-related investments in VIEs for which we did not have a controlling financial interest. We record the assets associated with such consolidated real estate-related investments in VIEs as a component of long inventory. After giving effect to non-recourse financing our net investment position in such consolidated VIEs was $2.9 billion and $1.8 billion at November 30, 2005 and 2004, respectively. See Note 2 to the Consolidated Financial Statements for a further discussion of our real estate held for sale.

In addition, we enter into other transactions with SPEs designed to meet clients' investment and/or funding needs. See Note 10 to the Consolidated Financial Statements for additional information about these transactions and SPE-related commitments.


Note 4 Securities Received and Pledged as Collateral

We enter into secured borrowing and lending transactions to finance inventory positions, obtain securities for settlement and meet clients' needs. We receive collateral in connection with resale agreements, securities borrowed transactions, borrow/pledge transactions, client margin loans and derivative transactions. We generally are permitted to sell or repledge these securities held as collateral and use the securities to secure repurchase agreements, enter into securities lending transactions or deliver to counterparties to cover short positions. We carry secured financing agreements on a

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

net basis when permitted under the provisions of FASB Interpretation No. 41, "Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements" ("FIN 41").

At November 30, 2005 and 2004, the fair value of securities received as collateral and Financial instruments and other inventory positions owned that have not been sold, repledged or otherwise encumbered totaled approximately $87 billion and $90 billion, respectively. At November 30, 2005 and 2004, the gross fair value of securities received as collateral that we were permitted to sell or repledge was approximately $528 billion and $524 billion, respectively. Of this collateral, approximately $499 billion and $487 billion at November 30, 2005 and 2004, respectively, has been sold or repledged, generally as collateral under repurchase agreements or to cover Financial instruments and other inventory positions sold but not yet purchased.

We also pledge our own assets, primarily to collateralize certain financing arrangements. These pledged securities, where the counterparty has the right, by contract or custom, to rehypothecate the financial instruments are classified as Financial instruments and other inventory positions owned, pledged as collateral, in the Consolidated Statement of Financial Condition as required by SFAS 140.

The carrying value of Financial instruments and other inventory positions owned that have been pledged or otherwise encumbered to counterparties where those counterparties do not have the right to sell or repledge was approximately $66 billion and $47 billion at November 30, 2005 and 2004, respectively.


Note 5 Business Combinations

In October 2003, we acquired Neuberger Berman Inc. and its subsidiaries ("Neuberger") by means of a merger into a wholly-owned subsidiary of Holdings. The results of Neuberger's operations are included in the Consolidated Financial Statements since that date. Neuberger is an investment advisory company that engages in wealth management services including private asset management, tax and financial planning, and personal and institutional trust services, mutual funds, institutional management and alternative investments, and professional securities services. We purchased Neuberger for a net purchase price of $2.5 billion, including equity consideration of $2.1 billion and cash consideration and incremental costs of $0.7 billion, and excluding cash and short-term investments acquired of $276 million.

During 2003, we also acquired two originators and servicers of residential loans, a diversified private equity fund investment manager, and a fixed income asset management business for an aggregate cost of $172 million, which was paid in cash and notes.

During 2004, we acquired three mortgage origination platforms for an aggregate cost of $184 million. These acquisitions completed early in 2004 were included in substantially all of our 2004 results and were not material to our 2003 results.

The following table sets forth unaudited pro forma combined operating results for the year ended November 30, 2003 as if the 2003 acquisitions discussed above had been completed at the beginning of 2003. These pro forma amounts do not consider any anticipated revenue or expense saving synergies.

Pro Forma Consolidated Statement of Income Information



In millions, except per share data
Year ended November 30

  2003

Net revenues   $ 9,383
Net income     1,722
Basic earnings per share     6.24
Diluted earnings per share     5.93


Note 6 Identifiable Intangible Assets and Goodwill

Aggregate amortization expense for the years ended November 30, 2005, 2004 and 2003 was $49 million, $47 million, and $11 million, respectively. Estimated amortization expense for each of the years ending November 30, 2006 through 2008 is approximately $45 million. Estimated amortization expense for both the years ending November 30, 2009 and 2010 is approximately $35 million.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Identifiable Intangible Assets

 
  2005
  2004

In millions
November 30

  Gross
Carrying
Amount

  Accumulated
Amortization

  Gross
Carrying
Amount

  Accumulated
Amortization


Amortizable intangible assets:                        
  Customer lists   $ 496   $ 93   $ 490   $ 47
  Other     100     37     96     34

    $ 596   $ 130   $ 586   $ 81

Intangible assets not subject to amortization:                        
  Mutual fund customer-related intangibles   $ 395         $ 395      
  Trade name     125           125      

    $ 520         $ 520      

The changes in the carrying amount of goodwill for the years ended November 30, 2005 and 2004, are as follows:

Goodwill


In millions

  Capital
Markets

  Investment
Management

  Total
 

 
Balance (net) at November 30, 2003   $ 154   $ 2,373   $ 2,527  
Goodwill acquired     34     41     75  
Goodwill disposed     (23 )       (23 )
Recognition of acquired tax benefit     (13 )       (13 )
Neuberger final purchase price valuation adjustment         (307 )   (307 )

 
Balance (net) at November 30, 2004     152     2,107     2,259  
Goodwill acquired     8     5     13  
Purchase price valuation adjustment         (2 )   (2 )

 
Balance (net) at November 30, 2005   $ 160   $ 2,110   $ 2,270  

 

During 2004, we finalized the purchase price valuation and allocation of our October 31, 2003 acquisition of Neuberger, based on an independent third-party study. As a result, we reduced the valuation of the purchase price by approximately $307 million related to certain securities we issued that were restricted from resale for periods extending through 2011. The initial allocation of the purchase price to identifiable tangible and intangible assets acquired and liabilities assumed did not change.


Note 7 Short-Term Borrowings

We obtain short-term financing on both a secured and unsecured basis. Secured financing is obtained through the use of repurchase agreements and securities loaned agreements, which are primarily collateralized by government, government agency and equity securities. The unsecured financing is generally obtained through short-term debt and the issuance of commercial paper.

Short-term borrowings consist of the following:

Short-Term Borrowings


In millions
November 30

  2005
  2004

Commercial paper   $ 1,776   $ 1,670
Other short-term debt     1,165     1,187

    $ 2,941   $ 2,857

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

At November 30, 2005 and 2004, the weighted-average interest rates for Short-term borrowings, including commercial paper, were 3.93% and 2.0%, respectively.


Note 8 Long-Term Borrowings

Long-term borrowings consist of the following:

Long-Term Borrowings


In millions
November 30

  2005
  2004

Senior notes   $ 58,599   $ 53,561
Subordinated notes     1,684     1,925
Junior subordinated notes     2,026     1,000

    $ 62,309   $ 56,486

Maturity Profile

The maturity dates of long-term borrowings are as follows:

 
  U.S. Dollar
  Non-U.S. Dollar
   
   

In millions
November 30

  Total
  Fixed
Rate

  Floating
Rate

  Fixed
Rate

  Floating
Rate

  2005
  2004

Maturing in fiscal 2005   $   $   $   $   $   $ 7,121
Maturing in fiscal 2006     3,423     2,968     842     1,177     8,410     12,619
Maturing in fiscal 2007     2,051     6,617     2,539     2,296     13,503     7,070
Maturing in fiscal 2008     3,939     1,875     110     2,361     8,285     6,550
Maturing in fiscal 2009     1,572     1,231     407     2,444     5,654     5,839
Maturing in fiscal 2010     3,653     776     1,071     707     6,207     2,850
December 1, 2010 and thereafter     6,822     2,974     3,753     6,701     20,250     14,437

    $ 21,460   $ 16,441   $ 8,722   $ 15,686   $ 62,309   $ 56,486

The weighted-average contractual interest rates on U.S. dollar and non-U.S. dollar borrowings were 5.11% and 2.96%, respectively, at November 30, 2005 and 4.77% and 2.82%, respectively, at November 30, 2004.

At November 30, 2005, $503 million of outstanding long-term borrowings are repayable at par value prior to maturity at the option of the holder. These obligations are reflected in the above table as maturing at their put dates, which range from fiscal 2006 to fiscal 2007, rather than at their contractual maturities, which range from fiscal 2006 to fiscal 2021. In addition, $7.3 billion of long-term borrowings is redeemable prior to maturity at our option under various terms and conditions. These obligations are reflected in the above table at their contractual maturity dates. Extendible debt structures totaling approximately $3.6 billion are shown in the above table at their earliest maturity dates. Such debt is automatically extended unless debt holders instruct us to redeem their debt at least one year prior to the earliest maturity date.

At November 30, 2005, our U.S. dollar and non-U.S. dollar debt portfolios included approximately $8.1 billion and $9.8 billion, respectively, of structured notes for which the interest rates and/or redemption values are linked to the performance of an underlying measure (including industry baskets of stocks, commodities or credit events). Generally, such notes are issued as floating rate notes or the interest rates on such index notes are effectively converted to floating rates based primarily on LIBOR through the use of derivatives.

End-User Derivative Activities

We use a variety of derivative products including interest rate, currency and equity swaps as an end-user to modify the interest rate characteristics of our long-term borrowing portfolio. We use interest rate swaps to convert a substantial portion of our fixed-rate debt to floating interest rates to more closely match the terms of assets being funded and to minimize interest rate risk. In addition, we use cross-currency swaps to hedge our exposure to foreign currency risk arising from our non-U.S.-dollar debt obligations, after consideration of non-U.S.-dollar assets that are funded with

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

long-term debt obligations in the same currency. In certain instances, we may use two or more derivative contracts to manage the interest rate nature and/or currency exposure of an individual long-term borrowings issuance.

End-user derivative activities resulted in the following mix of fixed and floating rate debt and effective weighted-average interest rates:

Effective Weighted-Average Interest Rates of Long-Term Borrowings


Dollars in millions

  Long-Term
Borrowings
After
End-User
Activities

  Effective
Rate
After
End-User
Activities

 

 
November 30, 2005            
U.S. dollar obligations:            
  Fixed rate   $ 568      
  Floating rate     43,144      

 
Total U.S. dollar obligations     43,712   4.60 %

 
Non-U.S. dollar obligations     18,597   2.62 %

 
    $ 62,309   4.00 %

 
November 30, 2004            
U.S. dollar obligations:            
  Fixed rate   $ 712      
  Floating rate     41,095      

 
Total U.S. dollar obligations     41,807   2.68 %

 
Non-U.S. dollar obligations     14,679   2.31 %

 
    $ 56,486   2.59 %

 

Junior Subordinated Notes

Junior subordinated notes are notes issued to trusts or limited partnerships (collectively, the "Trusts") which qualify as equity capital by leading rating agencies (subject to limitation). The Trusts were formed for the purposes of (a) issuing securities representing ownership interests in the assets of the Trusts; (b) investing the proceeds of the Trusts in junior subordinated notes of Holdings; and (c) engaging in activities necessary and incidental thereto. The securities issued by the Trusts are comprised of the following:


In millions
November 30

  2005
  2004

Trust Preferred Securities:            
  Lehman Brothers Holdings Capital Trust III   $ 300   $ 300
  Lehman Brothers Holdings Capital Trust IV     300     300
  Lehman Brothers Holdings Capital Trust V     400     400
  Lehman Brothers Holdings Capital Trust VI     225    
Euro Perpetual Preferred Securities:            
  Lehman Brothers UK Capital Funding LP     207    
  Lehman Brothers UK Capital Funding II LP     294    
Enhanced Capital Advantaged Preferred Securities (ECAPS):            
  Lehman Brothers Holdings E-Capital Trust I     300    

    $ 2,026   $ 1,000

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

The following table summarizes the key terms of Trusts with outstanding securities at November 30, 2005:

Trusts Issued Securities


November 30

  Issuance
Date

  Mandatory
Redemption Date

  Redeemable by Issuer
on or after


Holdings Capital Trust III   March 2003   March 15, 2052   March 15, 2008
Holdings Capital Trust IV   October 2003   October 31, 2052   October 31, 2008
Holdings Capital Trust V   April 2004   April 22, 2053   April 22, 2009
Holdings Capital Trust VI   January 2005   January 18, 2054   January 18, 2010
UK Capital Funding LP   March 2005   Perpetual   March 30, 2010
UK Capital Funding II LP   September 2005   Perpetual   September 21, 2009
Holdings E-Capital Trust I   August 2005   August 19, 2065   August 19, 2010

Credit Facilities

We maintain an unsecured revolving credit agreement with a syndicate of banks under which the banks have committed to provide up to $1.5 billion through April 2007. We also maintain a $1.0 billion multi-currency unsecured, committed revolving credit facility with a syndicate of banks for Lehman Brothers Bankhaus AG ("LBBAG"), with a term of three and a half years expiring in April 2008. There were no borrowings outstanding under either facility at November 30, 2005, although drawings have been made under both and repaid from time to time during the year. Our ability to borrow under such facilities is conditioned on meeting customary lending covenants. We have maintained compliance with the material covenants under these credit agreements at all times.


Note 9 Fair Value of Financial Instruments

We record financial instruments classified within long and short inventory (Financial instruments and other inventory positions owned, and Financial instruments and other inventory positions sold but not yet purchased) at fair value. Securities received as collateral and Obligation to return securities received as collateral are also carried at fair value. In addition, all off-balance-sheet financial instruments are carried at fair value including derivatives, guarantees and lending -related commitments.

Assets which are carried at contractual amounts that approximate fair value include: Cash and cash equivalents, Cash and securities segregated and on deposit for regulatory and other purposes, Receivables, and Other assets. Liabilities which are carried at contractual amounts that approximate fair value include: Short-term borrowings, Payables, and Accrued liabilities and other payables. The market values of such items are not materially sensitive to shifts in market interest rates because of the limited term to maturity of these instruments and their variable interest rates.

Long-term borrowings are carried at historical amounts, unless designated as the hedged item in a fair value hedge. We carry such hedged debt on a modified mark-to-market basis, which amount could differ from fair value as a result of changes in our credit worthiness. At November 30, 2005 and November 30, 2004, the carrying value of our long-term borrowings was approximately $339 million and $441 million less than fair value, respectively. The fair value of long-term borrowings was estimated using either quoted market prices or discounted cash flow analyses based on our current borrowing rates for similar types of borrowing arrangements.

We carry secured financing activities including Securities purchased under agreements to resell, Securities borrowed, Securities sold under agreements to repurchase, Securities loaned and Other secured borrowings, at their original contract amounts plus accrued interest. Because the majority of such financing activities are short-term in nature, carrying values approximate fair value. At November 30, 2005 and 2004 we had approximately $337 billion and $302 billion, respectively, of such secured financing activities. However, certain of the Company's secured financing activities are long-term in nature. At November 30, 2005 and 2004 we used derivative financial instruments with an aggregate notional amount of $6.0 billion and $7.3 billion, respectively, to modify the interest rate characteristics of certain of our secured financing activities. The total notional amount of these agreements had a weighted-average maturity of 2.9 years and 3.0 years at November 30, 2005 and 2004, respectively. At November 30, 2005 and 2004, the carrying values of these secured financing activities, which are designated as the hedged instrument in fair value hedges, approximated their fair values. Additionally, we had approximately $273 million and $398 million of long-term fixed rate repurchase agreements at November 30, 2005 and 2004, respectively, for which we had unrecognized losses of $11 million and $31 million, respectively.

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements


Note 10 Commitments, Contingencies and Guarantees

In the normal course of business, we enter into various commitments and guarantees, including lending commitments to high grade and high yield borrowers, private equity investment commitments, liquidity commitments and other guarantees. In all instances, we mark to market these commitments and guarantees with changes in fair value recognized in Principal transactions in the Consolidated Statement of Income.

Lending-Related Commitments

The following table summarizes lending-related commitments at November 30, 2005 and 2004:

 
  Amount of Commitment Expiration per Period
  Total
Contractual Amount


In millions

  2006
  2007
  2008–
2009

  2010–
2011

  2012 and
Later

  November 30,
2005

  November 30,
2004


High grade(1)   $ 2,405   $ 1,624   $ 3,270   $ 6,169   $ 571   $ 14,039   $ 10,677
High yield(2)     1,289     1,159     645     1,448     631     5,172     4,438
Mortgage commitments     9,024     176     209     8         9,417     12,835
Investment-grade contingent
    acquisition facilities
    3,915                     3,915     1,475
Non-investment-grade contingent
    acquisition facilities
    4,738                     4,738     4,244
Secured lending transactions,
    including forward starting
    resale and repurchase
    agreements
    62,470     1,124     320     873     995     65,782     105,879

(1)
We view our net credit exposure for high grade commitments, after consideration of hedges, to be $5.4 billion and $4.1 billion at November 30, 2005 and 2004, respectively.

(2)
We view our net credit exposure for high yield commitments, after consideration of hedges, to be $4.4 billion and $3.5 billion at November 30, 2005 and 2004, respectively.

High grade and high yield.    Through our high grade and high yield sales, trading and underwriting activities, we make commitments to extend credit in loan syndication transactions. We use various hedging and funding strategies to actively manage our market, credit and liquidity exposures on these commitments. We do not believe total commitments necessarily are indicative of actual risk or funding requirements because the commitments may not be drawn or fully used and such amounts are reported before consideration of hedges. These commitments and any related drawdowns of these facilities typically have fixed maturity dates and are contingent on certain representations, warranties and contractual conditions applicable to the borrower. We define high yield (non-investment grade) exposures as securities of or loans to companies rated BB+ or lower or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans that, in management's opinion, are non-investment grade. We had commitments to investment grade borrowers of $14.0 billion (net credit exposure of $5.4 billion, after consideration of hedges) and $10.7 billion (net credit exposure of $4.1 billion, after consideration of hedges) at November 30, 2005 and 2004, respectively. We had commitments to non-investment grade borrowers of $5.2 billion (net credit exposure of $4.4 billion after consideration of hedges) and $4.4 billion (net credit exposure of $3.5 billion after consideration of hedges) at November 30, 2005 and 2004, respectively.

Mortgage commitments.    Through our mortgage origination platforms we make commitments to extend mortgage loans. We use various hedging and funding strategies to actively manage our market, credit and liquidity exposures on these commitments. We do not believe total commitments necessarily are indicative of actual risk or funding requirements because the commitments may not be drawn or fully used and such amounts are reported before consideration of hedges. At November 30, 2005 and 2004, we had outstanding mortgage commitments of approximately $9.4 billion and $12.8 billion, respectively, including $7.7 billion and $10.9 billion of residential mortgages and $1.7 billion and $1.9 billion of commercial mortgages. These commitments require us to originate mortgage loans at the option of a borrower generally within 90 days at fixed interest rates. We sell residential mortgage loans, once originated, primarily through securitization. See Note 3 to the Consolidated Financial Statements for additional information about our securitization activities.

Contingent acquisition facilities.    From time to time we provide contingent commitments to investment and non-investment grade counterparties related to acquisition financing. Our expectation is, and our past practice has been, to

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LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

distribute our obligations under these commitments to third parties through loan syndications, if closed, consistent with our credit facilitation framework. We do not believe these commitments are necessarily indicative of our actual risk because the borrower may not complete a contemplated acquisition or, if the borrower completes the acquisition, it often will raise funds in the capital markets instead of drawing on our commitment. Additionally, in most cases, the borrower's ability to draw is subject to there being no material adverse change in the borrower's financial conditions, among other factors. These commitments also generally contain certain flexible pricing features to adjust for changing market conditions prior to closing. We provided contingent commitments to investment-grade counterparties related to acquisition financing of approximately $3.9 billion and $1.5 billion at November 30, 2005 and 2004. In addition, we provided contingent commitments to non-investment-grade counterparties related to acquisition financing of approximately $4.7 billion and $4.2 billion at November 30, 2005 and 2004, respectively.

Secured lending transactions.    In connection with our financing activities, we had outstanding commitments under certain collateralized lending arrangements of approximately $5.7 billion and $5.3 billion at November 30, 2005 and 2004, respectively. These commitments require borrowers to provide acceptable collateral, as defined in the agreements, when amounts are drawn under the lending facilities. Advances made under these lending arrangements typically are at variable interest rates and generally provide for over-collateralization. In addition, at November 30, 2005, we had commitments to enter into forward starting secured resale and repurchase agreements, primarily secured by government and government agency collateral, of $38.6 billion and $21.5 billion, respectively, compared with $55.0 billion and $45.6 billion, respectively, at November 30, 2004.

Other Commitments and Guarantees

The following table summarizes other commitments and guarantees at November 30, 2005 and November 30, 2004:

 
  Amount of Commitment Expiration per Period
  Notional/
Maximum Amount


In millions

  2006
  2007
  2008–
2009

  2010–
2011

  2012 and
Later

  November 30,
2005

  November 30,
2004


Derivative contracts(1)   $ 120,805   $ 68,171   $ 97,075   $ 89,813   $ 163,597   $ 539,461   $ 470,641
Municipal-securities-related
    commitments
    680     16     34     744     2,631     4,105     7,179
Other commitments with special
    purpose entities
    3,257     248     606     485     1,725     6,321     5,261
Standby letters of credit     2,608                     2,608     1,703
Private equity and other
    principal investment
    commitments
    328     243     316     40         927     695

(1)
We believe the fair value of these derivative contracts is a more relevant measure of the obligations because we believe the notional amount overstates the expected payout. At November 30, 2005 and 2004, the fair value of these derivative contracts approximated $9.4 billion and $9.0 billion, respectively.

Derivative contracts.    In accordance with FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"), we disclose certain derivative contracts meeting the FIN 45 definition of a guarantee. Under FIN 45, derivative contracts are considered to be guarantees if such contracts require us to make payments to counterparties based on changes in an underlying instrument or index (e.g., security prices, interest rates, and currency rates) and include written credit default swaps, written put options, written foreign exchange and interest rate options. Derivative contracts are not considered guarantees if such contracts are cash settled and we have no basis to determine whether it is probable the derivative counterparty held the related underlying instrument at the inception of the contract. We have determined these conditions have been met for certain large financial institutions. Accordingly, when these conditions are met, we do not include such derivatives in our guarantee disclosures. At November 30, 2005 and 2004, the maximum payout value of derivative contracts deemed to meet the FIN 45 definition of a guarantee was approximately $539 billion and $471 billion, respectively. For purposes of determining maximum payout, notional values are used; however, we believe the fair value of these contracts is a more relevant measure of these obligations because we believe the notional amounts greatly overstate our expected payout. At November 30, 2005 and 2004, the fair value of such derivative contracts approximated $9.4 billion and $9.0 billion, respectively. In addition, all amounts included above are before consideration of hedging transactions. We substantially mitigate our risk on these contracts through hedges, using other derivative contracts and/or cash instruments. We manage risk associated with derivative guarantees consistent with our global risk management policies. We record derivative contracts, including those considered to be guarantees, at fair value with related gains and losses recognized in Principal transactions in the Consolidated Statement of Income.

-96-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Municipal-securities-related commitments.    At November 30, 2005 and 2004, we had municipal-securities- related commitments of approximately $4.1 billion and $7.2 billion, respectively. Such commitments are principally comprised of liquidity commitments related to trust certificates issued to investors backed by investment grade municipal securities. We believe our liquidity commitments to these trusts involve a low level of risk because our obligations are supported by investment grade securities and generally cease if the underlying assets are downgraded below investment grade or default. In certain instances, we also provide credit default protection to investors in such QSPEs, which approximated $0.5 billion and $0.4 billion at November 30, 2005 and 2004, respectively.

Other commitments with SPEs.    In addition to the municipal-securities-related commitments, we make certain liquidity commitments and guarantees associated with VIEs. We provided liquidity of approximately $1.9 billion and $1.0 billion at November 30, 2005 and 2004, respectively, which represented our maximum exposure to loss, to commercial paper conduits in support of certain clients' secured financing transactions. However, we believe our actual risk to be limited because such liquidity commitments are supported by overcollateralization with investment grade collateral.

In addition, we provide limited downside protection guarantees to investors in certain VIEs. In such instances, we provide investors a guaranteed return of their initial principal investment. Our maximum exposure to loss under such commitments was approximately $3.2 billion and $2.9 billion at November 30, 2005 and 2004, respectively. We believe our actual risk to be limited because our obligations are collateralized by the VIEs' assets and contain significant constraints under which such downside protection will be available (e.g., the VIE is required to liquidate assets in the event certain loss levels are triggered).

We also provided guarantees totaling $1.2 billion and $1.4 billion at November 30, 2005 and November 30, 2004, respectively, of the collateral in a multi-seller conduit backed by short-term commercial paper assets. This commitment is intended to provide us with access to contingent liquidity of $1.2 billion and $1.4 billion as of November 30, 2005 and 2004, respectively, in the event we have greater than anticipated draws under our lending commitments.

Standby letters of credit.    At November 30, 2005 and 2004, we were contingently liable for $2.6 billion and $1.7 billion, respectively, of letters of credit primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges.

Private equity and other principal investments.    At November 30, 2005 and 2004, we had private equity and other principal investment commitments of approximately $0.9 billion and $0.7 billion, respectively.

Other.    In the normal course of business, we provide guarantees to securities clearinghouses and exchanges. These guarantees generally are required under the standard membership agreements, such that members are required to guarantee the performance of other members. To mitigate these performance risks, the exchanges and clearinghouses often require members to post collateral. Our obligations under such guarantees could exceed the collateral amounts posted; however, the potential for us to be required to make payments under such guarantees is deemed remote. In connection with certain asset sales and securitization transactions, we often make representations and warranties about the assets conforming to specified guidelines. If it is later determined the underlying assets fail to conform to the specified guidelines, we may have an obligation to repurchase the assets or indemnify the purchaser against any losses. To mitigate these risks, to the extent the assets being securitized may have been originated by third parties, we seek to obtain appropriate representations and warranties from these third parties when we acquire the assets.

Financial instruments and other inventory positions sold but not yet purchased represent our obligations to purchase the securities at prevailing market prices. Therefore, the future satisfaction of such obligations may be for an amount greater or less than the amount recorded. The ultimate gain or loss is dependent on the price at which the underlying financial instrument is purchased to settle our obligation under the sale commitment.

In the normal course of business, we are exposed to credit and market risk as a result of executing, financing and settling various client security and commodity transactions. These risks arise from the potential that clients or counterparties may fail to satisfy their obligations and the collateral obtained is insufficient. In such instances, we may be required to purchase or sell financial instruments at unfavorable market prices. We seek to control these risks by obtaining margin balances and other collateral in accordance with regulatory and internal guidelines.

Certain of our subsidiaries, as general partners, are contingently liable for the obligations of certain public and private limited partnerships. In our opinion, contingent liabilities, if any, for the obligations of such partnerships will not, in the aggregate, have a material adverse effect on our consolidated financial condition or results of operations.

-97-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Litigation

In the normal course of business we have been named as a defendant in a number of lawsuits and other legal and regulatory proceedings. Such proceedings include actions brought against us and others with respect to transactions in which we acted as an underwriter or financial advisor, actions arising out of our activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities firms, including us. We provide for potential losses that may arise out of legal and regulatory proceedings to the extent such losses are probable and can be estimated. Although there can be no assurance as to the ultimate outcome, we generally have denied, or believe we have a meritorious defense and will deny, liability in all significant cases pending against us, and we intend to defend vigorously each such case. Based on information currently available, we believe the amount, or range, of reasonably possible losses in excess of established reserves, not to be material to the Company's consolidated financial condition or cash flows. However, losses may be material to our operating results for any particular future period, depending on the level of income for such period.

During 2004, we entered into a settlement with our insurance carriers relating to several large proceedings noticed to the carriers and initially occurring prior to January 2003. Under the terms of the insurance settlement, the insurance carriers agreed to pay us $280 million. During 2004, we also entered into a Memorandum of Understanding to settle the In re Enron Corporation Securities Litigation class action lawsuit for $223 million. The settlement with our insurance carriers and the settlement under the Memorandum of Understanding did not result in a net gain or loss in our Consolidated Statement of Income as the $280 million settlement with our insurance carriers represented an aggregate settlement associated with several matters, including Enron, Worldcom and other matters. See Part 1, Item 3—Legal Proceedings in this Form 10K for additional information about the Enron securities class action and related matters.

Lease Commitments

We lease office space and equipment throughout the world. Total rent expense for 2005, 2004 and 2003 was $167 million, $135 million and $136 million, respectively. Certain leases on office space contain escalation clauses providing for additional payments based on maintenance, utility and tax increases.

Minimum future rental commitments under non-cancelable operating leases (net of subleases of $282 million) and future commitments under capital leases are as follows:

Minimum Future Rental Commitments Under Operating and Capital Lease Agreements


In millions

  Operating
Leases

  Capital
Lease

 


 
Fiscal 2006   $ 173   $ 61  
Fiscal 2007     165     61  
Fiscal 2008     157     66  
Fiscal 2009     151     88  
Fiscal 2010     143     90  
December 1, 2010 and thereafter     926     2,407  

 
Total minimum lease payments   $ 1,715     2,773  

 
Less: Amount representing interest           (1,608 )

 
Present value of future minimum capital lease payments         $ 1,165  

 

Note 11 Stockholders' Equity

Preferred Stock

Holdings is authorized to issue a total of 38,000,000 shares of preferred stock. At November 30, 2005, Holdings had 798,000 shares issued and outstanding under various series as described below. All preferred stock has a dividend preference over Holdings' common stock in the paying of dividends and a preference in the liquidation of assets.

Series C.    On May 11, 1998, Holdings issued 5,000,000 Depositary Shares, each representing 1/10th of a share of 5.94% Cumulative Preferred Stock, Series C ("Series C Preferred Stock"), $1.00 par value. The shares of Series C Preferred Stock have a redemption price of $500 per share, together with accrued and unpaid dividends. Holdings may redeem

-98-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

any or all of the outstanding shares of Series C Preferred Stock beginning on May 31, 2008. The $250 million redemption value of the shares outstanding at November 30, 2005 is classified in the Consolidated Statement of Financial Condition as a component of Preferred stock.

Series D.    On July 21, 1998, Holdings issued 4,000,000 Depositary 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 shares of Series D Preferred Stock have a redemption price of $5,000 per share, together with accrued and unpaid dividends. Holdings may redeem any or all of the outstanding shares of Series D Preferred Stock beginning on August 31, 2008. The $200 million redemption value of the shares outstanding at November 30, 2005 is classified in the Consolidated Statement of Financial Condition as a component of Preferred stock.

Series E.    On March 28, 2000, Holdings issued 5,000,000 Depositary Shares, each representing 1/100th of a share of Fixed/Adjustable Rate Cumulative Preferred Stock, Series E ("Series E Preferred Stock"), $1.00 par value. The initial cumulative dividend rate on the Series E Preferred Stock was 7.115% per annum through May 31, 2005. On May 31, 2005, Holdings redeemed all of our issued and outstanding shares, together with accumulated and unpaid dividends.

Series F.    On August 20, 2003, Holdings issued 13,800,000 Depositary Shares, each representing 1/100th of a share of 6.50% Cumulative Preferred Stock, Series F ("Series F Preferred Stock"), $1.00 par value. The shares of Series F Preferred Stock have a redemption price of $2,500 per share, together with accrued and unpaid dividends. Holdings may redeem any or all of the outstanding shares of Series F Preferred Stock beginning on August 31, 2008. The $345 million redemption value of the shares outstanding at November 30, 2005 is classified in the Consolidated Statement of Financial Condition as a component of Preferred stock.

Series G.    On January 30, 2004 and August 16, 2004 Holdings issued 5,200,000 and 6,800,000, respectively, Depositary Shares, each representing 1/100th of a share of Holdings' Floating Rate Cumulative Preferred Stock, Series G ("Series G Preferred Stock"), $1.00 par value, for a total of $130 million and $170 million, respectively. Dividends on the Series G Preferred Stock are payable at a floating rate per annum of one-month LIBOR plus 0.75%, with a floor of 3.0% per annum. The Series G Preferred Stock has a redemption price of $2,500 per share, together with accrued and unpaid dividends. Holdings may redeem any or all of the outstanding shares of Series G Preferred Stock beginning on February 15, 2009. The $300 million redemption value of the shares outstanding at November 30, 2005 is classified in the Consolidated Statement of Financial Condition as a component of Preferred stock.

The Series C, D, F and G Preferred Stock have no voting rights except as provided below or as otherwise from time to time required by law. If dividends payable on any of the Series C, D, F or G Preferred Stock or on any other equally-ranked series of preferred stock have not been paid for six or more quarters, whether or not consecutive, the authorized number of directors of the Company will automatically be increased by two. The holders of the Series C, D, F or G Preferred Stock will have the right, with holders of any other equally-ranked series of preferred stock that have similar voting rights and on which dividends likewise have not been paid, voting together as a class, to elect two directors to fill such newly created directorships until the dividends in arrears are paid.

Common Stock

Dividends declared per common share were $0.80, $0.64 and $0.48 in 2005, 2004 and 2003, respectively. During the years ended November 30, 2005, 2004 and 2003, we repurchased or acquired shares of our common stock at an aggregate cost of approximately $4.2 billion, $2.3 billion and $1.5 billion, respectively, or $103.17, $78.20, and $65.22 per share, respectively. These shares were acquired in the open market and from employees who tendered mature shares to pay for the exercise cost of stock options or for statutory tax withholding obligations on RSU issuances or option exercises.

-99-



LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

Changes in the number of shares of common stock outstanding are as follows:

Common Stock


November 30

  2005
  2004
  2003
 

 
Shares outstanding, beginning of period   274,159,411   266,679,056   231,131,043  
Exercise of stock options and other share issuances   26,571,357   18,474,422   11,538,125  
Shares issued to the RSU Trust   11,000,000   18,000,000   14,000,000  
Shares issued in connection with the Neuberger acquisition       33,130,804  
Treasury stock acquisitions   (40,293,665 ) (28,994,067 ) (23,120,916 )

 
Shares outstanding, end of period   271,437,103   274,159,411   266,679,056  

 

In 1997, we established an irrevocable grantor trust (the "RSU Trust") to provide common stock voting rights to employees who hold outstanding restricted stock units ("RSUs") and to encourage employees to think and act like owners. In 2005, 2004 and 2003, we transferred 11.0 million, 18.0 million and 14.0 million treasury shares, respectively, into the RSU Trust. At November 30, 2005, approximately 34.6 million shares were held in the RSU Trust with a total value of approximately $1.5 billion. These shares are valued at weighted-average grant prices. Shares transferred to the RSU Trust do not affect the total number of shares used in the calculation of basic and diluted earnings per share because we include amortized RSUs in the calculations. Accordingly, the RSU Trust has no effect on total equity, net income or earnings per share.


Note 12 Regulatory Requirements

We operate globally through a network of subsidiaries, with several subject to regulatory requirements. In the United States, LBI and Neuberger Berman, LLC ("NBLLC"), as registered broker-dealers, are subject to the Securities and Exchange Commission ("SEC") Rule 15c3-1, the Net Capital Rule, which requires these companies to maintain net capital of not less than the greater of 2% of aggregate debit items arising from client transactions, as defined, or 4% of funds required to be segregated for customers' regulated commodity accounts, as defined. At November 30, 2005, LBI and NBLLC had regulatory net capital, as defined, of $2.1 billion and $243 million, respectively, which exceeded the minimum requirement by $1.8 billion and $229 million, respectively.

Lehman Brothers International (Europe) ("LBIE"), a United Kingdom registered broker-dealer and subsidiary of Holdings, is subject to the capital requirements of the Financial Services Authority ("FSA") of the United Kingdom. Financial resources, as defined, must exceed the total financial resources requirement of the FSA. At November 30, 2005, LBIE's financial resources of approximately $5.9 billion exceeded the minimum requirement by approximately $1.8 billion. Lehman Brothers Japan Inc.'s Tokyo branch, a regulated broker-dealer, is subject to the capital requirements of the Financial Services Agency and, at November 30, 2005, had net capital of approximately $674 million, which was approximately $338 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 November 30, 2005 these other subsidiaries were in compliance with their applicable local capital adequacy requirements.

Lehman Brothers Bank, FSB (the "Bank"), our thrift subsidiary, is regulated by the Office of Thrift Supervision ("OTS"). Lehman Brothers Commercial Bank (the "Industrial Bank"), our Utah industrial bank subsidiary established during 2005, is regulated by the Utah Department of Financial Institutions and the Federal Deposit Insurance Corporation. The Bank and the Industrial Bank exceed all regulatory capital requirements and are considered to be well capitalized. In addition, our "AAA" rated derivatives subsidiaries, Lehman Brothers Financial Products Inc. ("LBFP") and Lehman Brothers Derivative Products Inc. ("LBDP"), have established certain capital and operating restrictions that are reviewed by various rating agencies. At November 30, 2005, LBFP and LBDP each had capital that exceeded the requirements of the rating agencies.

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. At November 30, 2005, approximately $7.6 billion of net assets of subsidiaries were restricted as to the payment of dividends to Holdings. In the normal course of business, Holdings provides guarantees of certain activities of its subsidiaries, including our fixed income derivative business conducted through Lehman Brothers Special Financing Inc.

-100-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

As of December 1, 2005, Holdings became regulated by the SEC as a consolidated supervised entity ("CSE"). As such, Holdings is subject to group-wide supervision and examination by the SEC and, accordingly, we are subject to minimum capital requirements on a consolidated basis. LBI is also authorized to calculate its net capital under provisions as specified by the SEC applicable rules.


Note 13 Earnings per Share

Earnings per share was calculated as follows:

Earnings per Share


In millions, except per share data
Year ended November 30

  2005
  2004
  2003


Numerator:                  
Net income   $ 3,260   $ 2,369   $ 1,699
Preferred stock dividends     69     72     50

Numerator for basic earnings per share—net income applicable to common stock   $ 3,191   $ 2,297   $ 1,649

Denominator:                  
Denominator for basic earnings per share—weighted-average common shares     278.2     274.7     245.7
Effect of dilutive securities:                  
  Employee stock options     12.7     13.8     12.2
  Restricted stock units     2.7     2.2     2.0

Dilutive potential common shares     15.4     16.0     14.2

Denominator for diluted earnings per share—weighted-average common and
    dilutive potential common shares(1)
    293.6     290.7     259.9

Basic earnings per share   $ 11.47   $ 8.36   $ 6.71
Diluted earnings per share   $ 10.87   $ 7.90   $ 6.35

(1)    Anti-dilutive options and restricted stock units excluded from the
         calculations of diluted earnings per share
    4.3     2.0     8.0

Note 14 Employee Incentive Plans

In 2004 the Company adopted the fair value recognition provisions of SFAS 123 using the prospective adoption method. The Company's adoption of SFAS 123 on a prospective basis in 2004 resulted in a change in measurement for employee stock awards. See Note 1 for a further discussion.

Employee Stock Purchase Plan

On June 30, 2004, the Employee Stock Purchase Plan (the "ESPP") expired following the completion of its 10-year term as approved by shareholders. The ESPP allowed employees to purchase Common Stock at a 15% discount from market value, with a maximum of $25,000 in annual aggregate purchases by any one individual. At November 30, 2004 6.3 million shares of Common Stock had cumulatively been purchased by eligible employees through the ESPP.

1994 Management Ownership Plan

On May 31, 2004 the Lehman Brothers Holdings Inc. Management Ownership Plan (the "1994 Plan") expired following the completion of its 10-year term. The 1994 Plan provided for the issuance of RSUs, performance stock units ("PSUs"), stock options and other equity awards for a period of up to ten years to eligible employees. At November 30, 2005, RSU, PSU and stock option awards with respect to 33.1 million shares of Common Stock have been made under the 1994 Plan, of which 3.1 million are outstanding and 30.0 million have been converted to freely transferable Common Stock.

-101-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

1996 Management Ownership Plan

The 1996 Management Ownership Plan (the "1996 Plan"), under which awards similar to those of the 1994 Plan may be granted, provides for up to 42.0 million shares of Common Stock to be subject to awards. At November 30, 2005, RSU, PSU and stock option awards with respect to 39.5 million shares of Common Stock have been made under the 1996 Plan of which 9.5 million are outstanding and 30.0 million have been converted to freely transferable Common Stock.

Employee Incentive Plan

The Employee Incentive Plan ("EIP") has provisions similar to the 1994 Plan and the 1996 Plan, and authorization from the Board of Directors to issue up to 246.0 million shares of Common Stock that may be subject to awards. At November 30, 2005 awards with respect to 231.9 million shares of Common Stock have been made under the EIP of which 93.0 million are outstanding and 138.9 million have been converted to freely transferable Common Stock.

Stock Incentive Plan

The Stock Incentive Plan ("SIP") has provisions similar to the 1994 Plan, the 1996 Plan and the EIP, and authorization from the Board of Directors to issue up to 10.0 million shares of Common Stock that may be subject to awards. At November 30, 2005 awards with respect to 2.3 million shares of Common Stock have been made under the SIP of which 2.3 million are outstanding.

1999 Long Term Incentive Plan

The 1999 Neuberger Berman Inc. Long-Term Incentive Plan (the "LTIP") provided for the grant of restricted stock, restricted units, incentive stock, incentive units, deferred shares, supplemental units and stock options. The total number of shares of Common Stock that may be issued under the LTIP may not exceed 7.7 million. At November 30, 2005, awards with respect to approximately 6.7 million shares of Common Stock have been made under the LTIP, of which approximately 3.7 million restricted shares, RSUs and stock options are outstanding and 3.0 million have been converted to freely transferable Common Stock.

1999 Directors Stock Incentive Plan

The 1999 Neuberger Berman Inc. Directors Stock Incentive Plan (the "DSIP") provided for the grant of stock options or restricted stock to non-employee members of Neuberger's board of directors. Non-employee directors could elect to exchange a portion of their annual cash retainer paid by Neuberger for services rendered as a director for restricted stock. At November 30, 2004, awards with respect to approximately 62,000 shares have been made under the DSIP of which all shares have been converted to freely transferable Common Stock. We do not intend to grant additional awards from the DSIP.

Restricted Stock Units

Eligible employees receive RSUs, in lieu of cash, as a portion of their total compensation. There is no further cost to employees associated with the RSU awards. For awards granted prior to 2004, we measure compensation cost for RSUs based on the market value of our Common Stock at the grant date in accordance with APB 25. For awards granted beginning in 2004 we measure compensation cost based on the market value of our Common Stock at the grant date less a discount for sale restrictions subsequent to the vesting date in accordance with our adoption of SFAS 123 on a prospective basis. RSUs granted in each of the years presented contain selling restrictions subsequent to the vesting date. We amortize the RSU awards over the applicable service periods. RSU awards made to employees have various vesting provisions and generally convert to unrestricted freely transferable Common Stock five years from the grant date. We accrue a dividend equivalent on each RSU outstanding (in the form of additional RSUs), based on dividends declared on our Common Stock.

-102-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

The following table summarizes RSUs outstanding under stock-based incentive plans:

Restricted Stock Units

 
  2005
  2004
  2003
   

   
Balance, beginning of year   64,242,393   64,343,313   69,338,068    
Granted   13,965,142   14,899,012   14,796,772 (1)  
Canceled   (1,512,954 ) (1,276,002 ) (1,447,319 )  
Exchanged for stock without restrictions   (16,485,744 ) (13,723,930 ) (18,344,208 )  

   
Balance, end of year   60,208,837   64,242,393   64,343,313    
Shares held in RSU Trust   (34,558,884 ) (38,861,068 ) (33,408,893 )  

   
RSUs outstanding, net of shares held in RSU trust   25,649,953   25,381,325   30,934,420    

   
(1)
Includes approximately 1.7 million RSUs granted in 2003 related to our acquisition of Neuberger. See Note 5 to the Consolidated Financial Statements for additional information about the Neuberger acquisition.

Of the RSUs outstanding at November 30, 2005, approximately 36 million were amortized and included in basic and diluted earnings per share, approximately 10 million will be amortized during 2006, and the remainder will be amortized subsequent to November 30, 2006. See Note 11 to the Consolidated Financial Statements for additional information.

Included in the previous table are PSUs awarded to certain senior officers prior to 2004. The number of PSUs that may be earned is dependent on achieving certain performance levels within predetermined performance periods. During the performance period, these PSUs are accounted for as variable awards. At the end of a performance period, any PSUs earned will convert one-for-one to RSUs that then vest in three or more years. At November 30, 2005, approximately 11.2 million PSUs had been awarded, of which 6.0 million remained outstanding, subject to vesting and transfer restrictions. The compensation cost for the RSUs payable in satisfaction of PSUs is accrued over the combined performance and vesting periods.

Stock Options

The following table summarizes stock option activity for the years ended November 30, 2005, 2004 and 2003:

Stock Option Activity

 
  Options
  Weighted-Average
Exercise Price

  Expiration
Dates


Balance, November 30, 2002   83,540,492   $ 44.21   11/03–11/12
Granted(1)   15,536,462   $ 66.98    
Exercised(1)   (10,595,469 ) $ 28.08    
Canceled(1)   (1,734,835 ) $ 46.63    

Balance, November 30, 2003   86,746,650   $ 50.21   12/03–11/13

Granted   5,423,596   $ 80.74    
Exercised   (17,167,352 ) $ 36.36    
Canceled   (1,459,299 ) $ 56.48    

Balance, November 30, 2004   73,543,595   $ 55.57   12/04–11/14

Granted   3,524,013   $ 111.53    
Exercised   (25,537,742 ) $ 48.76    
Canceled   (654,703 ) $ 66.76    

Balance, November 30, 2005   50,875,163   $ 62.72   12/05–11/15

(1)
Includes approximately 4.3 million stock options granted, 0.3 million stock options exercised, and 0.1 million stock options canceled in 2003 related to our acquisition of Neuberger. See Note 5 to the Consolidated Financial Statements for additional information about the Neuberger acquisition.

-103-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements

The exercise price for all stock options awarded has been equal to the market price of Common Stock on the day of grant. The table below provides further details related to stock options outstanding at November 30, 2005.

Stock Options

 
  Options Outstanding
  Options Exercisable

Range of
Exercise Prices

  Number
Outstanding

  Weighted-
Average
Exercise
Price

  Weighted
Average
Remaining
Contractual
Life (in years)

  Number
Exercisable

  Weighted
Average
Exercise
Price

  Weighted
Average
Remaining
Contractual
Life (in years)


$20.00—$29.99   1,797,889   $ 20.69   3.01   1,797,889   $ 20.69   3.01
$30.00–$39.99   1,377,796   $ 37.16   4.03   1,377,796   $ 37.16   4.03
$40.00–$49.99   8,295,915   $ 47.78   5.05   5,162,629   $ 48.47   4.50
$50.00–$59.99   14,324,484   $ 54.03   6.13   8,629,809   $ 54.43   5.64
$60.00–$69.99   6,539,260   $ 63.49   4.58   3,285,498   $ 63.58   3.19
$70.00–$79.99   11,545,366   $ 71.57   5.98   5,840,136   $ 71.70   4.47
$80.00–$89.99   4,777,248   $ 85.73   5.02   225,460   $ 85.50   5.33
$90.00–$99.99   22,500   $ 93.30   9.34   0     n/a   n/a
$100.00–$149.99   2,194,705   $ 127.20   6.37   0     n/a   n/a

    50,875,163   $ 62.72   5.46   26,319,217   $ 55.29   4.58

Restricted Stock

In connection with the 2003 Neuberger acquisition, we issued approximately 806,000 shares of restricted Common Stock to replace outstanding shares of Neuberger restricted Common Stock. During 2005, we awarded approximately 7,767 shares of our restricted Common Stock under the LTIP.

The following table summarizes restricted stock activity for the years ended November 30, 2005 and 2004:

Restricted Stock

 
  2005
  2004
 

 
Balance, beginning of year   770,846   805,587  
Granted   7,767   223,889  
Canceled   (18,723 ) (27,325 )
Exchanged for stock without restrictions   (238,702 ) (231,305 )

 
Balance, end of year   521,188   770,846  

 

Total compensation cost for stock-based awards recognized during 2005, 2004 and 2003 was approximately $1,055 million, $800 million and $625 million, respectively.

-104-


LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements


Note 15 Employee Benefit Plans
   

We provide both funded and unfunded noncontributory defined benefit pension plans for the majority of our employees worldwide. In addition, we provide certain other postretirement benefits, primarily health care and life insurance, to eligible employees. We use a November 30 measurement date for the majority of our plans. The following tables summarize these plans:

Defined Benefit Plans

 
  Pension Benefits
   
   
 
 
  Postretirement
Benefits

 

In millions
November 30

  U.S.
  Non-U.S.
 
  2005
  20