EX-13.01 10 j7875_ex13d01.htm EX-13.01

EXHIBIT 13.01

 

MANAGEMENT’S DISCUSSION & ANALYSIS

 

Certain Factors Affecting Results of Operations

 

33

Business Environment

 

34

Results of Operations

 

35

Segments

 

38

Geographic Diversification

 

43

Liquidity, Funding and Capital Resources

 

44

Summary of Contractual Obligations

 

48

Off-Balance-Sheet Arrangements

 

50

Risk Management

 

52

Critical Accounting Policies

 

56

New Accounting Developments

 

58

Effects of Inflation

 

59

REPORT OF INDEPENDENT AUDITORS

 

60

CONSOLIDATED FINANCIAL STATEMENTS

 

61

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

67

SELECTED FINANCIAL DATA

 

98

OTHER STOCKHOLDER INFORMATION

 

100

 

32

 

[Note: Page numbers correspond to pages in the printed 2002 Annual Report.]

 



 

Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company” or “Lehman Brothers”) is a leading financial services firm that provides investment banking and capital markets facilitation to a global client base. The Company’s business activities are divided into three segments: Investment Banking, Capital Markets and Client Services. The investment banking industry is influenced by several factors inherent in the global financial markets and economic conditions worldwide. As a result, revenues and earnings may vary from quarter to quarter and from year to year.

 

Forward-Looking Statements

 

Some of the statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, 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,” “plans,” “believes,” “estimates” and similar expressions, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. These statements are not historical facts but instead represent only the Company’s expectations, estimates and projections regarding future events. 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 listed below. The Company’s 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. The Company undertakes no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

 

Certain Factors Affecting Results of Operations

 

The Company’s results of operations may be affected by uncertain or unfavorable economic, market, legal and other conditions. These conditions include:

 

Market Fluctuations and Volatility

 

Changes in interest and foreign exchange rates, securities and commodities valuations and increases in volatility can increase risk and may also impact customer flow related revenues in the Capital Markets and Client Services businesses, as well as impact the volume of debt and equity underwritings and merger and acquisition transactions.

 

Industry Competition and Changes in Competitive Environment

 

Increased competition from both banking institutions and non-traditional financial services providers and industry consolidation could impact fees earned from the Company’s investment banking and capital markets businesses.

 

Investor Sentiment

 

This past year has seen a record number of accounting and corporate governance

 

33



 

scandals which have had a significant impact on investor confidence in the market place. In addition, geopolitical concerns about possible military action and terrorist activities can have an effect on the global financial markets.

 

Liquidity

 

Liquidity risk management is of critical importance to the Company. Liquidity could be impacted by the inability to access the long-term or short-term debt markets or the repurchase and securities lending markets. However, the Company’s liquidity and funding policies have been designed with the goal of providing sufficient liquidity resources to continually fund its balance sheet and to meet its obligations in all market environments.

 

Credit Ratings

 

The Company’s access to the unsecured funding markets is dependent upon the Company’s credit ratings. A reduction in the Company’s credit ratings could adversely affect the Company’s access to liquidity alternatives and its competitive position, and could increase the cost of funding or trigger additional collateral requirements.

 

Credit Exposure

 

Credit risk represents the possibility that a counterparty will be unable to honor its contractual obligations to the Company. Although the Company actively manages daily credit risk exposure as part of its risk management framework, counterparty default risk may arise from unforeseen events or circumstances.

 

Legal/regulatory

 

Legal and regulatory changes in the U.S. and other jurisdictions could have unfavorable impacts on the Company’s businesses and results.

 

Business Environment

 

The principal business activities of the Company are investment banking and capital markets facilitation. Through the Company’s investment banking, trading, research, structuring and distribution capabilities in equity and fixed income products, the Company continues to build on its client/customer business model. This model focuses on “customer flow” activities. The “customer flow” model is based upon the Company’s principal focus of facilitating customer transactions in all major global capital markets products and services. The Company generates customer flow revenues from institutional and high-net-worth clients/customers 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 rebalance their portfolios and diversify risks across different market cycles and (iii) acting as an underwriter to clients.

 

Marketplace uncertainties experienced throughout 2001 continued into 2002, with a further deterioration in global market conditions. The market downturn was fueled by a number of negative influences: a heightened degree of geopolitical risks, simultaneously weak levels of economic activity globally and reduced investor confidence levels, particularly in the U.S., resulting from certain corporate accounting practices and governance issues. These negative factors served to increase both the risk premium and volatility in the global equity markets, which resulted in lower returns in all major equity markets during 2002. The Dow Jones Industrial Average (“DJIA”) finished the year at 8,896, down 10% from fiscal year-end 2001. The NASDAQ composite and the S&P 500 decreased 23% and 18%, respectively, from the fiscal year-end of 2001. The FTSE 100 decreased 20% during the fiscal year while the DAX decreased 33%. In Asia, the Nikkei closed the year down 14%, reaching its lowest level in the past two decades, as Japan continued to be mired in a decade long recession. In November 2002, the Federal Reserve lowered the Federal Funds rate by 50 basis points to 1.25% in an attempt to stimulate growth after having left the Federal Funds rate unchanged for most of the fiscal year. The Bank of England kept rates unchanged at 4% throughout 2002 while the European Central Bank lowered rates in December of 2002 in hopes of spurring confidence and growth in the marketplace.

 

Declining market valuations had a significant impact on global equity origination activity. Fiscal 2002 global equity origination activity was at a five-year low, with volume slightly down from the already depressed levels of 2001.

 

Fixed income markets continued to benefit from low interest rates in 2002 with global debt origination relatively flat to the robust levels experienced in 2001. However, accounting and corporate governance scandals coupled with historically unprecedented numbers of debt downgrades and high profile defaults caused investors to move away from certain credit products and towards more defensive assets such as government and mortgage-backed securities. This resulted in a widening of credit spreads and

 

34



 

negatively impacted investment grade and high yield debt originations, which declined by 13% and 22%, respectively, from prior year levels. Asset- and mortgage-backed debt issuances benefited from the shift into more defensive asset classes and saw increases of 15% and 44%, respectively, during fiscal year 2002. (Statistics provided by Thomson Financial Securities Data Corp (“TFSD”).)

 

Mergers and acquisitions (“M&A”) advisory activity, which slowed in 2001, experienced even further declines in 2002 to its lowest level since 1995. Market conditions for acquisitions continued to be extremely difficult, as corporations concentrated on corporate governance matters and focused less on strategic transactions. Worldwide completed M&A activity for 2002 decreased 45% from the prior year, according to TFSD, and announced M&A activity for fiscal 2002 decreased 29% from the prior year’s levels.

 

Results of Operations

 

The Company reported net income of $975 million or $3.47 per share (diluted) in 2002 down from net income of $1,255 million and earnings per share (diluted) of $4.38 in 2001. Net revenues were $6,155 million and $6,736 million in 2002 and 2001, respectively. Although 2002 results decreased from the prior year’s levels, the Company believes that these results in an extremely challenging market environment, coupled with market share increases in many products, demonstrate the strength, diversity and resiliency of the Company’s franchise. The Company has improved its market position in a number of key areas including: M&A advisory and debt and common stock underwriting. The Company also continued to maintain a strict discipline with regard to its core competencies during the year, specifically managing expenses, risk management and capital deployment.

 

The Company’s results in 2002 include the impact of three special items: a pre-tax net gain of $108 million associated with September 11th related costs and insurance settlement proceeds, a $128 million pre-tax charge associated with decisions to reconfigure certain other global real estate holdings and an $80 million pre-tax charge related to the Company’s participation in the proposed settlement regarding allegations of research analyst conflicts of interest. The net pre-tax effect of these three items is a charge of $100 million ($78 million after-tax), which resulted in a decrease to earnings per share (diluted) of $0.30. (Additional information about these amounts can be found in Notes 2, 3 and 4 to the Consolidated Financial Statements.)

 

The Company’s 2001 results include the impact of a $127 million pre-tax charge ($71 million after-tax) stemming from the events of September 11th, which resulted in the displacement and relocation of substantially all of the Company’s New York based employees. The effect of the charge was a decrease to earnings per share (diluted) of $0.26. (Additional information about this charge can be found in Note 2 to the Consolidated Financial Statements.)

 

In 2000, the Company reported record net income of $1,775 million or $6.38 per share (diluted) and net revenues of $7,707 million, reflecting a much more favorable global market environment.

 

Net Revenues

 

The Company recorded net revenues of $6,155 million, $6,736 million and $7,707 million for fiscal years 2002, 2001 and 2000, respectively. The decrease in net revenues over this three- year period principally resulted from the deterioration of global market conditions from the more favorable environment in 2000 in which the Company recorded record net revenues. The 9% decrease in net revenues in 2002 was principally the result of lower M&A, equity origination and equity capital markets revenue levels, partially offset by an increase in fixed income capital markets revenues. Client Service revenues and debt origination revenue levels remained relatively unchanged from fiscal 2001. (See page 38 for a detailed discussion of revenues by segment.)

 

Global equity markets declined significantly throughout this period, as evidenced by an average decline in global equity indices of 20% and 17% in fiscal 2002 and fiscal 2001, respectively. The declines in equity market valuations negatively impacted both the volume of global M&A transactions, as completed transactions were approximately 65% lower in 2002 than 2000, and the level of global equity underwriting, as volumes were 45% lower in fiscal 2002 than fiscal 2000.

 

Global fixed income markets have benefited as a result of the historically low interest rate environment over the past two years. Global fixed income underwriting volumes reached record levels in 2002 from robust activity levels in 2001, fueled by lower interest rates globally, particularly in the U.S., which saw decreases in the Federal Funds rate of 75 basis points in fiscal 2002 and 450 basis points in fiscal 2001. Benefiting from the low interest rate environment as well as expanding market share, the Company increased its volume of global debt originations by 12% in fiscal 2002 and 51% in fiscal 2001. Revenues

 

35



 

from fixed income products were also bolstered by strong levels of institutional customer flow activity as investors sought more defensive asset classes in 2002 and 2001. However, record levels of accounting and corporate governance scandals as well as significantly higher levels of issuer defaults, resulted in a significant widening of credit spreads, and extreme volatility, which had a negative impact on valuations and customer flow trading volumes for certain credit sensitive products in 2002.

 

Principal Transactions, Commissions and Net Interest Revenues

 

The Company evaluates the performance of its Capital Markets and Client Services revenues in the aggregate, including Principal transactions, Commissions and net interest. Decisions relating to these activities are based on an overall review of aggregate revenues, which includes an assessment of the potential gain or loss associated with a transaction, including any associated commissions, and the interest revenue or expense associated with financing or hedging the Company’s positions. Therefore, the Company views net revenues from Principal transactions, Commissions and Interest revenue, offset by Interest expense, in the aggregate. Caution should be used when analyzing these revenue categories individually, as they are not always indicative of the performance of the Company’s overall Capital Markets and Client Services activities.

 

Principal transactions, Commissions and Net interest revenues totaled $4,339 million in 2002 as compared to $4,684 million in 2001 and $5,357 million in 2000. The 7% decrease in 2002 from 2001 principally reflects the negative conditions within the global equity markets. These negative conditions resulted in a decline in equity capital markets revenues, most notable in equity derivatives, as investor concerns regarding corporate governance and geopolitical risks resulted in reduced demand for these products. Equity capital markets revenues were also reduced by losses on the Company’s private equity investments in 2002. Despite these negative conditions, the Company improved its market share in both listed and NASDAQ trading volumes. Partially offsetting these revenue declines was an increase in fixed income revenues, particularly in mortgage products, which benefited from their less credit sensitive nature and low interest rate levels. Principal transactions, Commissions and net interest revenues decreased by $673 million or 13% in 2001 from 2000 as robust revenues from fixed income products, fueled by declining interest rates and increased customer flow activity as investors sought more defensive asset classes, were more than offset by lower revenues from equity products.

 

Within the above amounts, Principal transactions revenues were $1,951 million in 2002 as compared to $2,779 million in 2001 and $3,713 million in 2000. Commissions revenues were $1,286 million in 2002 as compared to $1,091 million in 2001 and $944 million in 2000. Interest and dividend revenues were $11,728 million in 2002 as compared to $16,470 million in 2001 and $19,440 million in 2000. Interest expense was $10,626 million in 2002 as compared to $15,656 million in 2001 and $18,740 million in 2000.

 

The decrease in Principal transactions revenues in 2002 and 2001 principally reflects reduced equity product revenues resulting from poor global market conditions. In addition, Principal transactions revenues decreased in 2002 as a result of the transition to a commission-based revenue structure on NASDAQ trades, whereby these revenues are classified as Commissions in 2002. In prior years, the Company’s NASDAQ trades for substantially all of its institutional customers were transacted on a spread basis, with related revenues classified within Principal transactions.

 

Commissions revenues increased in 2002 as compared to the prior year’s levels due to the migration to institutional commission-based pricing in the NASDAQ market, growth in market trading volumes and an increase in the Company’s market share of listed and NASDAQ trading volumes. Commission revenues increased in 2001 as a result of growth in market trading volumes and an increase in the Company’s market share of listed and NASDAQ trading volumes.

 

Interest and dividends revenues and Interest expense are a function of the level and mix of total assets and liabilities, principally financial instruments owned and secured financing activities, the prevailing level of interest rates, as well as the term structure of the Company’s financings. Interest and dividends revenues and Interest expense are integral components of the Company’s overall customer flow activities. The decline in interest revenues and interest expense in 2002 and 2001 is principally due to the substantial declines in interest rates during those periods. The increase in net interest revenue to $1,102 million in 2002 from $814 million in 2001 was due in part to a change in inventory mix to higher levels of interest-bearing assets in response to shifts in customer asset preferences. The increase in net interest revenue to $814 million in 2001 from $700 million in 2000 was primarily due to a decline in the cost of financing and a change in inventory mix to higher levels of interest bearing assets.

 

36



 

Investment Banking

 

Investment Banking revenues were $1,771 million for 2002 as compared to $2,000 million for 2001 and $2,216 million in 2000. Investment banking revenues result mainly from fees earned by the Company for underwriting public and private offerings of fixed income and equity securities, and advising clients on M&A activities and other services. In 2002, Investment banking revenues decreased 11% from 2001, reflecting the significant market weakness in equity underwriting and M&A advisory activities, partially offset by improvements in the Company’s market share for completed M&A transactions and underwriting of fixed income and certain equity products. In 2001, Investment banking revenues decreased by 10% driven by industry wide decreases in M&A and equity origination activities. (See page 40 for a detailed discussion of the Company’s Investment Banking segment.)

 

Non-Interest Expenses

 

In millions
Twelve months ended November 30

 

2002

 

2001

 

2000

 

Compensation and benefits

 

$

3,139

 

$

3,437

 

$

3,931

 

Nonpersonnel

 

1,517

 

1,424

 

1,197

 

September 11th related (recoveries)/expenses, net

 

(108

)

127

 

 

Other real estate reconfiguration charge

 

128

 

 

 

Regulatory settlement

 

80

 

 

 

Total non-interest expenses

 

$

4,756

 

$

4,988

 

$

5,128

 

Compensation and benefits/Net revenues

 

51.0

%

51.0

%

51.0

%

 

Non-interest expenses were $4,756 million for fiscal 2002, down 5% from $4,988 million in fiscal 2001 and down 3% in fiscal 2001 from $5,128 million in fiscal 2000. Total non-interest expenses in fiscal 2002 included a net gain of $108 million associated with September 11th related costs and insurance settlement proceeds, a charge of $128 million for certain other real estate reconfiguration costs and a charge of $80 million resulting from the Company’s regulatory settlement associated with allegations of research analyst conflicts of interest. Fiscal 2001 total non-interest expenses included a charge of $127 million related to September 11th insurance recoveries and expenses, net. (Additional information about these charges can be found in Notes 2, 3 and 4 to the Consolidated Financial Statements.)

 

Nonpersonnel expenses were $1,517 million in 2002 compared to $1,424 million in 2001. The increase in nonpersonnel expenses is principally attributable to increases in occupancy, technology and communication, and brokerage and clearance expenses, partially offset by decreases in discretionary spending items. Occupancy expenses increased to $287 million in 2002 from $198 million in 2001, principally attributable to additional space to accommodate the growth in headcount resulting from the Company’s expansion during the past several years as well as the increased cost of our new corporate headquarters. Technology and communication expenses were $552 million in 2002 compared to $501 million in 2001. This increase reflects additional spending to enhance the Company’s capital markets trading platforms and technology infrastructure. Brokerage and clearance expenses increased by 7% due to higher volumes in certain fixed income structured products. Business development and professional fees decreased by 20% and 15%, respectively, from 2001, due to lower discretionary spending in response to the current market environment. Nonpersonnel expenses increased 19% in 2001 from 2000 mainly attributable to increases in investments in technology and communications,  occupancy expenses to accommodate headcount growth and increased brokerage and clearance expenses.

 

Compensation and benefits expenses were $3,139 million in 2002, $3,437 million in 2001 and $3,931 million in 2000. Compensation and benefits expense as a percentage of net revenues in 2002 remained at 51%, consistent with fiscal 2001 and 2000. Compensation and benefits expense includes the cost of salaries, incentive compensation and employee benefit plans as well as the amortization of deferred stock compensation awards. Lower levels of revenues in 2002 resulted in lower variable compensation expenses, which decreased by 21% from 2001. Fixed compensation, consisting primarily of salaries and benefits, increased 6% in 2002 from 2001, due to an increase in pension expense, related to lower asset values and projected returns, as

 

37



 

well as higher severance costs related to headcount reductions made during the fourth quarter of 2002. Compensation and benefits expenses decreased 13% in 2001 from 2000 consistent with the decrease in the Company’s revenues.

 

Net pension expense/(income) was $26 million, $(32) million and $(34) million in 2002, 2001 and 2000, respectively. The Company views its pension cost as a component of compensation expense and, in keeping with its expense management discipline, has maintained total compensation at 51% of net revenues over the past several years.

 

Nonpersonnel and compensation expenses combined were $4,656 million, $4,861 million and $5,128 million in 2002, 2001 and 2000, respectively. The overall decrease year-over-year is principally associated with the decrease in net revenues coupled with the Company’s continued disciplined approach to expense management.

 

Income Taxes

 

The Company recorded an income tax provision of $368 million, $437 million, and $748 million for 2002, 2001, and 2000, respectively. These provisions resulted in effective tax rates of 26.3%, 25.0%, and 29.0%, respectively.

 

The increase in the effective tax rate in 2002 from 2001 was principally due to a less favorable mix of geographic earnings, partially offset by a greater impact of permanent differences, including tax-exempt income. The decrease in the effective tax rate in 2001 from 2000 was primarily due to a greater impact of permanent differences, resulting from a decrease in the level of pre-tax income, an increase in tax-exempt income, and a higher level of income from foreign operations.

 

Additional information about the Company’s income taxes can be found in Note 14 to the Consolidated Financial Statements.

 

Segments

 

The Company is segregated into three business segments (each of which is described below): Investment Banking, Capital Markets and Client Services. Each segment represents a group of activities and products with similar characteristics. These business activities result in revenues from both institutional and high-net-worth retail clients, which are recognized across all revenue categories contained in the Company’s Consolidated Statement of Income. (Net revenues also contain certain internal allocations, including funding costs, which are centrally managed.)

 

Segment Results

 

In millions
Twelve months ended November 30, 2002

 

Investment
Banking

 

Capital
Markets

 

Client
Services

 

Total

 

Principal Transactions

 

$

 

$

1,474

 

$

477

 

$

1,951

 

Interest and Dividends

 

 

11,691

 

37

 

11,728

 

Investment Banking

 

1,731

 

 

40

 

1,771

 

Commissions

 

 

1,059

 

227

 

1,286

 

Other

 

 

1

 

44

 

45

 

Total Revenues

 

1,731

 

14,225

 

825

 

16,781

 

Interest Expense

 

 

10,605

 

21

 

10,626

 

Net Revenues

 

1,731

 

3,620

 

804

 

6,155

 

Non-Interest Expenses(1)

 

1,321

 

2,722

 

613

 

4,656

 

Earnings Before Taxes(1)

 

$

410

 

$

898

 

$

191

 

$

1,499

 

 

38



 

In millions
Twelve months ended November 30, 2001

 

Investment
Banking

 

Capital
Markets

 

Client
Services

 

Total

 

Principal Transactions

 

$

 

$

2,342

 

$

437

 

$

2,779

 

Interest and Dividends

 

 

16,371

 

99

 

16,470

 

Investment Banking

 

1,925

 

 

75

 

2,000

 

Commissions

 

 

879

 

212

 

1,091

 

Other

 

 

13

 

39

 

52

 

Total Revenues

 

1,925

 

19,605

 

862

 

22,392

 

Interest Expense

 

 

15,581

 

75

 

15,656

 

Net Revenues

 

1,925

 

4,024

 

787

 

6,736

 

Non-Interest Expenses(2)

 

1,552

 

2,702

 

607

 

4,861

 

Earnings Before Taxes(2)

 

$

373

 

$

1,322

 

$

180

 

$

1,875

 

 

In millions
Twelve months ended November 30, 2000

 

Investment
Banking

 

Capital
Markets

 

Client
Services

 

Total

 

Principal Transactions

 

$

 

$

3,259

 

$

454

 

$

3,713

 

Interest and Dividends

 

 

19,271

 

169

 

19,440

 

Investment Banking

 

2,179

 

 

37

 

2,216

 

Commissions

 

 

731

 

213

 

944

 

Other

 

 

29

 

105

 

134

 

Total Revenues

 

2,179

 

23,290

 

978

 

26,447

 

Interest Expense

 

 

18,601

 

139

 

18,740

 

Net Revenues

 

2,179

 

4,689

 

839

 

7,707

 

Non-Interest Expenses

 

1,680

 

2,888

 

560

 

5,128

 

Earnings Before Taxes

 

$

499

 

$

1,801

 

$

279

 

$

2,579

 

 


(1) Excludes the impact of the real estate reconfiguration charge of $128 million, September 11th related (recoveries)/expenses, net gain of ($108) million and regulatory settlement charge of $80 million.

 

(2) Excludes the impact of September 11th related expenses, net of $127 million.

 

The following discussion provides an analysis of the Company’s results by segment for the above periods.

 

Lehman Brothers provides a full array of capital markets products and advisory services worldwide. Through the Company’s banking, trading, research, structuring and distribution capabilities in equity and fixed income products, the Company continues to effectively build its client/customer business model. This model focuses on “customer flow” activities, which represent a majority of the Company’s revenues. In addition to its customer flow activities, the Company also takes proprietary positions, the success of which is dependent upon its ability to anticipate economic and market trends. The Company believes its customer flow orientation helps to mitigate its overall revenue volatility.

 

The Company, through its subsidiaries, is a market-maker in all major equity and fixed income products in both the U.S. and international markets. In order to facilitate its market-making activities, the Company is a member of all principal securities and commodities exchanges in the U.S. and holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Milan and Paris stock exchanges. As part of its customer flow activities, the Company maintains inventory positions of varying amounts across a broad range of financial instruments, which are marked-to-market on a daily basis and, along with any proprietary trading positions, give rise to Principal transactions revenues.

 

Net revenues from the Company’s customer flow activities are recorded as either Principal transactions, Commissions or net interest revenues in the Consolidated Statement of Income, depending upon the method of execution, financing and/or hedging related to specific inventory positions. In assessing the performance of Capital Markets and Client Services, the Company evaluates Principal transactions, Commissions and net interest revenues in the aggregate. Decisions relating to Capital Markets and Client Services activities are based on an overall review of aggregate revenues, which includes an assessment of the potential gain or loss associated with a transaction including any associated commissions, and the interest revenue or expense

 

39



 

associated with financing or hedging the Company’s positions. Therefore, the Company views net revenues from Principal transactions, Commissions and Interest revenue, offset by related Interest expense, in the aggregate, because the revenue classifications, when analyzed individually, are not always indicative of the performance of the Company’s Capital Markets and Client Services activities.

 

Investment Banking

 

This segment’s net revenues result from fees earned by the Company for underwriting public and private offerings of fixed income and equity securities, and advising clients on merger and acquisition activities and other services. The division is structured into global industry groups—Communications & Media, Consumer/Retailing, Financial Institutions, Financial Sponsors, Healthcare, Industrial, Natural Resources, Power, Real Estate and Technology—where bankers deliver industry knowledge and the resources to meet clients’ objectives. Specialized product groups within Mergers and Acquisitions, Equity Capital Markets, Debt Capital Markets, Leveraged Finance and Private Placements are partnered with global relationship managers in the industry groups to provide comprehensive solutions for clients. The Company’s specialists in new product development and derivatives also are utilized to tailor specific structures for clients.

 

Investment Banking net revenues decreased 10% in 2002 to $1,731 million from $1,925 million in 2001, primarily due to a decline in M&A advisory revenues. Investment Banking net revenues decreased 12% in 2001 to $1,925 million from $2,179 million in 2000 as record fixed income underwriting activity in 2001 was more than offset by decreases in equity origination and M&A activity.

 

Investment Banking Net Revenues

 

In millions

 

2002

 

2001

 

2000

 

Debt Underwriting

 

$

886

 

$

893

 

$

585

 

Equity Underwriting

 

420

 

440

 

817

 

Merger and Acquisition Advisory

 

425

 

592

 

777

 

 

 

 

 

 

 

 

 

 

 

$

1,731

 

$

1,925

 

$

2,179

 

 

                  Named “Bank of the Year” in 2002 by International Financing Review Magazine

                  Increase in market share across most major product categories

                  Decline in Investment Banking net revenues reflects difficult global market conditions

 

Debt underwriting revenues of $886 million in 2002 remained relatively flat compared to the record results of $893 million in 2001 as issuers continued to take advantage of historically low interest rates. The Company also continued to improve its competitive position resulting in an increase in global market share for debt origination, which grew to 7.2% in calendar year 2002 from 6.9% in calendar year 2001, according to TFSD. In addition, the Company’s market share for high yield debt issuance increased to 7.9% from 6.3% and market share for leveraged loan transactions increased to 3.6% from 1.8%. In 2001, debt underwriting revenues increased 53% to a record $893 million from $585 million in 2000 as issuers took advantage of lower interest rates to raise long-term debt and replace short-term financing. In calendar year 2001, the Company’s market share increased to 6.9% from 5.9% in calendar year 2000.

 

Equity origination revenues of $420 million in 2002 were down 5% as compared to a year ago. Global equity markets remained challenging in 2002 as market-wide new issuance volumes declined for the second consecutive year. Despite the difficult market conditions, the Company increased its share of common stock new issuances to 4.2% in 2002 from 3.6% in the prior year, but saw a reduced share of activity in the convertibles market. Equity origination revenues decreased 46% in 2001 from $817 million in 2000 as industry-wide equity underwriting declined significantly during 2001, partially offset by an increase in the Company’s global equity underwriting market share in 2001.

 

40



 

M&A advisory fees decreased 28% to $425 million in 2002 from 2001. This decrease reflects extremely difficult global market conditions and weakened demand for strategic transactions as corporations remained conservative amid an uncertain business climate. Market volume in 2002 for M&A advisory was at a six-year low. Despite the low volume of activity in the advisory markets, the Company improved its market share for completed transactions in calendar year 2002 to 10.7% vs. 7.4% for calendar year 2001, and its market share for announced transactions increased to 10.7% for calendar year 2002 from 6.5% for calendar year 2001, according to TFSD. M&A advisory fees decreased 24% in 2001 to $592 million from 2000 record results as a result of depressed market conditions in 2001.

 

Investment Banking pre-tax earnings of $410 million in 2002 increased 10% from 2001, as the 10% decrease in net revenues was more than offset by lower expenses. The decrease in expenses reflects reduced compensation expenses associated with lower revenue and headcount levels and reduced nonpersonnel related expenses, particularly business development and professional fees, as the Company focused on minimizing discretionary spending in light of reduced revenue levels. In 2001, Investment Banking pre-tax earnings of $373 million decreased 25% from 2000, as a result of the 12% decrease in net revenues coupled with higher compensation and benefits expenses as a result of an increase in headcount.

 

Capital Markets

 

This segment’s earnings reflect institutional customer flow activities and secondary trading and financing activities related to fixed income and equity products. These products include a wide range of cash, derivative, secured financing and structured instruments.

 

Capital Markets Net Revenues

 

 

 

2002

 

2001

 

2000

 

In millions

 

Gross
Revenues

 

Interest
Expense

 

Net
Revenues

 

Gross
Revenues

 

Interest
Expense

 

Net
Revenues

 

Gross
Revenues

 

Interest
Expense

 

Net
Revenues

 

Fixed Income

 

$

10,674

 

$

(8,055

)

$

2,619

 

$

13,984

 

$

(11,757

)

$

2,227

 

$

16,671

 

$

(14,611

)

$

2,060

 

Equities

 

3,551

 

(2,550

)

1,001

 

5,621

 

(3,824

)

1,797

 

6,619

 

(3,990

)

2,629

 

 

 

$

14,225

 

$

(10,605

)

$

3,620

 

$

19,605

 

$

(15,581

)

$

4,024

 

$

23,290

 

$

(18,601

)

$

4,689

 

 

•     Record fixed income net revenues for second consecutive year

•     U.S. fixed income research team ranked #1 and fixed income trading ranked #2 by Institutional Investor

•     U.S. equity research ranked #2 by Institutional Investor in 2002, up from #5 in 2001

•     Gains in fixed income net revenues were more than offset by a 44% decline in equities net revenues in 2002

•     Market share increases in both listed and NASDAQ equity trading volumes in 2002

Capital Markets net revenues were $3,620 million for 2002, down 10% from 2001 as record fixed income revenues were more than offset by a 44% decline in equities net revenue. The decrease of $665 million in Capital Markets net revenues in 2001 was principally due to lower equities revenues as a result of declining global equity market valuations.

 

In fixed income, the Company remains a leading global market-maker in numerous products, including U.S., European and Asian government securities, money market products, corporate high grade and high yield securities, mortgage- and asset-backed securities, preferred stock, municipal securities, bank loans, foreign exchange, financing and derivative products. Net revenues from the fixed income component of capital markets increased 18% to a record $2,619 million from $2,227 million in the prior year. The increase was principally driven by a strong level of institutional customer flow activity, particularly in mortgage-related products, as secondary flow was aided by near record levels of origination activity as investors continued to minimize risk by moving toward more diversified and defensive

 

41



 

asset categories. The Federal Funds rate remained at historically low levels throughout the fiscal year, with a 50 basis point decrease in the rate occurring in November 2002. The low interest rate environment throughout 2002 contributed to strong results in the Company’s mortgage businesses, principally from increases in securitization transactions and the distribution of various mortgage loan products, which were bolstered by the active refinancing environment. Additionally, the Company had strong results in structured credit related products, particularly in collateralized debt obligations (“CDOs”), as clients migrated to products offering diversification and hedging capabilities. In 2001, fixed income net revenues increased 8% to a then record level of $2,227 million from $2,060 million in 2000, principally driven by a strong level of institutional customer flow activity as investors sought more defensive asset classes. Areas that benefited the most from the strength in institutional customer flow included mortgages, high grade debt and municipals.

 

In equities, the Company is one of the largest investment banks for U.S. and pan-European listed trading volume, and the Company maintains a major presence in over-the-counter U.S. stocks, major Asian large capitalization stocks, warrants, convertible debentures and preferred issues. In addition, the Company makes certain investments in private equity positions and/or partnerships for which the Company acts as general partner. Net revenues from the equities component of Capital Markets decreased 44% to $1,001 million in 2002 from $1,797 million in 2001, driven by negative market conditions which resulted in revenue declines across most equity products, including equity derivatives, equity financing and private equity. Equity derivative revenues declined primarily as a result of reduced client demand for structured equity derivative products given market weaknesses. The decrease in equity finance revenues was primarily attributed to a decline in customer balances in the prime brokerage business, while private equity investments suffered losses on both private and public investments. These declines in revenues were partially offset by improvements in the Company’s market share in both listed and NASDAQ securities, which increased to 7.2% and 3.6%, respectively, in 2002 from 5.7% and 3.2% in 2001. Net revenues from the equities component of Capital Markets decreased 32% to $1,797 million in 2001 from $2,629 million in 2000 primarily as a result of declining global equity markets.

 

Capital Markets pre-tax earnings of $898 million in 2002 decreased 32% from pre-tax earnings of $1,322 million in 2001, driven by a 10% decrease in net revenues. Capital Markets non-interest expenses remained relatively flat in 2002 when compared to the previous year as a decrease in compensation and benefits was offset by an increase in nonpersonnel expenses, including increased occupancy costs associated with increased headcount levels and higher technology spending in order to enhance the Company’s trading platforms and technology infrastructure. Capital markets pre-tax earnings of $1,322 million in 2001 decreased by 27% from $1,801 in 2000 as a result of a 14% decrease in net revenues, partially offset by a 6% decrease in non-interest expenses.

 

Interest and Dividends

 

The Company evaluates the performance of its Capital Markets business revenues in the aggregate, including Principal transactions, Commissions and net interest. Substantially all of the Company’s net interest is allocated to its Capital Markets segment. Decisions relating to these activities are based on an overall review of aggregate revenues, which includes an assessment of the potential gain or loss associated with a transaction, including any associated commissions, and the interest revenue or expense associated with financing or hedging the Company’s positions; therefore, caution should be utilized when analyzing revenue categories individually.

 

Interest and dividend revenues for Capital Markets businesses decreased 29% in 2002 from 2001, whereas interest expense decreased 32% over this same period, reflecting the decline in interest rates over the year. Net interest revenue increased 37% in 2002 over the prior year, reflecting benefits from the steepening yield curve environment and higher interest earning asset levels in 2002 as compared to 2001. Interest and dividend revenue for Capital Markets businesses decreased 15% in 2001 from 2000, whereas interest expense decreased 16% over this same period, reflecting the decline in interest rates during 2001. Net interest revenue increased 18% in 2001 over the prior year, primarily due to a decrease in the cost of funding coupled with a change in inventory mix.

 

42



 

Client Services

 

Client Services Net Revenues

 

In millions

 

2002

 

2001

 

2000

 

Private Client

 

$

762

 

$

711

 

$

795

 

Private Equity

 

42

 

76

 

44

 

 

 

$

804

 

$

787

 

$

839

 

 

                  Private Client net revenues increased 7% over prior year on strong fixed income activity among high-net-worth clients

                  Private Equity assets under management decreased 20% in 2002 to $4.5 billion from $5.6 billion in 2001

 

Client Services net revenues reflect earnings from the Company’s Private Client and Private Equity businesses. Private Client net revenues reflect the Company’s high-net-worth retail customer flow activities as well as asset management fees, where the Company strives to add value to its client base of high-net-worth individuals and mid-sized institutional investors through innovative financial solutions, global access to capital, research, global product depth and personal service and advice.

 

Private Equity net revenues include the management and incentive fees earned in the Company’s role as general partner for thirty-three private equity partnerships. Private Equity currently operates in five major asset classes: Merchant Banking, Real Estate, Venture Capital, Fixed Income-related and Third Party Funds. As of the fiscal year ended 2002, Private Equity had $4.5 billion of assets under management.

 

Client Services net revenues were $804 million in 2002 as compared to $787 million in 2001 and $839 million in 2000. Despite the weak equity markets, Private Client net revenues increased to $762 million in 2002 from $711 million in 2001 due to record fixed income activity which more than offset decreased performance in equities as the Company’s high-net-worth clients continued to reposition their portfolios to more defensive asset classes. Client Services net revenues were $787 million in 2001 compared to $839 million for 2000. Excluding a special performance-based asset management fee of $73 million in 2000 and a $20 million merchant banking incentive fee in 2001, Client Services results remained relatively flat in 2001, as the Company’s high-net-worth sales force continued to produce strong results despite the weak equity market environment.

 

Private Equity net revenues decreased $34 million in 2002 from 2001, principally as a result of lower incentive fees earned in 2002. Private Equity net revenues increased $32 million in 2001 from 2000, primarily due to a $15 million increase in management fees from new funds sponsored by the Company and the recognition of a $20 million incentive fee from a single merchant banking investment.

 

Client Services pre-tax earnings of $191 million in 2002 increased 6% from 2001 as a result of higher net revenues. Non-interest expenses of $613 million remained relatively flat in 2002 as compared to 2001. Client Services pre-tax earnings of $180 million in 2001 decreased 35% from $279 million in 2000 as a result of a 6% decrease in net revenues, coupled with an 8% increase in non-interest expenses, mainly attributable to the increase in headcount during 2001.

 

Geographic Diversification

 

The Company’s European and Asia Pacific regions continued to be affected by the global economic slowdown in 2002. Despite the dampened economic environment, the Company was able to improve certain rankings and market share in Europe and Asia, most prominently in M&A transactions, where market share in European completed transactions improved to 14.9% from 6.1% and market share in European announced transactions increased to 13.2% from 6.0% in calendar year 2002 from calendar year 2001 (according to TFSD).

 

International net revenues were $2,286 million in 2002, $2,495 million in 2001 and $3,215 million in 2000, representing approximately 37% of total net revenues in 2002 and 2001, and 42% in 2000. International net revenues as a percentage of total net revenues remained flat from 2001 to 2002 as a higher proportion of revenues earned from international Capital Markets businesses was offset by a decrease in international Investment Banking businesses. International net revenues, consistent with U.S. revenues, saw declines in revenues from equity products as such results were adversely impacted by declining equity indices. Partially offsetting this decrease were increased revenues from fixed income products in both Europe and Asia.

 

Net Revenues from the Company’s European region decreased 14% to $1,674 million in 2002 from $1,955 million in 2001.

 

43



 

Europe’s fixed income capital markets business experienced a record year driven by continued growth in structured transactions, including CDO’s, as well as strong performance in interest rate and real estate mortgage related products. This was offset by a significant decline in equity capital markets and investment banking net revenues due to a lack of corporate demand for equity derivative products and a continued decline in the European equity origination markets. Net revenues from the Company’s European region decreased 18% in 2001 versus 2000 as the region encountered the same weak market conditions experienced in the U.S. during 2001.

 

Net Revenues from the Company’s Asia Pacific region of $612 million in 2002 increased 13% from $540 million in 2001. Asia’s fixed income capital markets business experienced their second highest year ever, driven by strength in derivatives, high yield and mortgage-related products as a result of strong customer flow activities and new transactions, particularly in the distressed assets securitization business. This performance was partially offset by a decline in equity capital markets and investment banking net revenues due to a lack of corporate demand for equity derivatives, depressed equity markets and poor market conditions in the investment banking environment. Net revenues from the Company’s Asia Pacific region decreased 35% in 2001 from 2000 as a result of the difficult market conditions experienced during 2001.

 

Net Revenue Diversity by Geographic Region

 

[Graphic Omitted—pie chart showing:]

 

U.S.

 

63

%

 

 

 

 

 

 

 

 

 

 

 

 

Europe

 

27

%

|

 

 

 

 

 

 

 

|

 

37

%

Asia Pacific

 

10

%

|

 

 

 

 

                  International net revenues represented approximately 37% of total net revenues in 2002, compared with only 28% in 1997.

 

Liquidity, Funding and Capital Resources

 

Liquidity Risk Management

 

Liquidity and liquidity management are of paramount importance to the Company, providing a framework which seeks to ensure that the Company maintains sufficient liquid financial resources to continually fund its balance sheet and meet all of its funding obligations in all market environments. Our liquidity management philosophy incorporates the following principles:

 

                  Liquidity providers are credit and market sensitive and quick to react to any perceived market or firm specific risks. Consequently, firms must be in a state of constant liquidity readiness.

 

The Company maintains a large cash position at Holdings to help absorb the impact of a severe liquidity event.

 

                  During a liquidity event, certain secured lenders will require higher quality collateral, resulting in a lower availability of secured funding for “harder to fund” asset classes. Firms must therefore not overestimate the availability of secured financing, and must fully integrate their secured and unsecured funding strategies.

 

The Company has established “Reliable Secured Funding” levels by asset category and by counterparty and ensures that any secured funding above those levels is longer term.

 

                  Firms should not rely on asset sales to generate cash or believe that they can increase unsecured borrowings or funding efficiencies in a liquidity crisis.

 

The Company does not rely on reducing its balance sheet for liquidity reasons in a liquidity event (although it may do so for risk reasons).

 

                  A firm’s legal entity structure may constrain liquidity. Regulatory requirements can restrict the flow of funds between regulated and unregulated group entities and this should be explicitly accounted for in liquidity planning.

 

The Company seeks to ensure that each regulated entity and Holdings has sufficient stand-alone liquidity and that there is no “cross subsidization” of liquidity from the regulated entities to Holdings.

 

The Company’s Funding Framework incorporates the above principles and seeks to mitigate liquidity risk by helping to ensure that the Company maintains sufficient funding resources to withstand a severe liquidity event, including:

 

44



 

                  Sufficient cash capital (i.e., liabilities with remaining maturities of over one year) to fund:

 

Secured funding “haircuts,” (i.e., the difference between the market value of the available inventory and the estimated value of cash that would be advanced to the Company by counterparties against that inventory in a stress environment).

 

Less liquid assets, including fixed assets, goodwill, deferred taxes and prepaid assets.

 

Operational cash at banks and unpledged assets regardless of collateral quality.

 

Anticipated draws of unfunded commitments.

 

To ensure that the Company is operating “within its means,” the businesses operate within strict cash capital limits. This limit culture has been institutionalized and engages the entire Company in managing liquidity.

 

                  Sufficient “Reliable Secured Funding” capacity to fund the Company’s liquid inventory on a secured basis. This capacity represents an assessment of the reliable secured funding capacity, by asset class, that the Company would anticipate in a liquidity event.

 

The Company pays careful attention to validating this capacity through a periodic counterparty-by-counterparty, product-by-product review, which draws upon the Company’s understanding of the financing franchise and the funding experience with the counterparties.

 

In cases where a business has inventory at a level above its “Reliable Secured Funding” capacity, the Company requires the excess to be funded on a term basis.

 

The Company has increased the capacity for funding certain asset classes through the growth of Lehman Brothers Bank (a FDIC-insured thrift) and Lehman Brothers Bankhaus (a GDPF-insured bank). These entities operate in a deposit-protected environment and are able to source low cost unsecured funds that are generally insulated from a company- or market-specific event, thereby providing more reliable funding for mortgage products and select loan assets.

 

                  Sufficient liquidity to withstand a liquidity event characterized by:

 

The Company’s inability to issue any unsecured short-term and long-term debt for one year.

 

Haircut widening for secured funding; Funding requirements resulting from a credit rating downgrade (e.g., the increased collateral requirements for over-the-counter derivative transactions).

 

To provide liquidity to Holdings during periods of adverse market conditions, the Company maintains a portfolio of cash and unencumbered liquid assets, comprised primarily of U.S. Government and agency obligations, investment grade securities and listed equities, which can be sold or pledged to provide liquidity to Holdings where most of the unsecured debt is issued.

 

As of November 30, 2002, the estimated pledge value of this portfolio, along with the undrawn portion of Holdings’ committed credit facility (see “Credit Facilities” below) amounted to approximately $15.8 billion. Cash and unencumbered liquid assets that are presumed to be “trapped” in a regulated entity or required for operational purposes, and are therefore not seen as a completely reliable source of cash to repay maturing unsecured debt in a liquidity stress event, are not included in this portfolio.

 

The Company has developed and regularly updates its Contingency Funding Plan — which represents a detailed action plan to manage a stress liquidity event — including a communication plan for creditors, investors and customers during a funding crisis.

 

Funding

 

Short-Term Debt to Total Assets Less Matched Book

 

   [Graphic Omitted—bar graph showing: ]

 

1998

 

6.0

%

1999

 

4.2

%

2000

 

4.0

%

2001

 

3.0

%

2002

 

1.4

%

 

Short-Term Debt to Total Debt

 

   [Graphic Omitted—bar graph showing: ]

 

1998

 

19.6

%

1999

 

15.1

%

2000

 

14.1

%

2001

 

11.3

%

2002

 

5.8

%

 

                  Lehman Brothers has lowered its Short-Term Debt to Total Assets Less Matched Book and its Short-Term Debt to Total Debt ratios over the past five years to lessen the impact of short-term dislocations in the unsecured funding markets.

 

45



 

The Company issues debt in a variety of maturities and currencies. The Company’s funding strategy emphasizes long-term debt over short-term debt. As a result, the Company has reduced its reliance on short-term debt, including commercial paper, as a source of funding. As of November 30, 2002, the Company had $2.4 billion of short-term unsecured debt outstanding as compared to $7.8 billion five years ago.

 

In order to manage the refinancing risk of long-term debt the Company sets limits for the amount maturing over any three, six and twelve month horizon. The Company also manages the maturity refinancing risk of its term secured borrowings. Additionally, in order to limit its reliance on any given borrower, the Company also diversifies its lender base.

 

Managing Liquidity, Funding And Capital Resources

 

The Company’s Finance Committee is responsible for developing, implementing and enforcing the 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. Through the establishment and enforcement of capital and funding limits, the Company’s Finance Committee ensures compliance throughout the organization so that the Company is not exposed to undue risk.

 

Total Capital

 

Total Capital

 

In millions
November 30

 

2002

 

2001

 

2000

 

Long-Term Debt

 

 

 

 

 

 

 

Senior Notes

 

$

36,283

 

$

35,373

 

$

32,106

 

Subordinated Indebtedness

 

2,395

 

2,928

 

3,127

 

Subtotal

 

38,678

 

38,301

 

35,233

 

 

 

 

 

 

 

 

 

Preferred Securities Subject to Mandatory Redemption

 

710

 

710

 

860

 

Stockholders’ Equity

 

 

 

 

 

 

 

Preferred Equity

 

700

 

700

 

700

 

Common Equity

 

8,242

 

7,759

 

7,081

 

Subtotal

 

8,942

 

8,459

 

7,781

 

Total Capital

 

$

48,330

 

$

47,470

 

$

43,874

 

 

The Company’s Total Capital (defined as long-term debt, preferred securities subject to mandatory redemption and stockholders’ equity) increased 2% to $48.3 billion at November 30, 2002, compared to $47.5 billion at November 30, 2001. The increase in Total Capital principally resulted from increased equity from the retention of earnings as well as a net increase in long-term debt.

 

Long-term debt increased to $38.7 billion at November 30, 2002 from $38.3 billion at November 30, 2001 with a weighted-average maturity of 4.0 years at November 30, 2002 and 3.8 years at November 30, 2001.

 

The Company operates in many regulated businesses that require various minimum levels of capital. These businesses are also subject to regulatory requirements that may restrict the free flow of funds to affiliates. Regulatory approval is generally required for paying dividends in excess of certain established levels and making advancements to affiliated companies. Additional information about the Company’s capital requirements can be found in Note 12 to the Consolidated Financial Statements.

 

Total Capital

 

[Graphic Omitted—bar graph showing: ]

 

2000

 

$

43.9 billion

 

2001

 

$

47.5 billion

 

2002

 

$

48.3 billion

 

 

Credit Facilities

 

Holdings maintains a Revolving Credit Agreement (the “Credit Agreement”) with a syndicate of banks. Under the Credit Agreement, the banks have committed to provide up to $1 billion through April 2005. The Credit Agreement contains covenants that require, among other things, that the Company maintain a specified level of tangible net worth. The Company views the Credit Agreement as one of its many sources of liquidity available through its funding framework, and as such the Company utilizes this liquidity for general business purposes from time to time.

 

The Company also maintains a backstop $750 million Committed Securities Repurchase Facility (the “Facility”) for Lehman Brothers International (Europe) (“LBIE”), the Company’s major operating entity in Europe. The Facility provides secured multi-currency financing for a broad range of collateral types. Under the terms of the Facility, the bank group has agreed to provide funding for up to one year on a secured basis. Any loans outstanding on the commitment termination date may be extended for up to an additional year at the option of LBIE. The Facility contains covenants which require, among other things, that LBIE maintain specified levels of tangible net worth. This commitment expires at the end of October 2003.

 

46



 

There were no borrowings outstanding under either the Credit Agreement or the Facility at November 30, 2002. The Company has maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times.

 

Balance Sheet And Financial Leverage

 

The Company’s balance sheet consists primarily of cash and cash equivalents, securities and other financial instruments owned, and collateralized short-term financing agreements. The liquid nature of these assets provides the Company with flexibility in financing and managing its business. The majority of these assets are funded on a secured basis through collateralized short-term financing agreements.

 

The Company’s total assets increased to $260 billion at November 30, 2002 from $248 billion at November 30, 2001. The Company’s net balance sheet, defined as total assets less the lower of securities purchased under agreements to resell or securities sold under agreements to repurchase, remained relatively constant at $166 billion at November 30, 2002 compared to $165 billion at November 30, 2001. The Company believes that net balance sheet is a more effective measure of evaluating balance sheet usage when comparing companies in the securities industry. The Company utilizes its net balance sheet primarily to carry inventory necessary to facilitate customer flow trading activities. As such, the Company’s mix of net assets is subject to change depending principally upon customer demand. In addition, due to the nature of the Company’s customer flow activities and based upon the Company’s business outlook, the overall size of the Company’s balance sheet fluctuates from time to time and, at specific points in time, may be higher than the fiscal year-end or quarter-end amounts.

 

The increase in the Company’s total assets at November 30, 2002 was primarily driven by an increase in the Company’s matched book secured financing activities. The Company’s net balance sheet size at November 30, 2002 remained consistent with the prior year; however, 2002 saw a decrease in the level of equity inventory, consistent with reduced customer demand for equity products in light of the market weaknesses, with a corresponding increase in high quality fixed income inventory levels reflecting increased customer flow activities in these products.

 

Balance sheet leverage ratios are one measure used to evaluate the capital adequacy of a company. Leverage ratios are commonly calculated using either total assets or net balance sheet. The Company believes that net leverage (i.e., net balance sheet divided by total stockholders’ equity and preferred securities subject to mandatory redemption) is a more effective measure of financial risk when comparing companies in the securities industry. The Company’s net leverage ratios were 17.2x and 17.9x as of November 30, 2002 and 2001, respectively. Consistent with maintaining a single A credit rating, the Company targets a net leverage ratio of under 20.0x. The Company continues to operate below this level.

 

Credit Ratings

 

The Company, like other companies in the securities industry, relies on external sources to finance a significant portion of its day-to-day operations. The cost and availability of unsecured financing generally are dependent on the Company’s short-term and long-term credit ratings. Factors that may be significant to the determination of the Company’s credit ratings or otherwise affect the ability of the Company to raise short-term and long-term financing include its profit margin, its earnings trend and volatility, its cash liquidity and liquidity management, its capital structure, its risk level and risk management, its geographic and business diversification, and its relative positions in the markets in which it operates. A deterioration in any of the previously mentioned factors or combination of these factors may lead rating agencies to downgrade the credit ratings of the Company, thereby increasing the cost to the Company of, or possibly limiting the access of the Company to, certain types of unsecured financings. In addition, the Company’s debt ratings can impact certain capital markets revenues, particularly in those businesses where longer-term counterparty performance is critical, such as over-the-counter derivative transactions, including credit derivatives and interest rate swaps. As of November 30, 2002, the short- and long-term debt ratings of Holdings and LBI were as follows:

 

Credit Ratings

 

 

 

Holdings

 

LBI

 

 

 

Short-
term

 

Long-
term

 

Short-
term

 

Long-
term**

 

Fitch IBCA, Inc.

 

F-1

 

A+

 

F-1

 

A+/A

 

Moody’s(1)

 

P-1

 

A2

 

P-1

 

A1*/A2

 

Standard & Poor’s Corp.(2)

 

A-1

 

A

 

A-1

 

A+*/A

 

 


*Provisional ratings on shelf registration

**Senior/subordinated

(1) On October 8, 2002, Moody’s revised its outlook to positive from stable for all long-term debt ratings of Holdings. The short-term rating was affirmed.

(2) On August 15, 2002, Standard & Poor’s revised its outlook on Holdings to negative from stable. The ‘A’ long-term and ‘A-1’ short-term ratings were affirmed.

 

47



 

High Yield Securities

 

The Company underwrites, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade-rated companies. For purposes of this discussion, high yield debt instruments are defined as securities or loans to companies rated BB+ or lower, or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities, due to the issuer’s creditworthiness and the liquidity of the market for such securities. In addition, these issuers generally have relatively higher levels of indebtedness, resulting in an increased sensitivity to adverse economic conditions. The Company recognizes these risks and aims to reduce market and credit risk through the diversification of its products and counterparties. High yield debt instruments are carried at fair value, with unrealized gains or losses recognized in the Company’s Consolidated Statement of Income. Such instruments at November 30, 2002 and November 30, 2001 included long positions with an aggregate market value of approximately $4.0 billion and $3.5 billion, respectively, and short positions with an aggregate market value of approximately $1.1 billion and $1.0 billion, respectively. The Company mitigates its aggregate and single-issuer net exposure through the use of derivatives, non-recourse securitization financing and other financial instruments.

 

Private Equity

 

The Company has investments in thirty-three private equity-related partnerships, for which the Company acts as general partner, as well as related direct investments.

 

At November 30, 2002 and 2001, the Company’s private equity related investments totaled $965 million and $826 million, respectively. The Company’s policy is to carry its investments, including the appreciation of its general partnership interests, at fair value based upon the Company’s assessment of the underlying investments. Additional information about the Company’s private equity activities, including related commitments, can be found in Note 20 to the Consolidated Financial Statements.

 

Summary of Contractual Obligations

 

In the normal course of business, the Company enters into various commitments and guarantees, including lending commitments to high grade and high yield borrowers, liquidity commitments and other guarantees. In all instances, the Company marks-to-market these commitments and guarantees, with changes in fair value recognized in Principal transactions revenues.

 

As of November 30, 2002 and 2001, the Company was contingently liable for $0.8 billion and $1.1 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.

 

In connection with its financing activities, the Company had outstanding commitments under certain lending arrangements of approximately $1.5 billion and $2.1 billion, at November 30, 2002 and 2001, 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 the above lending arrangements are typically at variable interest rates and generally provide for over-collateralization based upon the borrowers’ creditworthiness. At November 30, 2002, the Company had commitments to enter into forward starting reverse repurchase and repurchase agreements, principally secured by government and government agency collateral, of $89.9 billion and $50.3 billion, respectively, as compared to $52.3 billion and $26.5 billion, respectively, at November 30, 2001.

 

The Company, through its high grade and high yield sales, trading and underwriting activities, makes commitments to extend credit in loan syndication transactions. The Company utilizes various hedging and funding strategies to actively manage its market, credit and liquidity exposures on these commitments. In addition, total commitments are not indicative of actual risk or funding requirements, as the commitments may not be drawn or fully utilized. These commitments and any related draw downs of these facilities typically have fixed maturity dates and are contingent upon certain representations, warranties and contractual conditions applicable to the borrower.

 

The Company had credit risk associated with lending commitments to investment grade borrowers (after consideration of hedges) of $3.2 billion and $4.1 billion at November 30, 2002

 

48



 

and November 30, 2001, respectively. In addition, the Company had credit risk associated with lending commitments to non-investment grade borrowers (after consideration of hedges) of $1.7 billion and $1.4 billion at November 30, 2002 and November 30, 2001, respectively. Before consideration of hedges, the Company had commitments to investment and non-investment grade borrowers of $7.1 billion and $1.8 billion as compared to $5.9 billion and $1.4 billion at November 30, 2002 and November 30, 2001, respectively. The Company had available undrawn borrowing facilities with third parties of approximately $5.2 billion and $4.9 billion at November 30, 2002 and November 30, 2001, respectively, which can be drawn upon to provide funding for these commitments. These funding facilities contain limits for certain concentrations of counterparty, industry or credit ratings of the underlying loans.

 

In addition, the Company provided high yield contingent commitments related to acquisition financing of approximately $2.8 billion and $0.6 billion at November 30, 2002 and 2001, respectively. The Company’s intent is, and its past practice has been, to sell down significantly all the credit risk associated with these loans, if closed, through loan syndications consistent with the Company’s credit facilitation framework. These commitments are not indicative of the Company’s actual risk, as the borrower’s ability to draw is subject to there being no material adverse change in either market conditions or the borrower’s financial condition, among other factors. In addition, these commitments contain certain flexible pricing features in order to adjust for changing market conditions prior to closing.

 

At November 30, 2002, the Company had liquidity commitments of approximately $4.4 billion related to trust certificates backed by investment grade municipal securities, as compared to $3.6 billion at November 30, 2001. The Company’s obligation under such liquidity commitments is generally less than one year and is further limited by the fact that the Company’s obligation ceases if the underlying assets are downgraded below investment grade or default. In addition, the Company had certain other commitments and guarantees associated with special purpose entities of approximately $5.0 billion and $0.7 billion, at November 30, 2002 and 2001, respectively. These commitments consist of liquidity facilities and other default protection to investors, which are principally overcollateralized with investment grade collateral.

 

As of November 30, 2002 and 2001, the Company had commitments to invest up to $672 million and $555 million, respectively, directly and through partnerships in private equity related investments. These commitments will be funded as required through the end of the respective investment periods, principally expiring in 2004.

 

Aggregate contractual obligations and other commitments as of November 30, 2002 by maturity are as follows:

 

Contractual Obligations and Commitments

 

In millions
November 30, 2002

 

Total
Contractual
Amount

 

Amount of Commitment Expiration Per Period

 

Less than
1 Year

 

1–3
Years

 

4–5
Years

 

After 5
Years

Lending commitments:

 

 

 

 

 

 

 

 

 

 

 

High grade

 

$

7,117

*

$

4,338

 

$

1,826

 

$

931

 

$

22

 

High yield

 

1,833

**

466

 

831

 

467

 

69

 

Contingent acquisition facilities

 

2,775

 

2,775

 

 

 

 

Secured lending transactions, including forward starting resale and repurchase agreements

 

141,762

 

125,952

 

13,221

 

500

 

2,089

 

Municipal securities related liquidity commitments

 

4,432

 

3,056

 

136

 

67

 

1,173

 

Other commitments and guarantees associated with other special purpose entities

 

4,964

 

3,050

 

308

 

1,033

 

573

 

Standby letters of credit

 

835

 

 

835

 

 

 

Private equity investments

 

672

 

 

434

 

 

238

 

Operating lease obligations

 

1,887

 

139

 

355

 

239

 

1,154

 

Capital lease obligations

 

2,468

 

 

102

 

102

 

2,264

 

Long-term debt maturities

 

38,678

 

7,971

 

17,113

 

7,169

 

6,425

 

 


*The Company views its net credit exposure for high grade commitments, after consideration of hedges, to be $3.2 billion.

** The Company views its net credit exposure for high yield commitments, after consideration of hedges to be $1.7 billion.

For additional information on contractual obligations see Note 20 to the Consolidated Financial Statements.

 

49



 

Off-Balance-Sheet Arrangements

 

Derivatives

 

Overview Derivatives are financial instruments, examples of which include swaps, options, futures, forwards and warrants, whose value is based upon an underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). Derivatives are often referred to as “off-balance-sheet instruments,” as a derivative’s notional amount is not recorded on-balance-sheet. Notional amounts are generally not exchanged, but rather represent the basis for exchanging cash flows during the duration of the contract. Notional amounts are generally not indicative of the Company’s at risk amount.

 

A derivative contract may be traded on an exchange or negotiated in the over-the-counter markets. Exchange-traded derivatives are standardized and include futures, warrants and certain option contracts listed on an exchange. Over-the-counter (“OTC”) derivative contracts are individually negotiated between contracting parties and include forwards, swaps and certain options, including caps, collars and floors. The use of derivative financial instruments has expanded significantly over the past decade. A primary reason for this expansion is that derivatives provide a cost-effective alternative for managing market risk. Additionally, derivatives provide users with access to market risk management tools that are often unavailable in traditional cash instruments, as derivatives can be tailored to meet client needs. Derivatives can also be used to take proprietary trading positions.

 

Derivatives are subject to various risks similar to non-derivative financial instruments including market, credit and operational risk. Market risk is the potential for a financial loss due to changes in the value of derivative financial instruments due to market changes, including changes in interest rates, foreign exchange rates and equity and commodity prices. Credit risk results from the possibility that a counterparty to a derivative transaction may fail to perform according to the terms of the contract. Therefore, the Company’s exposure to credit risk is represented by its net receivable from derivative counterparties, after consideration of collateral. Operational risk is the possibility of financial loss resulting from a deficiency in the Company’s systems for executing derivative transactions.

 

In addition to these risks, counterparties to derivative financial instruments may also be exposed to legal risks related to derivative activities, including the possibility that 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 the Company’s other trading-related activities.

 

As derivative products have continued to expand in volume, so has market participation and competition. As a result, additional liquidity has been added into the markets for conventional derivative products, such as interest rate swaps. Competition has also contributed to the development of more complex products structured for specific clients. It is this rapid growth and complexity of certain derivative products which has led to the perception, by some, that derivative products are unduly risky to users and the financial markets.

 

In order to remove the public perception that derivatives may be unduly risky and to ensure ongoing liquidity of derivatives in the marketplace, the Company supports the efforts of the regulators in striving for enhanced risk management disclosures which consider the effects of both derivative products and cash instruments. In addition, the Company supports the activities of regulators that are designed to ensure that users of derivatives are fully aware of the nature of risks inherent within derivative transactions. As evidence of this support, the Company has been actively involved with the various regulatory and accounting authorities in the development of additional enhanced reporting requirements related to derivatives.

 

The Company strongly believes that derivatives provide significant value to the financial markets and is committed to providing its clients with innovative products to meet their financial needs.

 

Lehman Brothers’ Use Of Derivative Instruments

 

In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end-user.

 

As an end-user, the Company utilizes derivative products to adjust the interest rate nature of its funding sources from fixed to floating interest rates, and to change the index upon which floating interest rates are based (e.g., Prime to LIBOR) (collectively, “End-User Derivative Activities”). For a further discussion of the Company’s End-User Derivative Activities, see Note 15 to the Consolidated Financial Statements.

 

The Company utilizes derivative products in a trading capacity  as a dealer to satisfy the financial needs of its clients, and in each

 

50



 

of its trading businesses (collectively, “Trading-Related Derivative Activities”). In this capacity the Company transacts extensively in derivatives including interest rate, credit (both single name and portfolio), foreign exchange and equity derivatives. The Company’s use of derivative products in its trading businesses is combined with transactions in cash instruments to allow for the execution of various trading strategies.

 

The Company conducts its derivative activities through a number of wholly-owned subsidiaries. The Company’s fixed income derivative products business is conducted through its subsidiary, Lehman Brothers Special Financing Inc., and separately capitalized “AAA” rated subsidiaries, Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc. The Company’s equity derivative product business is conducted through Lehman Brothers Finance S.A. In addition, as a global investment bank, the Company is also a market-maker in a number of foreign currencies and actively trades in the global commodity markets. Counterparties to the Company’s derivative product transactions are primarily financial intermediaries (U.S. and foreign banks), securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds.

 

The Company manages the risks associated with derivatives on an aggregate basis, along with the risks associated with its non-derivative trading and market-making activities in cash instruments, as part of its firmwide risk management policies. The Company utilizes industry standard derivative contracts whenever appropriate. These contracts may contain provisions requiring the posting of additional collateral by the Company in certain events, including a downgrade in the Company’s credit rating (as of November 30, 2002, the Company would be required to post additional collateral pursuant to derivative contracts of approximately $400 million in the event that the Company were to experience a downgrade of its senior debt). The Company believes that its funding framework incorporates all reasonably likely collateral requirements related to these provisions. For a further discussion of the Company’s risk management policies, refer to the discussion which follows. For a discussion of the Company’s liquidity management policies see page 44.

 

See the Notes to the Consolidated Financial Statements for a description of the Company’s accounting policies and further discussion of the Company’s Trading-Related Derivative Activities.

 

Other Off-Balance-Sheet Arrangements

 

Special purpose entities (“SPEs”) are corporations, trusts or partnerships which are established for a limited purpose. SPEs by their nature generally do not provide equity owners with significant voting powers, as the SPE documents govern all material decisions. The Company’s primary involvement with SPEs relates to securitization transactions in which transferred assets, including mortgages, loans, receivables and other assets, are sold to an SPE and repackaged into securities (i.e. securitized). SPEs may also be utilized by the Company to create securities with a unique risk profile desired by investors, and as a means of intermediating financial risk. In summary, in the normal course of business, the Company may establish SPEs; sell assets to SPEs; underwrite, distribute, and make a market in securities issued by SPEs; transact derivatives with SPEs; own securities or residual interests in SPEs; and provide liquidity or other guarantees for SPEs.

 

The Company accounts for the transfers of financial assets, including transfers to SPEs, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities–a replacement of SFAS No. 125” (“SFAS  140”). In accordance with this guidance, the Company recognizes transfers of financial assets as sales provided that 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). Therefore, in accordance with this guidance, the Company derecognizes financial assets transferred in securitizations provided that the Company has relinquished control over such assets.

 

The Company is also required to follow the accounting guidance under SFAS 140 and Emerging Issues Task Force (“EITF”) Topic D-14, “Transactions Involving Special-Purpose Entities,” to determine whether or not an SPE is required to be consolidated.

 

The majority of the Company’s involvement with SPEs relates to securitization transactions meeting the SFAS 140 definition of a qualifying special purpose entity (“QSPE”). A QSPE can generally be described as an entity with significantly limited powers which are intended to limit it to passively holding financial assets and distributing cash flows based upon pre-set terms. Based upon the guidance in SFAS 140, the Company is not required to and does

 

51



 

not consolidate such QSPEs. Rather, the Company accounts for its involvement with QSPEs under a financial components approach in which the Company recognizes only its retained involvement with the QSPE. The Company accounts for such retained interests at fair value with changes in fair value reported in earnings.

 

The Company is a market leader in mortgage (both residential and commercial), municipal and other asset-backed securitizations which are principally transacted through QSPEs. The Company securitized approximately $155 billion of financial assets during fiscal 2002 including $108 billion of residential, $15 billion of commercial and $32 billion of municipal and other financial assets. As of November 30, 2002, the Company had approximately $1.1 billion of non-investment grade retained interests from its securitization activities. Retained interests are recorded in Securities and Other Financial Instruments Owned within the Company’s Consolidated Statement of Financial Condition and primarily represent junior interests in commercial and residential securitization transactions. The Company records its trading assets, including retained interests on a mark-to-market basis, with related gains or losses recognized in Principal transactions in the Consolidated Statement of Income. (See Note 16 to the Consolidated Financial Statements.)

 

Certain special purpose entities 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). In instances in which the Company is either the sponsor of or transferor to a non-qualifying SPE, the Company follows the accounting guidance provided by EITF Topic D-14 to determine whether consolidation is required. Under this guidance, the Company would not be required to, and does not consolidate such SPE if a third party investor made a substantive equity investment in the SPE (minimum of 3%), was subject to first dollar risk of loss of such SPE, and had a controlling financial interest. Examples of the Company’s involvement with such SPEs include: CDOs, where the Company’s role is principally limited to acting as structuring and placement agent, warehouse provider and underwriter for CDO transactions; and Synthetic Credit Transactions, where the Company’s role is primarily that of underwriter and buyer of credit risk protection from SPEs.

 

On January 17, 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of  Variable Interest Entities – an interpretation of ARB No. 51,” (“Interpretation No. 46”). This interpretation provides new consolidation accounting guidance for entities involved with special purpose entities and will replace guidance provided by EITF Topic D-14. This guidance does not impact the accounting for securitizations transacted through QSPEs. This interpretation will require a primary beneficiary, defined as an entity which participates in either a majority of the risks or rewards of such SPE, to consolidate the SPE. An SPE would not be subject to this interpretation if such entity has sufficient voting equity capital (presumed to require a minimum of 10%), such that the entity is able to finance its activities without additional subordinated financial support from other parties. While the Company has not yet completed its analysis of the impact of the new interpretation, the Company does not anticipate that the adoption of this interpretation will have a material impact to the Company’s financial condition or its results of operations.

 

In addition to the above consolidation policies related to SPEs, the Company follows SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries,” for its dealings with operating entities. The Company consolidates operating entities when the Company has a controlling financial interest over the business activities of such entities. Non-controlled operating entities are accounted for under the equity method when the Company is able to exercise significant influence over the business activities of such entities. The cost method is applied when the ability to exercise significant influence is not present.

 

Risk  Management

 

As a leading global investment banking company, risk is an inherent part of the Company’s businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks to Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk Management is considered to be of paramount importance in the Company’s day-to-day operations. Consequently, the Company devotes significant resources (including investments in personnel and technology) across all of its worldwide trading operations to the measurement, management and analysis of risk.

 

The Company seeks to reduce risk through the diversification of its businesses, counterparties and activities in geographic regions. The Company accomplishes this objective by allocating the usage

 

52



 

of capital to each of its businesses, establishing trading limits and setting credit limits for individual counterparties, including regional concentrations. The Company seeks to achieve adequate returns from each of its businesses commensurate with the risks that they assume. Nonetheless, the effectiveness of the Company’s policies and procedures for managing risk exposure can never be completely or accurately predicted or fully assured. For example, unexpectedly large or rapid movements or disruptions in one or more markets or other unforeseen developments can have an adverse effect on the Company’s 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, higher volatility in the Company’s earnings, increases in the Company’s credit exposure to customers and counterparties and increases in general systemic risk.

 

Overall risk management policy is established at the Office of the Chairman level and begins with The Capital Markets Committee which consists of the Chief Executive Officer, other members of the Company’s Executive Committee, the Global Head of Risk, the Chief Economist and Strategist as well as various other business heads. The Capital Markets Committee serves to frame the Company’s risk opinion in the context of the global market environment. The Company’s Risk Committee, which consists of the Chief Executive Officer, members of the Executive Committee and the Global Head of Risk, meets weekly and reviews all risk exposures, position concentrations and risk taking activities.

 

The Global Risk Management Group (the “Group”) is independent of the trading areas and reports directly into the Office of the Chairman. The Group includes credit risk management, market risk management and operational risk management. Combining these disciplines facilitates the analysis of risk exposures, while leveraging personnel and information technology resources in a cost-efficient manner. The Group maintains staff in each of the Company’s regional trading centers and has daily contact with trading staff and senior management at all levels within the Company. These discussions include a review of trading positions and risk exposures.

 

Credit Risk

 

Credit risk represents the possibility that a counterparty will be unable to honor its contractual obligations to the Company. Credit risk management is therefore an integral component of the Company’s overall risk management framework. The Credit Risk Management Department (“CRM Department”) has global responsibility for implementing the Company’s overall credit risk management framework.

 

The CRM Department manages the credit exposure related to trading activities by giving initial credit approval for counterparties, establishing credit limits by counterparty, country and industry group and by requiring collateral in appropriate circumstances. In addition, the CRM Department strives to ensure that master netting agreements are obtained whenever possible. The CRM Department also considers the duration of transactions in making its credit decisions, along with the potential credit exposure for complex derivative transactions. The CRM Department is responsible for the continuous monitoring and review of counterparty credit exposure and creditworthiness and recommending valuation adjustments, where appropriate. Credit limits are reviewed periodically to ensure that they remain appropriate in light of market events or the counterparty’s financial condition.

 

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 the Company’s overall risk management framework. The Market Risk Management Department (“MRM Department”) has global responsibility for implementing the Company’s overall market risk management framework. It is responsible for the preparation and dissemination of risk reports, developing and implementing the firmwide Risk Management Guidelines, and evaluating adherence to these guidelines. These guidelines provide a clear framework for risk management decision making. To that end, the MRM Department identifies and quantifies risk exposures, develops limits and reports and monitors these risks with respect to the approved limits. The identification of material market risks inherent in positions includes, but is not limited to, interest rate, equity and foreign exchange risk exposures. In addition to these risks, the MRM Department also evaluates liquidity risks, credit and sovereign concentrations.

 

The MRM Department utilizes qualitative as well as quantitative information in managing trading risk, believing that 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 upon established statistical principles. To ensure high standards of qualitative analysis, the MRM Department has retained seasoned risk managers with the requisite experience and academic and professional credentials.

 

53



 

Market risk is present in cash products, derivatives and contingent claim structures that exhibit linear as well as non-linear profit and loss sensitivity. The Company’s exposure to market risk varies in accordance with the volume of client-driven market-making transactions, the size of the Company’s proprietary positions, and the volatility of financial instruments traded. The Company seeks to mitigate, whenever possible, excess market risk exposures through the use of futures and option contracts and offsetting cash market instruments.

 

The Company participates globally in interest rate, equity and foreign exchange markets. The Company’s Fixed Income division has a broadly diversified market presence in U.S. and foreign government bond trading, emerging market securities, corporate debt (investment and non-investment grade), money market instruments, mortgages and mortgage-backed securities, asset-backed securities, municipal bonds and interest rate derivatives. The Company’s Equities division facilitates domestic and foreign trading in equity instruments, indices and related derivatives. The Company’s foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts.

 

The Company incurs short-term interest rate risk when facilitating the orderly flow of customer transactions through the maintenance of government and high grade corporate bond inventories. Market-making in high yield instruments exposes the Company to additional risk due to potential variations in credit spreads. Trading in international markets exposes the Company to spread risk between the term structure of interest rates in different countries. Mortgages and mortgage-related securities are subject to prepayment risk and changes in the level of interest rates. Trading in derivatives and structured products exposes the Company to changes in the level and volatility of interest rates. The Company actively manages 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.

 

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

 

The Company enters into foreign exchange transactions in order to facilitate the purchase and sale of non-dollar instruments, including equity and interest rate securities. The Company is exposed to foreign exchange risk on its holdings of non-dollar assets and liabilities. The Company is active in many foreign exchange markets and has exposure to the Euro, Japanese yen, British pound, Swiss franc and Canadian dollar, as well as a variety of developed and emerging market currencies. The Company hedges its risk exposures primarily through the use of currency forwards, swaps, futures and options.

 

If any of the strategies utilized to hedge or otherwise mitigate exposures to the various types of risks described above are not effective, the Company could incur losses.

 

Operational Risk

 

Operational Risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational Risk Management (ORM) is responsible for implementing and maintaining the Company’s overall global operational risk management framework, which seeks to minimize these risks through assessing, reporting, monitoring and tracking operational risks.

 

Value-At-Risk

 

For purposes of Securities and Exchange Commission (“SEC”) risk disclosure requirements, the Company discloses an entity-wide value-at-risk for virtually all of its trading activities. In general, the Company’s value-at-risk measures potential loss of trading revenues at a given confidence level over a specified time horizon. Value-at-risk over a one-day holding period measured at a 95% confidence level implies that the potential loss of daily trading revenue will be at least as large as the value-at-risk amount on one out of every 20 trading days.

 

The Company’s methodology estimates a reporting day value-at-risk using actual daily trading revenues over the previous 250 trading days. This estimate is measured as the loss, relative to the median daily trading revenue. The Company also estimates an average value-at-risk measure over 250 rolling reporting days, thus looking back a total of 500 trading days.

 

54



 

Value-At-Risk

 

In millions

 

As of
November 30, 2002

 

As of
November 30, 2001

 

Year Ended November 30, 2002

 

Average

 

High

 

Low

 

Interest rate risk

 

$

15.8

 

$

14.6

 

$

14.9

 

$

16.0

 

$

12.6

 

Equity price risk

 

8.0

 

15.1

 

11.3

 

15.1

 

8.0

 

Foreign exchange risk

 

2.2

 

1.9

 

1.9

 

2.2

 

1.7

 

Diversification benefit

 

(5.2

)

(8.3

)

(7.1

)

 

 

 

 

Total Company

 

$

20.8

 

$

23.3

 

$

21.0

 

$

23.4

 

$

17.5

 

 

                  The average, high and low value-at-risk for the year ended November 30, 2001 were $23.8 million, $25.1 million and $22.4 million, respectively.

 

The above table sets forth the daily value-at-risk for each component of market risk as well as total value-at-risk.

 

Value-at-risk is one measurement of potential loss in trading revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. As with all measures of value-at-risk, the Company’s estimate has substantial limitations due to its reliance on historical performance, which is not necessarily a predictor of the future. Consequently, this value-at-risk estimate is only one of a number of tools the Company utilizes in its daily risk management activities. The increase in interest rate risk as of November 30, 2002 from November 30, 2001 reflects higher volatility in fixed income securities, while the decrease in equity risk is primarily related to lower equity positions held for customer flow purposes.

 

Distribution Of Trading Revenues

 

Substantially all of the Company’s inventory positions are marked-to-market on a daily basis as part of the Company’s Capital Markets business segment with changes recorded in net revenues. The following chart sets forth the frequency distribution for weekly net revenues for the Company’s Capital Markets and Client Services segments (excluding asset management fees) for the years-ended November 30, 2002 and 2001.

 

As discussed throughout Management’s Discussion and Analysis, the Company seeks to reduce risk through the diversification of its businesses and a focus on customer flow activities. This diversification and focus, combined with the Company’s risk management controls and processes, helps mitigate the net revenue volatility inherent in the Company’s trading activities. Although historical performance is not necessarily indicative of future performance, the Company believes its focus on business diversification and customer flow activities should continue to reduce the volatility of future net trading revenues.

 

Trading Net Revenues Distribution for 2002 and 2001

 

In weeks

 

[Graphic Omitted—Bar graph showing: ]

 

2002

Less than $0

 

2 weeks

 

 

$0-50 million

 

7 weeks

 

 

$50-100 million

 

25 weeks

 

 

$100-150 million

 

12 weeks

 

 

$150-200 million

 

5 weeks

 

 

$200+ million

 

1 weeks

 

 

 

 

 

 

2001

Less than $0

 

2 weeks

 

 

$0-50 million

 

9 weeks

 

 

$50-100 million

 

18 weeks

 

 

$100-150 million

 

18 weeks

 

 

$150-200 million

 

5 weeks

 

 

$200+ million

 

0 weeks

 

 

                  Average weekly trading net revenues for 2002 and 2001 were approximately $89 million and $90 million, respectively.

 

55



 

Critical Accounting Policies

 

In May 2002, the Securities and Exchange Commission proposed rules to require disclosures associated with critical accounting polices which are most important in gaining an understanding of an entity’s financial statements. The following is a summary of the Company’s critical accounting policies. For a full description of these and other accounting policies, see Note 1 to the Consolidated Financial Statements.

 

Use of Estimates

 

The Company’s financial statements are prepared in conformity with generally accepted accounting principles, many of which require the use of estimates and assumptions. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates particularly in light of the industry in which the Company operates.

 

Fair Value

 

The determination of fair value is a critical accounting policy which is fundamental to the Company’s financial condition and results of operations. The Company records its inventory positions including Securities and other financial instruments owned and Securities 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, the Company believes that it has established rigorous internal control processes to ensure that the Company utilizes reasonable and prudent measurements of fair value.

 

When evaluating the extent to which management estimates may be required to be utilized in preparing the Company’s financial statements, the Company believes it is useful to analyze the balance sheet as follows:

 

November 30, 2002
In millions

 

 

 

 

 

Assets:

 

 

 

 

 

Securities and other financial instruments owned

 

$

119,278

 

46

%

Secured financings

 

114,838

 

44

%

Receivables and other assets

 

26,220

 

10

%

Total Assets

 

$

260,336

 

100

%

 

November 30, 2002
In millions

 

 

 

 

 

Liabilities & Equity

 

 

 

 

 

Securities and other financial instruments sold but not yet purchased

 

$

69,034

 

26

%

Secured financings

 

114,706

 

44

%

Payables and other liabilities

 

28,266

 

11

%

Total capital

 

48,330

 

19

%

Liabilities & Equity

 

$

260,336

 

100

%

 

A significant majority of the Company’s assets and liabilities are recorded at amounts for which significant management estimates are not utilized. The following balance sheet categories comprising 54% of total assets and 74% of liabilities and equity are valued at either historical cost or at contract value (including accrued interest) which by their nature, do not require the use of significant estimates: Secured financings, Receivables/Payables and Other assets/liabilities and Total capital. The remaining balance sheet categories, comprised of Securities and other financial instruments owned and Securities and other financial instruments 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.

 

The majority of the Company’s long and short inventory is recorded at market value based upon listed market prices or utilizing third party broker quotes and therefore do not incorporate significant estimates. Examples of inventory valued in this manner include government securities, agency mortgage-backed securities, listed equities, money markets, municipal securities, corporate bonds and listed futures.

 

If listed market prices or broker quotes are not available, fair value is determined based on pricing models or other valuation techniques, including use of implied pricing from similar instruments. Pricing models are typically utilized to derive fair value based upon the net present value of estimated future cash flows including adjustments, where appropriate, for liquidity, credit and/or other factors. For the vast majority of instruments valued through pricing models, significant estimates are not required, as the market inputs into 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 utilizing pricing models or other valuation techniques include: OTC derivatives, private equity investments, certain high-yield positions, certain mortgage loans and direct real estate investments and non-investment grade retained interests.

 

56



 

 

 

Fair Value of OTC Derivative Contracts by Maturity At November 30, 2002

 

In millions

 

Less than 1 year

 

2-5 years

 

5-10 years

 

Greater than 10 years

 

Total

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Interest rate, currency and credit default swaps and options

 

$

1,079

 

$

3,012

 

$

3,395

 

$

1,560

 

$

9,046

 

Foreign exchange forward contracts and options

 

769

 

45

 

 

 

814

 

Other fixed income securities contracts

 

602

 

 

 

 

602

 

Equity contracts (including swaps, warrants and options)

 

1,624

 

380

 

347

 

33

 

2,384

 

Total

 

$

4,074

 

$

3,437

 

$

3,742

 

$

1,593

 

$

12,846

 

 

 

32

%

27

%

29

%

12

%

100

%

Liabilities

 

 

 

 

 

 

 

 

 

 

 

Interest rate, currency and credit default swaps and options

 

$

943

 

$

2,254

 

$

2,766

 

$

1,124

 

$

7,087

 

Foreign exchange forward contracts and options

 

1,093

 

64

 

 

 

1,157

 

Other fixed income securities contracts

 

215

 

 

 

 

215

 

Equity contracts (including swaps, warrants and options)

 

491

 

195

 

329

 

14

 

1,029

 

Total

 

$

2,742

 

$

2,513

 

$

3,095

 

$

1,138

 

$

9,488

 

 

 

29

%

26

%

33

%

12

%

100

%

 

OTC Derivatives

 

The fair value of the Company’s OTC derivative assets and liabilities at November 30, 2002 were $12.8 billion and $9.5 billion, respectively. OTC derivative assets represent the Company’s unrealized gains, net of unrealized losses for situations in which the Company has a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties.

 

The vast majority of the Company’s OTC derivatives are transacted in liquid trading markets for which fair value is determined utilizing pricing models with readily observable market inputs. Examples of such derivatives include: interest rate swaps contracts, TBA’s (classified in the above table as other fixed income securities contracts), 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 for certain less liquid derivatives requires the use of significant estimates and include: certain credit derivatives, equity option contracts greater than 5 years, and certain other complex derivatives utilized by the Company in providing clients with hedging alternatives to unique exposures. The Company strives to limit the use of significant judgment by using consistent pricing assumptions between reporting periods and utilizing observed market data for model inputs whenever possible. As the market for complex products develops, the Company refines its pricing models based upon market experience in order to utilize the most current indicators of fair value.

 

Private Equity Investments

 

The Company’s private equity investments of $965 million at November 30, 2002 include both public and private equity positions. The determination of fair value for these investments may require the use of estimates and assumptions as these investments are generally less liquid and often contain trading restrictions. The determination of fair value for private equity investments is based on estimates incorporating valuations which take into account expected cash flows, earnings multiples and/or comparison to similar market transactions. Valuation adjustments are an integral part of pricing these instruments, reflecting consideration of credit quality, concentration risk, sale restrictions and other liquidity factors.

 

High Yield

 

At November 30, 2002, the Company had high yield long and short positions of $4.0 billion and $1.1 billion, respectively. The majority of these positions are valued utilizing broker quotes or listed market prices. In certain instances, when broker quotes or listed prices are not available the Company utilizes prudent judgment in determining fair value which may involve the utilization of analysis of credit spreads associated with pricing of similar instruments, or other valuation techniques.

 

57



 

Mortgage Loans and Real Estate

 

The Company is a market leader in mortgage-backed securities trading and mortgage securitizations (both residential and commercial). The Company’s inventory of mortgage loans principally represents loans held prior to securitization. In this activity, the Company purchases mortgage loans from loan originators or in the secondary markets and then aggregates pools of mortgages for securitization. The Company records mortgage loans and direct real estate investments at fair value, with related mark-to-market gains and losses recognized in Principal transactions revenues.

 

As the Company’s inventory of residential loans turns over through sale to securitization trusts rather frequently, such loans are generally valued without the use of significant estimates.

 

The Company is also a market leader in the commercial lending and securitization markets. Commercial real estate loans are generally valued based upon an analysis of the loans’ carrying value relative to the value of the underlying real estate, known as loan-to-value ratios. As the loan-to-value ratio increases, the fair value of such loan is influenced to a greater extent by a combination of cash flow projections and underlying property values. Approximately $5.6 billion of the Company’s commercial real estate loans and direct real estate investments are valued using both cash flow projections as well as underlying property values. The Company utilizes independent appraisals to support management’s assessment of the property in determining fair value for these positions.

 

In addition, the Company held approximately $1.1 billion of non-investment grade retained interests at November 30, 2002, down from $1.6 billion at November 30, 2001. As these interests primarily represent the junior interests in commercial and residential mortgage securitizations, for which there are not active trading markets, estimates are generally required to be utilized in determining fair value. The Company values these instruments using prudent estimates of expected cash flows, and considers the valuation of similar transactions in the market. (See Note 16 to the Consolidated Financial Statements for additional information on the impact of adverse changes in assumptions on the fair value of these interests.)

 

New Accounting Developments

 

In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Under SFAS 142, intangible assets with indefinite lives and goodwill will no longer be amortized. Instead, these assets are required to be tested annually for impairment. The Company adopted the provisions of SFAS 142 as of the beginning of fiscal 2002, and such adoption did not have a material effect on the Company’s financial condition or results of operations.

 

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 provides accounting guidance for the impairment or disposal of long-lived assets, such as property, plant and equipment. In addition, SFAS 144 amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. The Company will adopt this standard in the first quarter of fiscal 2003. The Company does not expect that the adoption will have a material impact to the Company’s financial condition or results of operations.

 

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Company will adopt the provisions of SFAS 146 at the beginning of fiscal 2003 and does not expect the adoption to have a material impact to the Company’s financial condition or results of operations.

 

In October 2002, the EITF reached a consensus on Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” This issue clarifies the FASB staff view that profits should not be recognized at the inception of a derivative contract if the contract does not have observable pricing. In such instances, the transaction price is viewed by the FASB to be the best indicator of fair value. The Company does not expect the application of this guidance to have a material impact on the Company’s financial condition or results of operations.

 

58



 

On January 17, 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities — an interpretation of ARB No. 51,” (“Interpretation 46”). This interpretation provides new consolidation accounting guidance for entities involved with special purpose entities. This guidance does not impact the accounting for securitizations transacted through QSPEs. This interpretation will require a primary beneficiary, defined as an entity which participates in either a majority of the risks or rewards of such SPE, to consolidate the SPE. An SPE would not be subject to this interpretation if such entity had sufficient voting equity capital, such that the entity is able to finance its activities without the additional subordinated financial support from other parties. Interpretation 46 also requires additional disclosures related to involvement with SPEs. The accounting provisions of this interpretation are effective for new transactions executed after January 31, 2003. The interpretation will be effective for all existing transactions with SPEs beginning in the Company’s fourth quarter of 2003. While the Company has not yet completed its analysis of the impact of the new interpretation, the Company does not anticipate that the adoption of this interpretation will have a material impact to the Company’s financial condition or results of operations.

 

Effects of Inflation

 

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

 

59



 

Report of Independent Auditors

 

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. and Subsidiaries (the “Company”) as of November 30, 2002 and 2001, 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, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the 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. and Subsidiaries at November 30, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended November 30, 2002, in conformity with accounting principles generally accepted in the United States.

 

Ernst & Young LLP

 

New York, New York
January 10, 2003

 

60



 

Consolidated Statement of Income

 

In millions, except per share data
Twelve months ended November 30

 

2002

 

2001

 

2000

 

Revenues

 

 

 

 

 

 

 

Principal transactions

 

$

1,951

 

$

2,779

 

$

3,713

 

Investment banking

 

1,771

 

2,000

 

2,216

 

Commissions

 

1,286

 

1,091

 

944

 

Interest and dividends

 

11,728

 

16,470

 

19,440

 

Other

 

45

 

52

 

134

 

Total revenues

 

16,781

 

22,392

 

26,447

 

Interest expense

 

10,626

 

15,656

 

18,740

 

Net revenues

 

6,155

 

6,736

 

7,707

 

Non-Interest Expenses

 

 

 

 

 

 

 

Compensation and benefits

 

3,139

 

3,437

 

3,931

 

Technology and communications

 

552

 

501

 

341

 

Brokerage and clearance

 

329

 

308

 

264

 

Occupancy

 

287

 

198

 

135

 

Business development

 

146

 

183

 

182

 

Professional fees

 

129

 

152

 

184

 

Other

 

74

 

82

 

91

 

September 11th related (recoveries)/expenses, net

 

(108

)

127

 

 

Other real estate reconfiguration charge

 

128

 

 

 

Regulatory settlement

 

80

 

 

 

Total non-interest expenses

 

4,756

 

4,988

 

5,128

 

Income before taxes and dividends on trust preferred securities

 

1,399

 

1,748

 

2,579

 

Provision for income taxes

 

368

 

437

 

748

 

Dividends on trust preferred securities

 

56

 

56

 

56

 

Net income

 

$

975

 

$

1,255

 

$

1,775

 

Net income applicable to common stock

 

$

906

 

$

1,161

 

$

1,679

 

Earnings per common share

 

 

 

 

 

 

 

Basic

 

$

3.69

 

$

4.77

 

$

6.89

 

Diluted

 

$

3.47

 

$

4.38

 

$

6.38

 

 

See Notes to Consolidated Financial Statements.

 

61



 

Consolidated Statement of Financial Condition

 

In millions
November 30

 

2002

 

2001

 

Assets

 

 

 

 

 

Cash and cash equivalents

 

$

3,699

 

$

2,561

 

Cash and securities segregated and on deposit for regulatory and other purposes

 

2,803

 

3,289

 

Securities and other financial instruments owned: (includes $22,211 in 2002 and $28,517 in 2001 pledged as collateral)

 

119,278

 

119,362

 

Collateralized short-term agreements:

 

 

 

 

 

Securities purchased under agreements to resell

 

94,341

 

83,278

 

Securities borrowed

 

20,497

 

17,994

 

Receivables:

 

 

 

 

 

Brokers, dealers and clearing organizations

 

3,775

 

3,455

 

Customers

 

8,279

 

12,123

 

Others

 

1,910

 

1,479

 

Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $590 in 2002 and $424 in 2001)

 

2,075

 

1,495

 

Other assets

 

3,466

 

2,613

 

Excess of cost over fair value of net assets acquired (net of accumulated amortization of $155 in 2002 and $151 in 2001)

 

213

 

167

 

Total assets

 

$

260,336

 

$

247,816

 

 

See Notes to Consolidated Financial Statements.

 

62



 

Consolidated Statement of Financial Condition continued

 

In millions, except per share data
November 30

 

2002

 

2001

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Commercial paper and short-term debt

 

$

2,369

 

$

3,992

 

Securities and other financial instruments sold but not yet purchased

 

69,034

 

51,330

 

Collateralized short-term financing:

 

 

 

 

 

Securities sold under agreements to repurchase

 

94,725

 

102,104

 

Securities loaned

 

8,137

 

12,541

 

Other secured borrowings

 

11,844

 

7,784

 

Payables:

 

 

 

 

 

Brokers, dealers and clearing organizations

 

1,787

 

2,805

 

Customers

 

17,477

 

13,831

 

Accrued liabilities and other payables

 

6,633

 

5,959

 

Long-term debt:

 

 

 

 

 

Senior notes

 

36,283

 

35,373

 

Subordinated indebtedness

 

2,395

 

2,928

 

Total liabilities

 

250,684

 

238,647

 

Commitments and contingencies

 

 

 

 

 

Preferred securities subject to mandatory redemption

 

710

 

710

 

Stockholders’ Equity

 

 

 

 

 

Preferred stock

 

700

 

700

 

Common stock, $0.10 par value; Shares authorized: 600,000,000 in 2002 and 2001; Shares issued: 258,791,416 in 2002 and 256,178,907 in 2001; Shares outstanding: 231,131,043 in 2002 and 237,534,091 in 2001

 

25

 

25

 

Additional paid-in capital

 

3,628

 

3,562

 

Accumulated other comprehensive income (net of tax)

 

(13

)

(10

)

Retained earnings

 

5,608

 

4,798

 

Other stockholders’ equity, net

 

949

 

746

 

 

 

 

 

 

 

Common stock in treasury, at cost: 27,660,373 shares in 2002 and 18,644,816 shares in 2001

 

(1,955

)

(1,362

)

Total stockholders’ equity

 

8,942

 

8,459

 

Total liabilities and stockholders’ equity

 

$

260,336

 

$

247,816

 

 

See Notes to Consolidated Financial Statements.

 

63



 

Consolidated Statement of Changes in Stockholders’ Equity

 

In millions
Twelve months ended November 30

 

2002

 

2001

 

2000

 

Preferred Stock

 

 

 

 

 

 

 

5% Cumulative Convertible Voting, Series A and B:

 

 

 

 

 

 

 

Beginning balance

 

$

 

$

 

$

238

 

Shares subject to redemption

 

 

 

(150

)

Shares repurchased

 

 

 

(88

)

Ending balance

 

 

 

 

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

 

 

Shares issued

 

 

 

250

 

Ending balance

 

250

 

250

 

250

 

Redeemable Voting:

 

 

 

 

 

 

 

Beginning and ending balance

 

 

 

 

Total Preferred Stock, ending balance

 

700

 

700

 

700

 

Common Stock(1)

 

25

 

25

 

25

 

Additional Paid-In Capital(1)

 

 

 

 

 

 

 

Beginning balance

 

3,562

 

3,589

 

3,374

 

RSUs exchanged for Common Stock

 

63

 

(13

)

(54

)

Employee stock-based awards

 

53

 

53

 

101

 

Shares issued to RSU Trust

 

(401

)

(628

)

(210

)

Tax benefits from the issuance of stock-based awards

 

347

 

549

 

373

 

Other, net

 

4

 

12

 

5

 

Ending balance

 

$

3,628

 

$

3,562

 

$

3,589

 

 


(1) Amounts have been retroactively adjusted to give effect for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective on October 20, 2000.

 

 See Notes to Consolidated Financial Statements.

 

64



 

Consolidated Statement of Changes in Stockholders’ Equity continued

 

In millions
Twelve months ended November 30

 

2002

 

2001

 

2000

 

Accumulated Other Comprehensive Income

 

 

 

 

 

 

 

Beginning balance

 

$

(10

)

$

(8

)

$

(2

)

Translation adjustment, net(2)

 

(3

)

(2

)

(6

)

Ending balance

 

(13

)

(10

)

(8

)

Retained Earnings

 

 

 

 

 

 

 

Beginning balance

 

4,798

 

3,713

 

2,094

 

Net income

 

975

 

1,255

 

1,775

 

Dividends declared:

 

 

 

 

 

 

 

5% Cumulative Convertible Voting Series A and B Preferred Stock

 

 

(1

)

(9

)

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

 

(18

)

(18

)

(12

)

Redeemable Voting Preferred Stock

 

(25

)

(50

)

(50

)

Common Stock

 

(96

)

(75

)

(59

)

Ending balance

 

5,608

 

4,798

 

3,713

 

Common Stock Issuable

 

 

 

 

 

 

 

Beginning balance

 

2,933

 

2,524

 

1,768

 

RSUs exchanged for Common Stock

 

(463

)

(215

)

(247

)

Deferred stock awards granted

 

407

 

624

 

1,003

 

Other, net

 

(55

)

 

 

Ending balance

 

2,822

 

2,933

 

2,524

 

Common Stock Held in RSU Trust

 

 

 

 

 

 

 

Beginning balance

 

(827

)

(647

)

(717

)

Shares issued to RSU Trust

 

(297

)

(403

)

(231

)

RSUs exchanged for Common Stock

 

387

 

223

 

301

 

Other, net

 

(17

)

 

 

Ending balance

 

(754

)

(827

)

(647

)

Deferred Stock Compensation

 

 

 

 

 

 

 

Beginning balance

 

(1,360

)

(1,280

)

(797

)

Deferred stock awards granted

 

(407

)

(624

)

(1,003

)

Amortization of deferred compensation, net

 

570

 

544

 

520

 

Other, net

 

78

 

 

 

Ending balance

 

(1,119

)

(1,360

)

(1,280

)

Common Stock In Treasury, at Cost

 

 

 

 

 

 

 

Beginning balance

 

(1,362

)

(835

)

(150

)

Treasury stock purchased

 

(1,510

)

(1,676

)

(1,203

)

RSUs exchanged for Common Stock

 

 

5

 

 

Shares issued for preferred stock conversion

 

 

44

 

 

Employee stock-based awards

 

219

 

69

 

77

 

Shares issued to RSU Trust

 

698

 

1,031

 

441

 

Ending balance

 

(1,955

)

(1,362

)

(835

)

Total stockholders’ equity

 

$

8,942

 

$

8,459

 

$

7,781

 

 


(2) Net of income taxes of $(1) in 2002, $(1) in 2001 and $(8) in 2000.

 

See Notes to Consolidated Financial Statements.

 

65



 

Consolidated Statement of Cash Flows

 

In millions
Twelve months ended November 30

 

2002

 

2001

 

2000

 

Cash Flows From Operating Activities

 

 

 

 

 

 

 

Net Income

 

$

975

 

$

1,255

 

$

1,775

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

258

 

174

 

102

 

Deferred tax provision (benefit)

 

(670

)

(643

)

(169

)

Tax benefit from issuance of stock-based awards

 

347

 

549

 

373

 

Amortization of deferred stock compensation

 

570

 

544

 

520

 

September 11th (recoveries) expenses

 

(108

)

356

 

 

Other real estate reconfiguration charge

 

128

 

 

 

Regulatory settlement

 

80

 

 

 

Other adjustments

 

92

 

(1

)

65

 

Net change in:

 

 

 

 

 

 

 

Cash and securities segregated and on deposit

 

486

 

(855

)

(445

)

Securities and other financial instruments owned

 

1,708

 

(13,219

)

(16,148

)

Securities borrowed

 

(2,503

)

(376

)

1,779

 

Other secured financing

 

4,060

 

3,805

 

3,979

 

Receivables from brokers, dealers and clearing organizations

 

(320

)

(1,793

)

12

 

Receivables from customers

 

3,844

 

(4,538

)

1,747

 

Securities and other financial instruments sold but not yet purchased

 

17,704

 

16,045

 

(11,325

)

Securities loaned

 

(4,404

)

5,299

 

2,674

 

Payables to brokers, dealers and clearing organizations

 

(1,018

)

883

 

738

 

Payables to customers

 

3,646

 

2,194

 

666

 

Accrued liabilities and other payables

 

277

 

(27

)

1,262

 

Other operating assets and liabilities, net

 

(693

)

(325

)

(1,136

)

Net cash provided by (used in) operating activities

 

24,459

 

9,327

 

(13,531

)

Cash Flows From Financing Activities

 

 

 

 

 

 

 

Proceeds from issuance of senior notes

 

8,415

 

9,915

 

14,225

 

Principal payments of senior notes

 

(9,014

)

(7,646

)

(8,353

)

Principal payments of subordinated indebtedness

 

(715

)

(204

)

(192

)

Net proceeds from (payments for) commercial paper and short-term debt

 

(1,623

)

(1,808

)

324

 

Resale agreements net of repurchase agreements

 

(18,442

)

(8,957

)

8,922

 

Payments for repurchases of preferred stock

 

 

(100

)

(88

)

Payments for treasury stock purchases, net

 

(1,303

)

(1,676

)

(1,203

)

Dividends paid

 

(165

)

(163

)

(149

)

Issuances of common stock

 

61

 

54

 

99

 

Issuance of preferred stock, net of issuance costs

 

 

 

250

 

Net cash provided by (used in) financing activities

 

(22,786

)

(10,585

)

13,835

 

Cash Flows From Investing Activities

 

 

 

 

 

 

 

Purchases of property, equipment and leasehold improvements, net

 

(656

)

(1,341

)

(289

)

Proceeds from the sale of 3 World Financial Center, net

 

152

 

 

 

Acquisition, net of cash acquired

 

(31

)

 

(41

)

Net cash used in investing activities

 

(535

)

(1,341

)

(330

)

Net change in cash and cash equivalents

 

1,138

 

(2,599

)

(26

)

Cash and cash equivalents, beginning of period

 

2,561

 

5,160

 

5,186

 

Cash and cash equivalents, end of period

 

$

3,699

 

$

2,561

 

$

5,160

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions):

 

 

 

 

 

 

 

Interest paid totaled $10,686 in 2002, $15,588 in 2001 and  $18,500 in 2000.

 

 

 

 

 

 

 

Income taxes paid totaled $436 in 2002, $654 in 2001 and $473 in 2000.

 

 

 

 

 

 

 

 

See Notes to Consolidated Financial Statements.

 

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Notes to Consolidated Financial Statements

 

C O N T E N T S

 

Note 1

 

Summary of Significant Accounting Policies

 

67

Note 2

 

September 11th Related (Recoveries)/Expenses, Net

 

72

Note 3

 

Other Real Estate Reconfiguration Charge

 

72

Note 4

 

Regulatory  Settlement

 

73

Note 5

 

Short-Term Financings

 

73

Note 6

 

Long-Term Debt

 

74

Note 7

 

Preferred Securities Subject to Mandatory Redemption

 

76

Note 8

 

Preferred Stock

 

77

Note 9

 

Common Stock

 

78

Note 10

 

Incentive Plans

 

78

Note 11

 

Earnings Per Common Share

 

81

Note 12

 

Capital Requirements

 

81

Note 13

 

Employee Benefit Plans

 

82

Note 14

 

Income Taxes

 

83

Note 15

 

Derivative Financial Instruments

 

85

Note 16

 

Securitizations

 

88

Note 17

 

Fair Value of Financial Instruments

 

90

Note 18

 

Financial Instruments

 

90

Note 19

 

Securities Pledged as Collateral

 

91

Note 20

 

Other Commitments and Contingencies

 

91

Note 21

 

Segments

 

95

Note 22

 

Quarterly Information (unaudited)

 

97

 

Note 1 Summary of Significant Accounting Policies

 

Basis Of Presentation

 

The consolidated financial statements include the accounts of Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company” or “Lehman Brothers”). Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high-net-worth individual clients and customers. The Company’s worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by offices in additional locations in North America, Europe, the Middle East, Latin America and the Asia Pacific region. The Company is engaged primarily in providing financial services. The principal U.S. subsidiary of Holdings is Lehman Brothers Inc. (“LBI”), a registered broker-dealer. All material intercompany accounts and transactions have been eliminated in consolidation.

 

The consolidated financial statements are prepared in conformity with generally accepted accounting principles which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management estimates are required to be utilized in determining the valuation of trading inventory particularly in the area of OTC derivatives, certain high yield positions, private equity securities and mortgage loan positions. Additionally, management estimates are required in assessing the realizability of deferred tax assets, the outcome of litigation and determining the components of the September 11th related (recoveries)/expenses, net and the other real estate reconfiguration charge. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates.

 

The Company uses the trade date basis of accounting.

 

Certain prior period amounts reflect reclassifications to conform to the current year’s presentation.

 

Securities And Other Financial Instruments

 

Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. Market value is generally based on listed market prices. If listed market prices are not available, or if liquidating the Company’s position is reasonably expected to affect market prices, fair value is determined based on broker quotes, internal valuation models which take into account time value and volatility factors underlying the financial instruments or management’s estimate of the amounts that could be realized under current market conditions, assuming an orderly liquidation over a reasonable period of time.

 

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As of November 30, 2002 and 2001, all firm-owned securities pledged to counterparties where the counterparty has the right, by contract or custom, to sell or repledge the securities are classified as Securities owned (pledged as collateral) as required by Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a replacement of SFAS No.125” (“SFAS 140”).

 

Derivative Financial Instruments

 

A derivative is typically defined as an instrument whose value is “derived” from an underlying instrument, index or rate, such as a future, forward, swap, or option contract, or other financial instrument with similar characteristics. A derivative contract generally represents future commitments 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.

 

Derivatives are recorded at market or fair value in the Consolidated Statement of Financial Condition on a net by counterparty basis where a legal right of set-off exists and are netted across products when such provisions are stated in the master netting agreement. Derivatives are often referred to as off-balance-sheet instruments since neither their notional amounts nor the underlying instruments are reflected as assets or liabilities of the Company. Instead, the market or fair value related to the derivative transactions is reported in the Consolidated Statement of Financial Condition as an asset or liability 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 as Principal transactions revenues in the current period. Market or fair value is generally determined by either quoted market prices (for exchange-traded futures and options) or pricing models (for swaps, forwards and options). Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required for credit risk and liquidity risk. Further 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. Credit-related valuation adjustments incorporate business and economic conditions, historical experience, concentrations, estimates of expected losses and the character, quality and performance of credit sensitive financial instruments.

 

As an end-user, the Company primarily utilizes derivatives to modify the interest rate characteristics of its long-term debt and secured financing activities. The Company also utilizes equity derivatives to hedge its exposure to equity price risk embedded in certain of its debt obligations and foreign exchange forwards to manage the currency exposure related to its net monetary investment in non-U.S. dollar functional currency operations (collectively, “end-user derivative activities”).

 

Effective December 1, 2000, the Company adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” (collectively, “SFAS 133”), which requires that all derivative instruments be reported on the Consolidated Statement of Financial Condition at fair value.

 

Under SFAS 133, the accounting for end-user derivative activities is dependent upon the nature of the hedging relationship. In certain hedging relationships, both the derivative and the hedged item will be marked-to-market through earnings for changes in fair value (“fair value hedge”). In many instances, the hedge relationship is fully effective so that the mark-to-market on the derivative and the hedged item will offset. In other hedging relationships, the derivative will be marked-to-market with the offsetting gains or losses recorded in Accumulated other comprehensive income, a component of Stockholder’s Equity, until the related hedged item is realized in earnings (“cash flow hedge”). SFAS 133 also requires certain derivatives embedded in long-term debt to be bifurcated and marked-to-market through earnings.

 

SFAS 133 changed the accounting treatment for the hedged item in a fair value hedge (e.g., long-term debt or secured financing activities) from what was an accrual basis to a modified mark-to-market value. The hedged item’s carrying value may differ from a full mark-to-market value since SFAS 133 requires that the hedged item be adjusted only for changes in fair value associated with the designated risks being hedged during the hedge period.

 

The Company principally utilizes fair value hedges to convert a substantial portion of the Company’s fixed rate debt and certain long-term secured financing activities to floating interest rates. Any hedge ineffectiveness in these relationships is recorded as a component of Interest expense on the Company’s Consolidated Statement of Income. Gains or losses from revaluing foreign

 

68



 

exchange contracts associated with hedging the Company’s net investments in foreign affiliates are reported within Accumulated other comprehensive income in Stockholder’s Equity. Unrealized receivables/payables resulting from the mark-to-market on end-user derivatives are included in Securities and other financial instruments owned or sold but not yet purchased.

 

The adoption of SFAS 133, as of December 1, 2000, did not have a material effect on the Company’s Consolidated Statement of Financial Condition or the results of operations, as most of the Company’s derivative transactions are entered into for trading-related activities for which the adoption of SFAS 133 had no impact. Prior year amounts have not been restated to conform with the current SFAS 133 accounting treatment. Therefore, end-user derivative activities for all periods prior to December 1, 2000 are recorded on an accrual basis provided that the derivative was designated and deemed to be a highly effective hedge. For periods prior to fiscal 2001, realized gains or losses on early terminations of derivatives that were designated as hedges were deferred and amortized to interest income or interest expense over the remaining life of the instrument being hedged.

 

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 will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell. The Company monitors the market value of the underlying positions on a daily basis as compared to the related receivable or payable balances, including accrued interest. The Company requires counterparties to deposit additional collateral or return collateral pledged as necessary, to ensure that the market value of the underlying collateral remains sufficient. Securities and other financial instruments owned that are financed under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Income.

 

The Company utilizes interest rate swaps as an end-user to modify the interest rate exposure associated with certain fixed rate resale and repurchase agreements. In accordance with SFAS No. 133, the Company adjusted 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 the Company’s 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 are recorded at contractual amounts plus accrued interest.

 

Private Equity Investments

 

The Company carries its private equity investments, including its partnership interests, at fair value based upon the Company’s assessment of each underlying investment.

 

Income Taxes

 

The Company accounts for income taxes under the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). The Company recognizes 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.

 

In this regard, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carry-forwards, if in the opinion of management, it is more likely than not that the deferred tax asset will be realized. SFAS 109 requires companies to set up a valuation allowance for that component of net deferred tax assets which does not meet the “more likely than not” criterion for realization. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in future years.

 

Translation Of Foreign Currencies

 

Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the 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 separate component of Stockholders’ Equity. Gains or losses resulting from foreign currency transactions are included in the Company’s Consolidated Statement of Income.

 

69



 

Property, Equipment And Leasehold Improvements

 

Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized on a straight-line basis over the estimated useful lives. Buildings are depreciated up to a maximum of 40 years. Leasehold improvements are amortized over the lesser of their economic 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 of software which qualifies for capitalization under American Institute of Certified Public Accountants (“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 3 years, with a maximum of 7 years.

 

Long-Lived Assets

 

In accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” the Company reviews assets, such as property, equipment and leasehold improvements for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. If the total of the expected future undiscounted cash flows is less than the carrying amount of the asset, then an impairment loss would be recognized to the extent that the carrying value of such asset exceeded its fair value.

 

Goodwill

 

As of December 1, 2001, the Company adopted SFAS No. 141, “Business Combinations” (“SFAS 141”), and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. Under SFAS 142, intangible assets with indefinite lives and goodwill are no longer required to be amortized. Instead, these assets are evaluated annually for impairment. The Company adopted the provisions of SFAS 142 at the beginning of fiscal year 2002 and the change did not have a material impact to the Company’s financial position or its results of operations. Prior to December 1, 2001, the Company amortized goodwill using the straight-line method over periods not exceeding 35 years. Goodwill is reduced upon the recognition of certain acquired net operating loss carryforward benefits.

 

Stock-Based Awards

 

SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), established financial accounting and reporting standards for stock-based employee compensation plans. SFAS 123 permits companies either to continue accounting for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (“APB 25”) or using the fair value method prescribed by SFAS 123. The Company continues to follow APB 25 and its related interpretations in accounting for its stock-based compensation plans. Accordingly, no compensation expense has been recognized for stock option awards because the exercise price was at or above the fair market value of the Company’s common stock on the grant date.

 

Statement Of Cash Flows

 

For purposes of the Consolidated Statement of Cash Flows, the Company defines cash equivalents as highly liquid investments with original maturities of three months or less, other than those held for sale in the ordinary course of business.

 

Earnings Per Common Share

 

The Company computes earnings per common share in accordance with SFAS No. 128, “Earnings per Share” (“EPS”). Basic earnings per share is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the assumed conversion of all dilutive securities. All share and per share amounts have been restated for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective October 20, 2000. See Notes 9 and 11 of Notes to Consolidated Financial Statements for more information.

 

Consolidation Accounting Policies

 

Operating Companies The Company follows SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries” and consolidates operating entities when the Company has a controlling financial interest over the business activities of such entities. Non-controlled operating entities are accounted for under the equity method when the Company is able to exercise significant influence over the business activities of such entities. The cost method is applied when the ability to exercise significant influence is not present.

 

Special Purpose Entities For those entities which do not meet the definition of conducting a business, often referred to as special purpose entities (“SPEs”), the Company follows the accounting guidance under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a replacement of FASB No. 125,” and

 

70



 

Emerging Issues Task Force (“EITF”) Topic D-14, “Transactions Involving Special-Purpose Entities,” to determine whe