10-Q 1 a08-10156_110q.htm 10-Q

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

 

x                  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended February 29, 2008

 

OR

 

o                   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from  

 

 to 

 

 

 

Commission file number 1-9466

 

Lehman Brothers Holdings Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

13-3216325

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

745 Seventh Avenue, New York, New York

 

10019

(Address of principal executive offices)

 

(Zip Code)

 

(212) 526-7000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨

 

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

 

As of March 31, 2008, 553,646,048 shares of the Registrant’s Common Stock, par value $0.10 per share, were outstanding.

 

 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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LEHMAN BROTHERS HOLDINGS INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED FEBRUARY 29, 2008

 

Contents

 

 

Page

 

Number

 

 

Available Information

3

 

 

Part I. FINANCIAL INFORMATION

 

 

 

Item 1.

 Financial Statements—(unaudited)

 

 

 

 

 

Consolidated Statement of Income—
Quarters Ended February 29, 2008 and February 28, 2007

4

 

 

 

 

Consolidated Statement of Financial Condition—
February 29, 2008 and November 30, 2007

5

 

 

 

 

Consolidated Statement of Cash Flows—
Quarters Ended February 29, 2008 and February 28, 2007

7

 

 

 

 

Notes to Consolidated Financial Statements

8

 

 

 

 

Report of Independent Registered Public Accounting Firm

42

 

 

 

Item 2.

 Management’s Discussion and Analysis of Financial Condition and Results of Operations

43

 

 

 

Item 3.

 Quantitative and Qualitative Disclosures About Market Risk

88

 

 

 

Item 4.

 Controls and Procedures

88

 

 

 

 

Part II. OTHER INFORMATION

 

 

 

 

Item 1.

 Legal Proceedings

89

 

 

 

Item 1A.

 Risk Factors

89

 

 

 

Item 2.

 Unregistered Sales of Equity Securities and Use of Proceeds

90

 

 

 

Item 6.

 Exhibits

91

 

 

 

Signatures

92

 

 

 

Exhibit Index

93

 



 

LEHMAN BROTHERS HOLDINGS INC.

 

 

AVAILABLE INFORMATION

 

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

 

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

 

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

 

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

 

Lehman Brothers Holdings Inc.
Office of the Corporate Secretary
1271 Avenue of the Americas

42nd Floor

New York, New York 10020, U.S.A.

1-212-526-0858

 

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

 

 

- 3 -



 

LEHMAN BROTHERS HOLDINGS INC.

PART I—FINANCIAL INFORMATION

 

ITEM 1. Financial Statements

 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Income

(Unaudited)

 

 

 

Quarter Ended

 

In millions, except per share data

 

Feb 29, 2008

 

Feb 28, 2007

 

Revenues

 

 

 

 

 

 

 

Principal transactions

 

$

773

 

$

2,921

 

Investment banking

 

 

867

 

 

850

 

Commissions

 

 

658

 

 

540

 

Interest and dividends

 

 

9,635

 

 

9,089

 

Asset management and other

 

 

437

 

 

395

 

Total revenues

 

 

12,370

 

 

13,795

 

Interest expense

 

 

8,863

 

 

8,748

 

Net revenues

 

 

3,507

 

 

5,047

 

Non-Interest Expenses

 

 

 

 

 

 

 

Compensation and benefits

 

 

1,841

 

 

2,488

 

Technology and communications

 

 

302

 

 

266

 

Brokerage, clearance and distribution fees

 

 

253

 

 

194

 

Occupancy

 

 

185

 

 

146

 

Professional fees

 

 

98

 

 

98

 

Business development

 

 

89

 

 

84

 

Other

 

 

76

 

 

72

 

Total non-personnel expenses

 

 

1,003

 

 

860

 

Total non-interest expenses

 

 

2,844

 

 

3,348

 

Income before taxes

 

 

663

 

 

1,699

 

Provision for income taxes

 

 

174

 

 

553

 

Net income

 

$

489

 

$

1,146

 

Net income applicable to common stock

 

$

465

 

$

1,129

 

 

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

 

 

Basic

 

$

0.84

 

$

2.09

 

Diluted

 

$

0.81

 

$

1.96

 

Dividends paid per common share

 

$

0.17

 

$

0.15

 

 

See Notes to Consolidated Financial Statements.

 

 

- 4 -



 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Financial Condition

(Unaudited)

 

 

 

At

 

In millions

 

Feb 29, 2008

 

Nov 30, 2007

 

 

 

 

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

7,564

 

$

7,286

 

 

 

 

 

 

 

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

 

16,569

 

12,743

 

 

 

 

 

 

 

Financial instruments and other inventory positions owned
(includes $58,588 in 2008 and $63,499 in 2007 pledged as collateral)

 

326,658

 

313,129

 

 

 

 

 

 

 

Collateralized agreements:

 

 

 

 

 

 

 

 

 

 

 

Securities purchased under agreements to resell

 

210,166

 

162,635

 

 

 

 

 

 

 

Securities borrowed

 

158,515

 

138,599

 

 

 

 

 

 

 

Receivables:

 

 

 

 

 

 

 

 

 

 

 

Brokers, dealers and clearing organizations

 

11,915

 

11,005

 

 

 

 

 

 

 

Customers

 

37,298

 

29,622

 

 

 

 

 

 

 

Others

 

3,186

 

2,650

 

 

 

 

 

 

 

Property, equipment and leasehold improvements
(net of accumulated depreciation and amortization of $2,567 in 2008 and $2,438 in 2007)

 

4,189

 

3,861

 

 

 

 

 

 

 

Other assets

 

5,863

 

5,406

 

 

 

 

 

 

 

Identifiable intangible assets and goodwill
(net of accumulated amortization of $348 in 2008 and $340 in 2007)

 

4,112

 

4,127

 

 

 

 

 

 

 

Total assets

 

$

786,035

 

$

691,063

 

 

See Notes to Consolidated Financial Statements.

 

 

- 5 -



 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Financial Condition—(Continued)

(Unaudited)

 

 

 

At

 

In millions, except share data

 

Feb 29, 2008

 

Nov 30, 2007

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Short-term borrowings and current portion of long-term borrowings
(including $10,660 in 2008 and $9,035 in 2007 at fair value)

 

$

34,524

 

$

28,066

 

Financial instruments and other inventory positions sold but not yet purchased

 

196,903

 

149,617

 

Collateralized financings:

 

 

 

 

 

Securities sold under agreements to repurchase

 

197,128

 

181,732

 

Securities loaned

 

54,847

 

53,307

 

Other secured borrowings
(including $8,605 in 2008 and $9,149 in 2007 at fair value)

 

24,539

 

22,992

 

Payables:

 

 

 

 

 

Brokers, dealers and clearing organizations

 

11,717

 

3,101

 

Customers

 

72,835

 

61,206

 

Accrued liabilities and other payables

 

11,596

 

16,039

 

Deposit liabilities at banks
(including $12,421 in 2008 and $15,986 in 2007 at fair value)

 

28,829

 

29,363

 

Long-term borrowings
(including $26,593 in 2008 and $27,204 in 2007 at fair value)

 

128,285

 

123,150

 

Total liabilities

 

761,203

 

668,573

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ Equity

 

 

 

 

 

Preferred stock

 

2,993

 

1,095

 

Common stock, $0.10 par value:

 

 

 

 

 

Shares authorized: 1,200,000,000 in 2008 and 2007;

 

 

 

 

 

Shares issued: 612,948,910 in 2008 and 612,882,506 in 2007;

 

 

 

 

 

Shares outstanding: 551,384,099 in 2008 and 531,887,419 in 2007

 

61

 

61

 

Additional paid-in capital

 

11,129

 

9,733

 

Accumulated other comprehensive loss, net of tax

 

(343

)

(310

)

Retained earnings

 

19,880

 

19,698

 

Other stockholders’ equity, net

 

(3,739

)

(2,263

)

Common stock in treasury, at cost
(61,564,811 shares in 2008 and 80,995,087 shares in 2007)

 

(5,149

)

(5,524

)

Total common stockholders’ equity

 

21,839

 

21,395

 

Total stockholders’ equity

 

24,832

 

22,490

 

Total liabilities and stockholders’ equity

 

$

786,035

 

$

691,063

 

 

See Notes to Consolidated Financial Statements.

 

 

- 6 -



 

LEHMAN BROTHERS HOLDINGS INC.

Consolidated Statement of Cash Flows

(Unaudited)

 

 

 

Quarter Ended

 

In millions

 

Feb 29, 2008

 

Feb 28, 2007

 

Cash Flows From Operating Activities

 

 

 

 

 

Net income

 

$

 489

 

$

1,146

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

160

 

137

 

Non-cash compensation

 

424

 

287

 

Other adjustments

 

(41

)

9

 

Net change in:

 

 

 

 

 

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

 

(3,826

)

(202

)

Financial instruments and other inventory positions owned

 

(12,774

)

(29,129

)

Resale agreements, net of repurchase agreements

 

(32,135

)

5,378

 

Securities borrowed, net of securities loaned

 

(18,376

)

(13,344

)

Other secured borrowings

 

1,547

 

4,571

 

Receivables from brokers, dealers and clearing organizations

 

(910

)

183

 

Receivables from customers

 

(7,676

)

(2,989

)

Financial instruments and other inventory positions sold but not yet purchased

 

47,657

 

14,978

 

Payables to brokers, dealers and clearing organizations

 

8,616

 

7,789

 

Payables to customers

 

11,629

 

(968

)

Accrued liabilities and other payables

 

(4,439

)

(1,386

)

Other receivables and assets

 

(983

)

(528

)

Net cash used in operating activities

 

(10,638

)

(14,068

)

Cash Flows From Investing Activities

 

 

 

 

 

Purchase of property, equipment and leasehold improvements, net

 

(239

)

(218

)

Business acquisitions, net of cash acquired

 

(82

)

(304

)

Proceeds from sale of business

 

 

26

 

Net cash used in investing activities

 

(321

)

(496

)

Cash Flows From Financing Activities

 

 

 

 

 

Derivative contracts with a financing element

 

(371

)

(35

)

Tax benefit from the issuance of stock-based awards

 

45

 

176

 

Issuance of short-term borrowings, net

 

4,749

 

137

 

Deposit liabilities at banks

 

(534

)

1,079

 

Issuance of long-term borrowings

 

18,240

 

19,010

 

Principal payments of long-term borrowings, including the current portion of long term borrowings

 

(12,031

)

(6,224

)

Issuance of common stock

 

2

 

28

 

Issuance of preferred stock, net of issuance cost

 

1,856

 

 

Issuance of treasury stock

 

104

 

190

 

Purchase of treasury stock

 

(693

)

(1,562

)

Dividends paid

 

(130

)

(106

)

Net cash provided by financing activities

 

11,237

 

12,693

 

Net change in cash and cash equivalents

 

278

 

(1,871

)

Cash and cash equivalents, beginning of period

 

7,286

 

5,987

 

Cash and cash equivalents, end of period

 

$

 7,564

 

$

4,116

 

Supplemental Disclosure of Cash Flow Information (in millions):

 

 

 

 

 

Interest paid totaled $8,987 and $8,157 in 2008 and 2007, respectively.

 

 

 

 

 

Income taxes paid totaled $337 and $462 in 2008 and 2007, respectively.

 

 

 

 

 

 

See Notes to Consolidated Financial Statements.

 

 

- 7 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Contents

 

 

 

Page

 

 

Number

 

 

 

Note 1

Summary of Significant Accounting Policies

9

 

 

 

Note 2

Business and Geographic Segments

17

 

 

 

Note 3

Financial Instruments and Other Inventory Positions

19

 

 

 

Note 4

Fair Value of Financial Instruments

22

 

 

 

Note 5

Securities Received and Pledged as Collateral

26

 

 

 

Note 6

Securitizations and Special Purpose Entities

26

 

 

 

Note 7

Borrowings and Deposit Liabilities

30

 

 

 

Note 8

Commitments, Contingencies and Guarantees

31

 

 

 

Note 9

Earnings per Common Share

34

 

 

 

Note 10

Income Taxes

35

 

 

 

Note 11

Employee Benefit Plans

35

 

 

 

Note 12

Regulatory Requirements

36

 

 

 

Note 13

Condensed Consolidating Financial Statement Schedules

37

 

 

- 8 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Note 1 Summary of Significant Accounting Policies

 

Description of Business

 

Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company,” the “Firm,” “Lehman Brothers,” “we,” “us” or “our”) serves the financial needs of corporations, governments and municipalities, institutional clients and high net worth individuals worldwide with business activities organized in three segments, Capital Markets, Investment Banking and Investment Management. Founded in 1850, Lehman Brothers maintains market presence in equity and fixed income sales, trading and research, investment banking, asset management, private investment management and private equity. The Firm is headquartered in New York, with regional headquarters in London and Tokyo, and operates in a network of offices in North America, Europe, the Middle East, Latin America and the Asia-Pacific region. 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, Paris, Milan and Australian stock exchanges.

 

Basis of Presentation

 

The Consolidated Financial Statements are prepared in conformity with U.S. generally accepted accounting principles and include the accounts of Holdings, its subsidiaries, and all other entities in which the Company has a controlling financial interest or are considered to be the primary beneficiary. In the opinion of management, all normal recurring adjustments have been included for a fair statement of this interim financial information. All material inter-company accounts and transactions have been eliminated upon consolidation. Certain prior-period amounts reflect reclassifications to conform to the current year’s presentation.

 

Use of Estimates

 

In preparing the Consolidated Financial Statements and accompanying notes, management makes various estimates that affect reported amounts and disclosures. Broadly, those estimates are used in:

 

·                  measuring fair value of certain financial instruments;

 

·                  accounting for identifiable intangible assets and goodwill;

 

·                  establishing provisions for potential losses that may arise from litigation, regulatory proceedings and tax examinations;

 

·                  assessing the Company’s ability to realize deferred taxes; and

 

·                  valuing equity-based compensation awards.

 

Estimates are based on available information and judgment. Therefore, actual results could differ from estimates and that difference could have a material effect on the Consolidated Financial Statements and notes thereto.

 

Consolidation Policies

 

The Consolidated Financial Statements include the accounts of Holdings and the entities in which the Company has a controlling financial interest. The Company determines whether it has a controlling financial interest in an entity by first determining whether the entity is a voting interest entity (sometimes referred to as a non-VIE), a variable interest entity (“VIE”) or a qualified special purpose entity (“QSPE”).

 

Voting Interest Entity. Voting interest entities are entities that have (i) total equity investment at risk sufficient to fund expected future operations independently; and (ii) equity holders who have the obligation to absorb losses or receive residual returns and the right to make decisions about the entity’s activities. In accordance with Accounting Research Bulletin (“ARB”) No. 51, Consolidated Financial Statements, and Statement of Financial Accounting Standards (“SFAS”) No. 94, Consolidation of All Majority—Owned Subsidiaries, voting interest entities are consolidated when the Company has a controlling financial interest, typically more than 50% of an entity’s voting interests.

 

Variable Interest Entity. VIEs are entities that lack one or more voting interest entity characteristics. The Company consolidates VIEs in which it is the primary beneficiary. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities (revised December 2003)—an interpretation of ARB No. 51 (“FIN 46(R)”), the Company is the primary beneficiary if it has a variable interest, or a combination of variable interests, that will either (i) absorb a majority of the VIE’s expected losses; (ii) receive a majority of the VIE’s expected residual returns; or (iii) both. To determine if the Company is the primary beneficiary of a VIE, the Company reviews,

 

 

- 9 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

among other factors, the VIE’s design, capital structure, contractual terms, which interests create or absorb variability and related party relationships, if any. Additionally, the Company may calculate its share of the VIE’s expected losses and expected residual returns based upon the VIE’s contractual arrangements and/or position in the VIE’s capital structure. This type of analysis is typically performed using expected cash flows allocated to the expected losses and expected residual returns under various probability-weighted scenarios.

 

Qualified Special Purpose Entity. QSPEs are passive entities with limited permitted activities. SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125 (“SFAS 140”), establishes the criteria an entity must satisfy to be a QSPE, including types of assets held, limits on asset sales, use of derivatives and financial guarantees, and discretion exercised in servicing activities. In accordance with SFAS 140 and FIN 46(R), the Company does not consolidate QSPEs.

 

For a further discussion of the Company’s involvement with VIEs, QSPEs and other entities see Note 6, “Securitizations and Special Purpose Entities,” to the Consolidated Financial Statements.

 

Equity-Method Investments. Entities in which the Company does not have a controlling financial interest (and therefore do not consolidate) but in which the Company exerts significant influence (generally defined as owning a voting interest of 20 % to 50%, or a partnership interest greater than 3%) are accounted for either under Accounting Principles Board (“APB”) Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock or SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). For further discussion of the Company’s adoption of SFAS 159, see “Accounting and Regulatory Developments—SFAS 159” below.

 

Other. The Company has formed various non-consolidated private equity or other alternative investment funds with third-party investors that are typically organized as limited partnerships. The Company typically acts as general partner for these funds, and when third-party investors have (i) rights to either remove the general partner without cause or to liquidate the partnership; or (ii) substantive participation rights, the Company does not consolidate these partnerships in accordance with Emerging Issue Task Force (“EITF”) No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (“EITF 04-5”).

 

A determination of whether the Company has a controlling financial interest in an entity and therefore assessment of consolidation of that entity is initially made at the time the Company becomes involved with the entity. Certain events may occur which cause the Company to re-assess its initial determination of whether an entity is a VIE or non-VIE or whether the Company is the primary beneficiary if the entity is a VIE and therefore its assessment of consolidation of that entity. Those events generally are:

 

·                  The entity’s governance structure is changed such that either (i) the characteristics or adequacy of equity at risk are changed, or (ii) expected returns or losses are reallocated among the participating parties within the entity.

 

·                  The equity investment (or some part thereof) is returned to the equity investors and other interests become exposed to expected returns or losses.

 

·                  Additional activities are undertaken or assets acquired by the entity that were beyond those anticipated previously.

 

·                  Participants in the entity acquire or sell interests in the entity.

 

·                  The entity receives additional equity at risk or curtails its activities in a way that changes the expected returns or losses.

 

When the Company does not consolidate an entity or apply the equity method of accounting, the Company presents its investment in the entity at fair value.

 

 

- 10 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Currency Translation

 

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

 

Revenue Recognition Policies

 

Principal transactions. Realized and unrealized gains or losses from Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased, as well as the gains or losses from certain short- and long-term borrowing obligations, principally certain hybrid financial instruments, and certain deposit liabilities at banks that the Company measures at fair value are reflected in Principal transactions in the Consolidated Statement of Income.

 

Investment banking. Underwriting revenues, net of related underwriting expenses, and revenues for merger and acquisition advisory and other investment banking-related services are recognized when services for the transactions are completed. In instances where the Investment Banking segment provides structuring services and/or advice in a capital markets-related transaction, the Company records a portion of the transaction-related revenue as Investment Banking fee revenues.

 

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

 

Interest and dividends revenue and interest expense. The Company recognizes contractual interest on Financial instruments and other inventory positions owned and Financial instruments and other inventory positions sold but not yet purchased, excluding derivatives, on an accrual basis as a component of Interest and dividends revenue and Interest expense, respectively. The Company accounts for its secured financing activities and certain short- and long-term borrowings on an accrual basis with related interest recorded as interest revenue or interest expense, as applicable. Contractual interest expense on all deposit liabilities and certain hybrid financial instruments are recorded as a component of Interest expense.

 

Asset management and other. Investment advisory fees are recorded as earned. In certain circumstances, the Company receives asset management incentive fees when the return on assets under management exceeds specified benchmarks. Incentive fees are generally based on investment performance over a twelve-month period and are not subject to adjustment after the measurement period ends. Accordingly, the Company recognizes incentive fees when the measurement period ends.

 

The Company also receives private equity incentive fees when the returns on certain private equity or other alternative investment funds’ investments exceed specified thresholds. Private equity incentive fees typically are based on investment results over a period greater than one year, and future investment underperformance could require amounts previously distributed to the Company to be returned to the funds. Accordingly, the Company recognizes these incentive fees when all material contingencies have been substantially resolved.

 

Income Taxes

 

The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. 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. Deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carry-forwards. The Company records a valuation allowance to reduce deferred tax assets to an amount that more likely than not will be realized. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in future years.

 

The Company recognizes and measures its unrecognized tax benefits in accordance with FIN 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109 (“FIN 48”). The Company estimates the likelihood, based on their technical merits, that tax positions will be sustained upon examination based on the facts and circumstances and information available at the end of each period. The Company adjusts the level of unrecognized tax benefits when there is more information available, or when an event occurs requiring a change. The reassessment of unrecognized tax benefits could have a material impact on the Company’s effective tax rate in the period in which it occurs. For a discussion of the impact of FIN 48, see “Accounting and Regulatory Developments—FIN 48” below.

 

 

- 11 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Earnings per Share

 

The Company computes earnings per share (“EPS”) in accordance with SFAS No. 128, Earnings per Share. Basic EPS is computed by dividing net income applicable to common stock by the weighted-average number of common shares outstanding, which includes restricted stock units (“RSUs”) for which service has been provided. Diluted EPS includes the components of basic EPS and also includes the dilutive effects of RSUs for which service has not yet been provided and employee stock options.

 

Financial Instruments and Other Inventory Positions

 

Financial instruments and other inventory positions owned, excluding real estate held for sale, and Financial instruments and other inventory positions sold but not yet purchased are carried at fair value. Real estate held for sale is accounted for at the lower of its carrying amount or fair value less cost to sell. For further discussion of financial instruments and other inventory positions, see Note 3, “Financial Instruments and Other Inventory Positions,” to the Consolidated Financial Statements.

 

Firm-owned securities pledged to counterparties who have the right, by contract or custom, to sell or repledge the securities are classified as Financial instruments and other inventory positions owned and are disclosed as pledged as collateral. For further discussion of securities received and pledged as collateral, see Note 5, “Securities Received and Pledged as Collateral,” to the Consolidated Financial Statements.

 

The Company adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”) effective December 1, 2006. SFAS 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When observable prices are not available, the Company either uses implied pricing from similar instruments or valuation models based on net present value of estimated future cash flows, adjusted as appropriate for liquidity, credit, market and/or other risk factors.

 

Prior to December 1, 2006, the Company followed the American Institute of Certified Public Accountants (“AICPA”) Audit and Accounting Guide, Brokers and Dealers in Securities, when determining fair value for financial instruments, which permitted the recognition of a discount to the quoted price when determining the fair value for a substantial block of a particular security, when the quoted price was not considered to be readily realizable (i.e., a block discount).

 

For further discussion of the adoption of SFAS 157, see “Accounting and Regulatory Developments—SFAS 157” below.

 

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

 

Derivatives are recorded at fair value and included in either Financial instruments and other inventory positions owned or Financial instruments and other inventory positions sold but not yet purchased in the Consolidated Statement of Financial Condition. Derivatives are presented net-by-counterparty when a legal right of offset exists; net across different products or positions when applicable provisions are stated in a master netting agreement; and/or net of cash collateral received or paid on a counterparty basis, provided legal right of offset exists.

 

The Company enters into derivative transactions both in a trading capacity and as an end-user. Acting in a trading capacity, the Company enters into derivative transactions to satisfy the needs of clients and to manage the Company’s exposure to market and credit risks resulting from trading activities (collectively, “Trading-Related Derivatives”). For Trading-Related Derivatives, margins on futures contracts are included in receivables and payables from/to brokers, dealers and clearing organizations, as applicable.

 

As an end-user, the Company primarily uses derivatives to hedge its exposure to market risk (including foreign currency exchange and interest rate risks) and credit risks (collectively, “End-User Derivatives”). When End-User Derivatives are interest rate swaps they are measured at fair value through earnings and the carrying value of the related hedged item is adjusted through earnings for the effect of changes in the risk being hedged. The hedge ineffectiveness in these relationships is recorded in Interest expense in the Consolidated Statement of Income. When End-User Derivatives are

 

 

- 12 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

used in hedges of net investments in non-U.S. dollar functional currency subsidiaries, the gains or losses are reported within Accumulated other comprehensive income/(loss), net of tax, in Stockholders’ equity.

 

Prior to December 1, 2006, the Company followed EITF Issue No. 02-3, Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities (“EITF 02-3”). Under EITF 02-3, recognition of a trading profit at inception of a derivative transaction was prohibited unless the fair value of that derivative was obtained from a quoted market price supported by comparison to other observable inputs or based on a valuation technique incorporating observable inputs. Subsequent to the inception date (“Day 1”), the Company recognized trading profits deferred at Day 1 in the period in which the valuation of the instrument became observable. The adoption of SFAS 157 nullified the guidance in EITF 02-3 that precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative was obtained from a quoted market price or other valuation technique incorporating observable inputs. For further discussion of the adoption of SFAS 157, see “Accounting and Regulatory Developments—SFAS 157” below.

 

Securitization activities. In accordance with SFAS 140, the Company recognizes transfers of financial assets as sales, if control has been surrendered. The Company determines control has been surrendered when the following three criteria have been met:

 

·                  The transferred assets have been isolated from the transferor, or put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (i.e., a true sale opinion has been obtained);

 

·                  Each transferee (or, if the transferee is a QSPE, each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor; and

 

·                  The transferor does not maintain effective control over the transferred assets through either (i) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (ii) the ability to unilaterally cause the holder to return specific assets.

 

Collateralized Lending Agreements and Financings

 

Treated as collateralized agreements and financings for financial reporting purposes are the following:

 

·                 Repurchase and resale agreements. Securities purchased under agreements to resell and securities sold under agreements to repurchase are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities subsequently will be resold or repurchased plus accrued interest. The Company takes possession of securities purchased under agreements to resell. The fair value of the underlying positions is compared daily with 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 the fair value of the underlying collateral remains sufficient.

 

·                 Securities borrowed and securities loaned. Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. The Company values the securities borrowed and loaned daily and obtain additional cash as necessary to ensure these transactions are adequately collateralized. When the Company acts as the lender of securities in a securities-lending agreement and the Company receives securities that can be pledged or sold as collateral, the Company recognizes an asset, representing the securities received and a liability, representing the obligation to return those securities.

 

·                 Other secured borrowings. Other secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140. Additionally, Other secured borrowings includes non-recourse financings of entities that the Company has consolidated because the Company is the primary beneficiaries of such entities.

 

Long-Lived Assets

 

Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized using the straight-line method over the estimated useful lives of the assets. Buildings are depreciated up to a maximum of 40 years. Leasehold improvements are amortized over the lesser of their useful lives or the terms of the underlying leases, which range up to 30 years. Equipment, furniture and fixtures are depreciated over periods of up to 10 years. Internal-use software that qualifies for capitalization under AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, is capitalized and subsequently amortized over the estimated useful life of the software, generally three years, with a maximum of seven years. The

 

 

- 13 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Company reviews long-lived assets for impairment periodically and whenever events or changes in circumstances indicate the carrying amounts of the assets may be impaired. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized to the extent the carrying value of the asset exceeds its fair value.

 

Identifiable Intangible Assets and Goodwill

 

Identifiable intangible assets with finite lives are amortized over their expected useful lives, which range up to 15 years. Identifiable intangible assets with indefinite lives and goodwill are not amortized. Instead, these assets are evaluated at least annually for impairment. Goodwill is reduced upon the recognition of certain acquired net operating loss carryforward benefits.

 

Cash Equivalents

 

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

 

Accounting and Regulatory Developments

 

The following summarizes accounting standards that have been issued during the periods covered by the Consolidated Financial Statements and the effect of adoption on results of operations, if any, actual or estimated.

 

SFAS 157. In September 2006, the FASB issued SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value, outlines a fair value hierarchy based on inputs used to measure fair value and enhances disclosure requirements for fair value measurements. SFAS 157 does not change existing guidance as to whether or not an instrument is carried at fair value.

 

SFAS 157 also (i) nullifies the guidance in EITF 02-3 that precluded the recognition of a trading profit at the inception of a derivative contract, unless the fair value of such derivative was obtained from a quoted market price or other valuation technique incorporating observable inputs; (ii) clarifies that an issuer’s credit standing should be considered when measuring liabilities at fair value; (iii) precludes the use of a liquidity or block discount when measuring instruments traded in an active market at fair value; and (iv) requires costs related to acquiring financial instruments carried at fair value to be included in earnings as incurred.

 

The Company elected to early adopt SFAS 157 at the beginning of the 2007 fiscal year and recorded the difference between the carrying amounts and fair values of (i) stand-alone derivatives and/or certain hybrid financial instruments measured using the guidance in EITF 02-3 on recognition of a trading profit at the inception of a derivative, and (ii) financial instruments that are traded in active markets that were measured at fair value using block discounts, as a cumulative-effect adjustment to opening retained earnings. As a result of adopting SFAS 157, the Company recognized a $45 million after-tax ($78 million pre-tax) increase to opening retained earnings. For additional information regarding the Company’s adoption of SFAS 157, see Note 4, “Fair Value of Financial Instruments,” to the Consolidated Financial Statements.

 

SFAS 158. In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Retirement Plans (“SFAS 158”), which requires an employer to recognize the over- or under-funded status of its defined benefit postretirement plans as an asset or liability in its Consolidated Statement of Financial Condition, measured as the difference between the fair value of the plan assets and the benefit obligation. For pension plans, the benefit obligation is the projected benefit obligation; while for other postretirement plans the benefit obligation is the accumulated postretirement obligation. Upon adoption, SFAS 158 requires an employer to recognize previously unrecognized actuarial gains and losses and prior service costs within Accumulated other comprehensive income/(loss), net of tax, a component of Stockholders’ equity. In accordance with the guidance in SFAS 158, the Company adopted this provision of the standard for the year ended November 30, 2007. The adoption of SFAS 158 reduced Accumulated other comprehensive loss, by $210 million after-tax ($344 million pre-tax) at November 30, 2007.

 

SFAS 159. In February 2007, the FASB issued SFAS 159 which permits certain financial assets and financial liabilities to be measured at fair value, using an instrument-by-instrument election. The initial effect of adopting SFAS 159 must be accounted for as a cumulative-effect adjustment to opening retained earnings for the fiscal year in which the Company applies SFAS 159. Retrospective application of SFAS 159 to fiscal years preceding the effective date is not permitted.

 

The Company elected to early adopt SFAS 159 beginning in the 2007 fiscal year and to measure at fair value substantially all hybrid financial instruments not previously accounted for at fair value under SFAS No. 155, as well as certain deposit liabilities at the Company’s U.S. banking subsidiaries. The Company elected to adopt SFAS 159 for these instruments to

 

 

- 14 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

reduce the complexity of accounting for these instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. As a result of adopting SFAS 159, the Company recognized a $22 million after-tax increase ($35 million pre-tax) to opening retained earnings as of December 1, 2006, representing the effect of changing the measurement basis of these financial instruments from an adjusted amortized cost basis at November 30, 2006 to fair value. For additional information regarding the adoption of SFAS 159, see Note 4, “Fair Value of Financial Instruments,” to the Consolidated Financial Statements.

 

SFAS 141(R). In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”). SFAS 141(R) expands the definition of transactions and events that qualify as business combinations; requires that the acquired assets and liabilities, including contingencies, be recorded at the fair value determined on the acquisition date and changes thereafter reflected in revenue, not goodwill; changes the recognition timing for restructuring costs; and requires acquisition costs to be expensed as incurred. Adoption of SFAS 141(R) is required for combinations after December 15, 2008. Early adoption and retroactive application of SFAS 141(R) to fiscal years preceding the effective date are not permitted. The Company is evaluating the impact of adoption on its Consolidated Financial Statements.

 

SFAS 160. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interest in Consolidated Financial Statements (“SFAS 160”). SFAS 160 re-characterizes minority interests in consolidated subsidiaries as non-controlling interests and requires the classification of minority interests as a component of equity. Under SFAS 160, a change in control will be measured at fair value, with any gain or loss recognized in earnings. The effective date for SFAS 160 is for annual periods beginning on or after December 15, 2008. Early adoption and retroactive application of SFAS 160 to fiscal years preceding the effective date are not permitted. The Company is evaluating the impact of adoption on its Consolidated Financial Statements.

 

SFAS 161. In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”). SFAS 161 requires specific disclosures regarding the location and amounts of derivative instruments in the Company’s financial statements; how derivative instruments and related hedged items are accounted for; and how derivative instruments and related hedged items affect the Company’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued and for fiscal years and interim periods after November 15, 2008. Early application is permitted. Because SFAS 161 impacts the Company’s disclosure and not its accounting treatment for derivative instruments and related hedged items, the Company’s adoption of SFAS 161 will not impact the Consolidated Financial Statements.

 

FIN 48. In June 2006, the FASB issued FIN 48. FIN 48 sets out a framework for management to use to determine the appropriate level of tax reserves to maintain for uncertain tax positions. FIN 48 uses a two-step approach wherein a tax benefit is recognized if a position is more likely than not to be sustained, and the amount of benefit is then measured on a probabilistic approach, as defined in FIN 48. FIN 48 also sets out disclosure requirements to enhance transparency of an entity’s tax reserves. The Company adopted FIN 48 at the beginning of the 2008 fiscal year and recognized a decrease to opening retained earnings of approximately $178 million. For additional information regarding the adoption of FIN 48, see Note 10, “Income Taxes,” to the Consolidated Financial Statements.

 

SOP 07-1. In June 2007, the AICPA issued Statement of Position (“SOP”) No. 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”). SOP 07-1 addresses when the accounting principles of the AICPA Audit and Accounting Guide Investment Companies must be applied by an entity and whether those accounting principles must be retained by a parent company in consolidation or by an investor in the application of the equity method of accounting. The effective date for SOP 07-1 was initially for fiscal years beginning on or after December 15, 2007; however, in February 2008, the FASB directed the FASB staff to issue SOP 07-1-1 Effective Date of AICPA Statement of Position 07-1 (“SOP 07-1-1”), which indefinitely delays the effective dates for SOP 07-1 and FASB Staff Position (“FSP”) FIN 46(R)-7, Application of FASB Interpretation No. 46(R) to Investment Companies which was effective upon adoption of SOP 07-1.

 

FSP FIN 39-1. In April 2007, the FASB directed the FASB Staff to issue FSP No. FIN 39-1, Amendment of FASB Interpretation No. 39 (“FSP FIN 39-1”). FSP FIN 39-1 modifies FIN No. 39, Offsetting of Amounts Related to Certain Contracts, and permits companies to offset cash collateral receivables or payables with net derivative positions under certain circumstances. FSP FIN 39-1 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. FSP FIN 39-1 does not affect the Consolidated Financial Statements because it clarified the acceptability of existing market practice, which the Company uses, of netting cash collateral against net derivative assets and liabilities.

 

FSP FIN 48-1. In May 2007, the FASB directed the FASB Staff to issue FSP No. FIN 48-1, Definition of “Settlement” In FASB Interpretation No. 48 (“FSP FIN 48-1”). Under FSP FIN 48-1, a previously unrecognized tax benefit may be subsequently recognized if the tax position is effectively settled and other specified criteria are met. The Company

 

 

- 15 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

adopted FSP FIN 48-1 upon adoption of FIN 48.

 

FSP FAS 140-3.  In February 2008, the FASB directed the FASB Staff to issue FSP No. FAS 140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (“FSP FAS 140-3”).  Under FSP FAS 140-3, it is presumed that an initial transfer of a financial asset and a repurchase are considered part of the same arrangement, known as a linked transaction. However, if certain criteria are met, the initial transfer and repurchase financing may not be evaluated as a linked transaction and must be evaluated separately under FAS 140.  FSP FAS 140-3 will be effective for financial statements issued for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. Earlier application is not permitted. The Company is evaluating the impact of adopting FSP FAS 140-3 on the Consolidated Financial Statements.

 

SAB 109. In November 2007, the SEC issued Staff Accounting Bulletin (“SAB”) No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (“SAB 109”). SAB 109 supersedes SAB No. 105, Loan Commitments Accounted for as Derivative Instruments (“SAB 105”), and expresses the view, consistent with the guidance in SFAS 156 and SFAS 159, that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 105 also expressed the view that internally-developed intangible assets (such as customer relationship intangible assets) should not be recorded as part of the fair value of a derivative loan commitment. SAB 109 retains that view and broadens its application to all written loan commitments that are accounted for at fair value through earnings. Adoption of SAB 109 did not have a material affect on the Consolidated Financial Statements.

 

Effect of Adoption. The table presented below summarizes the impact of adoption from the accounting developments summarized above on the results of operations:

 

 

 

 

 

 

Accumulated Other

 

 

 

 

 

 

 

Comprehensive

 

Retained Earnings

 

In millions

 

Date of Adoption

 

Income/(Loss)

 

Increase/(Decrease)

 

Year Ended November 30, 2007

 

 

 

 

 

 

 

   SFAS 157

 

December 1, 2006

 

 

 

$

45

 

   SFAS 158

 

November 30, 2007

 

$(210

)

 

 

   SFAS 159

 

December 1, 2006

 

 

 

22

 

Quarter Ended February 29, 2008

 

 

 

 

 

   FIN 48

 

December 1, 2007

 

 

 

 

(178

)

 

The ASF Framework. On December 6, 2007, the American Securitization Forum (“ASF”), working with various constituency groups as well as representatives of U.S. federal government agencies, issued the Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans (the “ASF Framework”). The ASF Framework provides guidance for servicers to streamline borrower evaluation procedures and to facilitate the use of foreclosure and loss prevention efforts in an attempt to reduce the number of U.S. subprime residential mortgage borrowers who might default in the coming year because the borrowers cannot afford to pay the increased loan interest rate after their U.S. subprime residential mortgage variable loan rate resets. The ASF Framework requires a borrower and its U.S. subprime residential mortgage variable loan to meet specific conditions to qualify for a modification under which the qualifying borrower’s loan’s interest rate would be kept at the existing rate, generally for five years following an upcoming reset period. The ASF Framework is focused on U.S. subprime first-lien adjustable-rate residential mortgages that have an initial fixed interest rate period of 36 months or less, are included in securitized pools, were originated between January 1, 2005 and July 31, 2007, and have an initial interest rate reset date between January 1, 2008 and July 31, 2010 (defined as “Segment 2 Subprime ARM Loans” within the ASF Framework).

 

On January 8, 2008, the SEC’s Office of Chief Accountant (the “OCA”) issued a letter (the “OCA Letter”) addressing accounting issues that may be raised by the ASF Framework. Specifically, the OCA Letter expressed the view that if a Segment 2 Subprime ARM Loan is modified pursuant to the ASF Framework and that loan could legally be modified, the OCA will not object to continued status of the transferee as a QSPE under SFAS 140. Concurrent with the issuance of the OCA Letter, the OCA requested the FASB to immediately address the issues that have arisen in the application of the QSPE guidance in SFAS 140. Any loan modifications the Company makes in accordance with the ASF Framework will not have a material impact on its accounting for U.S. subprime residential mortgage loans nor securitizations or retained interests in securitizations of U.S. subprime residential mortgage loans.

 

 

- 16 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

At February 29, 2008, the Company had approximately 186 Segment 2 Subprime ARM Loans. None had been modified under the ASF Framework.

 

Basel II. As of December 1, 2005, the Company became regulated by the SEC as a consolidated supervised entity (“CSE”). This supervision subjects the Company to group-wide supervision and examination by the SEC, minimum capital requirements on a consolidated basis and reporting (including reporting of capital adequacy measurement consistent with the standards adopted by the Basel Committee on Banking Supervision) and notification requirements. CSE capital requirements for the Company are principally driven by market, credit and operational risk amounts computed using methodologies developed by the Company and approved by the SEC.

 

The Basel Committee on Banking Supervision published an updated framework to calculate risk-based capital requirements in June 2004 (“Basel II”). In September 2006, U.S. federal bank regulators announced their intent to implement Basel II in the U.S. On December 10, 2007, the U.S. federal bank regulators published final rules to implement new risk-based capital requirements in the U.S. for large, internationally active (core) banking organizations.

 

The CSE regulations are intended to provide consolidated supervision of investment bank holding companies that is broadly consistent with U.S. federal bank regulatory oversight of bank holding companies. Basel II is meant to be applied on a consolidated basis for banking institutions or bank holding companies that have consolidated total assets of $250 billion or more and/or consolidated total on-balance-sheet foreign exposure of $10 billion or more. Basel II provides two broad methods for calculating minimum capital requirements related to credit risk: (i) a standardized approach that relies heavily upon external credit assessments by major independent credit rating agencies; and (ii) an internal ratings-based approach, at foundation or advanced levels that permits the use of internal rating assessments in determining required capital.

 

Beginning January 2008, certain of the Company’s subsidiaries in Europe, became subject to the Basel II requirements. The time frame in which Basel II requirements would become effective for U.S. banking institutions or bank holding companies is contemplated to be on or after (i) completion of four consecutive quarterly parallel calculations, in which an entity would remain subject to existing risk-based capital rules but also calculate its risk-based capital requirements under the new Basel II framework; and (ii) a series of transitional periods during which an entity would report under the new framework, subject to supervisory mandated minimum regulatory capital requirements.

 

Additionally, and as an increasing number of global banking organizations become subject to Basel II, new interpretations may arise, and harmonization among regulators could impact the regulatory capital standards under which the Company operates as a CSE, as well as the requirements for some of the Company’s regulated subsidiaries.

 

Note 2 Business and Geographic Segments

 

Business Segments

 

The Company organizes its business operations into three business segments: Capital Markets, Investment Banking and Investment Management.

 

The business segment information for the periods ended February 29, 2008 and February 28, 2007 is prepared using the following methodologies and generally represents the information that is relied upon by management in its decision-making processes:

 

 

·

Revenues and expenses directly associated with each business segment are included in determining income before taxes.

 

 

 

 

·

Revenues and expenses not directly associated with specific business segments are allocated based on the most relevant measures applicable, including each segment’s revenues, headcount and other factors.

 

 

 

 

·

Net revenues include allocations of interest revenue, interest expense and revaluation of certain long-term and short-term debt measured at fair value to securities and other positions in relation to the cash generated by, or funding requirements of, the underlying positions.

 

 

 

 

·

Business segment assets include an allocation of indirect corporate assets that have been fully allocated to the segments, generally based on each segment’s respective headcount figures.

 

Capital Markets

 

The Capital Markets segment is divided into two components:

 

 

- 17 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Fixed Income — The Company makes markets in and trades municipal and public sector instruments, interest rate and credit products, mortgage-related securities and loan products, currencies and commodities. The Company also originates mortgages and structures and enters into a variety of derivative transactions. The Company provides research covering economic, quantitative, strategic, credit, relative value, index and portfolio analyses. Additionally, the Company provides financing, advice and servicing activities to the hedge fund community, known as prime brokerage services. The Company engages in certain proprietary trading activities and in principal investing in real estate that are managed within this component.

 

Equities — The Company makes markets in and trades equities and equity-related products and enters into a variety of derivative transactions. The Company also provides equity-related research coverage as well as execution and clearing services for clients. Through capital markets prime services, the Company provides prime brokerage services to the hedge fund community. The Company also engages in proprietary trading activities and private equity and other related investments.

 

Investment Banking

 

The Company takes an integrated approach to client coverage, organizing bankers into industry, product and geographic groups within the Investment Banking segment. Business services provided to corporations and governments worldwide can be separated into:

 

Global Finance — The Company serves clients’ capital raising needs through underwriting, private placements, leveraged finance and other activities associated with debt and equity products.

 

Advisory Services — The Company provides business advisory services with respect to mergers and acquisitions, divestitures, restructurings and other corporate activities.

 

Investment Management

 

The Investment Management business segment consists of:

 

Asset Management — The Company provides customized investment management services for high net worth clients, mutual funds and other small and middle market institutional investors. Asset Management also serves as general partner for private equity and other alternative investment partnerships and has minority stake investments in certain alternative investment managers.

 

Private Investment Management — The Company provides investment, wealth advisory and capital markets execution services to high net worth and middle market institutional clients.

 

Business Segments

 

 

 

Capital

 

Investment

 

Investment

 

 

 

In millions

 

Markets

 

Banking

 

Management

 

Total

 

Three months ended February 29, 2008

 

 

 

 

 

 

 

 

 

Gross revenues

 

$10,512

 

$

867

 

$

991

 

$

12,370

 

Interest expense

 

8,840

 

 

23

 

8,863

 

Net revenues

 

1,672

 

867

 

968

 

3,507

 

Depreciation and amortization expense

 

116

 

14

 

30

 

160

 

Other expenses

 

1,320

 

671

 

693

 

2,684

 

Income before taxes

 

$     236

 

$

182

 

$

245

 

$

663

 

Segment assets (in billions)

 

$  774.6

 

$

1.7

 

$

9.7

 

$

786.0

 

Three months ended February 28, 2007

 

 

 

 

 

 

 

 

 

Gross revenues

 

$12,222

 

$

850

 

$

723

 

$

13,795

 

Interest expense

 

8,720

 

 

28

 

8,748

 

Net revenues

 

3,502

 

850

 

695

 

5,047

 

Depreciation and amortization expense

 

102

 

10

 

25

 

137

 

Other expenses

 

2,031

 

650

 

530

 

3,211

 

Income before taxes

 

$  1,369

 

$

190

 

$

140

 

$

1,699

 

Segment assets (in billions)

 

$  552.4

 

$

1.5

 

$

8.4

 

$

562.3

 

 

Geographic Net Revenues

 

The Company organizes its operations into three geographic regions:

 

 

- 18 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

·                  Europe and the Middle East, inclusive of operations in Russia and Turkey;

 

·                  Asia-Pacific, inclusive of operations in Australia and India; and

 

·                  the Americas.

 

Net revenues presented by geographic region are based upon the location of the senior coverage banker or investment advisor in the case of Investment Banking or Asset Management, respectively, or where the position was risk managed within Capital Markets and Private Investment Management. Certain revenues associated with U.S. products and services that result from relationships with international clients have been classified as international revenues using an allocation process. The methodology for allocating the Firm’s revenues to geographic regions is dependent on the judgment of management. Additionally, because certain components of revenues reflect the overall performance of the Company as well as the performance of individual business units, performance in one segment may be affected by the performance of other segments.

 

The following presents, in management’s judgment, a reasonable representation of each region’s contribution to net revenues.

 

Geographic Net Revenues

 

 

Quarter Ended

In millions

 

February 29, 2008

 

February 28, 2007

 

Europe and the Middle East

 

$

760

 

$

1,368

 

Asia-Pacific

 

1,348

 

594

 

Total Non-Americas

 

2,108

 

1,962

 

U.S.

 

1,342

 

3,028

 

Other Americas

 

57

 

57

 

Total Americas

 

1,399

 

3,085

 

Net revenues

 

$

3,507

 

$

5,047

 

 

Note 3 Financial Instruments and Other Inventory Positions

 

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

 

 

 

 

 

 

 

Sold But Not

 

Owned

 

Yet Purchased

 

 

 

 

 

 

 

 

 

 

In millions

 

Feb 29, 2008

 

Nov 30, 2007

 

Feb 29, 2008

 

Nov 30, 2007

 

Mortgage and asset-backed securities

 

$

84,609

 

$

89,106

 

$

552

 

$

332

 

Government and agencies

 

44,574

 

40,892

 

108,759

 

71,813

 

Corporate debt and other

 

59,750

 

54,098

 

8,738

 

6,759

 

Corporate equities

 

56,118

 

58,521

 

41,035

 

39,080

 

Real estate held for sale

 

22,562

 

21,917

 

 

 

Commercial paper and other money market

 

 

 

 

 

 

 

 

 

instruments

 

3,433

 

4,000

 

12

 

12

 

Derivatives and other contractual agreements

 

55,612

 

44,595

 

37,807

 

31,621

 

 

 

$

326,658

 

$

313,129

 

$

196,903

 

$

149,617

 

 

Mortgage and asset-backed securities. Mortgage and asset-backed securities include residential and commercial whole loans and interests in residential and commercial mortgage-backed securitizations. Also included within Mortgage and asset-backed securities are securities whose cash flows are based on pools of assets in bankruptcy-remote entities, or collateralized by cash flows from a specified pool of underlying assets. The pools of assets may include, but are not limited to mortgages, receivables and loans.

 

It is the Company’s intent to sell through securitization or syndication activities, residential and commercial mortgage whole loans the Company originates, as well as those acquired in the secondary market. The Company originated approximately $2 billion and $15 billion of residential mortgage loans at February 29, 2008 and February 28, 2007, respectively, and approximately $2 billion and $13 billion of commercial mortgage loans at February 29, 2008 and February 28, 2007, respectively.

 

 

- 19 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Balances reported for Mortgage and asset-backed securities include approximately $10.2 billion and $11.9 billion at February 29, 2008 and November 30, 2007, respectively, of loans transferred to securitization vehicles where such transfers were accounted for as secured financings rather than sales. The securitization vehicles issued securities that were distributed to investors. The Company considers itself to have economic exposure only to the securities retained from those securitization vehicles; the Company does not consider itself to have economic exposure to the underlying assets in those securitization vehicles. For further discussion of securitization activities, see Note 6, “Securitizations and Special Purpose Entities,” to the Consolidated Financial Statements.

 

At February 29, 2008 and November 30, 2007, the Company’s inventory of Mortgage and asset-backed securities, excluding those that were accounted for as financings rather than sales, generally included the following types of assets:

 

In millions

 

February 29, 2008

 

November 30, 2007

 

Residential:

 

 

 

 

 

Securities(1)

 

$

18,179

 

$

16,709

 

Whole loans

 

11,913

 

14,235

 

Servicing and other

 

1,660

 

1,235

 

 

 

$

31,752

 

$

32,179

 

Commercial:

 

 

 

 

 

Whole loans

 

$

24,881

 

$

26,200

 

Securities and other(2)

 

11,229

 

12,738

 

 

 

$

36,110

 

$

38,938

 

 

 

 

 

 

 

Other asset-backed securities

 

$

6,553

 

$

6,163

 

 

 

 

 

 

 

Total

 

$

74,415

 

$

77,280

 

 

(1)    Includes approximately $8.1 billion of investment grade retained interests in securitizations and approximately $1.4 billion of non-investment grade retained interests in securitizations at February 29, 2008. Includes approximately $7.1 billion of investment grade retained interests in securitizations and approximately $1.6 billion of non-investment grade retained interests in securitizations at November 30, 2007.

(2)    Includes approximately $1.8 billion of investment grade retained interests in securitizations and $0.04 billion of non-investment grade retained interests in securitizations at February 29, 2008. Includes approximately $2.4 billion of investment grade retained interests in securitizations and approximately $0.03 billion of non-investment grade retained interests in securitizations at November 30, 2007.

 

At February 29, 2008 and November 30, 2007, the Company’s portfolio of U.S. subprime residential mortgages, excluding those that were accounted for as financings rather than sales, generally included the following types of assets:1

 

In millions

 

February 29, 2008

 

November 30, 2007

 

U.S. residential subprime mortgages

 

 

 

 

 

Whole loans(1)

 

$

1,295

 

$

3,226

 

Retained interests in securitizations

 

2,692

 

1,995

 

Other

 

30

 

55

 

Total

 

$

4,017

 

$

5,276

 

 

(1)            Excludes loans which were accounted for as financings rather than sales which were approximately $3.2 billion and $2.9 billion at February 29, 2008 and November 30, 2007, respectively.

 

Government and agencies. Included within these balances are instruments issued by a national government or agency thereof, denominated in the country’s own currency or in a foreign currency (e.g., sovereign) as well as municipals.

 

Corporate debt and other. Longer-term debt instruments, generally with a maturity date falling at least a year after their issue date, not issued by governments and may or may not be traded on major exchanges, are included within this component.

 

Non-derivative, physical commodities are reported as a component of this line item and were approximately $169 million and $308 million in February 29, 2008 and November 30, 2007, respectively.

 


1

The Company generally defines U.S. subprime residential mortgage loans as those associated with borrowers having a credit score in the range of 620 or lower using the Fair Isaac Corporation’s statistical model, or having other negative factors within their credit profiles. Prior to its closure in the third quarter of fiscal 2007, the Company originated subprime residential mortgage loans through BNC Mortgage LLC (“BNC”), a wholly-owned subsidiary of the Company’s U.S. regulated thrift Lehman Brothers Bank, FSB. BNC served borrowers with subprime qualifying credit profiles but also served borrowers with stronger credit history as a result of broker relationships or product offerings and such loans are also included in the Company’s subprime business activity. For residential mortgage loans purchased from other mortgage originators, the Company uses a similar subprime definition as for its origination activity. Additionally, second lien loans are included in the Company’s subprime business activity.

 

 

- 20 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Corporate equities. Balances generally reflect held positions in any instrument that has an equity ownership component, such as equity-related positions, public ownership equity securities that are listed on public exchanges, private equity-related positions and non-public ownership equity securities that are not listed on a public exchange.

 

Real estate held for sale. Real estate held for sale of $22.6 billion and $21.9 billion at February 29, 2008 and November 30, 2007, respectively, reflects debt and equity investments in parcels of land and related physical property. The Company invests in entities whose underlying assets are Real estate held for sale. The Company consolidates those entities in which the Company is the primary beneficiary in accordance with FIN 46(R). The Company considers itself to have economic exposure only to its direct investments in these entities; the Company does not consider itself to have economic exposure to the total underlying assets in these entities. The Company’s net investment positions related to Real estate held for sale, excluding the amounts that have been consolidated but for which the Company does not consider itself to have economic exposure, was $12.9 billion and $12.8 billion at February 29, 2008 and November 30, 2007, respectively.

 

Commercial paper and other money market instruments. Commercial paper and other money market instruments include short-term obligations, generally issued by financial institutions or corporations, with maturities within a calendar year of the financial statement date. These instruments may include promissory notes, drafts, checks and certificates of deposit.

 

Derivatives and other contractual agreements. These balances generally represent future commitments to exchange interest payment streams or currencies based on contract or notional amounts or to purchase or sell other financial instruments or physical assets at specified terms on a specified date. Both over-the-counter and exchange-traded derivatives are reflected.

 

The following table presents the fair value of Derivatives and other contractual agreements at February 29, 2008 and November 30, 2007. Assets included in the table represent 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 fair value of derivative contracts represents net receivable/payable for derivative financial instruments before consideration of securities collateral. Asset and liabilities are presented below net of cash collateral of approximately $26.5 billion and $17.6 billion, respectively, at February 29, 2008 and $19.7 billion and $17.5 billion, respectively, at November 30, 2007.

 

Fair Value of Derivatives and Other Contractual Agreements

 

 

February 29, 2008

 

November 30, 2007

In millions

 

Assets

 

Liabilities

 

Assets

 

Liabilities

 

Over-the-Counter: (1)

 

 

 

 

 

 

 

 

 

Interest rate, currency and credit default swaps and options

 

$ 31,082

 

$ 15,248

 

$ 22,028

 

$ 10,915

 

Foreign exchange forward contracts and options

 

3,087

 

3,679

 

2,479

 

2,888

 

Other fixed income securities contracts (including TBAs and forwards)

 

11,856

 

7,827

 

8,450

 

6,024

 

Equity contracts (including equity swaps, warrants and options)

 

6,330

 

9,309

 

8,357

 

9,279

 

Exchange Traded:

 

 

 

 

 

 

 

 

 

Equity contracts (including equity swaps, warrants and options)

 

3,257

 

1,744

 

3,281

 

2,515

 

 

 

$ 55,612

 

$ 37,807

 

$ 44,595

 

$ 31,621

 

 

(1)              The Company’s net credit exposure for OTC contracts is $45.7 billion and $34.6 billion at February 29, 2008 and November 30, 2007, respectively, representing the fair value of OTC contracts in a net receivable position, after consideration of collateral.

 

At February 29, 2008, commodity derivative assets and liabilities were $2.9 billion and $2.7 billion, respectively. At November 30, 2007, commodity derivative assets and liabilities were both approximately $1.5 billion.

 

Concentrations of Credit Risk

 

A substantial portion of securities transactions are collateralized and are executed with, and on behalf of, financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. The Company’s exposure to credit risk associated with the non-performance of these clients and counterparties in fulfilling their contractual obligations with respect to various types of transactions can be directly affected by volatile or illiquid trading markets, which may impair the ability of clients and counterparties to satisfy their obligations to the Company.

 

Financial instruments and other inventory positions owned include U.S. government and agency securities, and securities

 

 

- 21 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

issued by non-U.S. governments, which in the aggregate represented 6% of total assets at both February 29, 2008 and November 30, 2007. In addition, collateral held for resale agreements represented approximately 27% and 24% of total assets at February 29, 2008 and November 30, 2007, respectively, and primarily consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. The Company’s most significant industry concentration is financial institutions, which includes other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of business.

 

Note 4 Fair Value of Financial Instruments

 

Financial instruments and other inventory positions owned, excluding Real estate held for sale, and Financial instruments and other inventory positions sold but not yet purchased, are presented at fair value. In addition, certain long and short-term borrowing obligations, principally certain hybrid financial instruments, and certain deposit liabilities at banks, are presented at fair value.

 

Fair value is defined as the price at which an asset could be exchanged in a current transaction between knowledgeable, willing parties. A liability’s fair value is defined as the amount that would be paid to transfer the liability to a new obligor, not the amount that would be paid to settle the liability with the creditor. Where available, fair value is based on observable market prices or parameters or derived from such prices or parameters. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve some level of management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

 

Assets and liabilities recorded at fair value in the Consolidated Statement of Financial Condition are categorized based upon the level of judgment associated with the inputs used to measure their fair value. Hierarchical levels, defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities, are as follows:

 

Level 1 — Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

 

The types of assets and liabilities carried at Level 1 fair value generally are G-7 government and agency securities, equities listed in active markets, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

 

Level 2 — Inputs (other than quoted prices included in Level 1) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument’s anticipated life.

 

Fair valued assets and liabilities that are generally included in this category are non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments and certain derivatives.

 

Level 3 — Inputs reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

 

Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset-backed securities, certain corporate debt, certain private equity investments, certain municipal bonds, certain commitments and guarantees and certain derivatives.

 

 

- 22 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Fair Value on a Recurring Basis

 

Assets and liabilities measured at fair value on a recurring basis are categorized in the tables below based upon the lowest level of significant input to the valuations.

 

 

 

Assets at Fair Value as of February 29, 2008

 

In millions

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Mortgage and asset-backed securities(1)

 

$

270

 

$

60,527

 

$

23,812

 

$

84,609

 

Government and agencies

 

19,674

 

24,900

 

 

44,574

 

Corporate debt and other

 

336

 

55,164

 

4,250

 

59,750

 

Corporate equities

 

34,787

 

11,956

 

9,375

 

56,118

 

Commercial paper and other money market instruments

 

3,433

 

 

 

3,433

 

Derivative assets(2)

 

3,257

 

47,284

 

5,071

 

55,612

 

 

 

$

61,757

 

$

199,831

 

$

42,508

 

$

304,096

 

 

 

 

Assets at Fair Value as of November 30, 2007

 

In millions

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Mortgage and asset-backed securities(1)

 

$

240

 

$

63,914

 

$

24,952

 

$

89,106

 

Government and agencies

 

25,393

 

15,499

 

 

40,892

 

Corporate debt and other

 

324

 

50,692

 

3,082

 

54,098

 

Corporate equities

 

39,336

 

10,812

 

8,373

 

58,521

 

Commercial paper and other money market instruments

 

4,000

 

 

 

4,000

 

Derivative assets(2)

 

3,281

 

35,742

 

5,572

 

44,595

 

 

 

$

72,574

 

$

176,659

 

$

41,979

 

$

291,212

 

 

(1)    Includes loans transferred to securitization vehicles where such transfers were accounted for as secured financings rather than sales. The securitization vehicles issued securities that were distributed to investors. The Company does not consider itself to have economic exposure to the underlying assets in those securitization vehicles beyond the Company’s retained interests. The loans are reflected as an asset within Mortgages and asset-backed positions and the proceeds received from the transfer are reflected as a liability within Other secured borrowings. These loans are classified as Level 2 assets.

 

(2)    Derivative assets are presented on a net basis by level. Inter- and intra-level cash collateral, cross-product and counterparty netting at February 29, 2008 and November 30, 2007 was approximately $56.5 billion and $38.8 billion, respectively.

 

 

 

Liabilities at Fair Value as of February 29, 2008

 

In millions

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Mortgage and asset-backed securities

 

$

 

$

552

 

$

 

$

552

 

Government and agencies

 

103,999

 

4,760

 

 

108,759

 

Corporate debt and other

 

 

8,738

 

 

8,738

 

Corporate equities

 

40,450

 

585

 

 

41,035

 

Commercial paper and other money market instruments

 

12

 

 

 

12

 

Derivative liabilities(1)

 

1,744

 

33,760

 

2,303

 

37,807

 

 

 

$

146,205

 

$

48,395

 

$

2,303

 

$

196,903

 

 

 

 

Liabilities at Fair Value as of November 30, 2007

 

In millions

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Mortgage and asset-backed securities

 

$

 

$

332

 

$

 

$

332

 

Government and agencies

 

67,484

 

4,329

 

 

71,813

 

Corporate debt and other

 

22

 

6,737

 

 

6,759

 

Corporate equities

 

39,080

 

 

 

39,080

 

Commercial paper and other money market instruments

 

12

 

 

 

12

 

Derivative liabilities(1)

 

2,515

 

26,011

 

3,095

 

31,621

 

 

 

$

109,113

 

$

37,409

 

$

3,095

 

$

149,617

 

 

(1)    Derivative liabilities are presented on a net basis by level. Inter- and intra-level cash collateral, cross-product and counterparty netting at February 29, 2008 and November 30, 2007 was approximately $47.6 billion and $36.6 billion, respectively.

 

Level 3 Gains and Losses

 

The tables presented below summarizes the change in balance sheet carrying values associated with Level 3 Financial instruments for the three months ended February 29, 2008 and the twelve months ended November 30, 2007. Caution should be utilized when evaluating reported net revenues for Level 3 Financial instruments. The values presented exclude

 

 

- 23 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

economic hedging activities that may be transacted in instruments categorized within other fair value hierarchy levels. Actual net revenues associated with Level 3 Financial instruments inclusive of hedging activities could differ materially.

 

 

 

Mortgage and asset-

 

Corporate

 

Corporate

 

 

 

 

 

In millions

 

backed securities

 

debt and other

 

equities

 

Net derivatives

 

Total

 

Balance at December 1, 2007

 

$

 24,952

 

$

3,082

 

$

8,373

 

$

 2,477

 

$

 38,884

 

Net Payments, Purchases and Sales

 

46

 

524

 

360

 

73

 

1,003

 

Net Transfers In/(Out)

 

(519

)

655

 

(80

)

34

 

90

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

83

 

24

 

27

 

(20

)

114

 

Unrealized

 

(750

)

(35

)

695

 

204

 

114

 

Balance at February 29, 2008

 

$

 23,812

 

$

4,250

 

$

9,375

 

$

 2,768

 

$

 40,205

 

 

 

 

Mortgage and asset-

 

Corporate

 

Corporate

 

 

 

 

 

In millions

 

backed securities

 

debt and other

 

equities

 

Net derivatives

 

Total

 

Balance at December 1, 2006

 

$

 8,575

 

$

 1,924

 

$

 2,427

 

$

 686

 

$

 13,612

 

Net Payments, Purchases and Sales

 

2,349

 

428

 

210

 

283

 

3,270

 

Net Transfers In/(Out)

 

137

 

 

 

 

137

 

Gains/(Losses)(1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

176

 

19

 

21

 

7

 

223

 

Unrealized

 

(80

)

13

 

13

 

158

 

104

 

Balance at February 28, 2007

 

11,157

 

2,384

 

2,671

 

1,134

 

17,346

 

Net Payments, Purchases and Sales

 

1,671

 

50

 

977

 

(6

)

2,692

 

Net Transfers In/(Out)

 

(123

)

95

 

375

 

39

 

386

 

Gains/(Losses) (1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

274

 

31

 

5

 

48

 

358

 

Unrealized

 

(131

)

(11

)

135

 

65

 

58

 

Balance at May 31, 2007

 

12,848

 

2,549

 

4,163

 

1,280

 

20,840

 

Net Payments, Purchases and Sales

 

1,575

 

(299

)

545

 

(59

)

1,762

 

Net Transfers In/(Out)

 

9,856

 

(144

)

232

 

(160

)

9,784

 

Gains/(Losses) (1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

210

 

7

 

37

 

(4

)

250

 

Unrealized

 

(825

)

19

 

62

 

543

 

(201

)

Balance at August 31, 2007

 

23,664

 

2,132

 

5,039

 

1,600

 

32,435

 

Net Payments, Purchases and Sales

 

1,213

 

292

 

2,939

 

157

 

4,601

 

Net Transfers In/(Out)

 

1,480

 

615

 

103

 

31

 

2,229

 

Gains/(Losses) (1)

 

 

 

 

 

 

 

 

 

 

 

Realized

 

255

 

47

 

227

 

(166

)

363

 

Unrealized

 

(1,660

)

(4

)

65

 

855

 

(744

)

Balance at November 30, 2007

 

$

 24,952

 

$

 3,082

 

$

 8,373

 

$

 2,477

 

$

 38,884

 

 

(1)    Realized or unrealized gains/(losses) from changes in values of Level 3 Financial instruments represent gains/(losses) from changes in values of those Financial instruments only for the period(s) in which the instruments were classified as Level 3.

 

Net revenues (both realized and unrealized) for Level 3 Financial instruments are a component of Principal transactions in the Consolidated Statement of Income. Net realized gains associated with Level 3 Financial instruments were approximately $0.1 billion and $0.2 billion for the quarters ended February 29, 2008 and February 28, 2007, respectively. The net unrealized loss on Level 3 non-derivative Financial instruments was approximately $90 million and $54 million for the quarters ended February 29, 2008 and February 28, 2007, respectively, primarily consisting of unrealized losses from mortgage and asset-backed securities. The net unrealized gain on Level 3 derivative Financial instruments was approximately $204 million and $158 million for the quarters ended February 29, 2008 and February 28, 2007, respectively, primarily consisting of unrealized gains from credit and interest rate-related derivative positions. Level 3 Financial instruments may be economically hedged with financial instruments not classified as Level 3; therefore, gains or losses associated with Level 3 Financial instruments may be offset by gains or losses associated with financial instruments classified in other levels of the fair value hierarchy.

 

Fair Value Option

 

SFAS 159 permits certain financial assets and liabilities to be measured at fair value, using an instrument-by-instrument election. Changes in the fair value of the financial assets and liabilities for which the fair value option was made are reflected in Principal transactions in the Consolidated Statement of Income. As indicated above in the fair value hierarchy tables and further discussed in Note 1, “Summary of Significant Accounting Policies, Accounting and Regulatory DevelopmentsSFAS 159,” the Company elected to account for the following financial assets and liabilities at fair value:

 

 

- 24 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Certain hybrid financial instruments. These instruments are primarily structured notes that are risk managed on a fair value basis and within the Company’s Capital Market activities and for which hedge accounting under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, had been complex to maintain. Changes in the fair value of these liabilities, excluding any Interest income or Interest expense, are reflected in Principal transactions in the Consolidated Statement of Income. The Company calculates the impact of its own credit spread on hybrid financial instruments carried at fair value by discounting future cash flows at a rate which incorporates observable changes in its credit spread. At February 29, 2008, the estimated changes in the fair value attributable to the observable impact from instrument-specific credit risk was a gain of approximately $0.6 billion, attributable to the widening of the Company’s credit spreads during the period. The change in fair value attributable to the observable impact from instrument-specific credit risk was not material to the results of operations at February 28, 2007. As of February 29, 2008 and November 30, 2007, the aggregate principal amount of hybrid financial instruments classified as short-term borrowings and measured at fair value exceeded the fair value by approximately $510 million and $152 million, respectively. Additionally, and as of February 29, 2008 and November 30, 2007, the aggregate principal amount of hybrid financial instruments classified as long-term borrowings and measured at fair value exceeded the fair value by approximately $3.9 billion and $2.1 billion, respectively.

 

Other secured borrowings. Certain liabilities recorded as Other secured borrowings include the proceeds received from transferring loans to securitization vehicles where such transfers were accounted for as secured financings rather than sales under SFAS 140. The transferred loans are reflected as an asset within Mortgages and asset-backed positions and also accounted for at fair value and categorized as Level 2 in the fair value hierarchy. The Company considers itself to have economic exposure only to the securities retained from those securitization vehicles; the Company does not consider itself to have economic exposure to the underlying assets in those securitization vehicles. The change in fair value attributable to the observable impact from instrument-specific credit risk was not material to the results of operations.

 

Deposit liabilities at banks. The Company elects to account for certain deposits at the Company’s U.S. banking subsidiaries at fair value. The change in fair value attributable to the observable impact from instrument-specific credit risk was not material to the results of operations. As of February 29, 2008 and November 30, 2007, the difference between the fair value and the aggregate principal amount of deposit liabilities at banks carried at fair value was not material.

 

 

- 25 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Liabilities for which the fair value option was elected are categorized in the table below based upon the lowest level of significant input to the valuations.

 

 

 

At Fair Value as of February 29, 2008

 

In millions

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Certain hybrid financial instruments:

 

 

 

 

 

 

 

 

 

Short-term borrowings

 

 

$

10,660

 

 

$

10,660

 

Long-term borrowings

 

 

$

26,593

 

 

$

26,593

 

Other secured borrowings

 

 

$

8,605

 

 

$

8,605

 

Deposit liabilities at banks

 

 

$

12,421

 

 

$

12,421

 

 

 

 

At Fair Value as of November 30, 2007

 

In millions

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Certain hybrid financial instruments:

 

 

 

 

 

 

 

 

 

Short-term borrowings

 

 

$

9,035

 

 

$

9,035

 

Long-term borrowings

 

 

$

27,204

 

 

$

27,204

 

Other secured borrowings

 

 

$

9,149

 

 

$

9,149

 

Deposit liabilities at banks

 

 

$

15,986

 

 

$

15,986

 

 

Note 5 Securities Received and Pledged as Collateral

 

The Company enters into secured borrowing and lending transactions to finance inventory positions, obtain securities for settlement and meet clients’ needs. The Company receives collateral in connection with resale agreements, securities borrowed transactions, borrow/pledge transactions, client margin loans and derivative transactions. The Company generally is permitted to sell or repledge these securities held as collateral and use them to secure repurchase agreements, enter into securities lending transactions or deliver to counterparties to cover short positions.

 

At February 29, 2008 and November 30, 2007, the fair value of securities received as collateral that the Company was permitted to sell or repledge was approximately $929 billion and $798 billion, respectively. The fair value of securities received as collateral that the Company sold or repledged was approximately $852 billion and $725 billion at February 29, 2008 and November 30, 2007, respectively.

 

The Company also pledges its own assets, primarily to collateralize certain financing arrangements. These pledged securities, where the counterparty has the right by contract or custom to sell or repledge the financial instruments, were approximately $59 billion and $63 billion at February 29, 2008 and November 30, 2007, respectively. The carrying value of Financial instruments and other inventory positions owned that have been pledged or otherwise encumbered to counterparties where those counterparties do not have the right to sell or repledge, was approximately $96 billion and $87 billion at February 29, 2008 and November 30, 2007, respectively.

 

Note 6 Securitizations and Special Purpose Entities

 

Generally, residential and commercial mortgages, home equity loans, municipal and corporate bonds, and lease and trade receivables are financial assets that the Company securitizes through SPEs. The Company may continue to hold an interest in the financial assets securitized in the form of the securities created in the transaction, including residual interests (“interests in securitizations”) established to facilitate the securitization transaction. Interests in securitizations are presented within Financial instruments and other inventory positions owned (primarily in mortgages and asset-backed securities and government and agencies) in the Consolidated Statement of Financial Condition. For additional information regarding the accounting for securitization transactions, see Note 1, “Summary of Significant Accounting Policies—Consolidation Policies,” to the Consolidated Financial Statements.

 

 

- 26 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

For the quarters ended February 29, 2008 and February 28, 2007, the following financial assets were securitized:

 

 

 

Quarter ended

 

In millions

 

February 29, 2008

 

February 28, 2007

 

Residential mortgages

 

$6,868

 

$22,581

 

Commercial mortgages

 

 

2,829

 

Municipal and other asset-backed financial instruments

 

3,123

 

1,008

 

Total

 

$9,991

 

$26,418

 

 

At February 29, 2008 and November 30, 2007, the Company had approximately $1.5 billion and $1.6 billion, respectively, of non-investment grade interests from securitization activities.

 

The table below presents: the fair value of interests in securitizations at February 29, 2008 and November 30, 2007; model assumptions of market factors, sensitivity of valuation models to adverse changes in the assumptions, as well as cash flows received on such interests in the securitizations. The sensitivity analyses presented below are hypothetical and should be used with caution since the stresses are performed without considering the effect of hedges, which serve to reduce the Company’s actual risk. The Company mitigates the risks associated with the below interests in securitizations through various risk management dynamic hedging strategies. These results are calculated by stressing a particular economic assumption independent of changes in any other assumption (as required by U.S. GAAP). In reality, changes in one factor often result in changes in another factor which may counteract or magnify the effect of the changes outlined in the table below. Changes in the fair value based on a 10% or 20% variation in an assumption should not be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear.

 

Securitization Activity

 

 

 

February 29, 2008

 

November 30, 2007

 

 

 

Residential Mortgages

 

 

 

Residential Mortgages

 

 

 

 

 

 

 

Non-

 

 

 

 

 

Non-

 

 

 

 

 

Investment

 

Investment

 

 

 

Investment

 

Investment

 

 

 

Dollars in millions

 

Grade(1)

 

Grade

 

Other(2)

 

Grade(1)

 

Grade

 

Other(2)

 

Interests in securitizations
(in billions)

 

$

8.1

 

$

1.4

 

$

1.9

 

$

7.1

 

$

1.6

 

$

2.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average life (years)

 

8

 

5

 

5

 

9

 

4

 

6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average constant prepayment rate

 

12.5

%

15.4

%

 

12.4

%

17.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of 10% adverse change

 

$

84

 

$

20

 

$

 

$

55

 

$

8

 

$

 

Effect of 20% adverse change

 

$

175

 

$

33

 

$

 

$

111

 

$

10

 

$

 

Weighted-average credit loss assumption

 

0.6

%

3.3

%

1.0

%

0.5

%

2.4

%

0.7

%

Effect of 10% adverse change

 

$

59

 

$

43

 

$

52

 

$

107

 

$

104

 

$

6

 

Effect of 20% adverse change

 

$

126

 

$

78

 

$

104

 

$

197

 

$

201

 

$

12

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted-average discount rate

 

10.7

%

18.2

%

7.8

%

7.7

%

19.4

%

7.3

%

Effect of 10% adverse change

 

$

318

 

$

33

 

$

232

 

$

245

 

$

53

 

$

84

 

Effect of 20% adverse change

 

$

608

 

$

66

 

$

461

 

$

489

 

$

102

 

$

166

 

 

(1)

The amount of investment-grade interests in securitizations related to agency collateralized mortgage obligations was approximately $2.5 billion at both February 29, 2008 and November 30, 2007.

 

(2)

At February 29, 2008, other interests in securitizations included approximately $1.8 billion of investment grade commercial mortgages, approximately $42 million of non-investment grade commercial mortgages and the remainder relates to municipal products. At November 30, 2007, other interests in securitizations included approximately $2.4 billion of investment grade commercial mortgages, approximately $26 million of non-investment grade commercial mortgages and the remainder relates to municipal products.

 

 

 

- 27 -



 

LEHMAN BROTHERS HOLDINGS INC.

Notes to Consolidated Financial Statements

(Unaudited)

 

Cash flows received on interests in securitizations

 

 

 

Quarter Ended
February 29, 2008

 

Year Ended
November 30, 2007

 

 

 

Residential Mortgages

 

 

 

Residential Mortgages

 

 

 

 

 

 

 

Non-

 

 

 

 

 

Non-

 

 

 

 

 

Investment

 

Investment

 

 

 

Investment

 

Investment

 

 

 

In millions

 

Grade

 

Grade

 

Other

 

Grade

 

Grade

 

Other

 

 

 

$

282

 

$

234

 

$ 43

 

$

898

 

$

633

 

$ 130   

 

 

Mortgage servicing rights. Mortgage servicing rights (“MSRs”) represent the right to future cash flows based upon contractual servicing fees for mortgage loans and mortgage-backed securities. MSRs generally arise from the securitization of residential mortgage loans that the Company originates. MSRs are presented within Financial instruments and other inventory positions owned on the Consolidated Statement of Financial Condition. At February 29, 2008 and November 30, 2007, the Company had MSRs of approximately $1.6 billion and $1.2 billion, respectively. MSRs activities for the quarter ended February 29, 2008 and the year ended November 30, 2007 are as follows:

 

In millions

 

February 29, 2008

 

November 30, 2007

 

Balance, beginning of period

 

$  1,183

 

$