LEHMAN BROTHERS 1995 ANNUAL REPORT
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MANAGMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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Set forth on the following pages is Management's Discussion and Analysis of
Financial Condition and Results of Operations for the twelve months ended
November 30, 1995, the eleven months ended November 30, 1994 and the twelve
months ended December 31, 1993.
Business Environment
The principal business activities of Lehman Brothers Holdings Inc. ("Holdings")
and subsidiaries (collectively, the "Company" or "Lehman Brothers") are
investment banking and securities trading and sales, which by their nature are
subject to volatility, primarily due to changes in interest and foreign exchange
rates, global economic and political trends and industry competition. As a
result, revenues and earnings may vary significantly from quarter to quarter and
from year to year.
The adverse market conditions that prevailed during the last three quarters of
1994, characterized by rising interest rates and depressed underwriting volumes,
continued throughout most of the first quarter of 1995.
In the second quarter of 1995, market conditions showed signs of improvement as
expectations for lower U.S. interest rates prompted strong rallies in the stock
and bond markets. Although customer volumes increased in both the debt and
equity markets, market conditions continued to be volatile during this period.
In general, investors remained conservative and defensive due to uncertainties
surrounding the direction of U.S. interest rates and the value of the dollar.
Over the same period, derivative transaction volumes showed improvement as
customers and clients were looking for protection in a declining interest rate
and volatile currency environment.
The positive momentum established during the second quarter of 1995 continued
into the third quarter of 1995. In early July 1995, the U.S. Federal Reserve
Bank reduced the federal funds rate by one-quarter of a percentage point.
Investors reacted favorably to this long-awaited rate cut, leading to a rally in
the bond market. However, by the middle of July 1995, positive economic data
caused renewed investor concerns regarding inflation, the growth rate of the
economy and the future direction of interest rates. Towards the end of the third
quarter, the market tone turned decidedly more positive as investors concluded
that interest rate increases would be unnecessary. In addition, the dollar
continued to strengthen against key currencies such as the yen and the Deutsche
mark, providing further support for a more stable interest rate environment.
The fixed income and equity markets rallied as a result of these factors.
Improved market conditions allowed for a continuing increase in debt and equity
origination activity. Driving the robust equity markets were strong individual
company and industry fundamentals, near record levels of merger and acquisition
activity and substantial cash inflows into mutual funds.
The market rally, which began in September, accelerated through the months of
October and November. The more favorable view on interest rates provided strong
support for the U.S. equity market as the major equity indices hit all-time
highs. Business fundamentals have remained reasonably positive in the U.S. bond
market, as lower levels of inflation and the possibility of a deficit reduction
agreement by the U.S. Government have raised the potential for further interest
rate reductions by the U.S. Federal Reserve Bank. These conditions have been
positive for debt and equity origination activity and secondary trading volumes
for the industry as a whole. Internationally, lower growth rates in
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LEHMAN BROTHERS 1995 ANNUAL REPORT
the major European countries have prompted interest rate reductions from a
number of central banks and strong rallies in their respective bond and stock
markets. Higher relative returns in the U.S. markets vis-a-vis foreign markets
have bolstered international interest in U.S. securities and provided support
for the U.S. dollar. This positive market environment has continued into 1996.
Spin-Off from American Express
On May 31, 1994, American Express effected a special dividend to its common
shareholders of record on May 20, 1994, of approximately 98.2 million shares of
Holdings' common stock. (See Note 6 to the Consolidated Financial Statements.)
As part of the spin-off, Holdings' equity capital was increased and
restructured, with Holdings receiving a net increase of $1.25 billion of equity,
primarily from American Express. As a result of the Distribution, Holdings
became a widely held public corporation with its common stock traded on the New
York Stock Exchange.
Change in Year-End
Effective with the Distribution, the Company changed its year-end from December
31 to November 30, in order to shift certain year-end administrative activities
to a time period that conflicts less with the business needs of the Company's
institutional customers. As a result of the change in the Company's year-end, it
reported its 1994 financial statements on the basis of an eleven month
transition period ended November 30, 1994. Due to the eleven month reporting
period for 1994, the Company's 1994 results of operations are not directly
comparable with the Company's results for 1995 or 1993.
Businesses Sold
The Company completed the sale of three businesses during 1993: The Boston
Company, Shearson and SLHMC which were completed on May 21, July 31 and August
31, 1993, respectively. (See Note 21 to the Consolidated Financial Statements.)
The Company's operating results reflect The Boston Company as a discontinued
operation, while the operating results of Shearson and SLHMC are included in the
Company's results from continuing operations for all periods prior to their sale
in 1993. Because of the significant sale transactions completed during 1993, the
Company's historical financial statements are not fully comparable for all
periods presented.
Results of Operations
Summary
The Company reported net income of $242 million for 1995, including a $47
million aftertax gain related to the Company's sale of its interest in Omnitel
Sistemi Radiocellullari Italiani S.p.A. ("Omnitel") and a $58 million aftertax
charge for occupancy-related real estate expenses and severance. Excluding these
special items, net income was $253 million for 1995. The Company's 1995 results
reflect improved performance in corporate finance advisory activity and in fixed
income and equity origination as well as higher levels of customer activity in a
number of businesses. The Company benefited from the continuing increase in
merger and acquisition activity throughout the year and from a stronger market
climate beginning in the second quarter of 1995. Realization of benefits from
the continued investments in selective investment banking, research and sales
resources, combined with reductions in the Company's personnel and nonpersonnel
expenses, also had a positive effect on 1995 results. For 1994, the Company
reported net income of $113 million, including a $13 million ($23 million
pretax) charge for the cumulative effect of a change in accounting for
postemployment benefits, an $18 million ($33 million pretax) severance charge
recorded in the first quarter of 1994 related to the Company's ongoing review of
its personnel needs ("Severance Charge") and a $12 million ($15 million pretax)
spin-off charge related to the spin-off from American Express on May 31, 1994.
The 1994 results reflect the difficult market environment for many of the
Company's principal businesses. The Company reported a net loss of $102 million
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LEHMAN BROTHERS 1995 ANNUAL REPORT
for 1993 which included a loss of $646 million for businesses sold, net income
of $355 million for the Company's continuing businesses and a net gain of $189
million from discontinued operations. A detailed breakout of the 1993 results
into these three categories is included on page 39. The primary discussion and
comparison of operating results for 1993 includes only the continuing Lehman
Businesses, with a separate section for Businesses Sold/Discontinued Operations
listed subsequently on pages 39-40.
Net Revenues
Net revenues were $3,071 million for 1995, $2,738 million for 1994 and $3,555
million for 1993. Net revenues in 1995, excluding a special revenue gain of $129
million from the sale of the Company's investment in Omnitel, were $2,942
million. Revenues in 1995 were positively affected by increased underwriting
volumes and customer flow activity due to strong rallies in the stock and bond
markets during the last three quarters of the year. The Company's revenues
increased during each quarter of 1995. Although 1994 revenues on an annualized
basis were comparable to 1995 levels, the Company's 1994 revenues declined
throughout the year from a first quarter peak as increasing interest rates and
volatile equity markets served to depress underwriting volumes and to reduce
customer flow activity. Revenues in 1993 were affected by the positive economic
environment, which resulted in a record year for Lehman Brothers and for the
U.S. securities industry, as historically low interest rates, higher volumes of
new stock and bond issues and the continued restructuring of corporate balance
sheets produced strong results.
Since 1990, Lehman Brothers has focused on a "client/customer-driven" strategy.
Under this strategy, Lehman Brothers concentrates on serving the needs of major
issuing and advisory clients and investing customers worldwide to build an
increasing "flow" of business that leverages the Company's research,
underwriting and distribution capabilities. Customer flow continues to be the
primary source of the Company's net revenues. In addition to its customer flow
activities, the Company also takes proprietary positions based upon expected
movements in interest rate, foreign exchange, equity and commodity markets in
both the short- and long-term. The Company's success in this area is dependent
upon its ability to anticipate economic and market trends and to develop trading
strategies that capitalize on these anticipated changes. Consistent with the
Company's client/customer-driven strategy, proprietary trading activities
accounted for approximately 9% of net revenues in 1995, 6% in 1994 and 10% in
1993. Proprietary trading is not anticipated to grow significantly.
The Company, through its subsidiaries, is a market-maker in all major equity and
fixed income products in both the domestic and international markets. In order
to facilitate its trading activities, the Company is a member of all principal
securities and commodities exchanges in the United States and holds memberships
or associate memberships on several principal international securities and
commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt and
Milan stock exchanges. As part of its market-making activities, the Company
maintains inventory positions of varying amounts across a broad range of
financial instruments which are marked-to-market on a daily basis and along with
the Company's proprietary trading positions, give rise to principal transactions
revenues. The Company utilizes various hedging strategies to minimize its
exposure to significant movements in interest and foreign exchange rates and the
equity markets. Net revenues from the Company's market-making and trading
activities in fixed income and equity products are recognized as either
principal transactions or net interest revenues depending upon the method of
financing and/or hedging related to specific inventory positions. The Company
evaluates its trading strategies on an overall profitability basis which
includes both principal transaction revenues and net interest. Therefore,
changes in net interest should not be viewed in isolation but should be viewed
in conjunction with revenues from principal transactions. During 1995, net
interest revenues increased from 1994 levels, primarily related to the benefit
of the Company's liability management activities as well as decreased financing
costs due to the $1.2 billion infusion of capital in connection with the May 31,
1994 spin-off from the American Express Company. Such liability management
activities included the conversion of a portion of the Company's existing
long-term debt portfolio from fixed to floating rate through the use of interest
rate swaps.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
Net revenues from international sources as a percentage of total net revenues
(excluding Omnitel) were 44% for 1995, 42% for 1994 and 33% for 1993, reflecting
the Company's strategy to increase the global scope of its business activities.
This includes approximately $368 million, $337 million and $300 million of
revenues that were associated with domestic products and services in 1995, 1994
and 1993, respectively, that the Company estimates resulted from relationships
with international clients and customers.
The following table of net revenues by business unit and the accompanying
discussion have been prepared in order to present the Company's net revenues in
a format which reflects the manner in which the Company manages its businesses.
For internal management purposes, the Company has been segregated into five
major business units: Fixed Income, Equity, Corporate Finance Advisory, Merchant
Banking and Asset Management. Each business unit represents a grouping of
financial activities and products with similar characteristics. These business
activities result in revenues that are recognized in multiple revenue categories
contained in the Company's Consolidated Statement of Operations. Net revenues by
business unit contain certain internal allocations, including funding costs,
which are centrally managed.
TWELVE MONTHS ENDED NOVEMBER 30, 1995
Principal
Transactions
and Net Investment
Interest* Commissions Banking Other Total
--------- ----------- ---------- ----- -----
Fixed Income $1,390 $ 92 $ 180 $ 15 $1,677
Equity 419 330 218 2 969
Corporate Finance Advisory 231 231
Merchant Banking (35) 172 137
Asset Management 2 28 27 57
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$1,776 $ 450 $ 801 $ 44 $ 3,071
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* 1995 equity revenues include $129 million from the sale of Omnitel.
ELEVEN MONTHS ENDED NOVEMBER 30, 1994
Principal
Transactions
and Net Investment
Interest Commissions Banking Other Total
---------- ----------- ---------- ----- -----
Fixed Income $1,420 $ 103 $ 73 $ 25 $1,621
Equity 240 312 183 16 751
Corporate Finance 180 180
Advisory
Merchant Banking (8) 136 128
Asset Management 2 30 26 58
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$1,654 $ 445 $ 572 $ 67 $ 2,738
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TWELVE MONTHS ENDED DECEMBER 31, 1993
Principal
Transactions
and Net Investment
Interest Commissions Banking Other Total
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Fixed Income $ 1,718 $ 117 $ 208 $ (7) $ 2,036
Equity 472 339 344 52 1,207
Corporate Finance Advisory 133 133
Merchant Banking (12) 117 105
Asset Management 8 32 34 74
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$ 2,186 $ 488 $ 802 $ 79 $ 3,555
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- THIRTY THREE -
LEHMAN BROTHERS 1995 ANNUAL REPORT
For 1995, net revenues increased in all major business units except asset
management relative to the levels posted in 1994, as underwriting, merger and
acquisition and customer activity strengthened throughout the year. Net revenues
by business unit for 1994 were down in each major category except corporate
finance advisory and merchant banking in comparison to the business unit
revenues recorded in 1993, reflecting the particularly robust conditions in the
capital markets for the entire 1993 year. In 1995, fixed income revenues of
$1,677 million reflected a higher contribution from investment banking, as the
mix and after-market performance of the Company's underwriting improved from
1994 levels. Equity revenues increased to $969 million in 1995 ($840 million,
excluding Omnitel) as stronger market conditions resulted in a higher level of
investment banking underwriting activity as well as increased customer trading
volumes. Corporate finance advisory revenues of $231 million in 1995 reflected
the Company's increased participation in strategic mergers and acquisitions and
advisory activities throughout the year. Merchant banking revenues of $137
million in 1995 reflected a slight increase over 1994 due to favorable
valuations on the underlying investments in the Company's merchant banking
funds. Asset management revenues of $57 million in 1995 were virtually unchanged
from 1994 levels.
The following discussion provides an analysis of the Company's net revenues
based upon the various business units which generated these revenues.
Fixed Income The Company's fixed income revenues reflect customer flow
activities (both institutional and high-net-worth retail), secondary trading,
debt underwriting, syndicate and financing activities related to fixed income
products. Fixed income products include dollar and non-dollar government
securities, mortgage- and asset-backed securities, money market products, dollar
and non-dollar corporate debt securities, emerging market securities, municipal
securities, financing (global access to debt financing sources including
repurchase and reverse repurchase agreements), foreign exchange, commodities and
fixed income derivative products. Lehman Brothers is one of the leading 37
primary dealers in U.S. government securities and is a market-maker in the
government securities of all major industrial countries. The Company, through
its subsidiaries, is also a dominant market-maker for a broad range of other
fixed income products.
Fixed income revenues were $1,677 million for 1995, $1,621 million for 1994 and
$2,036 million for 1993. Reduced interest rates and a strengthening U.S. dollar
contributed to a favorable market environment in 1995, particularly during the
second half of the Company's year. The improved market environment contributed
to a stronger debt syndicate calendar and increased customer flow activities for
many of the Company's fixed income products, including high grade corporates,
municipals and foreign exchange. The most significant component of the increases
in fixed income revenues was investment banking due to a strengthening in
origination volumes and an improved mix of underwriting revenues compared to the
depressed 1994 levels. Lehman ranked #2 in lead-managed fixed income offerings
worldwide in 1995 with underwritings of $77 billion, based on Securities Data
Company information. Fixed income derivative revenues were down slightly in 1995
compared to 1994 due to a decrease in new customer activity early in the year.
Toward the end of 1995, derivative activities increased with related revenues in
the fourth quarter up substantially compared to the same quarter in 1994; much
of the increase was attributable to a broadening of the Company's international
customer and client business. This reflects a concerted effort to continue to
globalize the Company's efforts in these areas. Financing revenues were slightly
down in 1995 compared to 1994 due to decreased net interest spreads in certain
of the matched book portfolios.
Rising interest rates and inflationary concerns in 1994 had a negative effect on
customer activity resulting in reduced profitability for most of the fixed
income businesses as compared to 1993. Commission revenues which primarily
relate to the Company's foreign exchange and commodities trading in listed
products decreased slightly throughout the three year period.
- THIRTY FOUR -
LEHMAN BROTHERS 1995 ANNUAL REPORT
Equity The Company's equity revenues reflect customer flow activities (both
institutional and high-net-worth retail), secondary trading, equity
underwriting, equity finance, equity derivatives and arbitrage activities.
Equity revenues were $969 million for 1995, $751 million for 1994 and $1,207
million for 1993. Included in the 1995 results were net revenues of $129 million
resulting from the Company's sale of its stake in Omnitel. Excluding the Omnitel
transaction, equity revenues were $840 million for 1995. Revenues in 1995
reflect a very strong equity syndicate calendar that benefited both the
Company's NASDAQ and listed businesses. The favorable syndicate calendar in
1995 also contributed to increased customer flow in the Company's secondary
trading activities.Commission revenues were up as trading volumes on domestic
exchanges increased, partially offset by reduced market trading volumes on
certain Asian and European exchanges. The Company ranked third in total NYSE
listed trading volume throughout all of 1995. Equity derivative revenues in 1995
were up substantially compared to 1994 and 1993 due to increased customer
activity and more favorable market conditions. Equity finance revenues were down
in 1995 versus 1994 due to decreased net spreads in certain of the conduit
matched books.
The decrease in equity revenues in 1994 from 1993 reflected the difficult
business environment in 1994. The 1994 decline was broad based across most
equity-related products.
Corporate Finance Advisory Corporate finance advisory net revenues, classified
in the Consolidated Statement of Operations as a component of investment banking
revenues, result primarily from fees earned by the Company in its role as
strategic advisor to its clients. This role primarily consists of advising
clients on mergers and acquisitions, divestitures, leveraged buyouts, financial
restructurings, and a variety of cross border transactions. The net revenues for
corporate finance advisory increased in 1995 to $231 million from $180 million
and $133 million in 1994 and 1993, respectively. The increased revenues
reflected a strong mergers and acquisitions environment throughout 1995 as
companies concentrated on cost cutting and creating greater economies of scale
via acquisitions, asset sales, and corporate restructurings on a global basis.
During 1995, the Company acted as advisor for 141 completed transactions valued
at approximately $67 billion, based on Securities Data Company information.
Reflecting the international nature of the Company's corporate finance advisory
business, 47 of the transactions completed in 1995, valued at $21 billion, were
cross-border in nature. Corporate finance advisory exhibited renewed strength in
1994 versus 1993 as both the fees earned by the Company and the number of
completed transactions increased from 1993 levels.
Merchant Banking Merchant banking net revenues, classified in the Consolidated
Statement of Operations as a component of investment banking revenues, primarily
represent the net realized gains and net unrealized changes resulting from the
Company's participation in certain investment partnerships, less the related net
interest expense to finance capital contributions to the partnerships. Merchant
banking revenues were $137 million, $128 million and $105 million for 1995, 1994
and 1993, respectively.
The Company is the fund manager for five merchant banking partnerships,
including three institutional funds and two employee investment vehicles.
Current merchant banking investments held by the partnerships include both
publicly traded and privately held companies diversified on a geographic and
industry basis. For 1995, merchant banking revenues resulting from the
participation in these partnerships increased to $172 million from $136 million
for 1994. This increase was principally due to increases in the value of several
publicly traded investments within the institutional funds and employee
investment vehicles. For 1994, merchant banking revenues increased to $136
million from $117 million for 1993. Net revenues of the merchant banking
business include an allocation of net interest expense related to the Company's
investment in the partnerships. The method used to allocate interest expense was
revised in 1995 from prior periods to better reflect the costs of capital
utilized.
- THIRTY FIVE -
LEHMAN BROTHERS 1995 ANNUAL REPORT
The Company continues to pursue merchant banking opportunities that target
certain industries and geographic areas in both the U.S. and non-U.S. markets.
For example, during 1995, the Company established a $75 million fund
specifically designed to invest in the oil tanker industry. In addition, in
December 1995 the Company established a third employee investment vehicle, a
$225 million partnership that will invest in global merchant banking
opportunities.
Asset Management Revenues from asset management activities were $57 million for
1995, $58 million for 1994 and $74 million for 1993. These revenues primarily
consist of fees from the management of various funds, commissions from the sale
of funds to customers and fees from the management of certain accounts for
institutions and high-net-worth individuals. In December 1995, the Company
entered into an agreement to sell Lehman Brothers Global Asset Management, Ltd.
("LBGAM"), an offshore, retail oriented family of funds. Instead, the Company
plans to focus on sponsoring and distributing more sophisticated strategic funds
attractive to high-net-worth individuals and institutions. As a part of this
strategy, asset management launched two funds, a fixed income fund and an Asia
Pacific fund during 1995. Excluding the assets of LBGAM, total assets under
management were $10.1 billion, $6.9 billion and $8.2 billion at November 30,
1995, November 30, 1994 and December 31, 1993, respectively. The decrease in
revenues from 1993 to 1994 relates to the loss of certain commissions and other
revenues related to funds and customers transferred to Smith Barney in
conjunction with the sale of the retail division.
Non-Interest Expenses
Non-interest expenses were $2,702 million for 1995, including a restructuring
charge of $97 million and compensation and benefits expenses of $50 million
attributable to Omnitel. Non-interest expenses were $2,545 million and $2,990
million for 1994 and 1993, respectively. Non-interest expenses in 1994 included
a $33 million severance charge and a $15 million spin-off charge. Included in
the 1993 amount was a charge of $32 million related to certain non-core
partnership syndication activities in which the Company is no longer actively
engaged.
The restructuring charge in 1995 included an $80 million occupancy related
real-estate charge and a $17 million severance charge. The real-estate component
of the charge resulted from a complete review of the Company's real estate
requirements at current headcount levels and the elimination of excess real
estate, primarily in New York, London and Tokyo. This charge includes costs to
write-down the carrying value of leasehold improvements, as well as projected
shortfalls of sublease rentals versus expected operating costs related to the
Company's excess capacity. The excess real estate capacity resulted from
headcount reductions associated with the Company's cost reduction efforts. The
severance component of the charge relates to payments made to terminated
personnel arising from a formalized fourth quarter business unit productivity
review. The Company expects to realize approximately $24 million of reduced
occupancy and depreciation expenses on an annualized basis as a result of these
actions.
Excluding these special charges, non-interest expenses were $2,555 million for
1995, $2,497 million for 1994 and $2,958 million for 1993.
- THIRTY SIX -
LEHMAN BROTHERS 1995 ANNUAL REPORT
Compensation and benefits expenses declined as a percentage of net revenues to
50.8% for 1995 (excluding Omnitel) from 51.6% for 1994 and 51.4% for 1993.
Excluding special charges, nonpersonnel expenses decreased to $1,061 million for
1995, from $1,084 million for 1994 and $1,133 million for 1993. This decline in
compensation and benefits and nonpersonnel expenses in 1995 reflects the
Company's continued focus on improving productivity and reducing costs.
TWELVE MONTHS ELEVEN MONTHS TWELVE MONTHS
ENDED ENDED ENDED
NOVEMBER 30 NOVEMBER 30 DECEMBER 31
(IN MILLIONS) 1995(1) 1994 1993
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Compensation and
benefits expense $ 1,494 $ 1,413 $ 1,825
Compensation and
benefits/net revenues 50.8% 51.6% 51.4%
Nonpersonnel expenses:
Excluding reserves
and other charges $ 1,061 $ 1,084 $ 1,133
Reserves and other charges 97 48 32
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Total nonpersonnel
expenses $ 1,158 $ 1,132 $ 1,165
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Nonpersonnel expenses/net
revenues: Total nonpersonnel
(excluding reserves and
expenses and other charges) 36.1% 39.6% 31.9%
(1) 1995 amounts exclude revenues and expenses related to the Omnitel
transaction.
Cost Reduction Effort
At year-end 1994, the Company announced a cost reduction program to reduce
expenses by $300 million on an annualized basis (pretax) compared to the third
quarter 1994 expense run rate. The Company's cost reduction efforts were
targeted into three areas: personnel cost savings of $100 million, nonpersonnel
cost savings of $150 million and interest and tax expense savings of $50
million. Through November 1995, the Company achieved its cost reduction goals in
all the identified cost categories. In fact, through the fourth quarter of 1995,
the Company reduced total expenses by approximately $326 million on an
annualized basis compared to the third quarter of 1994. These cost savings
achieved do not include the $24 million of future cost savings attributable to
the real-estate related restructuring charge previously discussed.
With respect to the Company's personnel related cost reduction goals, the
Company reduced headcount to 7,771 at November 30, 1995 from 8,512 at November
30, 1994 and 17% from a peak of 9,400 in early 1994. As a result of these
reductions, the Company reduced its compensation and benefits ratio to 50.7% in
the fourth quarter of 1995 (excluding Omnitel) from the third quarter 1994
benchmark of 53.9%, translating into annualized cost savings of approximately
$100 million.
Nonpersonnel cost reductions were achieved as a result of a systematic and
comprehensive global review of all major expense categories. As a result,
nonpersonnel expenses decreased to $254 million in the fourth quarter of 1995
from the third quarter 1994 benchmark of $298 million, resulting in reduced
quarterly expenses of $44 million or annualized savings of approximately $177
million.
The Company achieved its $50 million cost reduction goal related to interest and
taxes through equal reductions in each category. The Company's interest expense
savings were accomplished as a result of the Company's efforts to improve the
Company's collateral utilization and long-term debt hedging strategies. Tax
savings of approximately $25 million were achieved as a result of the
implementation of additional tax planning strategies.
As a result of these efforts, the Company's expense base has been permanently
lowered. The Company plans to continue its focus on nonpersonnel costs, with the
goal of achieving further cost savings in excess of $50 million by the end of
1996.
- THIRTY SEVEN -
LEHMAN BROTHERS 1995 ANNUAL REPORT
Income Taxes
Through affirmative actions the Company continues to aggressively pursue
maintaining a low effective tax rate. The actions taken in 1995 include the
restructuring of certain legal entities and a general review of overall
operations to assure the Company is operating in the most tax efficient manner.
The Company anticipates ongoing benefits related to the actions taken.
The Company had an income tax provision of $127 million, $67 million and $318
million for 1995, 1994 and 1993, respectively. The effective tax rate for the
Company was 34% for 1995, 35% for 1994 and 37% for 1993. The lower tax rate in
1995 versus 1994 reflects the Company's continued focus on generating income
subject to preferential tax treatment as well as creating organizational
structures that optimize tax results. The lower tax rate in 1994 versus 1993
reflects a reduction in pretax results and an increase in benefits attributable
to income subject to preferential tax treatment, partially offset by the impact
of certain nondeductible foreign losses and the nondeductibility of a portion of
the spin-off charge. The 1993 income tax provision includes a provision of $221
million for continuing businesses and a tax benefit of $11 million related to
non-core business reserves. The 1993 effective tax rate was greater than the
statutory U.S. federal income tax rate, principally due to state and local
income taxes, partially offset by benefits attributable to income subject to
preferential tax treatment and increased foreign profits. During the third
quarter of 1993, the statutory U.S. federal income tax rate was increased to 35%
from 34%, effective January 1, 1993. The Company's 1993 tax provision includes a
one-time benefit of approximately $10 million from the impact of the federal
rate change on the Company's net deferred tax assets.
The Company's net deferred tax assets increased $89 million to $309 million at
November 30, 1995 from $220 million at November 30, 1994. The net increase is
primarily attributable to the reversal of certain temporary differences. It is
anticipated that the remaining deferred tax asset will be realized through
future earnings. The Company's net deferred tax assets decreased $71 million to
$220 million at November 30, 1994 from $291 million at December 31,1993. The
net reduction is attributable to the reversal of certain temporary difference,
partially offset by an increase in the deferred tax asset resulting from the
ability to recognize benefits related to the 1988 acquisition of E. F. Hutton.
As of November 30, 1995, the Company had approximately $25 million of tax net
operating losses available to offset future taxable income.
1993 Results
Because of the significant sale transactions completed during 1993, the
Company's 1993 financial statements are not fully comparable with 1995 and 1994.
In order to facilitate an understanding of the Company's 1993 results, the
following table segregates the Company's results between the results of the
Lehman Businesses (the results of the businesses that now comprise Lehman
Brothers), Businesses Sold (the results of Shearson and SLHMC through their
respective sale dates; the loss on the sale of Shearson; and the reserves for
non-core businesses) and Discontinued Operations (the results of The Boston
Company accounted for as a discontinued operations).
- THIRTY EIGHT -
LEHMAN BROTHERS 1995 ANNUAL REPORT
Twelve months ended December 31
1993
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Lehman Businesses Discontinued
(In millions) Businesses Sold Operations Historical
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Revenues:
Principal transactions $1,732 $ 323
Investment banking 802 170
Commissions 488 828
Interest and dividends 5,679 161
Other 79 412
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Total revenues 8,780 1,894
Interest expense 5,225 143
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Net revenues 3,555 1,751 $ 5,306
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Non-interest expenses:
Compensation and benefits 1,825 1,164
Other expenses 1,133 470
Loss on sale of Shearson 535
Reserves and other charges 32 120
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Total non-interest expenses 2,990 2,289 5,279
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Income (loss) from continuing operations
before taxes 565 (538) 27
Provision for income taxes 210 108 318
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Income (loss) from continuing operations 355 (646) (291)
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Income from discontinued operations,
net of taxes $ 189 189
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Net income (loss) $ 355 $ (646) $ 189 $(102)
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The discussion of the 1993 results for the Lehman Businesses has been
included in the previous sections discussing revenues, non-interest expenses
and taxes. The following section includes a discussion of the Businesses
Sold/ Discontinued Operations.
Businesses Sold/Discontinued Operations
This discussion is provided to analyze the results of the Businesses Sold.
All 1993 amounts for the Businesses Sold include results through their
dates of sale.
The Businesses Sold recorded a net loss of $646 million for 1993. The 1993
results include a loss on the sale of Shearson of $630 million and a $79
million charge recorded in the first quarter as a reserve for non-core
businesses in anticipation of the sale of SLHMC. The loss on the sale of
Shearson included a reduction in goodwill of $750 million and
transaction-related costs such as relocation, systems and operations
modifications and severance. Excluding the $630 million aftertax loss on
the sale, Shearson's net income was $63 million for 1993. Excluding the $79
million aftertax charge discussed above, SLHMC operations were break-even
in 1993.
Net revenues related to the Businesses Sold were $1,751 million for 1993.
Excluding the loss on the sale of Shearson and the reserve for non-core
businesses related to SLHMC, non-interest expenses of the Businesses Sold
were $1,634 million for 1993. Compensation and benefits expense were $1,164
million for 1993.
The 1993 tax provision of $108 million for the Businesses Sold included (i)
expenses of $54 million related to the operating results of Shearson: (ii)
an expense of $95 million from the sale of Shearson and (iii) a tax benefit
of $41 million related to the $120 million reserve for non-core businesses
recorded in anticipation of the sale of SLHMC. The provision related to the
sale of Shearson primarily resulted from the write-off of $750 million of
goodwill which was not deductible for tax purposes.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
The Company reported net income of $189 million from discontinued
operations of The Boston Company, including an aftertax gain of $165
million on the sale and aftertax earnings of $24 million. (See Note 21 for
further discussion of the Businesses Sold and the Discontinued Operations)
Liquidity and Capital Resources
The Company's total assets increased to $115.3 billion at November 30, 1995
from $109.9 billion at November 30, 1994. The increase in total assets is
primarily the result of the change in the Company's clearing arrangements,
partially offset by decreases in other areas. At the close of business on
February 17, 1995, the Company became self-clearing for equities, municipal
securities and corporate debt instruments. As a result of this arrangement,
assets increased at that time by approximately $11 billion which were
predominantly funded with offsetting liabilities. The Company's
Consolidated Statement of Financial Condition now includes accounts
previously cleared, settled and carried by Smith Barney Inc. Principal
areas impacted include the Company's stock borrow and lending activities
and high-net-worth customer business. The Company has entered into an
agreement for a term of five years with the Bear Stearns Securities Corp.
("BSSC") pursuant to which BSSC has agreed to process the transactions
previously cleared by Smith Barney Inc.
The Company's balance sheet is highly liquid and consists primarily of cash
and cash equivalents, securities and other financial instruments owned
which are marked-to-market daily and collateralized short-term financing
agreements which arise primarily from the Company's customer flow
securities transactions. As the Company's primary activities are based on
customer flow, the assets experience a rapid turnover rate. In addition,
the highly liquid nature of these assets provides the Company with
flexibility in financing and managing its business. At November 30, 1995,
short-term assets, those which can be converted to cash in less than one
year, represented approximately 97% of the Company's total balance sheet.
Long-term assets consist primarily of other receivables, property,
equipment and leasehold improvements, deferred expenses and other assets
and excess of cost over fair value of net assets acquired. The Company has
set a goal of prudently liquidating those long-term assets, which are not
part of the core operating business. These non-operating assets have
decreased by approximately $800 million during 1995, with the majority of
this reduction being comprised of two items. On June 22, 1995, American
Express repaid $700 million of a $945 million interest bearing receivable
which was due in June 1996. The maturity of the remaining $245 million was
extended to the year 2000. Portions of this note will be repaid by American
Express, prior to the maturity date in proportion to the Company's payments
and prepayments on any indebtedness related to its obligations for the
World Financial Center. On December 12, 1995, American Express repaid an
additional $37 million reducing the outstanding receivable to $208 million.
Further payments and prepayments on the World Financial Center debt are
expected to reduce the amount of the receivable to $88 million by November
30, 1997. In addition, on November 16, 1995, American Marketing Industries
Holdings Inc. repaid in full its $98 million long-term subordinated
indebtedness.
Balance sheet leverage ratios are one methodology to evaluate the financial
risk inherent in the balance sheet. The Company evaluates this risk by
monitoring its adjusted leverage, defined as total assets less the lower of
securities purchased under agreements to resell or securities sold under
agreements to repurchase, which represent short-term collateralized
transactions with high quality assets, divided by stockholders' equity. As
of November 30, 1995 and 1994 the Company's adjusted leverage ratios were
21.4x and 21.3x, respectively, which are in line with the Company's peer
group of competitor firms.
Funding and Capital Policies
The Company's Global Asset and Liability Committee ("ALCO"), which includes
senior officers from key areas of the Company, are responsible for
establishing and managing the funding and liquidity policies of the
Company. This includes recommendations for balance sheet size as well as
the allocation of balance sheet to product areas as determined by internal
profitability models and return on equity targets. In addition, in
coordination with the Regional Asset and Liability Committees, ALCO works
to ensure coordination of global funding efforts. The Regional Asset and
Liability
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LEHMAN BROTHERS 1995 ANNUAL REPORT
Committees are aligned with the Company's geographic funding centers and
are responsible for implementing funding strategies consistent with the
direction set by ALCO and to monitor and manage liquidity for the region.
The primary goal of the Company's funding principles as set by ALCO are to
provide sufficient liquidity and availability of funding sources throughout
all market environments. These funding principles are:
I To maintain an appropriate overall capital structure to support the
business activities in which the Company is engaged.
The Company manages Total Capital, defined as long-term debt, both senior
notes and subordinated indebtedness, plus stockholders' equity, on a
business and product level. The determination of the amount of capital
assigned to each business and product is a function of asset quality, risk,
liquidity and regulatory capital requirements. Periodically, the Company
reallocates capital to its businesses based upon their ability to obtain
targeted returns, perceived opportunities in the marketplace and the
Company's long term strategy.
II To maximize the portion of the Company's balance sheet that is funded
through collateralized borrowing sources and conversely minimize the use of
commercial paper and short term debt.
Collateralized borrowing sources include securities and other financial
instruments sold but not yet purchased, as well as collateralized short
term financings, defined as securities sold under agreements to repurchase
("repos") and securities loaned.
Because of their secured nature, repos and other types of collateralized
borrowing sources are less credit-sensitive and have historically been a
more stable financing source under adverse market conditions. Also,
collateralized borrowing sources generally provide the Company with access
to lower cost funding. The Company has been able to exceed its goal of
maintaining repo funding lines significantly in excess of actual
utilization.
III To minimize refunding risk by funding the Company's assets with
liabilities which have maturities similar to the anticipated holding period
of the assets. Where the Company deems it to be appropriate, foreign
currency denominated assets are financed with corresponding foreign
currency denominated liabilities.
The Company continually reviews its mix of long- and short-term borrowings
as it relates to maturity matching and the availability of secured and
unsecured financing. In general, long-term assets are financed with fixed
rate long-term debt and stockholders' equity and inventories and all other
short-term assets are financed with a combination of short-term funding and
floating rate long-term debt and stockholders' equity.
IV To diversify and expand the Company's borrowing sources to maximize
liquidity and reduce concentration risk. The Company seeks financing from a
global investor base with the goal of broadening the availability of its
funding sources and maintaining funding availability well in excess of
actual utilization.
The Company obtains global funding from both the banking community and
short- and long-term investors through its centers in New York, London,
Tokyo, Hong Kong and Frankfurt. In addition to maintaining geographic
diversification, the Company also utilizes a broad range of debt
instruments, which it issues in varying maturities and currencies.
The Company accesses both commercial paper and other short-term debt
instruments, including master notes and bank borrowings under uncommitted
lines of credit. To reduce liquidity risk, the Company carefully manages
its maturities to avoid large refinancings on any one given day. In
addition, the Company limits its exposure to any single investor to avoid
concentration risk.
V To maintain sufficient liquidity in a period of financial stress.
Financial stress is defined as any event which severely constrains the
Company's access to unsecured funding sources.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
The Company's liquidity contingency plans are continually reviewed and
updated as the Company's asset/liability mix and liquidity requirements
change. The Company's liquidity contingency plan is based on an estimate of
its ability to meet its funding requirements through a combination of
collateralized short-term financings and short-term secured debt as well as
Total Capital.
To achieve this objective, the Company's liquidity policies include
maintaining sufficient excess unencumbered securities to use as collateral,
if necessary, to obtain secured financing to meet maturities of short-term
unsecured liabilities as well as current maturities of long-term debt.
Also, the Company maintains a sufficient amount of Total Capital to enable
the Company to fund those assets which are less liquid. Lastly, the Company
periodically tests its secured and unsecured credit facilities to ensure
availability and operational readiness. The Company believes that these
policies position the Company to meet its liquidity requirements in all
periods including those of financial stress.
Short-Term Funding
To implement the policies as noted above, each business is required to fund
its products primarily through global collateralized financings. There are
two principal business areas which are responsible for these efforts,
Lehman Brothers' Fixed Income Financing ("Financing") and Equity Finance.
Financing works in conjunction with the institutional fixed income sales
and trading professionals to provide financing to customers and the firm
through the repurchase markets. Equity Finance provides a similar function
in the equity markets typically through securities loaned/securities
borrowed transactions. An ability to leverage global market expertise and
the Company's distribution capabilities are key to successful financing
efforts. The amount of the Company's collateralized borrowing activities
will vary reflecting changes in the mix and overall levels of securities
and other financial instruments owned and global market conditions.
However, at all times, the majority of the Company's assets are funded with
collateralized borrowing sources.
The Company's treasury area works closely with Financing and Equity Finance
to develop funding plans to support the business areas, as well as to
execute daily funding activities. On a daily basis, treasury is responsible
for meeting any funding needs not met through Financing and Equity Finance.
Funding through treasury is managed globally with regional centers which
have access to the capital markets through the issuance of commercial paper
as well as bank lines of credit and other short- and long- term debt
instruments.
At November 30, 1995 and 1994, $81 billion and $77 billion, respectively,
of the Company's total balance sheet was financed using collateralized
borrowing sources. The remainder of the financing for the balance sheet is
comprised of commercial paper and short-term debt, payables and Total
Capital.
In addition, in October 1995, the Company established a $1 billion Secured
Revolving Credit Facility (the "Facility") for Lehman Brothers
International (Europe) ("LBIE"), the Company's major operating entity in
Europe. Under the terms of this committed Facility, the bank group has
committed to provide up to $1 billion for up to 364 days on a secured basis
with a variety of financial instruments as collateral. The bank group has
further committed to provide loans under the Facility for up to 6 months
beyond the Facility maturity date. The loans provided by the bank group are
available in several currencies including U.S. dollar, British pound
sterling, Deutsche mark, ECU, French franc, and Italian lira, as well as
many other currencies as required. There were no borrowings outstanding
under this Facility as of November 30, 1995. However, the Company
anticipates utilizing this Facility for general corporate purposes from
time to time.
In conjunction with the increase in collateralized short-term financings,
as well as the increase in the Company's Total Capital, as discussed below,
the Company's use of commercial paper and short-term debt decreased to $6.2
billion at November 30, 1995 from $9.8 billion at November 30, 1994. Of
these amounts, commercial paper outstanding at November 30, 1995 was $1.4
billion with an average maturity of 78 days, compared to $2.8 billion with
an average maturity of 53 days at November 30, 1994.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
At November 30, 1995 Holdings maintained a Revolving Credit Agreement with
a group of banks. Under the terms of the credit agreement, the banks have
committed to provide up to $2 billion for up to 364 days. The credit
agreement contains restrictive covenants which require, among other things
that the Company maintain specified levels of consolidated stockholders'
equity and tangible net worth, as defined. The Company has been in
compliance with these covenants at all times. There were no borrowings
outstanding under this agreement as of November 30, 1995.
The Company's uncommitted lines of credit provide an additional source of
secured and unsecured short-term financings. At November 30, 1995, the
Company had $14.1 billion of uncommitted lines of credit compared to $12.5
billion at November 30, 1994. Uncommitted lines consist of facilities that
the Company has been advised are available but for which no contractual
lending obligations exists.
Total Capital
Long-term assets are financed with Total Capital.The Company maintains
Total Capital in excess of its long-term assets to provide additional
liquidity, which the Company uses to meet its short-term funding
requirements and to reduce its reliance on commercial paper and short-term
debt.
At November 30, 1995 the Company had $16.5 billion of Total Capital
compared to $14.7 billion at November 30, 1994. During 1995, the Company
issued $5.3 billion in long-term debt, compared to $3.9 billion for 1994.
The Company issued $1.4 billion in excess of its maturing debt to further
strengthen the Company's Total Capital base. In conjunction with the
Company's liquidity policies, the Company increased the average maturity of
its long-term debt portfolio. At November 30, 1995 the Company had
long-term debt outstanding of $12.8 billion with an average life of 3.7
years, compared with $11.3 billion with an average life of 2.9 years at
November 30, 1994. Moreover, for debt with a maturity of greater than one
year, the average life increased to 4.6 years at November 30, 1995 from 3.8
years at November 30, 1994.
The diversity of the Company's long-term funding sources and the expansion
of its investor base, has allowed the Company to increase its total
long-term debt and extend the average maturity, at spreads over treasuries
which were lower than issuing spreads in 1994, despite the downgrade of the
Company's credit ratings by Moody's Investors Service Inc.("Moody's").
At November 30, 1995 the Company had approximately $7.8 billion available
for issuance of debt securities under various shelf registrations and debt
programs.
The Company's stockholders' equity increased to $3.7 billion at November
30, 1995 from $3.4 billion at November 30, 1994 primarily due to the
retention of 1995 earnings and the recognition of common stock issuable
under the Company's stock award plans. (See Note 9 to the Consolidated
Financial Statements.) Over time the Company intends to either repurchase
shares in the open market or issue additional common stock or a combination
of both to fund common stock issuable under the Company's employee
incentive compensation programs.
Additionally, the Company closely monitors its primary double leverage
ratio. Primary double leverage, defined as Holdings' investment in
subsidiaries divided by Holdings' stockholders' equity, was 1.01 at
November 30, 1995, a continued decrease from 1.10 at November 30, 1994 and
2.06 at December 31, 1993.
At November 30, 1995 Lehman Brothers Inc.'s net capital, as defined by
regulatory authorities, aggregated $1.4 billion and was $1.3 billion in
excess of the minimum regulatory requirements. The Company is subject to
certain rules and regulations which limit the amount of capital which can
be withdrawn from regulated entities. As of November 30, 1995, the Company
is in compliance with all such regulatory capital requirements.
In 1996, the Company expects to maintain Total Capital at levels consistent
with the amount outstanding at November 30, 1995.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
In February 1996, the Company issued $200 million of Quarterly Income
Capital Securities Series A Subordinated Debentures ("Series A QUICS"). The
Series A QUICS have an interest rate of 8.3% and mature in 2035, subject to
early redemption by the Company on or after March 31, 2001. The Company
retains the right to defer interest payments on the Series A QUICS on one
or more occasions for a period of up to twenty consecutive quarters.
Interest payments may not be deferred beyond the maturity of the Series A
QUICS. The Series A QUICS are subordinated to all senior and subordinated
debt of the Company. The Company repurchased the $200 million 8.44%
Cumulative Preferred Stock owned by American Express with the proceeds from
the Series A QUICS. The repurchase of the preferred stock included a
premium of $2 million over the par value. In future periods, preferred
dividends will decrease by $16.9 million on an annual basis, with net
income available to common stockholders and cash flow increasing by
approximately $7 million on an annual basis, assuming a 40% effective tax
rate for interest paid on the Series A QUICS. Net income available to
common stockholders will decrease by approximately $1.7 million in the
first quarter of 1996 due to the premium paid on the repurchase of the
preferred stock net of the partial period savings realized on the issuance
of the Series A QUICS.
Dependence on Credit Ratings
The Company, like other companies in the securities industry, relies on
external sources to finance a significant portion of its day-to-day
operations. Access to global capital markets for short-term financing, such
as commercial paper and short-term debt, senior notes and subordinated
indebtedness are dependent on the Company's short- and long-term debt
ratings. The current short- and long-term senior debt ratings of Holdings
and the current short- and long-term senior and subordinated ratings of the
Company's principal subsidiary, Lehman Brothers Inc. ("LBI") are as
follows:
Holdings LBI
Short-term Long-term Short-term Long-term**
- -------------------------------------------------------------------------------------------
Duff & Phelps Credit Rating Co. D-1 A D-1 A/A-
Fitch Investors Service Inc. F-1 A F-1 A/A-
IBCA A1 A- A1 A/A-
Moody's P2 Baa1 P2 A3*/Baa1
S&P+ A-1 A A-1 A+*/A
Thomson BankWatch TBW-1 A- TBW-1 A/A-
* Provisional ratings on shelf registration
** Senior/subordinated
+ Long-term ratings outlook revised to negative on September 21, 1994
On March 21, 1995 Moody's lowered the ratings of Holdings and its
subsidiaries. The Company currently estimates that the Moody's action
increased interest expense before the effect of compensation and taxes by
approximately $15 million on an annual basis.
End User Activities
To achieve certain asset and liability management objectives as set forth
by ALCO, the Company utilizes a variety of derivative products as an end
user to modify the interest rate characteristics of its long-term debt
portfolio and to reduce borrowing costs (see Note 5 to the Consolidated
Financial Statements).
In addition, the Company also enters into interest rate swap agreements as
an end user to modify its interest rate exposure associated with its secured
financing activities, including securities purchased under agreements to
resell, securities borrowed, securities sold under agreements to repurchase and
securities loaned (see Note 16 to the Consolidated Financial Statements).
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LEHMAN BROTHERS 1995 ANNUAL REPORT
Stockholders' Equity
Stockholders' equity increased 9% to $3.7 billion at November 30, 1995 from
$3.4 billion at November 30, 1994 primarily due to the retention of 1995
earnings and the recognition of common stock issuable under the Company's
stock award plans. Such increases in equity were partially offset by dividends
declared on the Company's common and preferred stock.
In 1994, to broaden and increase the level of employee ownership in
Holdings, the Company's Compensation and Benefits Committee (the
"Compensation Committee") approved the 1994 Management Ownership Plan (the
"1994 Plan") pursuant to which it has awarded in 1995 and 1994
approximately 8.0 million and 5.2 million Restricted Stock Units ("RSUs"),
respectively, to employees as a portion of total compensation in lieu of
cash, subject to vesting and transfer restrictions. Included in the 1995
awards are Performance Stock Units ("PSUs") granted by the Compensation
Committee to members of the Corporate Management Committee as part of a
three year long-term incentive award. The number of PSUs which may be
earned, if any, is dependent upon the achievement of certain performance
levels within a two-year period. At the end of the performance period, any
PSUs earned will convert one-for-one to RSUs which then vest at the end of
the third year. Stockholders' equity increased by approximately $124
million and $87 million in 1995 and 1994, respectively, as a result of RSUs
and PSUs awarded, net of cancellations.Holdings will meet the share
requirements for the 1994 Plan and other common stock based compensation
and benefit plans by either repurchasing shares in the open market or
issuing additional common stock or a combination of both.
Cash Flows
Cash and cash equivalents decreased $90 million in 1995 to $874 million, as
the net cash used in financing and investing activities exceeded the net
cash provided by operating activities. Net cash provided by operating
activities of $1,855 million included income from continuing operations
adjusted for non-cash items of approximately $439 million for 1995. Net
cash used in financing and investing activities was $1,893 million and $52
million, respectively.
Cash and cash equivalents decreased $369 million in 1994 to $964 million,
as the net cash used in operating and investing activities exceeded the net
cash provided by financing activities. Net cash used in operating
activities of $1,395 million included income from continuing operations
adjusted for non-cash items of approximately $639 million for 1994. Net
cash provided by financing activities was $1,202 million and net cash used
in investing activities was $176 million.
Cash and cash equivalents increased $692 million in 1993 to $1,333 million,
as the net cash provided by investing activities exceeded the net cash used
in operating and financing activities. In addition, cash and cash equivalents
for discontinued operations increased $42 million in 1993. Net cash used in
operating activities of $1,361 million included the loss from continuing
operations adjusted for non-cash items of approximately $651 million for
1993. Net cash used in financing activities was $372 million in 1993. Net cash
provided by investing activities of $2,467 million in 1993 included cash
proceeds from the sales of The Boston Company, Shearson and SLHMC of $2,570
million.
Off-Balance Sheet Financial Instruments and Derivatives
Overview
Derivatives are financial instruments, which include swaps, options,
futures and forwards whose value is based upon an underlying asset (e.g.,
treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). A
derivative contract may be traded on an exchange or negotiated in the
over-the-counter markets. Exchange-traded derivatives are standardized and
include futures, and certain option contracts listed on an exchange.
Over-the-counter ("OTC") derivative contracts are individually negotiated
between contracting parties and include forwards, swaps and certain
options, including caps, collars and floors. The use of derivative
financial instruments has expanded significantly over the past decade.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
One reason for this expansion is that derivatives provide a cost effective
alternative for managing market risk. In this regard, derivative contracts
provide a reduced funding alternative for managing market risk since
derivatives are based upon notional values, which are generally not
exchanged, but rather are used merely as a basis for exchanging cash flows
during the duration of the contract. Derivatives are also utilized
extensively as highly effective tools that enable users to adjust risk
profiles, such as interest rate, currency, or other market risks, or to
take proprietary trading positions, since OTC derivative instruments can be
tailored to meet individual client needs. Additionally, derivatives provide
users with access to market risk management tools which are often times
unavailable in traditional cash instruments.
Derivatives are subject to various risks similar to non-derivative
financial instruments including market, credit and operational risk. The
risks of derivatives should not be viewed in isolation but rather should be
considered on an aggregate basis along with the Company's other
trading-related activities. A brief description of these risks is included
below.
Market Risk Market risk is the potential for a financial loss due to
changes in the value of derivative financial instruments due to market
changes. Market risk includes interest rate risk, foreign exchange risk,
equity price risk and commodity price risk. Market risk is affected by
both the absolute levels and volatility of interest and foreign exchange
rates and equity and commodity prices. Market risk is also directly
impacted by the size, diversification and duration of positions held, and
the liquidity in the markets in which the related underlying assets are
traded.
Credit Risk Credit risk is the possibility that a loss may occur from the
failure of a counterparty to perform according to the terms of a
contract. Credit risk is a significant factor in the evaluation of OTC
derivatives. Credit risk considerations for OTC derivative instruments
include assessing the credit quality of the counterparty, length of time
to the maturity of the derivative contract, collateral arrangements and
the existence of a master netting agreement. At any point in time, the
credit risk for OTC derivative contracts is limited to the net unrealized
gain for each counterparty for which a master netting agreement exists,
net of collateral received. Exchange clearing houses require margin to be
posted on exchange-traded contracts on the origination of the contract
and for any changes in the market value of open contracts on a daily
basis (certain foreign exchanges extend settlement to three days). Due to
the daily settlement of variation margin, credit risk related to
exchange-traded contracts is limited to unsettled variation and original
margin outstanding.
Operational Risk Operational risk is the possibility of a deficiency in
systems for executing derivative transactions. Such risks include the
potential for liabilities resulting from one's role in the execution of a
derivative transaction in which there was a breakdown in information
transfer or settlement systems.
In addition to these risks, counterparties to derivative financial
instruments may also be exposed to legal risks related to its derivative
activities including the possibility that a transaction may be
unenforceable under applicable law. The Company may be exposed to the
risk that a derivative transaction may not be enforceable against the
counterparty. The Company mitigates this risk through a process of
carefully reviewing derivative transactions with the counterparties to
ensure that they fully understand the economic and legal consequences of
entering into a derivative products transaction. In addition, the Company
performs its own legal due diligence to ensure that the counterparty has
the legal capacity to enter into the derivative product transaction and
that the transaction is appropriately documented.
As derivative products have continued to expand in volume, so has market
participation and competition. As a result, additional liquidity has been
added into the markets for conventional derivative products, such as
interest rate swaps. Competition has also contributed to the development of
more complex products structured for specific clients. It is this rapid
growth and complexity of certain derivative products which has led to the
perception, by some, that derivative products are unduly risky to users and
the financial markets. In order to remove the public perception that
derivatives may be unduly risky and to ensure ongoing liquidity of
derivatives in the marketplace, the Company supports the efforts of the
regulators in striving for enhanced risk management disclosures which
consider the effects of both derivative products and cash instruments. In
addition, the Company supports the activities of regulators which are
designed to ensure
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LEHMAN BROTHERS 1995 ANNUAL REPORT
that users of derivatives are fully aware of the nature of risks inherent
within derivative transactions. As evidence of this support, the Company,
through its participation as a member of the Derivatives Policy Group,
provided leadership in the development of a framework for voluntary
industry self regulation of derivatives. The Company has also been actively
involved with the various regulatory and accounting authorities in the
development of additional enhanced reporting requirements related to
derivatives. The Company strongly believes that derivatives provide
significant value to the financial markets and is committed to providing
its clients with innovative products to meet their financial needs.
Lehman Brothers' Use of Derivative Instruments
In the normal course of business, the Company enters into derivative
transactions both in a trading capacity and as an end user. As an end user,
the Company utilizes derivative products to adjust the interest rate nature
of its funding sources from fixed to floating interest rates and vice
versa, and to change the index upon which floating interest rates are based
(i.e., Prime to LIBOR) (collectively, "End User Derivative Activities").
For a further discussion of the Company's End User Derivative Activities
see Note 16 to the Consolidated Financial Statements.
The Company utilizes derivative products in a trading capacity both as a
dealer to satisfy the financial needs of its clients and in each of its
trading businesses (collectively, "Trading Related Derivative Activities").
The Company's use of derivative products in its trading businesses is
combined with cash instruments to fully execute various trading strategies.
As a dealer, the Company conducts its activities in fixed income derivative
products through its special purpose subsidiary, Lehman Brothers Special
Financing Inc., and a separately capitalized triple-A rated subsidiary,
Lehman Brothers Financial Products Inc. As a dealer of interest rate swap
products, the Company enters into derivative transactions to satisfy the
financial needs of its clients who wish to modify the nature of their
interest rate risk based upon existing positions or speculate on the
direction or volatility of interest rates. These fixed income derivative
products include swaps (interest and currency), interest rate option
contracts (caps, collars, and floors), swap options and similar
instruments. In addition, the Company also takes proprietary positions to
profit from market movements based upon the Company's expectations
regarding the level and volatility of interest rates. The counterparties to
the Company's fixed income derivative products business are primarily other
swap dealers, commercial banks, insurance companies, corporations and other
financial institutions.
The Company conducts its equity derivative products business primarily
through its special purpose equity derivatives subsidiary, Lehman Brothers
Finance S.A. ("LBF"). LBF enters into OTC equity option contracts,
warrants, equity swaps and other sophisticated equity derivatives as a
dealer in equity derivatives and through the Company with respect to
exchange-traded derivatives. As a dealer and position taker in equity
derivatives in the global equity markets, the Company is exposed to risks
related to the absolute levels and volatility of equity security/index
prices. The counterparties to the Company's equity derivative products
business are primarily other investment banks, brokers and dealers,
commercial banks, investment funds, and other corporations.
In addition to these businesses, the Company also enters into derivative
transactions in its role as a global investment bank. The Company is a
market-maker in a number of foreign currencies. As a market-maker, the
Company actively trades currencies in the OTC spot, forward and futures
markets and also takes positions in the currency markets in which the
Company seeks to profit from pricing inconsistencies in the spot, forward
and futures currency markets. The Company also makes a market in foreign
currency options and offers clients currency swaps as a means to hedge or
speculate in the currency markets on a longer-term basis. The significant
majority of the Company's foreign exchange transactions are conducted in
major foreign currencies, including: Canadian dollar, Deutsche mark, French
franc, British pound sterling, Swiss franc and the Japanese yen. The
Company also transacts in a broad range of other foreign currencies,
including the currencies of emerging market countries. The counterparties
to the Company's OTC foreign exchange transactions primarily include
central banks, commercial banks, other investment banks, brokers and
dealers and other corporations.
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As a global investment bank the Company also actively trades in the global
commodity markets. The Company is a market-maker in physical metals (base
and precious) and energy products (principally oil and natural gas) and is
active in trading a variety of derivatives related to these commodities,
such as futures, forwards and exchange and OTC options. The counterparties
to the Company's commodity derivative transactions primarily include energy
and precious metal producers, consumers and refiners, central banks and
shipping companies.
The Company manages the risks associated with derivatives on an aggregate
basis along with the risks associated with its proprietary trading and
market-making activities in cash instruments as part of its firmwide risk
management policies. For a further discussion of the Company's risk
management policies refer to Management's Discussion and Analysis page 51.
The Company's Trading-Related Derivative Activities have increased during
the current year to a notional value of $1,209 billion at November 30, 1995
from $1,104 billion at November 30, 1994 primarily as a result of growth in
the Company's activities as a dealer in fixed income and equity derivative
products. Notional values are not recorded on the balance sheet and are not
indicative of potential risk, but rather they provide a measure of the
Company's involvement with such instruments.
As a result of the Company's Trading-Related Derivative Activities, the
Company is subject to credit risk. With respect to OTC derivative
contracts, the Company's credit exposure is directly with its
counterparties and extends through the duration of the derivative
contracts. The Company views its net credit exposure to be $3,732 million
at November 30, 1995, representing the fair value of the Company's OTC
contracts in an unrealized gain position, after consideration of
collateral. Collateral held related to OTC contracts generally includes
cash and U.S. government and federal agency securities. At November 30,
1995 approximately 81% of the Company's net credit risk exposure related to
OTC contracts was with counterparties rated single-A or better.
Additionally, the Company is exposed to credit risk related to its
exchange-traded derivative contracts. Exchange-traded derivative contracts
include futures contracts and certain options. Futures contracts and
options on futures are transacted on the respective exchange. The exchange
clearing house is a counterparty to the futures contracts and options. As a
clearing member firm, the Company is required by the exchange clearing
house to deposit cash or other securities as collateral for its obligation
upon the origination of the contract and for any daily changes in the
market value of open futures contracts. Unlike OTC derivatives which
involve numerous counterparties, the number of counterparties from
exchange-traded derivatives include only those exchange clearing houses of
which the Company is a clearing member firm or utilizes other member firms
as agents. Substantially all of the Company's exchange-traded derivatives
are transacted on exchanges of which the Company is a clearing member firm.
To protect against the potential for a default, all exchange clearing
houses impose net capital requirements for their membership. Therefore, the
potential for losses from exchange-traded products is limited. As of
November 30, 1995, the Company had approximately $898 million on deposit
with futures exchanges consisting of cash and securities (customer and
proprietary), and had posted approximately $250 million of letters of
credit. Included within this amount was $94 million and $804 million of
cash and securities related to domestic and foreign futures exchanges,
respectively, and $152 million and $98 million of letters of credit to
domestic and foreign exchanges, respectively. As of November 30, 1995, the
following cash and securities were on deposit with foreign futures
exchanges: $346 million with the Tokyo Stock Exchange, $104 million with
the Singapore International Monetary Exchange, $102 million with the Osaka
Securities Exchange, $102 million with Deutsche Termin Borse, and $48
million with the London Clearing House. In addition, the Company had
letters of credit of approximately $90 million on deposit with the London
Clearing House.
See Note 16 to the Consolidated Financial Statements for a further
discussion of the Company's Trading-Related Derivative Activities.
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LEHMAN BROTHERS 1995 ANNUAL REPORT
Specific Business Activities and Transactions
The following sections include information on specific business activities
of the Company which affect overall liquidity and capital resources:
High Yield Securities
The Company underwrites, trades, invests and makes markets in high yield
corporate debt securities. The Company also syndicates, trades and invests
in loans to below investment grade companies. For purposes of this
discussion, high yield debt securities are defined as securities or loans
to companies rated as BB+ or lower, or equivalent ratings by recognized
credit rating agencies, as well as non-rated securities or loans which, in
the opinion of management, are non-investment grade. Non-investment grade
securities generally involve greater risks than investment grade securities
due to the issuer's creditworthiness and the liquidity of the market for
such securities. In addition, these issuers have higher levels of
indebtedness, resulting in an increased sensitivity to adverse economic
conditions. The Company recognizes these risks and aims to reduce market
and credit risk through the diversification of its products and
counterparties. High yield debt securities are carried at market value and
unrealized gains or losses for these securities are reflected in the
Company's consolidated statement of operations. The Company's portfolio of
such securities at November 30, 1995 and 1994 included long positions with
an aggregate market value of approximately $1.2 billion and $1.1 billion,
respectively, and short positions with an aggregate market value of
approximately $172 million and $94 million, respectively. The portfolio
may, from time to time, contain concentrated holdings of selected issues.
The Company's largest high yield position was $73 million at November 30,
1995 and $252 million at November 30, 1994.
Westinghouse
In May 1993, the Company and Westinghouse Electric Corporation
("Westinghouse") entered into a partnership to facilitate the disposition
of Westinghouse's commercial real estate portfolio, valued at approximately
$1.1 billion, to be accomplished substantially through securitizations,
asset sales and mortgage remittances. The Company's original investment in
the partnership was approximately $136 million. The Company also advanced
approximately $750 million of financing to the partnership in 1993, which
has subsequently been repaid in its entirety from proceeds related to the
disposition of the real estate assets. In August 1995, the Company agreed
to purchase the partnership interests owned by Westinghouse. The Company
also entered into an agreement to sell a portion of its partnership
interest to an affiliate of Lennar Inc., a third party mortgage servicer,
so that the Company and Lennar Inc. would own 75% and 25%, respectively, of
the partnership. The Company's net investment in the partnership at
November 30, 1995 is $142 million. As a result of its increased ownership
percentage, the Company's consolidated financial statements at November 30,
1995 include the accounts of the partnership. The partnership expects to
substantially liquidate the remaining real estate assets by the end of
1996.
Merchant Banking Partnerships
At November 30, 1995 the Company's investment in merchant banking
partnerships, for which the Company acts as a general partner, was $261
million. At November 30, 1995 the Company had no remaining commitments to
make investments through these partnerships. The Company's policy is to
carry its interests in merchant banking partnerships at fair value based
upon the Company's assessment of the underlying investments. The Company's
merchant banking investments, made primarily through a series of
partnerships are consistent with the terms of those partnerships and are
expected to be sold or otherwise monetized during the remaining term of the
partnerships. In December 1995, the Company established Capital Partners
III, its third employee investment vehicle. The Company has a commitment to
invest up to $200 million in the $225 million partnership previously
discussed.
Non-core Activities and Investments
In March 1990, the Company discontinued the origination of partnerships
(the assets of which are primarily real estate) and investments in real
estate. Currently, the Company acts as a general partner for approximately
$4 billion of partnership investment capital and manages the remaining real
estate investment portfolio. At November 30, 1995 the Company
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LEHMAN BROTHERS 1995 ANNUAL REPORT
had $45 million of investments in these real estate activities, as well as
$107 million of commitments and contingent liabilities under guarantees and
credit enhancements, both net of applicable reserves. In certain
circumstances, the Company provides financial and other support and
assistance to such investments to maintain investment values. There is no
contractual requirement that the Company continue to provide this support.
The Company also has equity, partnership and debt investments made in
previous years that are unrelated to its ongoing businesses. On November
16, 1995, American Marketing Industries Holdings Inc. ("AMI") repaid in
full its $98 million subordinated loan held by the Company. The Company has
other investments that are also awaiting their disposition or the
occurrence of certain events which will ultimately lead to their
liquidation. The Company carries these equity, partnership and debt
investments, at their estimated net realizable value, which approximates
$84 million at November 30, 1995.
Non-core activities and investments have declined 39% since November 30,
1994. Management's intention with regard to non-core assets is the prudent
liquidation of these investments as and when possible.
New Accounting Pronouncements
In October 1995, the Financial Accounting Standards Board issued SFAS No.
123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). SFAS No.
123 establishes financial accounting and reporting standards for
stock-based employee compensation plans. The financial accounting standards
of SFAS No. 123 permit companies to either continue accounting for stock-based
compensation under existing rules or adopt SFAS No. 123 and begin reflecting the
fair value of stock options and other forms of stock-based compensation in the
results of operations as additional expense. The disclosure requirements of SFAS
No. 123 require companies which elect not to record the fair value in the
statement of operations to provide pro forma disclosures of net income and
earnings per share in the notes to the consolidated financial statements as if
the fair value of stock-based compensation had been recorded. The disclosure
requirements of SFAS No. 123 are effective for financial statements for
fiscal years beginning after December 15, 1995. The Company will provide
the pro forma disclosures beginning with its 1996 Annual Report and will
continue accounting for such plans under the existing accounting rules.
During the first quarter of 1994, the Company adopted Financial Accounting
Standards Board Interpretation No. 39, "Offsetting of Amounts Related to
Certain Contracts" ("FIN No. 39"). FIN No. 39 restricts the historical
industry practice of offsetting certain receivables and payables. In
January 1995, the Financial Accounting Standards Board issued
Interpretation No. 41, "Offsetting of Amounts Related to Certain Repurchase
and Reverse Repurchase Agreements" ("FIN No. 41"). FIN No. 41 is a
modification to FIN No. 39, to permit certain limited exceptions to the
criteria established under FIN No. 39 for offsetting certain repurchase and
reverse repurchase agreements with the same counterparty. The Company has
adopted this modification, effective January 1995, which partially
mitigates the increase in the Company's gross assets and liabilities
resulting from the implementation of FIN No. 39.
Effective January 1, 1994, the Company adopted SFAS No. 112, "Employers'
Accounting for Postemployment Benefits." SFAS No. 112 requires the accrual
of obligations associated with services rendered to date for employee
benefits accumulated or vested for which payment is probable and can be
reasonably estimated. These benefits principally include the continuation
of salary, health care and life insurance costs for employees on service
disability leaves. The Company previously expensed the cost of these
benefits as they were incurred. The cumulative effect of adopting SFAS No.
112 reduced net income for the first quarter of 1994 by $13 million
aftertax ($23 million pretax). Excluding the cumulative effect of this
accounting change, the effect of this change on the 1994 results of
operations was not material.
Effects of Inflation
Because the Company's assets are, to a large extent, liquid in nature, they
are not significantly affected by inflation. However, the rate of inflation
affects the Company's expenses, such as employee compensation, office space
leasing costs
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LEHMAN BROTHERS 1995 ANNUAL REPORT
and communications charges, which may not be readily recoverable in the
price of services offered by the Company. To the extent inflation results
in rising interest rates and has other adverse effects upon the securities
markets, it may adversely affect the Company's financial position and
results of operations in certain businesses.
Risk Management
As a leading global investment company, risk is an inherent part of all of
Lehman Brothers' businesses and activities. The extent to which Lehman
Brothers properly and effectively identifies, assesses, monitors and
manages each of the various types of risks involved in its trading,
brokerage, and investment banking activities is critical to the success and
profitability of the Company. The principal types of risks involved in
Lehman Brothers' activities are market risk, credit or counterparty risk,
and transaction risk. Lehman Brothers has developed a control
infrastructure to monitor and manage each type of risk on a global basis
throughout the Company.
The Company aims to reduce risk through the diversification of its
products, counterparties and activities in geographic regions. The Company
accomplishes this objective through allocating the usage of capital to each
of its businesses, establishing trading limits for individual products and
traders, and the approval of credit limits for individual counterparties
including regional concentrations. In addition, the Company is committed to
employing qualified personnel with expertise in each of its various
businesses who are responsible for the establishment of risk management
policies and the continued review and evaluation of these policies in light
of changes in market conditions, counterparty credit status, and the long-
and short-term goals of the Company. Senior management plays a critical
role in the ongoing evaluation of risks, including credit, market,
operational and liquidity risks and makes necessary changes in risk
management policies in light of these factors.
The Company's risk management strategy is based on a multi-tier approach to
risk which includes many independent groups (i.e., risk management,
finance, legal, front office senior management, credit) being included in
the risk monitoring process. The Company's risk management department
independently reviews the Company's trading portfolios on a daily basis
from a market risk perspective which includes value at risk and other
quantitative and qualitative risk measurements and analyses. The risk
management department has full time professionals dedicated to each of our
trading and geographic areas.The Company's trade analysis department
performs independent verification of the prices of trading positions,
regularly monitors the aging of inventory, and performs daily review and
analysis of the Company's profitability, by business unit. The corporate
credit department, which has operations in New York, London, Frankfurt,
Tokyo and Hong Kong has the responsibility for establishing and monitoring
counterparty limits, structuring and approving specific transactions, and
establishing collateral requirements or other credit enhancement features
(such as financial covenants, guarantees or letters of credit), when deemed
necessary, to secure the Company's position. The Company's Commitment
Committee has the responsibility for reviewing and approving proposed
transactions involving the underwriting or placement of securities by
Lehman Brothers, while the Investment Committee performs a similar function
in reviewing and approving proposed transactions related to investments of
capital in connection with the Company's investment banking and merchant
banking activities. Additionally, the Company employs an internal audit
department that reports directly to the Company's Audit Committee and the
Board of Directors. This group performs periodic reviews to evaluate
compliance with established control processes. These reviews include
performing tests on the accuracy of inventory prices, compliance with
established credit and trading limits, and compliance with securities and
other laws. The Company's control structure and various control mechanisms
are also subject to periodic reviews as a result of examinations by the
Company's external auditors as well as various regulatory authorities.
The Company seeks to ensure that it achieves adequate returns from each of
its business units commensurate with the risks assumed. To achieve this
objective, the Company periodically re-allocates capital to each of its
businesses based upon their ability to obtain returns consistent with
established guidelines as well as perceived opportunities in the
marketplace and the Company's long-term strategy.
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