- Global growth assumptions underpin view on investment banking activity going forward. The company expects announced M&A bonds to finish the year up 15% to 20% versus 2006, with strategic buyers who currently comprise 75% of M&A, accounting for a larger proportion of overall deal volume, and stock to become a more prominent consideration in transactions.
- Given the changes seen in cross currency rates and the current trade imbalances, the company expects cross border M&A and international activity to increase. Higher equity market volatility will most likely cause equity issuance to be down for the remainder of the year. However, the company expects a strong level of offerings from the financial, tech, energy and industrial sectors over the coming months, and it still expect fixed income origination to grow to over $10 trillion for the year 2007, with increased activity from non-U.S. borrowers more than offsetting a decline in mortgage securitizations.

- Despite credit spread widening, absolute rates for high grade borrowers have changed due to rallies in government bonds. The company is seeing large numbers of borrowers terming out commercial paper, given the shape of the credit curve, and various parts of the structured bond market have reopened recently, as it has successfully executed a limited number of transactions in NBS, CNBS, and CLOs over this difficult period.
- In the equity capital markets, the company has witnessed mostly positive performance in the month of August and total returns year-to-date running at 4.5%. The company expects a full year return of about 10% in local currency turns in equities, while projecting corporate earnings to increase 9% in 2007.


- Fixed income capital markets will continue to face some uncertainties over the near term. Issues in the asset-backed commercial paper market still remain to be resolved, as programs are unwound, re-equitized, or funded in the term market, although recent information indicates some improvement in the short-term market.
- The same is true in a number of other structured products. Investor confidence needs to be further restored and investors are looking to central bank policy to provide them with more conviction. However, fixed income investors cannot stay on a buying strike for extended periods of time, due to the inherent cash accumulation and portfolios from regular coupon payments and maturities. By estimate, approximately $2.6 trillion of cash globally is coming due to investors through year-end from interest payments and redemptions.
- Since cash carries zero duration, this automatically shortens an investor’s average interest rate sensitivity at a time when most investors want to be long duration.
- Yields on broad classes of fixed income securities have now become attractive. The company is beginning to see more activity in leverage financed loans, and it is seeing the formation of a number of new investment pools to take advantage of pricing dislocations in various fixed income asset classes.
- Customer activity continues to be high, with significant portfolio reallocations and rebalancings occurring to take advantage of the significant opportunities that now exist. In general, higher volatility is beneficial for a number of businesses, particularly fixed income and equity derivatives.
- In addition, higher volatility, as well as wider spreads, provides more profitable training opportunities in the secondary markets, and given the strength of customer franchise, the company expects capital markets revenue base to benefit from this trading opportunity going forward.

Key questions from the third quarter earnings call conducted by Lehman Brothers Holdings Inc. on September 18, 2007.

William Tanona (Goldman Sachs): What were the leverage loan commitments and what were the mortgage-backed security hits, on both a gross and a net basis?

Chris O’Meara: They are big on both sides, the hedging programs as these instruments move, the hedging that is employed, the dynamic hedging strategies, particularly around the mortgage business, which is a business we have always had a full set of hedges on, will move with it. Knowing the gross numbers particularly in that business, we do not think is a meaningful thing. On the leverage loan side, we did take significant hits as we have mentioned, and we sized that by saying they were in excess of a $1 billion, and not a small amount in excess of a $1 billion. Not $50 million or $100 million more, but we do not want to give the details of it. It may put us in a position where some investors might try to figure out what those marks are, and we do not want that. We want to competitively keep that to ourselves but they were significant and we are marked at the current market.

William Tanona (Goldman Sachs): What have you seen thus far in the first couple of weeks in September across all of your businesses?

Chris O’Meara: It is early, and we do not give guidance on future periods but the worst of this credit correction is behind us.

William Tanona (Goldman Sachs): You made the adjustments for the 700 net marks in the FIC business but it still look like it was down sequentially. Your commentary sounded like commodities had stronger quarter-over-quarter rates, and foreign exchange was also stronger quarter-over-quarter. Were the underlying businesses in both just credit and mortgages down on a sequential basis?

Chris O’Meara: The liquid markets business includes rates and foreign exchange. The foreign exchange business was strong, but it is a relatively smaller business for us, and the commodities business which is largely the energy business for us, is a relatively new business for us, so it is working off a small base and growing. Those two businesses do not carry a lot of relative weight in terms of their size contribution to the revenue base, so they will not drive the results, but they are showing good signs of growth. On the other side, the mortgage business on the origination side continues to be underchallenged, the securitization levels were lower, and the revenue spreads that we have been making off those are lower as well, so that running rate continues to be relatively low by historical standards. The reality is it has been in the second quarter FIC was low as well. On that estimate of the $700 million impact net of all of the different valuation items, tells the story about what the difference is there versus the normal running.

William Tanona (Goldman Sachs): Was credit down more on a sequential basis than mortgages were?

Chris O’Meara: Yes.

Guy Moszkowski (Merrill Lynch): If spreads were not to widen any further on the LBO types of assets, you would then not expect that you would have any further declines in those commitments, is that correct?

Chris O’Meara: That is correct.

Guy Moszkowski (Merrill Lynch): You have marked all of the commitments, even if they were deals that were not going to fund until well in the fourth quarter. Is that correct?

Chris O’Meara: That is correct.

Guy Moszkowski (Merrill Lynch): Mortgage inventory was the bulk of the marks taken to the mortgage portfolio within the net $700 million applied to the $11 billion securitization residuals including the non-investment grade stuff. Is that correct?

Chris O’Meara: Yes, but the marks, there was credit spread widening across all assets. The bulk of it was to the lower-rated instruments.

Guy Moszkowski (Merrill Lynch): Can you give an idea of the percentage of the net writedown of $700 million that was in the U.S. versus international?

Chris O’Meara: Most of it was in the U.S. Percentage-wise.

Guy Moszkowski (Merrill Lynch): Your leverage increased both gross and net sequential quarters. Is it fair to assume that part of that was because you had to book some assets that you would not normally have wanted to book, but were a result of commitments?

Chris O’Meara: It is a small amount of that, so the amount that we have on our books from the commitments that were here at the end of the second quarter that have channeled through the system, we own about $4 billion of funded positions from that $44 billion that we had on at the end. The commitments, what formerly were commitments, many of them were funded, sold into the market, many of them fell away because we were paired up with other financiers and we had booked the commitment in at 100%, but we wound up being 25% in the end. $4 billion of that, of the amount of that reduction came on to our books as funded positions.

Guy Moszkowski (Merrill Lynch): Commercial paper facilities and things like that might have dumped some assets on to your books. Did any of that happen?

Chris O’Meara: No. Our involvement in that commercial paper and the asset-backed commercial paper market is one of a dealer remarketing agent to the world, not as a principal, and so we have had little that we have positioned in our books.

Guy Moszkowski (Merrill Lynch): If you backed out the $4 billion that was an involuntary asset growth, you would not see a net deleveraging of your balance sheet in the quarter. Is that correct?

Chris O’Meara: There is no deleveraging. What you might see is that the mortgage positions are up as we have continued to originate, albeit at a slower pace, and we are originating and the securitization levels are down, so we have not securitized everything that we have originated, just given where the market is. We have built up some although it is not a real significant amount; we have built up some whole loans that are going to be delayed in securitization given the market conditions.

Guy Moszkowski (Merrill Lynch): You expected that the securitization markets and the structured product markets would be subdued and the core profitability of some of those types of businesses has been high. In the scenario that you are currently contemplating some of that stuff is weaker but some of your commodities and other buildouts are going to help offset that. Is it wise for you to expect that your Fixed Income business can produce similar margins to what it had been over the four quarters and do you expect that margins would be weaker?

Chris O’Meara: There will be a slower level of origination, but there are different opportunities that present themselves in this type of dislocated market, and there are trading opportunities, so the revenue generation will be less about new issue origination and more about working with investors about restructuring their portfolios and trying to transition out of those structured products, and working with them in the secondary trading market. There are opportunities there that will fill in part of the revenue slowdown that we would expect on the new issue side. There are lots of different businesses that are inside this Fixed Income series of businesses, and we are encouraged by seeing the benefits that we derive. The securitized products are an important element of what is in there, but they have been performing in a lower in the last couple of quarters. Other businesses have grown up into filling in that space, and we would not expect a significant fall-off on balance across these different asset categories.