Within the residential mortgage, the sub-prime balance sheet exposure amounted to $5.3 billion, compared to $6.3 billion last quarter. This $5.3 billion sub-prime breakdown is as follows: $3.2 billion of home loans, $1.9 billion of investment grade securities, and about $160 million of non-investment grade securities and residuals. In addition, the firm had approximately $1 billion of ABS CDOs on the balance sheet at quarter-end. After consideration of hedges, the firm remained modestly net short in the ABS CDO asset class.

In commercial mortgages and CMBS, the bulk of this product is a floating rate, with an average term of two to three years. The CMBS component, the vast majority is AAA-rated. It is important to note that this is a regionally diversified portfolio with about half of the commercial mortgages in the US and the other half in Europe and Asia.

In terms of other exposures, the firm has largely mitigated its risks. The firm does not own or sponsor any SIVs. In the asset-backed commercial paper market, the company generally participates as an agent only. The net exposure to monolines after hedges and credit reserves is minimal. In terms of counterparty credit exposure, over 95% of the exposure is to investment grade entities.

Market Environment in the Fourth Quarter:

In the first part of the quarter, the company saw stabilization and then a recovery in both the corporate debt and the equity markets, underpinned by interest rate relief provided by the Fed. However, conditions reversed dramatically in November as the firm saw a major wave of risk aversion prompted by rating agency downgrades of certain structured products, asset repricing, leading to large write-downs, unresolved issues with SIVs, and dislocations in the interbank market. These factors resulted in higher risk premiums across the board and fundamental questions about the valuation of securities.

In Fixed Income, US credit spreads hit multiyear wides with investment grade spreads at their widest level since December 2002, and high yield spreads at their widest level since July 2003. As a result, November was the single worst month on record for US investment-grade corporates and asset-backed securities, tallying negative excess returns ranging from negative 300 to 338 basis points. This dramatic spread is widening, and it lead to Flight to Quality, as the two-year treasury rallied over a 100 basis points, and the yield curve steepened.

The equity markets followed a similar pattern rallying in the first half of the period. This was mainly in response to a larger than expected cut in interest rates, a general feeling that the credit crisis was behind, a sentiment that there would be a soft landing, and the DOW reaching a new all-time high. The sell-off in the later part of the quarter reflected weaker corporate earnings, renewed concerns about credit and the consumer, oil reaching all-time highs, and a further slowdown in housing. Volatility rose dramatically. In fact, it was the most volatile November for the S&P 500 since 1987.

In the Investment Banking, weaker valuations, higher credit spreads and increased volatility in the secondary markets also had a negative impact on underwriting activity. Industry-wide fixed income underwriting volumes fell 29% on a sequential basis. With slower financial sponsor activity, due to a large overhang of deals and weaker financing markets, the volume of announced M&A transactions declined 28%. Equity underwriting volumes dropped in the Americas and Europe, the markets most affected by the downdraft.

Performance Analysis of Segments

Investment Banking

The firm posted revenues of $831 million, down 3% year-over-year and down 22% from the sequential period, due to the weakening market climate. The pre-tax income for this segment was $207 million.

The M&A advisory revenues were $388 million, up significantly from the year ago period, but down somewhat from last quarter''s record levels. Nevertheless, this represents the second highest level of quarterly revenues ever for the M&A advisory business. For the quarter, the volume of completed M&A transactions totaled approximately $380 billion. Lehman Brothers advised on three of the top four deals completed in all of 2007. The firm’s global announced M&A market share rose to 17.3% year-to-date, versus 15.5% for full year 2006. The company’s completed M&A market share rose to 20.9% year-to-date, versus 15.8% for full year 2006, all in a calendar year basis. The company had strong share gains in this business overall.

In Equity Origination, the revenues were $210 million, down 6% year-over-year and a decrease of 29% from last quarter''s level. For the quarter, the volume of Equity Origination totaled approximately $4.6 billion, down significantly from last quarter''s level with convertibles accounting for a significant part of the decline. Despite a particularly difficult IPO market, where many transactions were pulled in the period, the firm’s IPO franchise realized particular success. For the quarter, the company ranked number one in US IPOs, and it had 13.8% market share as it completed transactions for Och-Ziff, DuPont Fabros and SandRidge Energy.

Fixed Income origination revenues were $233 million, down significantly from both benchmark periods. This was due to the weakness in the leverage loan and high yield markets as the credit spread hit their wide for the year. This deterred a number of high-grade and high-yield borrowers from accessing the markets. Despite these pressures, the firm ended the quarter on a positive note, leading the $6 billion preferred transaction for Freddie Mac.

Despite recent market conditions, the company continues to have momentum in the Investment Banking business. Although the aggregate fee backlog of over $800 million at year-end was lower than its peak during 2007, it is 7% higher than it was prior when it started 2007.

Capital Market Segment

The segment posted revenues of over $2.7 billion, down 10% year-over-year, but up 12% sequentially. This segment absorbed the bulk of the risk re-pricing witnessed over the period. The pre-tax income for this segment was $761 million.

In the Equities component of the Capital Market segment, the firm posted record revenues of approximately $1.9 billion, up significantly versus both benchmark periods, and reflecting the higher revenue run-rate achieved in this business all year. These gains reflect the broader customer franchise around the globe, where for the current quarter, the firm’s sales credit volumes were up by 66% versus the prior year''s period. As a result, the firm posted higher revenues year-over-year in its Execution Services business, driven by significant increases in European and Asian franchises.

Results in our Equity Derivatives business continued to be strong as market volatility remained at far higher levels, and the company tripled its results relative to the comparable 2006 period. In prime brokerage, the balances rebounded from third quarter levels, and given the relative stability of the firm’s franchise, it added 45 new clients over the period, bringing the total client base to 630 at year-end. The company’s principal trading strategies were also stronger versus both benchmark periods.

In the Fixed Income component of our Capital Market segment, the firm posted revenues of $860 million, down significantly from both benchmark periods. Compared to last quarter''s results, the variance was the result of a contingent that was broader in the current quarter, and compensated more asset classes in regional Europe as well as the US.
This impacted the firm’s business in three major ways. The company had negative marks on its Fixed Income inventory. In some instances, its risk mitigation strategies were less effective as correlations broke down, and it incurred a higher degree of basis risks. Heightened risk aversion was among investors, which caused them to shift their trading activity to higher quality and more liquid products, which tend to be less profitable for the firm.