–
Capital Markets: posted revenues of negative $2.4 billion, compared with $1.7 billion in the sequential period and $3.6 billion in the second quarter of last year as results were impacted by the mark-to-market adjustments.
- Capital markets’ client revenues were up 30% versus the first half of 2007.
- In the fixed income segment of capital markets, client revenues grew 40%, including growth of over 35% in each of our regions.
- Growth in the fixed income franchise was broad-based, especially in securitized products, municipal, commodities, foreign exchange, high grade credit, interest rates, and financing, which are all up significantly versus a year ago.
- Equity trading market share grew on most major global exchanges, including NASDAQ, where the trading share increased from 7.7% in 2007 to 8.5% year-to-date.
Significant Exposures:
- SunCal is one of the largest developers of master planned communities in the US and the firm’s exposure is primarily in Southern California and consists of 23 separate residential land development projects and one luxury high-rise residential development.
- These positions, approximately 90% of which were originated as senior debt, have an aggregate carrying value of $1.6 billion and are marked in the mid-70s.
- Excluding the high-rise and waterfront properties, the firm carries the properties at an average basis of $29,500 per residential lot, including the $20,000 per lot of the Inland Empire.
- The portfolio is marked to where an investor could achieve a 15% unlevered return over in excess of a five-year hold period.
The second large exposure is the Archstone, which owns a diversified portfolio of high-quality apartment assets, the underlying fundamentals of which continue to improve.
- The company has an extensive development platform and land inventory, which do not generate current cash flow but have substantial value and are often overlooked in evaluating its valuation.
- The development platform will deliver projects with over 5,000 units that will begin to contribute to revenue in fiscal 2008.
- The company’s completed asset portfolio was $328,000 per unit, which is at a significant discount to replacement costs of $390,000 per unit estimated by the company last year.
- Equity exposure in Archstone is currently carried at 75 for a value of less than $1.8 billion, after it took a mark on the equity position of $350 million this quarter.
- The company has sold $2 billion of assets and is under contract or in active negotiation on in excess of another $2 billion.
Risk Management and Capital:
- Period end value at risk at May 31st was $75 million on an un-weighted basis, a decline of 16% compared to an un-weighted VAR of $89 million at February 29th.
- To quantify this risk, if all mono-lines were to default entirely with zero recovery, losses on related positions would be $265 million.
- The firm ended the quarter with total stockholders’ equity of approximately $26 billion, up 6% from the first quarter level.
- Long-term capital rose to $154.5 billion from $153 billion and tier-one capital ratio under the Basel II like CSE regulatory framework will be over 10% at May 31st.
Liquidity Positions:
- Lehman’s increased the cash capital surplus to $15 billion from $7 billion at the end of the first quarter, and the liquidity pool to $45 billion from $34 billion.
- The firm has completed the funding plan for 2008, having issued all the long-term debt necessary to refinance current portions this year and do not expect to return to the market, with the exception of possible opportunistic pre-fundings for 2009.
- It had $47 billion of assets funded in the bank, up from $44 billion at both the end of the first quarter and year-end.
- The holding company liquidity position, which does not include liquidity at the regulated broker dealers and banks, nor the $4.5 billion in long-term committed unsecured bank facilities, is available to mitigate the liquidity impact of a severe stress event.
With respect to the secured funding position, total repo is $188 billion, of which match book and customer funding is between one-third and a half, with the remainder firm inventory.
- Of this amount, $83 billion is treasuries and agencies and the remaining $105 million is tri-party repo, of which $40 billion consists of central bank eligible collateral.
- Of the remaining $65 billion of repo, $25 billion is in investment grade, fixed income securities and major index equities, for which there exists a very active, reliable, and liquid repo market, and a further $8 billion of assets are funded within own banks.
- The average tenure of the non-central bank eligible tri-party repo is now over 40 days and any loss of repo capacity may be absorbed within the pools of liquidity available to the broker dealers, which represent more than 150% of the remaining repo.
Strategic Insights:
- The firm had the benefit of much greater price visibility due to the number of assets that were sold, especially in the commercial and residential mortgage area.
- This was the result of deleveraging and the strong trading volumes in the cash and then certain derivative markets that gave important additional valuation information.
- Lehman reduced gross assets by $147 billion over the quarter, which exceeded the targets set and also raised $10 billion of tangible equity since the beginning of the second quarter.
- Pro forma, it now has $33 billion of tangible equity, so is in a position today to support clients in these challenging markets.
For many years, the firm has built a set of businesses that are diversified by product and by region.
- It is the leading global capital market client franchise across both equities and fixed income, with client revenues up about 30% year over year.
- The investment banking franchise is growing fee share, most of that coming from increased market share and M&A and equity and equity-related and high-grade debt issuance.
- It also has a number of growth opportunities focusing on Asia broadly and the BRIC countries, and then globally in the equity flow businesses, rates and credit flow trading businesses, prime services and commodities and foreign exchange and private equity.
Key questions and answers from the second quarter earnings call conducted by Lehman Brothers Inc. (LEH) on June 16, 2008.
Meredith Whitney (Oppenheimer & Co.):
What steps are you going to take either on a revenue side or on a cost side to ensure a mid-teens ROE and what timetable are we looking at for that?
Ian T. Lowitt: If we maintain our leverage ratio in the low double-digits, we would have net assets of probably $400 billion to $410 billion. If you are looking at revenues to assets, you’d need between 4.7 and 4.9 in order to get you to the $4.9 billion to $5 billion of quarterly revenues.
Given the extra balance sheet that we have and historical levels of revenue to assets, you can see how you could get to $4.9 billion to $5 billion of quarterly revenues and then when you play that through the comp and NPE, a little bit below $1 billion and a 30% tax rate, that translates after the preferred payouts to a number that generates 15% ROE on our new common equity.
Glenn Schorr (UBS):
In terms of the actual sales that took place during the quarter in both the residential and commercial books, could you make any comment in terms of vintages sold versus your last disclosure at the conference in May?
Ian T. Lowitt: The sales were across sort of all asset classes, across all the types.
Glenn Schorr (UBS):
Comment on the ratings downgrade last month?
Ian T. Lowitt: Their focus is on the earnings power going forward. They are very comfortable with the capital.
Glenn Schorr (UBS):
Do you expect anything in terms of material changes from the regulatory standpoint?
Richard S. Fuld Jr.: If they are going to give the investment banks access to the window, I do believe they have the right for oversight. What that means though particularly as far as capital levels or asset requirements, way too early to tell.
Guy Moszkowski (Merrill Lynch):
The whole loan balance in Europe came down by about $1.4 billion and the securities balance rose by $1.2 billion, does that reflect some restructuring of whole loans into securitized assets to facilitate later sales?
