Lehman Brothers (LEHMQ)

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Lehman Brothers (NYSE: LEH) was, until its Chapter 11 bankruptcy filing on September, 15, 2008, the fourth-largest securities firm in the U.S. and a leading provider of financial products that let companies package and re-sell risk. Lehman has a particularly strong history in fixed-income, which is a broad term for any investment that yields a regular (fixed) return. In recent years, the firm has recognized its heavy reliance on fixed income as a source of revenue and has moved to diversify into other areas of finance such as investment banking and investment and asset management.

Until the 2007 collapse of the U.S. subprime mortgage industry and resulting credit crisis, Lehman generated a significant portion of its revenue through the issuance of mortgage-backed and asset-backed securities. When mortgage default rates began to rise and the demand for these securities began to disappear, Lehman was left with billions of dollars of rapidly depreciating securities on its balance sheet, forcing it to take large write downs and write-offs. Eventually, the company's efforts to shed risky assets proved unsuccessful, and investors sold off shares of Lehman in the fear that it wouldn't have enough capital to continue business as usual.

On September 2, the state-owned Korean Development Bank confirmed that it was in talks to buy up to a 25% stake in Lehman, though the deal eventually fell through.[1] The following weekend, Lehman put itself up for sale, and the U.S. Federal Reserve called an emergency meeting of Wall Street executives to aide in the sale. The two main bidders, Bank of America (BAC) and Barclays (BCS), dropped out on Sunday after the federal government refused to absorb Lehman's future losses with taxpayer dollars. Left with no potential buyers, Lehman's board of directors decided to file for Chapter 11 bankruptcy protection on the morning of Monday, September 15, ending the firm's 158-year history and claiming the title of the largest bankruptcy filing on record.[2]

History and Business Overview

Lehman Brothers was founded in 1850 as a commodities trading business by three brothers . As the company continued to grow throughout the 20th century, it expanded into several different areas of the financial services sector. In 1977, Lehman Brothers merged with Kuhn, Loeb & Co., an investment bank, and continued its successful growth in the financial services industry for several more years. A power struggle ensued in the early 1980's between the firm's traders and investment bankers, which caused many key personnel to leave the company. In 1984, American Express Company (AXP) acquired the struggling company for $360 million. Later, in the early 1990's, American Express decided to get out of the investment banking business and spun off the former Lehman Brothers Kuhn Loeb operations in an initial public offering.

Annual income data, in millions[3] FY2003 FY2004 FY2005 FY2006 FY2007 6M2008
Total Revenue$17,287$21,250$32,420$46,709$59,003$18,610
Interest Expense$8,640$9,674$17,790$29,126$39,746$15,771
Net Revenue $8,647 $11,576 $14,630 $17,583 $19,257 $2,839
Other Operating Expenses $6,111 $8,058 $9,801 $11,678 $13,244 $6,263
Operating Income $2,536 $3,518 $4,829 $5,905 $6,013-$3,434
Net Income $1,771 $2,393 $3,260 $4,007 $4,192 -$2,408

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M&A completed in the first 9 months of 2007

Investment Banking

Lehman's investment banking operations accounted for just 20% of the company's 2007 revenue. Nevertheless, this department is seen as an increasingly important factor in Lehman's future growth plans. Investment banking is split into two key areas: Mergers and Acquisitions (M&A), or advising companies on how to buy or combine with other firms, and Corporate Finance, which includes advising companies on IPO's, debt and capital restructuring, etc. Over the past several years, Lehman has been able to expand its revenue from equity underwriting (guarantees that Lehman gives to clients that ensure investors will be found to buy newly issued stock) and M&A advisory businesses (more profitable areas of investment banking), while continuing to provide many fixed income banking services such as issuing corporate and government bonds for companies (fixed income underwriting).

Fixed income underwriting activities have accounted for 45% of Lehman's investment banking revenues over the past several years. As long as fixed income products continue to play a large role in the capital markets division, it is likely that fixed income underwriting will remain important to Lehman's investment banking business .

Capital Markets

The Capital Markets division consists of the sales, trading, and research divisions within an investment bank. Equity research involves the study of companies or industries in order to produce research that aids institutional investors in making investment decisions. Lehman makes most of its money within capital markets by charging its clients fees for access to its research or for buying and selling investment securities on their behalf. Lehman's clients in this division are usually institutional investors, such as pension or hedge fund managers, insurance companies, and other entities with large amounts of capital to invest.

Fixed Income

Over the last 8 years, roughly 40% of Lehman's net revenues have come from fixed income sales and trading. Some of the different fixed income investments that Lehman deals with include derivatives and swaps, which allow investors to enter into agreements to exchange money, assets, or some other object of value, at a future date in order to minimize their risk; mortgage-backed securities (MBS), which allow banks to sell off the rights to the income from home mortgages and thus reduce the bank's exposure to the risk of mortgage defaults; and futures, which smooth out price fluctuations for commodities like oil and natural gas by allowing producers or purchasers to lock in a future price today. Lehman Brothers generates most of its income through its sales and trading division, which acts as an intermediary between the entities that supply the mortgages, bonds, etc., that make up these fixed income investment products and the investors who buy them. Lehman salesmen work with traders to find clients (institutional investors) who are willing to buy derivatives, futures, swaps, MBS, and other financial products.

Key areas for Lehman in the fixed income sales and trading division are:

  • Mortgage-backed security business: Lehman buys mortgages from originators such as banks and subprime lenders. The firm then packages these mortgages and sells investors the rights to the income stream that they produce; these are called a mortgage-backed securities. Investors will buy these securities to obtain either a high, but risky, income stream or a low, but relatively safe, income stream. The main risk with these types of instruments is that the borrowers who hold the loans might default. A substantial portion of Lehman's Mortgage backed securities are backed by subprime loans, which are more likely to enter default than ordinary mortgages. This is particularly relevant in light of the currently unfolding collapse of the subprime mortgage industry.
  • Derivatives & structured products: This segment includes a variety of financial instruments in which participants agree to exchange an underlying asset at some future date, usually at a fixed price. Examples of derivatives include options, futures, and swaps.
  • Energy and commodities: Lehman just opened its energy trading business in September 2005 and is looking to generate revenues from this area in the coming years.

Investment Management

The investment management business provides a stable earning base because its fee-based structure generates revenues based on assets under management rather than the total number of transactions. In other words, Lehman will still generate relatively steady revenues even if there are substantially fewer total transactions, as long as its total assets under management don't decrease significantly. This is viewed as a huge plus for Lehman because it offsets some of the instability that comes with being heavily reliant on the capital markets division.

In 2003, Lehman acquired the fixed-income asset management business of Lincoln Capital Management and the asset management company Neuberger Berman. With the two acquisitions, Lehman raised its investment management revenues to be inline with the percentage of total revenues that other large domestic investment banks generate from their investment management divisions.

Lehman's investment management division is composed of two business segments: Asset Management and Private Investment Management. Asset Management includes revenues from fees that Lehman generates from its clients of the Neuberger Berman acquisition, as well as profits it makes from its own small private equity business, which is where Lehman invests in private companies on the behalf of its institutional investors. Private Investment Management includes revenues from fees that Lehman generates from high-net-worth clients.

Net Revenue by Division, in millions FY2007 FY2006 FY2005 FY2004
Capital Markets 12,257 12,006 9,807 7,694
% Total Revenue 64% 68% 67% 66%
Investment Banking 3,903 3,160 2,894 2,188
% Total Revenue 20% 18% 20% 19%
Investment Management 3,097 2,417 1,929 1,694
% Total Revenue 16% 14% 13% 15%
Source: Lehman Brothers Annual Report, 4Q2007 Earnings Release

Business Drivers

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Private Equity

Lehman derives approximately 30% of its investment banking revenues from advisory and underwriting services for private equity firms; investments in either private equity or hedge fund ventures are classified as alternative assets. For example, when a private equity fund decides to take one of its companies public, it must find an investment bank, like Lehman, who is willing to guarantee the company's stock will be sold. Because of the importance of private equity clients, any factor that affects the private equity industry will impact the performance of Lehman's highly profitable investment banking business. Many analysts have stated that the private equity industry is beginning to slow down because many of the attractive takeover targets have already been snatched up. Additionally, the contracting credit markets in late 2007 and into 2008 have decreased the availability of capital to fund private equity activities. If this this trend continues, Lehman's revenue from private equity services could fall considerably.

Subprime Lending

Subprime lending is the extension of credit to borrowers whose credit scores or incomes aren't sufficient to qualify for ordinary loans. Due to the inherently riskier nature of these loans, lenders usually charge subprime borrowers considerably higher interest rates as a way to compensate for the added risk. In the early 2000s, adjustable-rate mortgages, or ARMs, became very popular in the subprime industry. This type of mortgage, rather than having a fixed interest rate, has a variable rate that changes along with current prevailing interest rates. While default rates for subprime loans remained relatively low through 2005, they have increased dramatically since then. The higher default rate has been driven in part by higher rising rates on adjustable-rate mortgages (and subsequently higher payments) and a cooling housing market.

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Interest rates over time

Lehman derives a substantial portion of its revenue from the sale of mortgage-backed and asset-backed securities. The defaults among subprime (and other) borrowers has led to the devaluation of many of these types of securities, which Lehman both sells and owns. If the rate of mortgage defaults continues to rise, the value of these securities will further decline, forcing additional write-downs on Lehman's balance sheet. Moreover, the company also lends money to subprime originators and has financial interests in several lenders themselves, further exposing Lehman to the subprime fallout.

Despite its exposure to the ailing subprime industry, Lehman has taken steps to manage its risks and limit losses. Despite very tough market conditions, Lehman reported earnings for the first quarter of fiscal 2008 that beat analysts' expectations significantly. Though income for the quarter was still down 57% from the previous year, many had expected an even steeper decline.[4]

Interest Rates

Interest rates can be thought of as the cost of borrowing money. Though the impact of interest rates spans across the economy, businesses and lenders are particularly sensitive to fluctuations in interest rates. As interest rates increase, businesses are less likely to issue debt or equity given that the price of borrowing has increased. Interest rates have, however, been fairly low since 2004, which has played a significant role in driving business activities. Additionally, since September, 2007, the Federal Reserve has cut its Federal Funds Rate from 5.25% to 2.25%, hoping to further stimulate business activity and ward off a housing slump-driven recession. Lehman has benefited from high levels of mergers and acquisitions, underwriting, and IPO activities over the last three years. Lower interest rates also benefit the housing market, as it becomes cheaper for people to borrow money to buy homes.

Hedge Funds

Lehman plans to expand its Prime Brokerage division over the next several years. This division provides services to hedge funds, or private investment funds. Prime Brokerage services may include providing research materials, trading services, computer services, etc. The recent growth of hedge funds has made this a key area of growth for investment banks, and Lehman wants to take advantage of its solid position in fixed income investments to attract more business from hedge funds.

Comparison to Competitors

Lehman Brothers is the fourth-largest of the domestic investment banks. While its revenues are only a fraction of those of its major competitors, it is actually more profitable than both Merrill Lynch (MER) and Morgan Stanley (MS). Because of its size, Lehman is much more focused in several key areas, the most important of which is its fixed income sales and trading business. Lehman derives more of its net revenues from fixed income sales and trading than any of its industry peers. Nevertheless, this reliance on capital markets has made Lehman into the best investment bank in trading efficiency (i.e., Trading Revenues/VaR), meaning the company generates more revenue per unit of risk taken than its competitors. This has been a strong contributor to the firms profitability in recent years.

2007 metrics Goldman Sachs Group (GS) Morgan Stanley Merrill Lynch Lehman Brothers Bear Stearns
Gross earnings ($B) 45.6 23.1 -
Pre-tax income ($M) 17,604 3,441 -12,831 6,013 193
1-yr revenue growth (%) 23 -9.7 N/A9.5-52
Equity origination revenue ($B) 1,382 1,570 1,6291,015N/A
M&A advisory revenue ($B) 4,222 2,541 1,740 1,337 828
Debt underwriting revenue ($B) 1,951 1,427 1,550 1,551 N/A
Note: Bear Stearns Companies (BSC) reported $529 million in revenue for all its underwriting activities but did not provide a breakdown of debt vs. equity underwriting in its Form 10-K.

While Lehman derives substantially more of its revenues from trading and securitization activities than its peers, it has made significant strides towards diversifying its business mix over the last four years. This was evident in its Q2 2007 results. Lehman's net income was up 27% despite a 14% subprime-inspired drop in its fixed income sales and trading division. While Lehman's investment banking practice is still much smaller than those of its peers, it is playing an increasingly significant role in providing Lehman with more consistent results.

Fixed Income Sales and Trading Revenues as % of Total Revenues (1998-2005) Trading as % of Net Assets Avg. Trading Efficiency
Lehman Brothers 40% 2.75% 60
Bear Stearns 35% 1.75% 50
Goldman Sachs 27% 2.00% 55
Morgan Stanley 20% 1.25% 35
Merrill Lynch 15% 1.9% 25


  1. Lehman drops to lowest level in more than a decade - CNNmoney.com
  2. Lehman Brothers files for Chapter 11 protection - Forbes
  3. Lehman Brothers Holdings Inc Financial Statements | Stocks | Reuters.com
  4. FT.com / Home UK / UK - Sigh of relief at Goldman and Lehman results
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