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Lehman Brothers Holding Inc. (LEH)

F3Q06 Earnings Conference Call

September 13, 2006 11:00 am ET

Executives

Shaun Butler - Director, IR

Chris O'Meara - CFO

Analysts

Bill Tanona - Goldman Sachs

Daniel Goldberg - Bear Stearns

Guy Moszkowski - Merrill Lynch

Glenn Schorr - UBS

Meredith Whitney - CIBC World Markets

Mike Mayo - Prudential Equity Group

Dick Bove - Punk, Ziegel

Michael Hecht - Banc of America

Presentation

Operator

Good morning and welcome to Lehman Brothers third quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Shaun Butler, Director of Investor Relations. Thank you, you may begin.

Shaun Butler

Good morning and thank you for joining us. Before we begin, let me point out that this presentation contains forward-looking statements. These statements are not guarantees of future performance. They only represent the firm's current expectations, estimates, and projections regarding future events. The firm's actual results and financial conditions may differ, perhaps materially, from the anticipated results and financial conditions of any such forward-looking statements.

These forward-looking statements are inherently subject to significant business, economic, and competitive uncertainties and contingencies, many of which are difficult to predict and beyond our control. For more information concerning the risks and other factors that could affect the firm's future results and financial conditions, see risk factors and management's discussion and analysis of financial conditions and results of operations in the firm's most recent annual report on Form 10-K and quarterly report on Form 10-Q as filed with the SEC.

This presentation contains certain non-GAAP financial measures. Information relating to these non-GAAP financial measures can be found under selective statistical information, reconciliation of average common stockholder's equity to average tangible common stockholders equity and growth leverage and net leverage calculations in this morning's earnings press release, which has been posted on the firm's website, www.lehman.com and filed with the SEC in Form 8-K, available at www.sec.gov. With that, let me now turn the remarks over to Chris O'Meara, our CFO.

Chris O’Meara

Hello, everyone, and thank you for joining our third quarter update. As you've seen in this morning's press release, we've reported another quarter of strong results. In fact, this was our best third quarter ever, and our third best quarter ever, which is notable given the more challenging environment we faced during the period. This also marked the third consecutive quarter that our revenues have exceeded $4 billion.

For the quarter, we achieved record revenues in Investment Management and in Europe, with solid performances across our other businesses and regions. Our increased breadth and scale, the broader diversification in our businesses, and continued strong productivity from our people all contributed to this strong performance.

Strong risk management practices also made an important contribution to the overall results as rapid shifts in market sentiment and reduced liquidity in certain asset classes combined to produce a trend-less, choppy market environment during the period.

In terms of the underlying market conditions, financial institutions faced a number of challenges over the period. In part, the increased risk aversion we saw in May continued into the first two months of this quarter. Concerns about inflation, the U.S. housing market, a slowdown in economic growth, record high oil prices, the potential for weaker corporate profitability, and elevated geopolitical risk all weighed heavily on the markets for much of the period.

Economic growth in the U.S. and Japan slowed in the second calendar quarter while the European economies continued to grow at a faster clip. In general, the major central banks around the globe tightened interest rates during the period to contain inflationary pressures. Most notably, the bank of Japan ended its policy of quantitative easing and raised rates for the first time in six years. All of these factors impacted the capital markets for much of the period.

In U.S. equity markets, the S&P remained range bound within an 81-point band, but choppy. The NASDAQ hit a nine-month low in July on fears about growth in the technology sector before rebounding in August; and trading volumes declined on virtually all major equity exchanges in the period.

In the fixed income markets, yield curves flattened globally as central banks continued to increase short-term rates and in the U.S. and the U.K., the yield curve was inverted for much of the period. Investors became more risk averse and repositioned portfolios into more defensive asset classes. As a result, credit spreads widened and fixed income volatility decreased, both presenting challenges to total return investors.

The capital markets did not stage a recovery until early August, when the Fed paused in its rate hiking campaign, causing a relief rally in the treasury market and a narrowing of credit spreads. The stock markets also achieved a full recovery from the correction in the spring.

The investment banking market was not immune to the dislocations in the capital markets. Debt origination volumes fell as credit spreads widened and issuance did not recover until August. Equity origination volumes also fell, as many transactions were postponed due to weaker valuations and high single stock volatility. Completed M&A volumes also fell during the period. So overall, a more challenging backdrop for the period.

Despite these conditions, for the quarter, we posted net revenues of approximately $4.2 billion, up 8% from the comparable period last year and down 5% from last quarter's level. Net income was $916 million, up 4% from the year ago period, down 9% from last quarter. Diluted earnings per share was $1.57, up 7% from the year ago period and down 7% from last quarter.

This strong financial performance once again illustrates the significant momentum we've established in our franchise and demonstrates the firm's increased earnings capacity and capability to deliver strong results in different market environments. Now let me review each of our three business segments.

Starting with our capital market segment, we posted revenues of over $2.8 billion, up 13% from the prior year period and down 8% from last quarter's record level. This represents our third highest revenue level ever for this segment. Our pre-tax income for this segment was over $1.1 billion.

In the equities component of our capital market segment, our revenues were $837 million, up 31% from the year-ago period and down 5% from last quarter's level. This was an extremely challenging period in the global equity markets, as valuations remained flat to negative in June and July due to the concerns I noted earlier. It was only after the Feds pause in interest rate hikes in early August that the market stabilized and then recovered to end with slight gains for the quarter.

Despite these factors and the difficulty in execution they produced, we realized our second-highest performance in our cash business. We increased our secondary market share on NASDAQ and in Europe. We were also the number one ranked dealer in program trading for the period based on volumes; and we saw strong results in our merger arbitrage business.

In our prime broker and financing businesses, we realized record revenues as we continued to grow this unit by adding new clients and growing balances with existing clients. Our revenues declined in equity derivatives compared to both comparable periods. However, we did see some strength in Europe in both flow derivatives and structured derivatives for various corporate clients.

Our convertible business also declined versus both comparable periods, as origination and trading volumes were affected by both the prospect of rising rates and weaker equity markets.

Overall, for equities business, we benefited from increased market share, a broader customer franchise, and our regional diversification. Lastly, gains from our private equity investments were approximately $54 million.

Moving on to the fixed income component of our capital market segment, we posted revenues of $2 billion, up 6% from the year-ago period and down 9% from last quarter. Once again, the depth and breadth of this diversified global set of businesses was evident during the period, as strong results in certain asset classes and regions helped to offset weakness in others.

Our commercial real estate business posted record results on strong activity levels, including increased volumes of commercial mortgage-backed securitizations, as global demand for this asset class remains high and market conditions remain favorable.

Our foreign exchange business also posted strong results given the shifting volatility of the U.S. dollar and the continued build-out of our client platform.

Results in our global interest rate products business were negatively affected by the high levels of uncertainty regarding interest rates and inflation that affected the markets for most of the period. Widening credit spreads had a negative impact on our high-yield and municipal businesses. Our high-grade credit business was strong, primarily due to the increased investor activity we saw in August and a slight narrowing of credit spreads at that time.

Results in our U.S. residential mortgage business remained solid. However, they declined versus both comparable periods as we experienced a modestly lower level of origination volumes in the U.S., along with some spread compression and securitization margins during the period. Our securitization volumes remained robust, totaling $35 billion for the period.

In terms of the global mortgage business, we continued to benefit from the growth of our non-U.S. platforms, where we saw record origination in the quarter with the further expansion in Europe and the commencement of operations in Asia. We also broadened our asset origination and securitization business into student loans during the period through the acquisition of a student loan originator in the U.S.

So overall, in our fixed income businesses, a quarter where our diversification continued to produce solid results.

Moving on to our investment banking segment, we posted revenues of 726 million, down 11% year-over-year, and down 2% from last quarter. Our pre-tax income for this segment was $131 million. Our M&A advisory services revenues totaled $195 million for the quarter down 13% from the year ago period and down 20% from last quarter. For the quarter, our volume of completed M&A transactions totaled approximately $100 billion. We gained market share and completed M&A over the period as our share rose to almost 19% in the current fiscal quarter versus 13.5% in the second quarter.

We advised on several notable transactions that closed during the quarter, including Kerr-McGee's sale to Anadarko Petroleum, Time Warner's acquisition of Adelphia Communications, and BASF's acquisition of Engelhard Corporation. We have significant momentum in this business and our pipeline remains extremely robust. This reflects several noteworthy trends in the current M&A marketplaces that play to our strengths, including a significant level of financial sponsor activity, continued consolidation in the financial institutions and REIT sectors, and renewed interest in the commodity and technology sectors.

In equity origination, our revenues totaled $183 million, down 28% from last year and down 12% from last quarter's level. Our lead managed equity origination volumes for the quarter totaled approximately $5.5 billion, a 17% decline from last quarter's level, whereas the industry suffered a 37% sequential decline. Clearly, market uncertainty, weak pricing relative to targets, poor after-market performance, and high intraday and sector volatility forced a substantial number of issuers to postpone transactions. Part of the reason our volumes fared better than the overall market was due to our relative strength in secondary offerings, where our market share increased substantially.

Our results also benefited from an increase in equity derivative-related activity for corporate clients. It is important to note that we maintain an excellent backlog of equity offerings that are expected to come to market, once market conditions stabilize and issuers become more comfortable that liquidity has once again fully returned to the market.

Moving now to fixed income origination, our revenues were $348 million, up 4% year-over-year and up 20% from last quarter. This is our second-highest level of revenues for this business ever, which is notable for what is generally the slowest quarter of the year for fixed income origination. Origination revenues for the period were certainly affected by our product mix as one stop high yield and leverage loan transactions to finance sponsor-related M&A dominated the calendar. Stronger demand for CLO products globally has helped sponsors optimize terms and pricing on leverage loans.

Non-U.S. asset-backed transactions also increased and even investment grade debt was active, primarily related to M&A financing, the funding of stock buybacks, the rollover of maturing debt by European corporates as well as the resurgence of the hybrid capital market toward the end of the quarter.

August was clearly an inflection point as the pause by the Fed caused treasuries to rally, spreads to tighten and the most opportunistic of borrowers, financial institutions to fund in the more favorable environment.

Despite a more challenging third quarter, our current pipeline of investment banking activity remains very strong and we have a record fee pipeline. At quarter end, our M&A volume pipeline was $359 billion, our equity origination pipeline was $22 billion and our debt origination pipeline was a record $86 billion. Those are all volume pipeline numbers.

Moving to our third segment, investment management, we posted record revenues of $605 million, up 18% from the year-ago period and up 2% from the previous record we set last quarter. Our pre-tax income for this segment was $122 million. We report our investment management segment in two major components, asset management and private investment management.

Our asset management business reported revenues of $349 million, up 28% from the year-ago quarter and up 1% from last quarter. This represents the second highest level of revenues ever for this business. Results in asset management were driven by an increase in assets under management across all asset classes, businesses, and regions. We ended the quarter with a record level of assets under management at $207 billion, and we continue to grow the Neuberger Berman businesses where we also have record AUM.

Our strong track record of performance has helped attract net inflows, which accounted for a large chunk of the increase in AUM from the end of last year.

Aside from performance, we continue to expand the breadth of our alternatives business. Alternatives now represent approximately 19 billion of our assets under management.

Our money market assets have also grown at rapid clip as we continue to pursue cross-divisional referrals to provide cash management services to our investment banking clients. We have also successfully launched a number of funds outside the U.S. over the period, most notably a series of funds in Europe and the first QDII open end mutual fund in China in conjunction with Hua'an Fund Management.

In private investment management, which encompasses our high network client distribution business, we realized record revenues of $256 million, up 7% from the year-ago period and up 4% from last quarter. Fixed income revenues increased versus last quarter while equity activity remains strong, and our results were enhanced by an increase in structured transactions for clients utilizing both fixed income and equity derivatives. We continue to see strong productivity from our growing high net worth sales force.

Now let me briefly the review the results in our non-U.S. businesses. For the quarter, we posted non-U.S. revenues of approximately $1.6 billion. This is the third best quarter ever for the firm in terms of non-U.S. revenues, which now represent 38% of the firm-wide revenues for the period. Our non-U.S. revenues were up 24% from a year ago and down 1% versus last quarter's record level.

In Europe, we posted record revenues of approximately $1.2 billion, up 36% from the year-ago period and up 7% from last quarter, driven by strength in both capital markets and investment banking. We achieved record revenues in fixed income capital markets in Europe in the quarter on strength in our real estate, credit, and mortgage businesses in the region.

Our equities business in Europe benefited from the growth of our prime brokerage activities and strength in derivatives, which have both seen significant investment and expansion over the last few years. In investment banking in Europe, our revenues were strong, bolstered by solid debt and equity origination, along with structured derivative transactions for a number of our corporate clients.

In Asia, we posted revenues of $429 million, essentially unchanged from a year-ago period and down 17% from last quarter. In fixed income capital markets in Asia, our results were negatively impacted by the uncertain interest rate environment, partially offset by strength in real estate and high yield where the former business has benefited from the liquidity generated from private equity funds and REITs in Japan. We've continued to invest in broadening our client platform, particularly in interest rate and equity derivatives and prime brokerage in Asia.

In addition, we launched mortgage platforms in both Korea and Japan and plan to begin securitizations early next year. We remain excited about the opportunities in Asia and are committed to expanding our franchise in the region. Year-to-date, we have made significant progress in increasing scale as we have substantially completed our hiring plan for 2006.

Moving briefly to expenses. For the quarter, we posted a compensation to revenue ratio of 49.3%, a level consistent with the ratio we posted for full-year 2005. Over the period, our headcount rose approximately 6% to 24,775 people. This increase reflects several factors, including the addition of our new classes of analysts and associates along with strategic new initiative hires across all of our divisions and regions. This was partly offset by a slight reduction in staff in our U.S. mortgage origination businesses.

Consistent with our strategic objectives, more than half of this quarter's net headcount increase was outside the U.S. For the quarter, our non-personnel expenses totaled $751 million, up approximately 2% from last quarter's level. This increase was attributable to higher technology and communication expenses, recruiting fees, and equity brokerage and clearance fees as we continue to build out and grow the firm. Taking all of this into account, we reported a pre-tax margin of 32.7% for the quarter; our effective tax rate was 33%; return on equity for the quarter was 21%; and our return on tangible equity was 26.1%.

What this quarter's results demonstrate first and foremost is our cross cycle resiliency which is predicated upon the depth and breadth of our product capabilities where we benefit from our client activity driven business model. The growth of our customer franchise, where in the capital markets, banking, and the high net worth space, our roster of clients continues to grow, and the growth in our capacity which has allowed us to cover a larger group of clients in a broader range of asset classes and regions.

Additionally, our continued vigilance with regard to expense and risk management has allowed us to post strong returns, despite the challenges we faced in the market environment this quarter.

Taking a step back and looking at our results year-to-date, the firm has posted record revenues, net income, and diluted earnings per share. For the first nine months of 2006, our net revenues of approximately $13.1 billion are 19% ahead of the comparable period last year. Every business segment and region posted record revenues for the nine-month period. Our net income of $3 billion is up 23% year-over-year. Our diluted earnings per share of $5.09 is up 26% year-over-year, and our return on equity is 24% and return on tangible equity is 30% for the nine months. These are very strong results.

Let me make a few comments about our balance sheet. Over the period, our stockholder's equity increased to approximately $18.4 billion. Book value per share increased to $32.16, up nearly 12% since the beginning of the year, and we ended the quarter with a net leverage ratio of 13.6X. Our average value at risk from both a revenue volatility and historical simulation perspective was in line with the second quarter. And over the course of the quarter, we repurchased approximately 11.9 million shares at an average price of $64.07 per share.

Both Moody's and Fitch raised their outlook on our long-term debt from stable to positive during this quarter. Recognizing our improved market share and business mix and the strength of our risk management and funding practices.

Before we go to questions, let me briefly discuss our outlook for the remainder of 2006 and 2007. We believe that the more positive market environment established in August provides a favorable basis for business activity in the fourth quarter. And we remain well positioned to benefit from this stronger level of flow, given our client activity business model.

Importantly, the fundamentals underpinning our business prospects remain positive. First and foremost is the growth in the global economy. Here, our outlook is for the global economy to grow at a rate of 3% for 2006 and 2.3% for 2007. Levels that continue to provide a favorable support for activity in our sector.

This growth projection takes into account our view that the Fed funds rate will increase the 5.75% by January and that the ECB will raise rates two more times in 2006. This is a somewhat more hawkish view than is shared by the Street, since we continue to project inflationary forces that exceed central bank targets.

Nevertheless, we anticipate that the central banks will succeed in navigating a soft landing and we also believe that we are nearing the end of the tightening cycle in the U.S. and Europe. We expect global corporate profitability to remain resilient and we are looking for profits to grow by 14% in 2006 and 7% in 2007. So our outlook for the global economy remains positive.

Second, we continue to believe that the pace of growth in the capital markets will exceed the growth of the overall economy. This has certainly been the case this year. Where year-to-date outstandings in the global capital markets have grown by 10% relative to global GDP growth of about 3.5%.

In terms of M&A, activity has picked up significantly over the course of this year and we believe this will continue. Companies are still looking to grow and strategic M&A is a viable option to achieve this objective, particularly with the strong and liquid balance sheets companies now have. Financial sponsor activity continues unabated given the substantial capital they have raised. If anything, transaction sizes have continued to increase.

We are also seeing encouraging signs in Europe where year-to-date the volume of announced M&A transactions actually exceeds levels in the U.S. Overall, our view is that the volume of global M&A announcements for 2006 will increase more than 30% from 2005 levels given these strong fundamentals and early indications are that this pace shows no signs of slowing in 2007.

In equity underwriting, the industry-wide calendar at quarter end was $40 billion, an increase of more than 90% year-over-year. Despite recent postponements, clients have been anxious for the markets to stabilize in order to raise capital. Our projection for debt underwriting in 2006 has been raised to $9.1 trillion for the year, which if completed will be an all-time high. This reflects an upward revision in the M&A financing component, the growth in the securitization markets worldwide, an increase in companies using debt proceeds for buybacks as well as the need to refinance maturing debt.

The debt calendar for the fourth quarter is exceptionally strong, with over 70 billion of high-yield product expected to come to market and a resurgence in the hybrid capital market, just as we saw last week, with the $2 billion euro and sterling offer we led for GECC. So with our fee pipeline at a record level, we feel positive about our prospects in investment banking.

Moving to capital markets, liquidity remains abundant with investors needing to put the proceeds of cash M&A, buybacks, and maturing debt to work in the marketplace. We anticipate stronger equity markets for the remainder of the year with global market indices gaining 9% for the full year as corporate profitability remains robust.

We continue to expect strong growth in the global fixed income markets where outstandings have grown from $16 trillion in 2000 to $31 trillion currently and are expected to increase to $43 trillion by the end of 2009. This growth is being driven by disintermediation around the globe as the capital markets continue to represent a deeper and more viable source of liquidity.

Lastly, over the past several years, our firm has demonstrated an ability to grow our business by serving a greater number of clients and winning a growing share of their business. This has primarily been achieved by growing our capacity as we continue to better align our resources with the most rapidly growing fee pools in the world.

To that end, in the current quarter, we made some notable hires, including senior investment bankers in all regions, a new global head of foreign exchange, a new head of equity sales for Asia and of course, Felix Rohatyn as a senior advisor to the firm.

In conclusion, we believe our franchise has tremendous momentum. We continue to consistently post strong results under varying market conditions, including the results we reported today in this more challenging market environment. Given our larger scale, the resiliency of our client driven business model and our disciplined approach to expense risk and capital management, our earnings capacity continues to grow stronger.

Our outlook remains positive and we continue to benefit from the favorable secular forces that are driving growth for both us and the industry as a whole. Now I'll be happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Bill Tanona - Goldman Sachs.

Bill Tanona - Goldman Sachs

Obviously you guys had a pretty solid equity quarter in such a tough environment. I know you talked about the cash equities business, but were there any specific regions or areas of the business that you guys have been growing out that contributed to that out performance, if you will?

Chris O’Meara

I think that what I would highlight here is we have been making investments across the globe in equities and in particular in equity derivatives both in the product capability side and on the sales distribution side. So we do see the power of that coming together, including with our corporate clients as we market corporate derivatives to our clients.

The other point I would highlight is that in our prime brokerage business, where we have been making substantial investments for quite a period of time and we are seeing the results of that as we had record revenues in that business. And we feel very good about the progress we are making in that business.

Bill Tanona - Goldman Sachs

That would be the $54 million that you guys had indicated in terms of the private equity gain, I assume that's all in the equity capital markets line?

Chris O’Meara

Correct.

Bill Tanona - Goldman Sachs

Moving over to mortgage and the real estate business. You’ve indicated that things are obviously slowing down for you on the U.S. mortgage side, but it seems like you guys are doing very well on the international front. Can you guys give us a sense as to what the contribution is to your mortgage real estate-related business as it pertains to international versus U.S. now?

Chris O’Meara

We don't disclose that, but what I certainly can tell you is that it's a meaningful contributor. As we've pointed out in remarks today, it's a growing contributor as we've had record origination in the non-U.S. mortgage space. As you know, the securitization spreads, when these originated loans ultimately get to the stage of securitization, the securitization spreads are greater outside the U.S. than inside the U.S. This speaks to the diversification that we've been trying to achieve in this business, both across products and across regions and we have plenty of room to grow in this area, particularly outside of the U.S.

Bill Tanona - Goldman Sachs

Could you give us a sense as to how different those spreads are on the international markets versus the U.S.? In the past, Dave has talked about having a third of your revenues coming from origination, securitization, and trading within the mortgage business. Has that composition changed dramatically as you've migrated to international as well?

Chris O’Meara

Those were rough numbers. This idea that we were sort of generally balanced between those different functions: origination, securitization, and trading. So I would say that the overall business as we pointed out is down a little bit and I think we're in the same range in terms of each of those functions being meaningful contributors in a reasonably balanced way.

Bill Tanona - Goldman Sachs

And then in terms of the differential in terms of profitability as it pertains to international versus the U.S. markets?

Chris O’Meara

I don't want to go into the specifics of the spreads, but they are significantly different, meaning the outside the U.S. is quite a bit higher than inside the U.S.

Bill Tanona - Goldman Sachs

In terms of headcount as it pertains to your mortgage originations in the U.S., is there any thought that we should expect that your headcount will decline here in the U.S. and lose some of the infrastructure as it relates to the U.S. mortgage business to save yourself some costs?

Chris O’Meara

We certainly are conscious of that. When we built this business, this was something that we were very focused on, was building a business that we could scale up or down to take advantage of the changing market environments, which obviously are cyclical. So we may have more depending on the environment, depending on what the opportunity is, we would adjust our headcount appropriately. So it really depends on the market.

What we've been seeing in the U.S. is that the origination volume has stabilized, it was down a little bit this period versus last period and versus last quarter. So this quarter versus last quarter, the U.S. mortgage originations were down a little bit, but we think we've sort of hit a stabilization point here. But if we haven't, we'll be making adjustments, which is good news about the scalability, the variability of the cost space in this business.

Bill Tanona - Goldman Sachs

Great, very helpful.

Operator

Our next question is from Daniel Goldberg - Bear Stearns.

Daniel Goldberg - Bear Stearns

Good morning, Chris. Just one more follow-up on the mortgage business. Obviously with you bringing staffing levels down in the U.S. and some of your competitors actually buying and building out that business, how should we think about the competitive landscape from Lehman's perspective?

Chris O’Meara

Well, this is a competitive market, always has been. There's obviously a very big market that's available to tap. The environment is such that refinancings are down substantially, as everyone knows, but new home purchases continue to be pretty strong. So it's a competitive business, always has been, having additional competitors in the mix is something we would expect. They're good competitors, but we think there's plenty of opportunity for us to continue to do quite well in this business.

Daniel Goldberg - Bear Stearns

Okay. In terms of your investment banking business and the debt underwriting sequential growth about 20%, can you give a little bit of color there? Anything else you can offer, what maybe differentiated your business in the quarter versus one of your competitors who has reported already who had somewhat of a drop-off in this line item?

Chris O’Meara

Sure. In each period it's different depending on the mix of business that actually gets completed in that period, but for us, we had a very strong period of completions for leveraged finance, and that includes LBO sponsors and various other acquisition situations that we have financed, and it’s just a terrific quarter in the leverage finance side for us. Particularly leveraged loans.

Daniel Goldberg - Bear Stearns

Just lastly on the compensation, how should we think about that as you go into the fourth quarter, historically the comp ratios are a bit lower as you true up the numbers. How do you view the leverage of the downside protection you have going through the fourth quarter based on what you've accrued to date?

Chris O’Meara

Well, we think that the 49.3%, in and around that level for the year, is what we're forecasting. We've spent time on this and this is what we're forecasting as of now. We don't have any reason to think that it won't be in and around that level for the year.

Daniel Goldberg - Bear Stearns

Okay, thank you.

Operator

Our next question is from Guy Moszkowski - Merrill Lynch.

Guy Moszkowski - Merrill Lynch

Thanks, good morning, Chris. You talked about the investment banking fee pipeline being at record levels and I think you alluded to M&A as a record within there, too -- correct me if I'm wrong. Any significant shift in the composition of the investment banking fee pipeline relative to what you would have seen three or six months ago?

Chris O’Meara

First of all, the M&A fee pipeline is a record and but it is not a record in volume terms, it's a record in fee terms. So really from our perspective is fees are really a better indicator, just because of the roles that you might play in different M&A transactions. You might have small M&A transactions of big fees or big M&A transactions with small fees so looking at fees we think is probably a better indicator.

In terms of, has there been a change in the mix, we've been very, very successful. If you look into the pipeline, you'll see a lot in media and telecom for us, you'll see some in energy. You'll see something in all the sectors, but media and telecom, I think, are very strong in our backlog.

Guy Moszkowski - Merrill Lynch

And in terms of the mix just between M&A versus equity versus fixed income, any meaningful changes there?

Chris O’Meara

Well, when we look at the global fee pipeline, we have a record fee pipeline in debt, so in overall debt, which is really driven by leverage finance. So very, very strong debt fee pipeline. Our equity fee pipeline is not a record, but it is still quite strong.

Guy Moszkowski - Merrill Lynch

Okay, that's helpful, thanks. Another question going back to the mortgage origination business. Is there any change in the way you're managing your pipeline now, given declining or at least stabilizing housing prices across the country and the potential presumably for rising mortgage default rates?

Chris O’Meara

We're certainly conscience of that. When we underwrite our loans, we underwrite to a standard that really has not deviated. So we haven't been ticking up the loan to value, for example. We've been keeping vigilant on that.

The other thing is, just to point out is that we do not issue or originate negative amortizing loans. So the option payment ARMs that you read about a lot, that we are not a originator of that product, which is something that in a flat to declining housing market is something of concern.

Guy Moszkowski - Merrill Lynch

Okay, that's real helpful. Thanks. I think that's all I've got. Appreciate it.

Operator

Our next question is from Glenn Schorr - UBS.

Glenn Schorr - UBS

Thanks very much. Hi, Chris. Real quickly on the buyback, a little bit bigger than we have seen and there's a net buyback there, we haven't seen that in a while. Anything different in the mindset and how to think about going forward?

Chris O’Meara

Nothing really different. There is a modest excess buyback here and as we think about going into the fourth quarter, if you look at the basic diluted share, the basic shares outstanding on weighted average, we would expect that the fourth quarter would be in and around there, maybe slightly higher, but just sort of right in and around the level that it's at. It actually finished down from what the weighted average is, and we would expect it to go back up a little bit to achieve that same weighted average for the fourth quarter.

Glenn Schorr - UBS

Does the stock price movement have any impact?

Chris O’Meara

It's something we certainly look at. You mean in terms of the treasury stock method of accounting for dilution. Yes, there was some amount of reduced shares in the shares outstanding, the diluted shares outstanding because of the decrease in stock price. That would be about 5 million shares, 4 million shares or so. It came down as a result of the lower stock price and its impact on the treasury stock method of accounting for dilution.

Glenn Schorr - UBS

Great. I'm sure this won't be the last question on mortgage, but just given the activity levels that we've seen both volume-wise and then composition coming in, I know Lehman is still interested in growing outside the U.S. Does Lehman still have interest inside the U.S. at the right price?

Chris O’Meara

Certainly. If the right conditions are present, the right culture and it is an area that is a strategic fit for us, and the right price for the right opportunity, we would be interested in looking at it.

Glenn Schorr - UBS

You mentioned within your comments about private equity and investment banking pipelines, the $70 billion or so high yield/leverage loan pipeline. Can you just give us two seconds of color on where you think Lehman's financial sponsor business stacks up in general and then relative to that pipeline?

Chris O’Meara

Sure. We have a growing and very highly regarded financial sponsor banking coverage presence. And so that is something that is one of the areas we've been investing in pretty significantly over time and it has been paying dividends for us. We have a number of terrific operators there and our whole business from coverage right through to the folks who do execution and syndication on the financing side has been growing out and is very, very well-regarded. So we are in a good spot with financial sponsor clients generally.

And in terms of the backlog, that we have a nice share of what's in that $70 billion backlog. So we feel very good about the prospects and progress we're making in that business.

Glenn Schorr - UBS

Okay, appreciate it, Chris.

Operator

Our next question is from Meredith Whitney - CIBC World Markets.

Meredith Whitney - CIBC World Markets

Good morning. I had a question on your equity backlog. Most of the deals that were done in the third quarter on the equity side look like they were energy deals. You guys obviously did very well in that space. Can you talk about the composition of your equity backlog going into the fourth quarter?

Chris O’Meara

Okay. We have a varied pipeline. There continues to be items that are in the energy space. There are items in the industrial space and the financial institution space. So we have a pretty diversified backlog, and that's not just in the U.S., that's also in Europe that we have a pretty good backlog.

Meredith Whitney - CIBC World Markets

Okay. All flavors.

Chris O’Meara

Backlog is reasonably well spread out.

Meredith Whitney - CIBC World Markets

My next question is, the addition of Felix Rohatyn obviously is great headline news. How material is it going to be on moving the needle in terms of European revenues and how material will it be in terms of changing the composition of those revenues?

Chris O’Meara

Well, we feel great about Felix joining the firm and obviously in addition to just being a terrific advisor with huge amounts of experience is that Felix brings a lot of contacts and we just feel great about him coming on the platform and all that he can bring. So we're very optimistic about the impact that Felix will have.

Meredith Whitney - CIBC World Markets

Should we expect that near term, or did he bring a good bag of tricks, a good bag of deals on his arrival or?

Chris O’Meara

I'm not sure it's quite that, but it's about the transformation that we're making in our European business and it's not just European, it's all over the world that he is overseeing the global advisory committees that we have. So we think his impact will be felt strongly over time.

Meredith Whitney - CIBC World Markets

Okay, terrific. Congrats on that.

Operator

Our next question is from Mike Mayo - Prudential Equity Group.

Mike Mayo - Prudential Equity Group

Good morning. You mentioned that August was an inflection point. Does that mean the results for the month of August were better?

Chris O’Meara

Not really, Mike. It's more about that the market environment turned, but August is the most seasonally impacted period. So I wouldn't take away from that comment that August was a higher revenue generating month than the others.

Mike Mayo - Prudential Equity Group

You mentioned the equity side, some deals got pulled. Are those deals back in your backlog numbers, or not yet?

Chris O’Meara

Most of them are. Some of them are not.

Mike Mayo - Prudential Equity Group

Okay. How much did you lose because the deals were pulled?

Chris O’Meara

I'm not going to quantify that, but I think you know, you're still working with these clients, trying to work on advising them and raising the financing necessary for them to continue to develop their businesses. So I don't think we really lose much. I think it just gets delayed, for the most part and that it gets executed. These clients need to raise capital to grow with good business plans and they are going to raise it, it's just a matter of timing.

Mike Mayo - Prudential Equity Group

So most of that will be caught up in the fourth quarter then, you think, if conditions stayed decent?

Chris O’Meara

Correct, I would think.

Mike Mayo - Prudential Equity Group

Outside the U.S., how do the profit margins from the U.S. compare to those outside and maybe versus Europe and Asia?

Chris O’Meara

It depends on the quarter. Asia’s quarter was a little bit lower. Europe had a record quarter, so their profit margins were strong. We think about them being interestingly right around the same level of profitability as in the U.S. and as the firm as a whole, as a consequence, in terms of pre-tax margins, for example.

Mike Mayo - Prudential Equity Group

I was assuming Asia might be a little bit lower since you're spending so much more there. Might not be getting the bang for the buck. Maybe if you can elaborate?

Chris O’Meara

We're certainly making the investments in both Europe and Asia. And as we saw earlier in the year, Asia had terrific revenue generation which made them a significant pre-tax margin contributor and that's come down a bit. But, yes, we continue to make investments, significant investments in both Europe and Asia.

Mike Mayo - Prudential Equity Group

Lastly, just on the fixed income environment, you've had an inverted yield curve, you had the Feds stop. As we look out over the next year, year-and-a-half, what are the main drivers of your fixed income revenues in very simple terms? It seems like you're managing through the slight inversion on the front end just fine. What concerns you most there?

Chris O’Meara

Well, the main drivers for us are really the activity that is taking place by our clients. Clients are staying invested, they're repositioning portfolios. We're there to service their flow. Our business model really is predicated mostly on the activity and trying to take fees out of the transaction volumes. So we're interested in having very high volumes of transactions. That is the thing that's for us. So far, we've seen that hold in.

Importantly, as I mentioned before, is the diversified nature of the business. So there's loads of different businesses under the umbrella of fixed income, both in the U.S. and globally.

We're most concerned, the thing we would be most concerned about is if inflation gets away, which we're not anticipating. We're anticipating that there'll be a soft landing and the monetary stimulus or monetary response to that would bring in for a soft landing. That is something that we do have as a concern, is if inflation were to get out of control. That would create even more challenges for the fixed income business.

Mike Mayo - Prudential Equity Group

Did you see the Mortgage Banker Association report on the real estate finance industry? I guess it's like 182 pages and so it's raising concerns about the mortgage finance business over the next several years. Did you see that?

Chris O’Meara

I'm sure that I've seen some excerpts of it or a summary of it. I haven't read the 182 pages.

Mike Mayo - Prudential Equity Group

As far as you can see right now, the mortgage finance business is doing just fine, even if it's just a little bit less?

Chris O’Meara

Yes, I think the mortgage finance business is doing fine. It's a solid contributor to us. Obviously it is down a bit in terms of its revenue-generating capacity or contribution here. But as we've talked about, we're working to grow that business on a global scale, and it's not just in the places that we're in. We're in the U.K., we're in the Netherlands, we're in Japan now, we're in Korea. We've got a strategic partnership in Italy. We're looking at various other opportunities around the world and we will continue to grow this business.

Mike Mayo - Prudential Equity Group

That mortgage finance business, is that also about 38% outside the U.S., like the firm, or is it less or more?

Chris O’Meara

We don't disclose the percentage that's outside the U.S., but it is a meaningful percentage. Maybe not quite that high.

Mike Mayo - Prudential Equity Group

All right, thank you.

Operator

Our next question is from Dick Bove - Punk, Ziegel.

Dick Bove - Punk, Ziegel

Good morning. I'm just following up on one of the questions that was recently asked. I know that your projection is for interest rates to go up again before the Fed stops, but most people think that the Fed has stopped and I'm wondering if that's resulting in a lot of rebalancing trades as banks and insurance companies et cetera restructure their portfolio, now believing that the interest rate environment is going to be stable.

Chris O’Meara

Well, I think there continue to be different views around this. So there continues to be some uncertainty in the market. I think what people are most focused on is that we're coming to the end. We're all in agreement, we're coming to the end. The question is, are we at the end or is there one or two more hikes to go as we look out? So there's some uncertainty in the market on that.

But as we look out and we think about this in a broader context interest rates continue to remain low, whether they stay flat or go up 50 basis points from here. They continue to be relatively low interest rates, which support lots of financing activities and financial sponsors executing transactions, et cetera.

Dick Bove - Punk, Ziegel

What I was wondering about, though, was we weren't getting these big rebalancing trades when people thought rates were rising because people didn't know how to structure their portfolios. I'm wondering if you're seeing a large number of those trades coming in now because of let's say perhaps a clearer view of where rates might be?

Chris O’Meara

We certainly have seen some. So investors extend duration when rate hikes stop. So we have seen a little bit of that and we would expect to see some more as the picture clarifies over time here.

Dick Bove - Punk, Ziegel

Something that confuses me in your numbers and also I guess in Goldman's numbers yesterday. That is the yield curve is inverted, spreads are supposed to be narrowing. Yet, growth interest income is growing faster than growth interest costs. I don't understand that. I know that trading and interest income are related to each other, but why in an inverted yield curve environment are you growing your interest income faster than your interest expenses?

Chris O’Meara

There's so many factors that go into that analysis. When we think about our businesses, we think about the totality of a transaction, the principal activity and the interest together. We don't really think about when we enter transactions, we don't think about the component pieces. We have seen our balance sheet is up a bit. Interest rates on the short end are up a bit, so we do see the amounts of the interest having ticked up. It's not something that when we look at the net, that we really think about.

Dick Bove - Punk, Ziegel

But those numbers would imply that the inverted yield curve isn't impacting your business at all.

Chris O’Meara

It's not yet, because we're not really a spread carry trade player.

Dick Bove - Punk, Ziegel

One last question. Obviously your debt underwriting volume went up meaningfully in the quarter, but your trading of fixed income product went down and I always thought that those two things would be linked. I'm wondering if it's because you're trading a lot more products now which are not related to where you're doing the underwriting, that the two things are delinked.

Chris O’Meara

I think in general they're linked. I think when you get into a summer period, just the volume of secondary activity will slow down. But in general, if there's good, strong origination, there's going to be lots of opportunities to trade on the back of that origination as clients move in and out of that new issue product and you handle a big percentage of the flow in that.

Dick Bove - Punk, Ziegel

Okay, thank you.

Operator

Our final question comes from Michael Hecht - Banc of America.

Michael Hecht - Banc of America

Chris, good morning. I just wanted to follow-up on the results you guys are showing in equities capital markets. Clearly you guys are having a great year in equities with year-to-date growth of about 53% here. I was just hoping for a little more year-to-date attribution. I thought maybe you could rank/order for us. The business is making larger contributions across cash, derivatives, prime brokerage.

I just wanted to clarify, I think you noted $54 million in private equity gains. I would just like you to remind us how that compared to last quarter and maybe a year ago?

Chris O’Meara

Okay. First on the equities business, just a comment about our development of that business over time. That is a business that we have been building out for many years now and we're seeing the fruits of that. When we look out, it's really across the board as we look at the different components of what makes up that increase through the nine months of this year versus last year at the same time. It's really across the board.

We have had significant increases in all of the businesses and one of the things that we're very, very proud of and focused on for the longer term is the prime brokerage business and we have seen significant gains in that business over time, and that's partly a result of the marketplace getting bigger and partly as a result of us making gains in share in that business.

So we feel very good about that and then also equity derivatives, as I mentioned earlier, is that we have been making investments in both the product capability side and also the distribution side and we do see that paying off. We see it paying off outside the U.S. as we've made investments for a number of years now.

Michael Hecht - Banc of America

Okay, fair enough. So no one area kind of standing out from an attribution perspective, really it's across the board?

Chris O’Meara

No. And on the other point about the $54 million, the last quarter was about $20 million and last year, same quarter, was about $30 million.

Michael Hecht - Banc of America

Okay, great. Thanks a lot.

Chris O’Meara

Take care, Michael.

Operator

There are no further questions.

Chris O’Meara

Thank you very much, everybody, for joining our call today. We really appreciate it. We again have posted these strong results in a more difficult market environment and look forward to the fourth quarter and beyond. Take care.

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Source: Lehman Brothers F3Q06 (Qtr End 08/31/06) Earnings Call Transcript (LEH)
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