Lehman Brothers F2Q07 (Qtr End 5/31/07) Earnings Call Transcript

Jun.12.07 | About: Lehman Brothers (LEH)
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Lehman Brothers Holdings Inc. (LEH)

F2Q07 Earnings Call

June 12, 2007 10:00 am ET

Executives

Shaun Butler - IR

Christopher O'Meara - CFO

Analysts

William Tanona - Goldman Sachs

Guy Moszkowski - Merrill Lynch

Glenn Schorr - UBS

Michael Mayo - Deutsche Bank

Meredith Whitney - CIBC World Markets

Douglas Sipkin - Wachovia Securities

James Mitchell - Buckingham Research

Michael Hecht - Banc of America

Presentation

Operator

Good morning and welcome to Lehman Brothers second quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. 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 condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statement. The forward-looking statements are inherently subject to 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 can affect the firm's future results and financial conditions, see risk factors and management's discussion and analysis of financial condition 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 related to these non-GAAP financial measures can be found under selected statistical information, reconciliation to average stockholder's equity and average tangible common stockholder's equity 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 a Form 8-K, available at www.sec.gov. With that, let me now turn the remarks over to Chris O'Meara, our CFO.

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Christopher O'Meara

Thanks, Shaun. Good morning, everyone and thank you for joining us today for our second quarter update. As you've seen in this morning's press release, we have reported another quarter of record results. These results were broad-based, including record results in each of our three business segments and in our European and Asian regions. Importantly, they also demonstrate significant progress in diversification of our businesses as we had significant revenue growth in investment banking, investment management and equities capital markets this quarter, as well as further geographic diversification as we generated almost 50% of our revenues from outside the U.S. during the period.

Market conditions improved steadily over the period and were generally favorable for our businesses, despite the slowing GDP growth in the U.S. and Japan and the early risk layer we saw that carried over from the end of last quarter.

Global equities rallied strongly following the late February sell-off, driven by better than expected earnings results in the U.S. and Europe, coupled with a continued increase in M&A and LBO activity. Global equity markets rose approximately 8% in local currency terms during the quarter, with Europe and the U.S. rising approximately 9% and Asia 5%. Several indices reached all-time highs during the period, including the Dow, the S&P 500, the FTSE Europe, the FTSE Asia and the Hang Seng. Global equity trading volumes rose approximately 13% in dollar value terms compared to the prior quarter, with activity increasing the most in Europe followed by the U.S.

In the fixed income capital markets, interest rate actions by central banks remained fairly benign over the period. The Federal Reserve and the Bank of Japan kept rates unchanged while the European Central Bank increased rates once during the period and then again last week. The Bank of England raised interest rates once over the course of the quarter.

High grade credit spreads widened very slightly during the quarter, while high yield and emerging market credit spreads tightened significantly to their all-time narrowest levels as investor demand for incremental yield continued to drive risk premiums lower.

Conditions in the U.S. subprime mortgage business remained challenging during the quarter, although we did see some signs of improvement by the end of the period. We continue to believe the subprime market challenges are, and will continue to be, reasonably contained to this asset class.

All of these conditions provided a strong underpinning to M&A and underwriting activity. The volume of announced M&A transactions was a record $1.7 trillion for the period, rising 69% sequentially and surpassing the prior record set in 2000. In equity underwriting, volumes increased by 23% versus the prior period, driven by an increase in IPO and convertible activity. Debt underwriting volumes grew by 8% compared to the sequential period.

In asset management, flows remained solid across asset classes; so overall, a generally constructive backdrop for the period. With this favorable environment we posted net revenues for the quarter of $5.5 billion, up 25% year over year and up 9% from the previous record we set last quarter. Net income was $1.3 billion, up 27% from the prior year and up 11% from last quarter's record level. Diluted EPS was $2.21, up 31% year over year and up 13% from the first quarter. This strong financial performance once again illustrates the significant momentum we have established in our franchise, and our ability to translate our product breadth and growing wallet share with clients into a higher level of earnings.

The businesses that showed the strongest increases in this period are areas where we have made considerable investments over the past number of years and have continued to improve the overall level of client related revenues as evidence by a record level of capital market sales credits and our highest level of revenues ever in our fee-based businesses.

Now let me review each of our three business segments. Starting with our investment-banking segment, we posted record revenues of approximately $1.15 billion, up 55% year over year and up 35% from last quarter’s levels. This marks the first time quarterly revenues for this business segment have exceeded $1 billion. Our pretax income for this segment was $338 million. Within investment banking, each major business line also posted record revenues. Fixed income origination revenues were $540 million, up 87% year-over-year and up 26% from last quarter’s record level. On a sequential basis, our volumes rose more than the overall market. These strong results reflect a heavy volume of high yield and leveraged loan activity along with robust investment grade issuance.

Results in leveraged finance were a record for the period and up substantially over first quarter levels due to heavy financial sponsor M&A activity as well as refinancings. High-grade volumes remained strong. We also witnessed a resurgence in the hybrid securities market in the period as well as an increase in whole business securitizations, and we remain a market leader in both of these products. An abundance of loan product fueled strong issuance of CLOs during the period.

In equity origination, our revenues were a record $333 million, up 60% year over year, and up 90% from the sequential period. For the quarter, our volume of equity origination transactions totaled approximately $9 billion, up 35% sequentially, versus a 23% increase for the overall market. Results for the period were driven by a strong IPO market due in part to financial sponsor monetizations. Noteworthy lead-manage transactions for the period included China Citic Bank’s IPO and a convertible offering for Sinopec, among others.

Our advisory revenues were $277 million, up 14% year over year and up 12% from last quarter. For the quarter, our volume of completed M&A transactions totaled approximately $155 billion. We advised on several noteworthy transactions that closed during the period including CVS Corporation’s merger with Caremark, Cerberus Capital’s acquisition of BAWAG, and Altria Group’s spinoff of Kraft Foods, among others. Our volume of announced M&A transactions totaled $414 billion, a 73% increase over first quarter levels, and our global market share for both completed and announced M&A improved to 20% and 24% respectively for the quarter. Financial sponsor activity continues to be a significant driver of this business as well, and we are advising on three of the top four announced global transactions in the quarter, including assignments for ABN Amro, Alcoa, and Endesa.

Just a quick comment on the overall results for investment banking: Strategically, they demonstrate significant progress in a number of areas where we have chosen to focus, including financial sponsors where we are currently advising on seven of the largest 15 sponsor-led transactions announced this year; also in developing markets where we have completed significant transactions in China, the Middle East and in Eastern Europe; and in sourcing non-traditional investment banking revenues, primarily through derivative risk solutions for our corporate clients.

We have significant momentum in the investment banking business and our volume pipelines for each of our major businesses were at record levels at quarter end as was our aggregate fee backlog. Both measures were substantially ahead of our prior record levels. Our M&A volume pipeline was $584 billion. Our equity origination pipeline was $30 billion and our debt origination pipeline was $167 billion. Our aggregate fee backlog was approximately $1.6 billion at quarter end, double the level we reported at the beginning of the year.

Moving to our capital market segment, we posted record revenues of approximately $3.6 billion, up 17% year over year and up 3% sequentially. Our pretax income for this segment was approximately $1.35 billion. In the equities component of our capital market segment, we posted revenues of $1.7 billion, nearly double the year-ago period and up 27% from the previous record set last quarter. These results, which were supported by the constructive environment I noted earlier, demonstrate the benefits we are realizing from the investments we have been making in people and technology, most notably in derivatives and prime brokerage.

We recorded increased revenues in our execution services business as client activity was very strong across all regions and we capitalized on positive equity market trends during the period. Our revenues in equity derivatives rose significantly versus both benchmark periods, driven by higher levels of trading volumes particularly in Europe and Asia including flow derivatives, corporate derivatives, structured note products and exotics. We attribute this growth to increased investor appetite for taking market exposure through derivatives as well as for the utilization of derivatives to hedge existing positions with products such as bespoke put baskets.

Our prime broker and financing businesses posted record revenues as well, with results bolstered by seasonally higher European activity. We increased prime broker client balances for the eighth quarter in a row and ended the period with record balances of $212 billion, up 22% from last quarter's levels. We continue to see terrific opportunity for our prime broker services. For example, we are seeing increased interest from historically long-only clients who are now positioning one 30:30 portfolio products as well as increased interest from new hedge funds in both Europe and Asia. We were recently ranked number one prime broker in Europe and number one prime broker in Japan by Global Custodian.

Lastly, gains from our private equity investments totaled approximately $87 million for the period. So all told, an extremely strong quarter where our results directly reflect our increased client capacity and geographic breadth. The non-U.S. component of this business continues to be a very important contributor to these results. We continue to grow our client base in the regions, extend our coverage to newer pools of capital and increasingly service the growth in U.S. investor demand for international product.

In the fixed income component of our capital market segment, we posted revenues of approximately $1.9 billion, down 14% year over year and down 13% from last quarter's levels. Results in our credit businesses, while still strong, were down from last quarter's record level due to a lower level of trading opportunities in the marketplace.

In our securitized products business, which includes residential mortgages, revenues were down versus first quarter levels due to the ongoing challenges in the subprime sector. Our global origination volumes for the period were up a bit from the first quarter, primarily driven by higher Alt A and non-U.S. activity while U.S. subprime origination volumes were flat for the first quarter. Our global securitization volumes were up from last quarter, mostly driven by securitization activity on government agency collateral, which generates lower fee spreads.

In general, securitization margins were compressed in the quarter, particularly in subprime transactions which had a negative impact on the overall economics of the business. Although we believe that the U.S. subprime business will continue to face headwinds for the near term, we are seeing some positive signs such as gradual improvement in pricing power for lenders and a pickup in secondary market investor activity, including for non-investment grade positions.

Overall, there's been a reduction in subprime origination capacity in the market and the credit quality of originations has improved. We believe the securitization business environment improved toward the back end of the quarter including for subprime and we have a strong non-U.S. residential securitization pipeline for the second half of the year.

In other fixed income businesses, our municipal business revenues declined versus both benchmark periods. Results in our commercial real estate business continue to be strong, and during the period we securitized over $5 billion of commercial real estate loans. Results in our liquid markets business which includes interest rate products and foreign exchange, rose versus both benchmark periods as lower revenues in the U.S. were more than offset by higher results in Europe.

Moving to our third segment, investment management, we posted record revenues of $768 million, up 30% year over year and up 11% from the previous record we set last quarter. Our pretax income for this segment was $188 million. For the asset management component of this segment, we reported revenues of $460 million, our highest level ever, up 33% year over year and up 11% from the first quarter.

Results in asset management were driven by an increase in assets under management across all businesses and asset classes as well as higher revenues from our minority investments in hedge fund managers. We ended the quarter with a record level of assets under management, $263 billion, up 11% from last quarter as we had net inflows of $16 billion and market appreciation of $11 billion during the period.

In terms of inflows, the business with the largest percentage increase for the period was alternatives as we raised a new global merchant banking fund of $3.3 billion and saw additional flows into our latest private equity fund to funds offering.

In private investment management, which encompasses our high net worth client distribution business, we realized record revenues of $308 million, up 26% from the year ago period and up 10% from last quarter's levels as our client were active in both fixed income and equity related products.

Now let me briefly review the results for Europe and Asia. For the quarter, Europe and Asia combined posted record revenues of approximately $2.6 billion, up 62% year over year and up 28% from the previous record we set last quarter. In total, our non-U.S. revenues accounted for 48% of our revenues for the period.

In Europe, we posted record revenues of over $1.8 billion, up 68% year over year and up 34% from the previous record we set last quarter. We posted increased revenues in all three major business segments versus both benchmark periods. In European capital markets, we saw improvements in real estate, interest rate products and high grade within fixed income. In equities, our revenue gains were most notable in European cash, derivatives and prime services. In Europe, just as in the U.S., strong corporate profitability, active M&A and shareholder activism all drove higher secondary activity levels.

Revenues in investment banking in Europe rose versus both comparable periods. Revenues in banking were our highest on record, reflecting strong performances in M&A and leveraged finance. The European M&A market continues to be very strong and our European M&A volume pipeline and fee backlog are at record levels. Investment management revenues in Europe also rose over first quarter levels, reflecting our growing asset management platform, as well as the launching of several alternative funds.

In the Asia Pacific region, we posted record revenues of $762 million, up 48% year over year and up 17% from the previous record we set last quarter. We posted increased revenues in capital markets and investment banking versus both comparable periods. In Asian capital markets, our results were strong in real estate, CDOs, equity volatility and prime services. Additionally in Japan, our commercial mortgage and residential mortgage businesses continued to grow.

In investment banking in Asia, we have had notable successes in China, as demonstrated by our recent transactions for Citic and Signopec that I mentioned earlier, and we continue to have tremendous momentum in the region. We currently have four equity transactions for Chinese companies in our pipeline, so some great successes in Asia over the period that re-affirm our stepped-up investment in the region.

Moving briefly to expenses, for the quarter we posted a compensation to revenue ratio of 49.3%, a level consistent with the ratio we realized in 2006 and in the first quarter of this year. Over the period, our headcount rose approximately 5% to over 28,000. For the quarter, our non-personnel expenses totaled $915 million, up approximately 6% from last quarter's levels. This increase was driven by two factors. First, higher levels of business activity as we incurred increased brokerage and clearance and business development expenses to help drive revenue expansion. Second, expenses associated with the continued expansion of our global footprint, which includes technology investments, expenses associated with acquisitions, increased space requirements and recruiting fees. Overall, our non-personnel expenses as a percentage of revenues declined to 16.6% for the period.

Taking all of this into account, we reported a pretax margin of 34.1% for the quarter, our second highest level ever. Our effective tax rate was 32.3%. Return on equity for the quarter was 25.8% and return on tangible equity was 31.6%. So overall, an extremely strong performance for the quarter that demonstrates the benefits we have derived through diversification across businesses and regions that has more than offset softer results in certain asset classes. We are extremely pleased with the firm's performance, as we continue to realize increased productivity due to our larger scale and as we see payback from the investment initiatives we have made over the years.

Now let me make a few comments about our balance sheet. Over the period, our total stockholder's equity increased to $21.1 billion. Book value per share increased to $37.15, up approximately 6% during the period and nearly 10% year-to-date. We ended the quarter with a net leverage ratio of 15.5 times. Our average historical simulation value at risk increased to $78 million in the current period, reflecting an increase in both interest rate and equity risk, which is consistent with our growth globally and supported by our growing equity base.

Over the course of the quarter we have repurchased 7.2 million shares at an average price of $73.83 per share, bringing our first-half buybacks to a total of 28.2 million shares.

Looking forward, our outlook remains optimistic given the significant secular changes we see in the marketplace that continue to create meaningful opportunities for our sector and our firm. The global economy remains healthy and our outlook is for global GDP to grow 3.2% in 2007, a slower rate than was realized in 2006 but still a level that continues to provide a favorable underpinning for our sector. In the U.S., the economy faces risks of below trend growth on the one hand, but above target inflation on the other. As a result, we expect the Fed to remain on hold for the remainder of the year. Our interest rate outlook elsewhere is equally benign. We expect the ECB to raise rates one more time, the Bank of England to hike rates two more times, and the Bank of Japan prepare to raise rates gradually.

Furthermore, global liquidity remains strong with considerable corporate cash on hand, large pools of uninvested capital from financial sponsors, a growing allocation of assets to hedge funds, cash consideration from M&A, proceeds from share buybacks that need to be invested and continued inflows from regions such as Asia and the Middle East. If anything, these trends are accelerating, with announced global M&A, announced LBO and stock buyback plans all up significantly. This pool of liquidity continues to provide a strong underpinning for the global capital markets and for our own client-focused business model.

Our view is that the global equity market indices will rise about 14% for full calendar year in 2007 in local currency terms, and with corporate earnings for the first quarter coming in better than expected, we have raised our earnings forecast for the year and we now expect corporate earnings to increase 9% in 2007 globally.

So we expect continued strength in capital markets activity for the remainder of 2007, with risk mitigation playing a more important role in investor decisionmaking. We also expect continued strength in investment banking activity for the remainder of 2007. We expect announced M&A volumes to grow by about 30% for full year '07. Our view is that equity origination will also increase by 10% to 15% this year and we project gross global debt origination to rise 6% from the previous record in 2006, with non-U.S. origination representing a larger share of this growing pie. Consistent with the results we have reported today, our view is that Europe and Asia will continue to contribute a higher proportion of the growing fee pool in investment banking and capital markets.

So going forward, a favorable environment with significant opportunities for the firm as we continue to grow our franchise. Our commitment to growth is evidenced by the capacity and scale we continue to build in those businesses and regions, with the most rapid fee pool growth. To that end, we made a number of significant investments during the period. We closed on the acquisition of Grange Securities to further expand our geographic footprint into Australia, the market with the second largest fee pool in Asia. We announced an agreement to acquire Eagle Energy Partners, a provider of energy marketing and services in the U.S. We completed the purchase of a 20% interest in the D.E. Shaw Group and we acquired a minority stake in Wilton Re, a U.S. life re-insurer, to further diversify our securitized products business.

During the quarter, we also continued to add senior talent throughout the organization, including significant hires in Russia, the Middle East and India, among others. Within the firm, we continue to devote resources to those areas where we have identified significant potential for high margin business growth. In investment banking, we continue to enhance our coverage of sponsors and alternative investment managers and build our product breadth in risk solutions, pension advisory and spin-offs.

Clearly, from a regional perspective, we are in more countries than ever before. In equities, we continue to bolster our market-making capabilities and desk-based analytics while broadening our prime brokerage and structured derivative platforms in all three regions.

In fixed income, we continue to focus on the evolution of the securitization markets into newer asset classes and regions, our growing presence in the energy business, and on the development of new second and third-order products in the derivative space.

In investment management, we continue to target new pockets of wealth as we expand our platform outside the U.S. while bolstering our product offerings, particularly in alternatives. All of these actions are intended to bolster our capacity to generate future growth in our businesses as we cover more clients in more asset classes, in more markets around the globe.

In conclusion, our outlook remains optimistic and we believe our franchise has tremendous momentum and has never been better positioned to serve our clients and attract the best talent into the organization.

Now, I will be happy to take questions.

Question-and-Answer Session

Operator

Our first question is from William Tanona – Goldman Sachs.

William Tanona - Goldman Sachs

Did you say that the subprime U.S. residential mortgage business was a negative contributor this quarter?

Christopher O’Meara

I didn't say it was a negative contributor, I said it was a lower contributor than it was in the past.

William Tanona - Goldman Sachs

As we look at the fixed income business, obviously you had a very good all-around quarter, but fixed income trading kind of was the lowest we've seen since the fourth quarter of 2005. I would suspect that mortgages was a big part of that. Can you give us a sense as to where we might be on the revenue side to historic quarters as it relates to mortgage?

Christopher O’Meara

We don't give guidance looking forward, but mortgages obviously are at a low point in this recent period here and I think as we look forward, without giving specific guidance, I would think that we would be in for better performance looking forward.

William Tanona - Goldman Sachs

Are we at 2003 levels on the mortgage side, 2004? What timeframe would you say we're at as it relates to where we are in the mortgage revenues?

Christopher O’Meara

It's hard to say just because the business is so different now. We've significantly diversified this business over time into both asset classes and different geographies. So it's hard to say. I think the business is much bigger and broader than it was in the past, at any time in the past. We're going through the down part of this cycle -- and this is a cyclical business, as everybody knows -- so I think we're in the late innings in terms of its revenue generation in our firm.

William Tanona - Goldman Sachs

Equities, obviously very strong on a sequential basis. You highlighted some areas there. Could you give us a sense in terms of the delta quarter over quarter? What were the largest contributors as it pertains to derivatives, prime brokerage, prop trading, and execution services?

Christopher O’Meara

Sure. Just thinking about quarter to quarter, we've had this very, very significant increase and it really is across the board. It's across regions and products, all of those products you just mentioned are up and up significantly. We continue to build this business out. We've talked about the improvement in our capacity, our capabilities, our technology, and importantly our brand. So we have seen that and it really is taking shape, particularly overseas, where we really are getting a great share of business and are serving clients in a very, very strong way. We see that through the surveys that come back from independent survey providers where they come back and talk about the quality of our service offering. When you get that right, I think the business follows right on the back of that. And we're seeing that now.

William Tanona - Goldman Sachs

But in terms of what was the largest contributor, quarter over quarter? Was it derivatives, was it prop trading, was it prime brokerage? Which of those was the biggest contributor? Or if you could rank order those, that would be great.

Christopher O’Meara

As a percentage, we don't disclose the specifics of the components. These are all big businesses, so when you look at it, obviously we have a big execution services business, which was strong. The derivatives business, largely a volatility business, is also quite strong, and then prime services. So if you think about those businesses as being ranked in that order, but pretty close to one another, that's a fair way to look at it.

William Tanona - Goldman Sachs

And then in terms of the operating leverage or margins, revenues were up 25% year over year, expenses followed and were commensurate, up 25%, so we really didn't see much in the way of operating leverage. I know you guys are investing heavily, particularly overseas. Can you give us a sense as to how margins are in the U.S. versus your international markets? When would you expect this investment spend to slow down here, because it has been growing at such a rapid pace?

Christopher O’Meara

We're encouraged by the investments that we've been making and the opportunities we've seen overseas, and we're also encouraged by how quickly some of these opportunities are paying off. For example, you asked about the pretax margins. While we don't disclose that region by region, I can tell you that all of them were over 30% in terms of the pretax margins. All three regions were over 30% and that's a very encouraging sign, particularly for Asia where we've been making very significant investments and many of those investments are paying off quite quickly.

William Tanona - Goldman Sachs

Chris, do you expect that the investment spend will continue for another couple of years, quarters, or when would we expect that to start slowing down?

Christopher O’Meara

We do expect the investment spend to continue. I think around the non-comp expenses we have had a significant increase in those expenses which we talked about last quarter as being a higher level of expenses on the margin, just because we were getting into new places and new businesses, which requires a higher level of non-personnel expenses to actually get into new space and new countries, et cetera. So I would expect the rate of growth of the non-personnel expenses to diminish significantly as we move forward here.

As we are making continued investments, I think, around the non-personnel side, the rate of growth will come down, but a big portion of that growth is business activity driven, and so that's a variable factor. But I think also that we've targeted a 49.3% comp to revenue ratio, and we're satisfied that we're living within that and still making significant investments in our people around the world, so we would expect that to be the case as we continue to make investments to live within that 49.3%.

Operator

Your next question comes from Guy Moszkowski – Merrill Lynch.

Guy Moszkowski - Merrill Lynch

In fixed income, to what extent was the decline that we saw versus first quarter results due to meaningful marks that you might have made in residual positions in subprime or Alt A securitizations?

Christopher O’Meara

We certainly had a bigger movement in the first quarter, but as I mentioned, we had quite effective hedges in the first quarter and I would say that in general that held true through the second quarter. So while these positions are moving around and being marked on a day-to-day basis, we do have hedging strategies that are in place and have proven to be quite effective.

Guy Moszkowski - Merrill Lynch

It sounds like what you're saying is that most of the reduction in revenue that we saw in the quarter in mortgages really was from some combination of reduction in new product flow or secondary trading and spreads?

Christopher O’Meara

The spreads piece is part of it and we think that was particularly acute in this period. As I mentioned, toward the end of the period we actually saw that getting into better condition, particularly for the new originations of sub-prime assets. So this is turning out to be a vintage challenge here where the ’06 vintage is one that is particularly challenged but the newer originations, which are being originated to a higher credit quality, are the subject of great investor demand at this point.

But we did have -- some amount of marks were taken in the period and this fee compression that we think was particularly acute in this period and probably limited to the second quarter and that had to do with a number of factors that were taking place in the quarter.

Guy Moszkowski - Merrill Lynch

Can you give us a sense for what decline you saw in mortgage origination versus the first quarter and versus the year-ago? And it would be particularly helpful if you could break that up into sub-prime Alt-A on the one hand versus more agency stuff on the other.

Christopher O'Meara

If we take the originations we originated in the period, $17 billion, and that’s up a bit from the $15 billion and change that we originated actually in both benchmark periods, and so if you look at the first quarter, for example, on sub-prime we originated about just under $4 billion and we had roughly the same in the second quarter. So sub-prime origination volume was about the same. And then Alt-A is the bigger component of what we issue, or what we originate, so the combination of Alt-A and outside the U.S. was the remainder but with the lion’s share of it in Alt-A.

Guy Moszkowski - Merrill Lynch

I think you mentioned something about CNBS trends but I kind of missed it. Can you give us a sense for how that revenue trend shaped up versus the benchmark periods and what was going on in terms of originations versus spread?

Christopher O'Meara

In our overall real estate business, we did have strong results. In the commercial securitization, the commercial mortgage-backed securitization business, we did about $5 billion of securitizations and are replenishing that with a significant amount of originations. I don’t have that number in front of me but that business remains quite active.

So the business was strong, the revenue generation was strong but we also saw in the period some fee compression around securitizations that we think was limited to the second quarter as well.

Guy Moszkowski - Merrill Lynch

Great, that’s helpful. Just talking about the current environment, obviously we’ve had since the end of the quarter some pretty significant turmoil in the rate environment. Can you comment a little bit about how that is affecting your business and how you would expect it to affect your business, given what you’ve seen in the past? Are you seeing a pick-up in rates business, for example, versus the decline in the rate business that you talked about in the second quarter?

Christopher O'Meara

We would expect that additional volatility, you know, we’ve been living with three years of very low fixed income volatility. This recent flare has increased volatility and, as everybody has seen, has had a significant change in risk-free rates. So I think that that is generally, provided that it stays within a range, we’d like to see volatility be in place in the market because it leads to more activity by clients. But I don’t think anything’s fundamentally changed and I do think that probably for that particular business in our system, I think we’ll benefit from more volatility in interest rates.

Guy Moszkowski - Merrill Lynch

If I could just turn for a second to your leverage ratio, as you pointed out it was a little bit higher again, both gross and net, although the net wasn’t up too much. Can you give us a sense for what changes in the business mix might be driving this and how much of it is driven by growth in prime brokerage services?

Christopher O'Meara

It’s really everything. As we continue to build out our businesses around the globe and add all those people that are new when we get into new markets, the net leverage ratio of 15.5 times is right in line with the 15.4 times we had at the end of the first quarter and it is a combination of everything. If you look across our businesses, they are all growing and we feel great about it and across our regions as well. So it’s not limited to a particular thing. We do have certainly the prime brokerage is certainly a component of that but so are the various other businesses that we have, particularly outside the U.S.

Guy Moszkowski - Merrill Lynch

Final question, which is sort of reflective of the leverage, your diluted shares were down about 2.5% now versus the year-ago. Half of that reduction took place in the quarter that just ended. Is there any change in your capital management and share repurchase policy here?

Christopher O'Meara

No, there’s no change. Really, that reduction is driven by just the share price under the treasury stock method of accounting for diluted shares. So that I would expect to not be the same as we look forward, meaning I would expect the diluted share count to go up a bit as we look forward.

Guy Moszkowski - Merrill Lynch

Great, thanks very much, Chris, appreciate it.

Operator

Thank you. Our next question is from Glenn Schorr. You may ask your question and please state your company name.

Glenn Schorr - UBS

UBS. One quick follow-up on the equity side, just bigger picture; you gave us a lot of detail about the growing businesses, product wise and geographically. It’s still it’s just an uncomfortable thing, I think, for all of us as we look at the model and you clip along over the last couple of years of $600 million, $700 million, $800 million, $900 million and then last quarter, you’re like boom, $1.4 billion, $1.7 billion. Every comment that you’ve made to this point leads us to believe -- not to the dollar amount, I’m not looking for guidance but I’m just saying we’re at a different earnings level in your equities business for all the reasons you mentioned. Is that fair enough?

Christopher O'Meara

I think that’s fair enough. Having said that, I don’t think we can necessarily count on every quarter to be a record quarter. There are some things at play in here, as I mentioned. The market was very favorable in this period. There was some amount of seasonality, particularly in Europe prime services around financing, where there’s a seasonal positive that’s at play around dividend season when stocks become harder to borrow and you get paid more to facilitate that activity.

But I think in general your statement around we are at a different earnings level in the equities business is I think a right-on point.

Glenn Schorr - UBS

Cool. That’s good. And then on the expense side, obviously everything you’re doing in terms of investments is working. You made the comment that things are having quicker pay-offs than you had even hoped, which is great. So you do have 22% year-to-date versus year-to-date last year expense growth, which is what you would qualify as good expenses. But as you think about still the need to continue to build out in Asia, just a quick comment on how you think about flexibility and is part of that spending during great times, do you have flexibility if the third quarter turns out to be seasonally soft? I mean, maybe too short of a timeframe but just curious on your thoughts on flexibility.

Christopher O'Meara

We certainly do have flexibility in the overall system, as we have -- let’s say for our compensation, it’s about 55% variable when you look at the component pieces of our aggregate compensation. So we certainly have a variable expense base and that’s something that this industry enjoys, a highly variable expense base, as you know.

So I think we are very thoughtful about how we are putting our investments to work but most importantly is that we see these long-term opportunities that we have the ability to get at and we have, we think, competitive advantage and can get into these opportunities and begin to build these businesses and we’re after it. So we have continued to make investments. We set out an investment program at the beginning of the year and we dole out the investment dollars around the globe and into the different businesses and we had a second round where we let out some additional investment dollars early in the second quarter and we feel great about it.

Glenn Schorr - UBS

Excellent. All right, thanks, that’s it.

Operator

Thank you. Our next question is from Mike Mayo. You may ask your question and please state your company name.

Michael Mayo - Deutsche Bank

Deutsche Bank. Can you confirm -- I guess you had no growth in the U.S. and great growth outside the U.S.? So if you look at it geographically, anything else in the U.S. that kind of depressed the growth some?

Christopher O'Meara

I’m sorry, Mike, you just faded out there. Can you say that again?

Michael Mayo - Deutsche Bank

It looks like you had no growth in the U.S. and great growth outside the U.S., so any other factors that hurt the U.S. growth other than the mortgage business?

Christopher O'Meara

Well, it was the fixed income business was it. As we mentioned, the mortgage business is in a very challenging situation and really that’s it. But we’re really excited about the diversification and the outside the U.S. We really want to emphasize how great we feel about this, the development of the businesses outside the U.S. The U.S. businesses are still strong and have great margins, just down a bit from what we saw in the first quarter.

Michael Mayo - Deutsche Bank

And remind us how much sub-prime and Alt-A mortgages are total?

Christopher O'Meara

We didn’t give out what Alt-A is or the other businesses inside of the securitization business system but what we said in the last period was that over the past six quarters, on average the sub-prime business has contributed less than 3% of the total revenues of the firm.

Michael Mayo - Deutsche Bank

And in terms of your backlog, I know it’s at a record but what’s the relative strength of the backlog outside of the U.S. versus in the U.S.?

Christopher O'Meara

If I could just give you some numbers to put that in context and the fees are a little different than the value pipeline but let me give you the value pipeline, to just take a look at. In advisory, we have $580 billion pipeline of deals, volume of deals in the firm and there’s 200 -- we actually have more outside the U.S. than inside the U.S. One of the large transactions we’re advising on is the ABN AMRO transaction. So you see that in M&A and I think on the financing side, we’re certainly more heavily weighted in the U.S. but importantly, we have record pipeline in Europe and feel great about the developing investment banking opportunities that are there.

Michael Mayo - Deutsche Bank

Is there any limit to where you want the non-U.S. to go or are you fine for those to stay at 50% or 60% or even higher percent?

Christopher O'Meara

We had set out a goal of getting to 50% over the next several years and we are heading toward that. So it’s not necessarily where we are setting something. We just want to make sure that we’ve got a very diversified business system and we’re growing high margin businesses and we’re putting our investments where the best opportunities are. So without giving a specific number around where we ultimately want it to go, we’d like for it to go to 50% here over the reasonably near-term.

Michael Mayo - Deutsche Bank

Lastly, a follow-up on what’s happened in June so far with the selloff of the 10-year. You mentioned trading it could be good. What about issuance? Are you seeing that decline somewhat?

Christopher O'Meara

Well, it’s too early to tell, Mike, but people have their issuance plans together. We actually saw issuance pick up when there was the first fed rate move, treasury rate move to the north because some were waiting for a rate cut. And then when they saw that it looked like it was going the other direction, they quickly went and did some issuance so it’s too early to tell what’s going to happen. But we don’t think this has fundamentally changed the outlook for issuance.

Michael Mayo - Deutsche Bank

Thank you.

Operator

Thank you. Meredith Whitney, you may ask your question and please state your company name.

Meredith Whitney - CIBC World Markets

CIBC. I hope this comes through okay. I’m on a cell phone in London but I wanted to clarify a couple of points. Am I okay?

Christopher O'Meara

Yes, you’re okay.

Meredith Whitney - CIBC World Markets

Great. I was hoping you’d say this and you did and I want to make sure that this is new guidance in terms of last quarter you gave guidance of flat global debt issuance and today you said 6% growth in global issuance. How new is that? Am I missing a report or is this new as of this conference call?

Christopher O'Meara

Yes, this is new as of this conference call.

Meredith Whitney - CIBC World Markets

Okay, that being a very big deal and then the other issue is the Citic deal, obviously a seminal deal this quarter and you said that you had four equity deals in Asia in the hopper and that’s versus zero last year. Is this related to a banking team that you hired, and then is this suggestive of the fact that your revenue growth from this channel is really accelerating?

Christopher O'Meara

It’s not related to a new banking team. We’ve had some terrific operators on field. It takes time to generate those relationships and opportunities and we feel great about the traction that we have there, in China and elsewhere throughout Southeast Asia. We think that is a trend, that we’re going to be seeing more banking business coming from that region.

Meredith Whitney - CIBC World Markets

Okay, great. Thanks, good for you guys. Thanks so much.

Operator

Thank you. Our next question is from Douglas Sipkin. You may ask your question and please state your company name.

Douglas Sipkin - Wachovia Securities

This is Douglas Sipkin from Wachovia. Two questions; first, more specifically on the mortgages, I’m just curious. I’m hoping you can just shed some color on how have all the competitive dynamics changed in the U.S. with some of your competitors making large-scale mortgage origination acquisitions and maybe getting more vertical in their businesses? How have you been feeling that competitive pressure?

Christopher O'Meara

This has always been quite a competitive business and with the capacity reduction that has come from some players dropping out of the market and actually some teams from within some of those institutions being picked up by firms like us, for example, but overall capacity has come out and the only thing that it does is it just takes that deal flow away from the likelihood that we will acquire it and securitize it. But in terms of the competitive pressure around origination, it’s always been there so I don’t think anything’s really changed by the competitor group getting into this space.

Douglas Sipkin - Wachovia Securities

Shifting gears to the asset management, obviously you guys have become inquisitive with respect to alternatives. Are there any other products, more traditional fixed income equity, et cetera, where you guys are looking to grow possibly or inorganically, or is it going to continue to be a focus on alternatives?

Christopher O'Meara

We’re certainly open to opportunities, particularly outside the U.S., to make an acquisition. If we found the right thing for the right criteria, we would certainly consider it. But we do want to be in a situation where we have an established platform with a great track record with great operators and we have found that in the form of alternatives where we do believe that in the alternative space, there will continue to be a flow of assets toward active asset managers. And that’s been true for the last several years and we expect that to continue to be true. But we are interested in both.

Douglas Sipkin - Wachovia Securities

And then, just in terms of obviously you provided some color around non-comp. Can you just shed a little color on headcount growth expectations for the remainder of the year going forward?

Christopher O'Meara

Sure. We would expect headcount growth to continue to increase. We’re up about 9% in terms of headcount growth through the half-year point versus the beginning of the year. We still have the classes of undergrad and business school folks coming in in the third quarter, so we would expect that the headcount growth will continue. I would expect another 3% to 6% actually over the back-half so you can think about us as growing headcount in this year, full year of somewhere between 12% and 15%.

Douglas Sipkin - Wachovia Securities

Great. Thanks.

Operator

Thank you. James Mitchell, you may ask your question and please state your company name.

James Mitchell - Buckingham Research

Buckingham Research. Two questions, one on the commodities build-out. Can you talk a little bit about the progress there and how much of an impact the acquisition of Eagle Energy will provide?

Christopher O'Meara

Sure. We are making progress. We do have capability now, particularly in natural gas and power and oil, in each of our three regions but it still is a relatively new business for us, so it’s a relatively small contributor in terms of revenues but it is growing. We feel great about it.

With adding Eagle adds, in addition to some very seasoned operators who have great relationships, it adds client contacts and business know-how around intermediation in the physical space where these folks are marketing service providers and we feel great about adding them into the platform in terms of what it’s going to be, the lift that it will be able to create for the rest of the business. And we couple that with an excellent investment banking business that we have and the relationships we have there, we’re looking for good things to come in the future.

James Mitchell - Buckingham Research

Do you expect the trading part of it though, probably would expect is still not generating a big profit at this point, or it could be losing money. Do you expect that to turn meaningfully profitable at some point, maybe next year?

Christopher O'Meara

We do expect it to turn meaningfully profitable. It certainly does take time to build up capability in this business and so revenue generation is to come. But we look at it as a client-related business that is like any major client-related business, takes time to grow and develop. But we have capability and we have some excellent operators. It certainly is going to take a little more time but we do see that as one of the builds for the future which will give us lift as we look forward into the coming years.

James Mitchell - Buckingham Research

Okay, and then switching gears on the NBS business one more time, with the rates backing up a little bit and a lot of arms expected to adjust over the next 12 months, do you worry at all about the impact of potentially further negative impact on loss rates or delinquencies or things like that? Or do you feel that that’s mostly in the market at this point?

Christopher O'Meara

We certainly do worry about it because it’s never good in a situation where folks can’t afford to stay in their homes but we do think that from a market perspective that that has been baked in. There have been a lot of very thoughtful research pieces that have been put out in the market that have explained this situation and what is likely to happen. I think the market understands it well, different than how the market understood some other things leading up to it but I think at this point, the market understands the rate increases that are coming up from the 2-and-28s that were originated a couple of years ago that are going to be resetting here in the back-half of the of ’07 and into ’08.

So I think it’s priced in but it’s never good when you see a situation where some folks are going to face the payment shock that some folks are going to face.

James Mitchell - Buckingham Research

Okay, fair enough. Thanks.

Operator

Thank you. Our final question is from Michael Hecht. You may ask your question and please state your company name.

Michael Hecht - Banc of America

Banc of America. Just a follow-up on the equity capital markets, and I’m sorry if I missed this in your prepared remarks -- did you talk about the contribution from private equity gains this quarter? And then just generally, how should we think about just how maybe the increase in risk appetite is helping to drive some of the higher revenues, either across proprietary trading or just kind of principally oriented trades, and could you tie into that where your equity var kind of ended the quarter, relative to a quarter ago?

Christopher O'Meara

Sure. We did talk about the private equity. What we said was $87 million for the quarter. I think that is the same as last quarter. I think that is something that we have come to have some amount of that that is, as we talked about before, is that we do put some amount of investment into our own private equity funds alongside of our clients and this is the result of that, is a return from that. It’s actually been reasonably consistent over I’d say a four quarter rolling average. It has some choppiness but in general I think it is -- if you look at it, you would see reasonable consistency.

As far as risk appetite and the tick-up in the equity risk over the course of the quarter, we’re in the risk business and I think as the evolving equity markets continue to change and we play in that in service and client flow, we certainly serve as a principal and risk taker around client flow and our objective is to try to intermediate that and take out small spreads out of lots of transactions. But certainly it is a risk business and the increase in var is reflective of the growth of the firm, including getting into new markets outside the U.S.

Michael Hecht - Banc of America

Okay, that’s fair enough. And then just a follow-up on the fixed income side, I guess I was a little surprised to hear that Alt-A activity for you guys was flattish sequentially versus what I think has been decent declines in the industry. Can you just talk a little bit more about the drivers and trends you’re seeing there? Also, just coming back on your outlook in Alt-A specifically in terms of originations and spreads?

Christopher O'Meara

We have a leading Alt-A origination franchise, one of the top ones in the country. So we actually had terrific performance on the origination side around the Alt-A business. We originated, as I mentioned before, a higher level than we had in each of the two benchmark periods. So we will continue to be invested in this business. We understand it. We’ve been through cycles before and we’re looking forward to what the future holds around the business for us.

Michael Hecht - Banc of America

Okay, great, thanks.

Operator

Thank you. I’m showing no further questions.

Christopher O'Meara

Okay, great. Let me say thank you to everybody for joining us today and we look forward to speaking with you during the next quarter call. Take care.

Operator

Thank you. This concludes today’s conference. Thank you for participating. You may disconnect at this time.

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