Lehman Brothers Business Update Call Transcript

 |  About: Lehman Brothers Holdings Inc. (LEH)
by: SA Transcripts

Lehman Brothers (LEH) Business Update Call June 9, 2008 10:00 AM ET


Good morning and welcome to Lehman Brothers conference call. (Operator Instructions) I would now like to turn the call over to Ed Grieb, Director of Investor Relations.

Edward Grieb

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 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 condition, 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 most recent Quarterly Report on Form 10-Q as filed with the SEC.

The firm’s financial statements for the second fiscal quarter of 2008 are not finalized until they are filed in its Quarterly Report on Form 10-Q for the second fiscal quarter of 2008.

The firm is required to consider all available information through the finalization of its financial statements and the possible impact on its financial condition and results of operations for the reporting period including the impact of such information on the complex and subjective judgments that will be discussed on today’s call as well as estimates the firm made in preparing certain of the preliminary information included in these remarks.

Subsequent information or events may lead to material differences between the preliminary results of operations described in these remarks and the results of operations that will be described in the firm’s subsequent earnings release and between such subsequent earnings release and the results of operations described in the firm’s Quarterly Report on Form 10-Q for the second fiscal quarter of 2008. Those differences may be adverse. Listeners to these remarks should consider this possibility

This presentation contains certain non-GAAP financial measures. Information relating to these financial measures can be found under the footnotes in this morning’s preliminary 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.

Now I would like to turn the call over to our Chief Financial Officer, Erin Callan.

Erin Callan

I really appreciate your joining on such short notice this morning. Today I want to cover the press releases we issued earlier in the day. The press release of our second quarter estimated earnings and the offering of $6 billion of equity, which is comprised of $4 billion of common and $2 billion of a mandatory convertible preferred stock.

First, very importantly up front I want to caveat since we are only approximately one-week into our quarterly financial closing process, the financial information I will be talking about today is all preliminary and represents estimates that are still subject to refinement and to change. As indicated in the release, we expect hold a follow-up call covering our full results with greater detail and another presentation next Monday, June 16.

I will take Q&A at the end, however, again be patient given the preliminary nature of these earnings numbers. Please understand and expect that some of the answers I’m going to give will be more limited than usual and certain questions we may not be able to answer at this time but we will have the intent to answer them next week. There will be an opportunity for additional Q&A with the presentation on June 16.

The estimated net loss in our press release this morning that we reported for the second quarter is $2.8 billion, which results in a diluted EPS loss of approximately $5.14 per share. These amounts include approximately $4.9 billion of mark-to-market adjustments, principal investment losses and other dynamic hedging losses.

Our estimated net revenues for the quarter are negative $700 million, compensation expense is $2.3 billion, non-personnel expense is $1.1 billion, our tax rate for the quarter is approximately 32%, preferred dividends this quarter about $100 million, and we estimated our diluted share account to be 559 million shares ahead of today’s offering.

Book value per share again without counting this morning’s transaction at the end of the quarter is estimated to be slightly over $34 per share. The net loss of $2.8 billion compared to net income of $489 million last quarter and $1.3 billion in the second quarter of 2007.

Importantly and you’ll hear this throughout the call during the quarter we executed on a number of the capital and liquidity goals that we set out for ourselves which includes as follows.

Lowering gross and net leverage to less than 25 times and less than 12.5 times respectively, both of those numbers are prior to today’s capital raise; reducing our gross assets by approximately $130 billion and our net assets by approximately $60 billion with a large part of the reduction, as I will talk about in detail, coming from less liquid asset categories and also providing significant price visibility for marking the remainder of our inventory.

We significantly reduced our exposure to asset classes such as residential and commercial mortgages, and real estate held for sale of approximately 15% to 20% in each case and acquisition and finance exposure by almost 35%. We also reduced our high yield or non-investment grade debt inventory in the aggregate, which includes our funded acquisition finance position by greater than 20% in the quarter.

I want to be clear at this point that we do not intend to lower our leverage ratios from these levels. From a liquidity perspective, we made great progress growing our cash capital surplus to approximately $15 billion, that’s the surplus, from $7 billion in the first quarter. We grew our liquidity pool to almost $45 billion and that compares with $34 billion at the end of the first quarter.

We completed in its entirety our budgeted funding plan for the full year 2008 of approximately $33 billion that also includes $5.5 billion of public benchmark long-term debt that we’ve executed in the last two months alone. We spent a reasonable amount of time increasing our overfunding amount on the repo side increasing those to approximately 25% in overfunding from 15% last quarter.

We executed on all of these goals in a market environment that was especially challenging and was consistent with our commitment we made at the beginning of the quarter. Our gross and net mark-to-market adjustments this quarter were $3.6 billion and $3.7 billion respectively and came primarily in the residential and commercial mortgage books.

For the quarter, we benefited from the widening of our credit spreads on our own debt and recorded approximately $400 million of gains on structured debt liabilities since end of February.

Our hedges on illiquid assets generated approximately $100 million of additional losses this quarter as gains from some hedging activity were more than offset by losses in others and I will talk about that in more detail.

The overall efficiency of hedges this quarter was significantly impacted from the unprecedented dislocation between our derivative hedges and the underlying cash markets, a theme that took place throughout the broader capital markets.

In addition to the hedging of our less liquid asset exposures we also maintained defensive positions in our credit and rates businesses. Market movements in the quarter including an anomalous shift in basis resulted in approximately $700 million in losses this quarter.

Our principal and private equity portfolios also incurred losses of approximately $500 million and on a combined basis, aggregating all these losses, continued asset repricing of $3.7 billion, principal and other losses, all served to negatively impact our revenues by a total of approximately $4.9 billion.

When we look at this number versus the $700 million of negative reported revenues this corresponds to run rate revenues for the quarter of approximately $4.2 billion in what was a very challenging and eventful market environment. As we look forward, our underlying client franchise remains remarkably strong given the broader market context for the quarter across our peer group.

Capital markets client revenues declined by only about 2% quarter-over-quarter. We continue to see our share of wallet with our institutional capital market clients increase. Our U.S. fixed income-trading share increased to 12.8% year-to-date from 12.2% last year. And we improved our global equity-trading share for the year across most major stock exchanges.

Longer-term, we see real opportunity in the capital markets as the competitive landscape is improving in our favor and as risk is being priced more appropriately. When asked about of the viability of a mid teens ROE earnings model with lower leverage, we see the recent trends supporting higher ROAs and margins and a markedly advantageous competitive environment from Lehman Brothers.

For example, we also strengthened our market share in Investment Banking this year including completed M&A where we’ve grown our global market share to 24.4% from 19.4% last year, and our global equity market share rose to 5.8% from 3.6% last year. And activity levels across all our businesses, which were slow early in the quarter, picked up in the latter part of the quarter. So, let me go through some additional detail on our revenues and net income performance to give you more perspective.

Our capital markets revenues of negative $2.4 billion were significantly impacted by the mark-to-market adjustments and other losses that I noted earlier. This compared with $1.7 billion in the sequential period and $3.6 billion in the second quarter of last year.

Within capital markets, fixed income revenues were negative $3 billion and equities capital market revenues were $600 million with the equity revenues being impacted by a $300 million principal related loss this quarter. We lay out our gross and net mark-to-market adjustments on Page 9 of this morning’s earnings release to simplify it.

In residential mortgages, our gross adjustments were approximately $2.4 billion. These losses arose primarily from two different factors. First the collapse of a large mortgage hedge fund Peloton and then events around Bear Stearns at the beginning of the quarter caused significant price deterioration, particularly at the top of the capital structure for resi assets.

Second as I mentioned earlier, we actively reduced our exposure throughout the quarter particularly in high-risk positions such as non-performing loans and subprime, which allowed us better pricing information on this asset class.

Our residential hedges provided only $400 million of benefits this quarter, in other words hedges offset approximately 17% of the losses. As a reminder, this compares to a benefit of over 70% in the prior quarter and similar amounts in Q3, Q4 ‘07. This lower benefit resulted from the dislocation between cash assets and the asset-backed, single name and index derivatives that we use as hedges.

Thus our net write-downs in residential mortgages were $2 billion. It is worth noting that it was an extremely active quarter for secondary trading of residential products, outside these asset losses our business generated strong operating revenues on the back of that trading activity.

In other non-residential asset-backed securities our gross and net adjustments were approximately $300 million. There are a variety of different debt instruments included in this category such as franchise related whole business financing, student loans, small business loans, auto loans, credit cards, most of which were categorized as Level 2 assets in the first quarter. These assets include securitized asset-backed issuances as well as whole loans.

In response to specific questions on this category, these assets do not include any ABS CDO balances. Our exposure in ABS CDOs is approximately $600 million and is included in our residential mortgage exposure lines. Last quarter approximately 12% of the balance of asset-backed securities was unrated and therefore reported as below investment grade. We have now received AA ratings on a significant amount of this previously non-rated portion.

Commercial mortgages and real estate had gross mark-to-market totaling approximately $1 billion. This quarter we sold over $7 billion of commercial mortgage positions across different parts of the capital structure to over 170 different client accounts and primarily in the form of whole loans.

The breadth and scale of this selling is a sign of the return of investor appetite to this asset class and gives us very good price observability in marking the remainder of our commercial book. Also more than 75% of the $7 billion sale volume were outright sales without financing and mezzanine sales were consistent with a 20% mezzanine pro rata portion of this total book.

However, during the quarter we did see spreads on our commercial hedges tighten by several hundred basis points. For example, the CMBX 4 Series has tightened anywhere from 100 to 300 basis points depending on the tranche while the spreads on our largely floating rate positions did not change materially. Thus our hedges, including single name and index derivatives, had losses of approximately $400 million resulting in an aggregate commercial mark-to-market adjustment of $1.4 billion.

I would like to stop for a moment and comment on the many questions we have received about two investments, Archstone is the first. Archstone is a company which owns a very diversified portfolio of high quality apartment assets, the underlying fundamentals of which continued to improve. For example, it had first quarter ‘08 same-store revenue growth of 5%.

Notwithstanding that performance in recognition of the change in real estate market valuation metrics we have taken a significant mark on that position. The current mark reflects a projected mid-teens internal rate of return on net capital. As a matter of Lehman policy and consistent with industry practice, we do not disclose specific marks.

Similarly our SunCal exposure, which resides in both our fixed income and third-party managed funds area, represents approximately $1.6 billion of unlevered direct Lehman exposure. The exposure has been marked to reflect an approximate 15% unleveraged internal rate of return.

That mark takes into account recent similar large transactions that have occurred in relevant markets. For example, of the total exposure, approximately $250 million is in the Inland Empire with an adjusted basis of approximately $20,000 per lot.

Moving on, in acquisition finance our gross and net mark-to-market adjustments were approximately $300 million and $400 million respectively. It has been suggested we have not been sufficiently aggressive in marking on our inventory. In fact I believe our successful hedging performance over the past year has muted the magnitude of our gross markdowns.

To give you the cumulative size of gross losses we’ve taken on these asset classes since the beginning of fiscal ‘07 most of which occurred in the past 12 months, in residential mortgages and other asset backed securities we’ve taken over $11 billion of aggregate write-downs. In commercial mortgages and real estate held for sale we’ve taken approximately $3.5 billion of gross write-downs.

In acquisition finance we’ve written down almost $2 billion of assets. In total we’ve taken approximately $17 billion in gross mark-to-market adjustments since the beginning of last year offset by hedging benefits of approximately $7.5 billion.

Given the lack of benefit from hedging this period I’d like to make a few comments on our hedging strategy that we’ve used against illiquid assets. First and foremost it remains our intent to actively hedge our exposures with the goal of mitigating the impact of market movements.

We believe the ineffectiveness of our hedges this quarter was an aberration. Shorting cash assets is not practical because of limits on borrow. Derivatives are and will continue to be the most efficient hedging option and we do not expect further divergence between derivatives and cash from here.

I’d also like to point out how each month of the quarter was quite distinct. March was characterized by the effects of Peloton and the collapse at Bear Stearns, which both put tremendous pressure on the senior part of the residential mortgage capital structure. This is evident in the level of gross write-downs we again saw in resis in March.

April was characterized by the dislocation of credit spread tightening between cash and derivatives and lastly in May we saw some returns to normalcy. In fact, excluding asset marks May was one of our stronger run rate revenue months.

Within the broader context of fixed income capital markets, our overall client activity levels remained strong. Fixed income client revenues were down slightly from a strong first quarter. Year-to-date 2008 client revenues are up substantially versus last year and importantly our relationships with clients and counterparties remains strong with no material loss of lenders, clients, nor counterparties during the quarter.

We saw continued strong secondary flows in securitized products, municipals, energy, credit, interest rates and financing which are all up significantly versus a year-ago.

Equities capital market revenues of approximately $600 million declined 60%, but included within the mark to equity segment are losses on private equity and principal. The market environment in this area was also challenging this quarter for principal as we experienced estimated losses of $300 million in equities driven in part by depreciation of our investment in GLG. We had a gain of approximately $200 million on principal and private equity last quarter, so a $500 million swing period-over-period for that segment.

In the second quarter of ‘07, the comparable gain was approximately $300 million. Excluding these principal and private equity marks, we saw client revenues in the equities business remain essentially flat versus both comparable periods. Volatility revenues declined versus both periods while execution services remained solid year-over-year but down versus the trailing quarter. And prime services had record revenues even in the face of continued deleveraging by hedge funds post the events of mid-March.

Turning to Investment Banking, we had revenues of approximately $860 million, which were flat to last quarter down 25% versus a year-ago, and flat in the context of significantly declining market activity. Debt underwriting revenues were down versus last quarter as investment grade issuance remains strong while both comparable periods contained stronger high yield revenues.

Equity underwriting revenues were up more than 50% from last quarter, and flat versus a year-ago on strong issuances and participation by Lehman in the financial sector while IPO activity remained lower than the year-ago period. Advisory revenues were also lower given the current financing environment.

For investment management, revenues of approximately $850 million declined 12% versus last quarter and 10% higher than the second quarter of ‘07. Private investment management revenues remained strong in both fixed income and equities.

Asset management declined 20% versus the first quarter primarily on the back of a declining incentive fee revenue and income from minority investments and third party hedge fund managers. We expect our assets under management balances to be essentially flat this quarter at $277 billion despite all the market turmoil.

Moving to expenses for the quarter, our total compensation expense is estimated to be $2.3 billion, which reflects the $480 million increase from last quarter. During the quarter, we incurred severance costs that were included in this comp expense.

Also during the quarter, our headcount declined by 1900 people, most notably in the U.S., as we continue to scale our businesses to their respective opportunities. For the quarter, our non-personnel expense totaled $1.1 billion. In this area we’ve implemented a number of further cost saving initiatives during the quarter, which will generate approximately $250 million in annualized savings going forward, particularly in real estate occupancy.

Now let me make a few additional comments about our balance sheet and our capital. We ended the quarter with total stockholder equity of approximately $26 billion, again, prior to capital raise and up 6% from the first quarter. This includes the issuance of $4 billion of convertible preferred stock in April.

Our long-term capital rose to $156 billion from $153 billion at the end of the first quarter. In addition to the convert we raised in April, we raised an additional $5.5 billion in benchmark long-term issuances this quarter including $2 billion of 30-year subordinated debt. Consequently, as I mentioned earlier, we’ve completed our entire budgeted funding plan for all of 2008 and do not need to revisit the debt market.

Book value per share declined this quarter to approximately $34 a share driven by our net loss. Taking into account today’s capital rate, we estimate book value per share to be approximately $33 a share.

As we have previously stated our goal in the second quarter was to bring down gross and net leverage most importantly we wanted to accomplish that by reducing exposure to residential and commercial mortgages and leveraged finance exposures. And we’ve done this.

For the quarter, we estimate we reduced our total assets by approximately $130 billion from $786 billion at February 29. With this reduction in gross assets combined with our convertible preferred issuance in April, we expect to report a gross leverage ratio less than 25 times; again this excludes the latest capital raise, which brings us below 22 times.

We reduced our net assets by approximately $60 billion this quarter resulting in net leverage of under 12.5 times versus 15.4 in the first quarter and again less than 10 times net leverage with the capital raise. I will provide more on these specific reductions and exposures on our earnings call on June 16.

However, I do feel comfortable stating today that residential mortgage, commercial mortgages and real estate held for sale will each be down between 15% and 20% and acquisition finance exposure is down approximately 35% on the quarter. Our deleveraging was aggressive as you can see and is complete.

For Level 3 assets, just to make a comment, I can’t give you any specific amounts at this time as it is too early in the closing process of our books. While the valuation of all our assets is complete, our positions must now be evaluated, and that includes thousands of positions, to determine the level of price transparency and observability on May 30, in order to appropriately classify them for our 10-Q disclosure.

Once we complete this process, I am sure we will see a number of reclassifications into and out of Level 3 this quarter. Certainly there were a number of sales that took place out of Level 3 and also transfers. Our CFC capital ratios for Tier 1 and total capital are very strong and we will provide additional details next week on those numbers for the conference call.

To address the capital raise, we also announced today the offering of $6 billion of equity comprised of $4 billion of common equity and $2 billion of mandatorily convertible preferred stock. Both offerings were substantially oversubscribed, have been fully allocated and commenced trading.

The proceeds of the offering will be used to bolster capital in light of our loss for the quarter and to increase our financial flexibility. To be clear, we do not expect to use the proceeds of this equity raise to further decrease leverage, but rather to take advantage of future market opportunities, which are abundant and overall, we stand extremely well capitalized to take advantage of these new opportunities.

From a risk management perspective, we continue to operate in our disciplined manner we’re known for. Our balance sheet and exposure levels declined throughout the period as discussed and this was reflected in our risk numbers as well. Our period-end valuate-at-risk was $75 million on an unweighted basis and $104 million on a weighted basis. This compares to unweighted VaR of $89 million at the end of last quarter and weighted VaR of $106 million at February 29.

From a counterparty exposure perspective, our non-investment grade derivative counterparty exposure continues to be approximately only 5% and our exposure to monolines remains minimal.

Liquidity, next I will review liquidity and the framework in a bit more detail. First given the unprecedented market events over the past few months, let me review some of the recent funding and liquidity actions we have taken to be responsive.

We have significantly increased our cash capital surplus and liquidity pools since mid-March, we completed our targeted funding plan for the year. We increased the funding provided by our banks with customer deposits for less liquid assets and we will continue to grow this funding source and we increased the overfunding amount in our tri-party repo and extended the maturities of these facilities.

We ended the quarter with holding company liquidity pool of approximately $45 billion, which is our largest ever. This compares to a liquidity pool at holdings of $34 billion in the first quarter. To note the liquidity pool is primarily invested in cash, bank deposits, government securities and overnight repo collateralized by government securities.

As discussed in the past, our liquidity framework is structured just to cover our expected cash outflows at the holding company for a 12-month period without raising new cash in the unsecured market or selling assets outside the liquidity pool.

At the end of the second quarter, the $45 billion of our liquidity pool was well in excess of our short-term unsecured financing liabilities, which includes the current portion of long-term debt totaling $31 billion. So the combination of short-term debt and long-term debt rolling into current portion approximates that $31 billion.

Additionally, our bank entities in regulated broker dealers carry significant excess liquidity in the form of unencumbered collateral to fund qualifying assets. As I have noted previously, we have tested the Fed’s new primary dealer credit facility on occasion with no outstanding balance at quarter end. The last time we accessed this facility was April 16 on an overnight basis. I will provide more details on our secured funding position on our full earnings call on June 16.

All in all this was an extraordinarily active quarter, from an operating prospective it was a very challenging market environment where our practice of utilizing derivatives to significantly hedge our less liquid market exposures did not provide the benefits we have seen in prior quarters and our defensive positioning strategy also worked against us.

We also experienced a fair amount of volatility early in the quarter arising from the fallout of the events of mid-March. At the same time, we took significant and dramatic steps to reduce our asset exposures to reduce our leverage, while simultaneously improving our liquidity and capital position. Deleveraging is complete. We do not expect to take the balance sheet side down from here.

In spite of the volatile market environments, our employees continue to stay focused on our clients and providing quality, valued services enabling us to continue to take market share and key assets at all our business as we did the last three months even in the light of the most difficult quarter in our history.

We are raising additional equity of $6 billion, which serves to mitigate the loss of $2.8 billion this quarter and to give us flexibility going forward. Our lower leveraged enhanced equity base and rescaled business platform leave us well positioned as we enter the second half of 2008.

A time when we are seeing more business opportunities including institutional capital markets activity increasing after a slow start in Q2, a pickup in investment banking activity particularly since the middle of the quarter, new asset management mandates in our expanding platform and our growing presence outside the U.S. where markets continue to develop more rapidly than inside the United States.

And so, our client driven business model is providing us with a competitive advantage. There is a significant global fee pool out there as we’ve talked about before and we’ll continue focusing on our clients, delivering value to them every day and providing the financial and more importantly the intellectual capital that they expect from us. We’ll also stay focused on the core disciplines we have known for: risk, expense, liquidity and capital management as we move into the second half.

Now I will be happy to take questions, however just to repeat again given the preliminary nature of these earnings numbers, please understand and expect that some of my answers may be more limited than usual and certain questions we may not be able to answer at this time.

Question-and-Answer Session


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

William Tanona – Goldman Sachs

So, just obviously you were pretty defensive I would say this quarter as you went through the whole deleveraging process. How do you change the attitude of the traders and to get back into a profit making, risk-taking mode after going through that type of a deleveraging process?

Erin Callan

I think part of the rationale for us this quarter of why we were so aggressive, why we put out a list of targets and why we had such a tight schedule, was exactly that. We didn’t want to create a long-term distraction factor to the business operators. So, we’ve done that, they knew what the targets were.

We were explicit from the beginning of the quarter. They knew there was light at the end of the tunnel. We’re already seeing them back in business in terms of risk taking in an active way and so I think the discipline of getting it done primarily in a single quarter was important to keep the mindsets focused.

William Tanona – Goldman Sachs

Is that also why there was possibly no strategic investor involved in this capital raising? You felt you had gone as aggressively as you should have and didn’t have the need for additional balance sheet help if you will?

Erin Callan

Yes, on the strategic side, look for several years, and you have heard it from Dick. We have talked about interest in a strategic partner. So, it’s not to say we don’t continue to have interest, if there is an appropriate partner for us. But it will be consistent with our objectives and certainly balance sheet is not something we need at this point from a strategic partner.

William Tanona – Goldman Sachs

And then obviously you’ve commented briefly on the Level 3 assets, but given the commentary that you had provided and the level of liquidations that you have done and the number of sales that were done is it safe to assume that your Level 3 assets are going to be down materially here in the quarter?

Erin Callan

Bill, that’s not safe to assume. Certainly there has been a significant portion that went out the door in the sales out of Level 3, but there is a number of other asset class reclassifications that I am expecting can happen this quarter.

For example, our U.K. resi portfolio would be a good case. That market really lost its price transparency during the quarter. So, it’s too early to tell how the sum total of all these effects will take place, but I can’t give you an assurance that that number is going down, that’s not my expectation.

William Tanona – Goldman Sachs

Obviously comp and non-comp expenses have jumped up, I know you had talked about severance and some other factors in there. But as we think about those line items going forward what type of comp to net revenue ratio should we assume? And also what baseline, non-comp expenses should we assume?

And given all the capital raises that you’ve done this quarter, what’s your expectations for the ROE that you still think that the core Lehman franchise can generate particularly in this environment?

Erin Callan

So, let me address your first two. It is a little difficult to comment on comp obviously we spent a long time during the first quarter in the context of positive revenue, thinking long and hard about the appropriate comp to revenue ratio, which was 52.5 for the quarter reflecting a lower revenue environment, neither here nor there during the course of this quarter.

I think we are just going to have to see greater visibility as we get out in the year. It’s very hard to predict right now. We are going to be competitive; hard to say yet what competitive means. So don’t have a strong perspective I can give you on that.

On non-comp expenses at $1.1 billion this quarter, I think that should be pretty consistent as we move forward. Talked about the savings we’re implementing for the rest of the year, it could come down a bit, but I don’t expect it to tick up from here.

On ROE, as I talked about during the course of the presentation, look, we have had a lot of debate on can you achieve reasonable return with lower leverage, and as I talked about, we are seeing higher ROAs. We’re getting paid more for our intellectual capital and for our balance sheet capital.

So, we are seeing better margins in the business, this is a moment in time on our leverage ratio. We don’t anticipate staying here as we complete the transformation of this balance sheet away from less liquid assets. So, I still think on a cross-cycle basis a mid teens ROE is a realistic assumption.


Your next question comes from Guy Moszkowski - Merrill Lynch.

Guy Moszkowski - Merrill Lynch

Just to make sure that we are interpreting your percentage reductions numbers correctly, is it fair to assume then that of the $130 billion or so in asset reduction that about $25 billion is in the resi and commercial real estate finance and leveraged finance category?

Erin Callan

In terms of the mortgage inventory across the board is probably closer to $20 billion.

Guy Moszkowski - Merrill Lynch

Then whatever the leveraged finance actual amount of the reduction would be?

Erin Callan

Yes, the leveraged finance is more meaningful. That’s going to be a bigger number.

Guy Moszkowski - Merrill Lynch

A bigger percentage?

Erin Callan

Apologies, we really wanted to give the specific number but as I’ve given the approximation of the balance sheet numbers at this point, we actually pulled back on that and we will definitely give those numbers next Monday.

Guy Moszkowski - Merrill Lynch

Can you respond maybe to critics who are going to say that the $130 billion of asset sales must be the absolutely easiest assets to sell? Can you give us some flavor for some of the more difficult asset class reductions and whether they are in line with those overall percentages and the extent to which you might have therefore bitten the bullet with some of those more difficult asset classes and then reflected those prices across the remainder of the book?

Erin Callan

Yes it very much is the latter, Guy, so just to give some anecdotal evidence of that at this point and we’ll give more next week. But in terms of the residential block and what we sold there, the vast majority of what we sold was in the form of whole loans, not the securities portion.

So, the securities portion arguably had greater price transparency in the market, so we sold whole loans and a significant part was in sub-prime and NPLs. So, we did sell the risk asset classes, which did give us a tremendous amount of visibility back into pricing the rest of our inventory.

The story on the commercial side is very similar. Virtually everything that we sold on the commercial side was in the whole loan category. That does reflect the market appetite that it’s harder to find the bids for cash securities without providing financing, which we were generally loathe to do. So, the bids that we found were back into a conventional whole loan market.

I mentioned selling to 170 customers those assets, I think gives us a very, very strong sense of where the bid is and 20% of those sales were mezzanine. So, these sales were not limited to our AAA security portfolio, in fact if anything it was the other way around. We were selling the risk component of these asset classes.

Guy Moszkowski - Merrill Lynch

Can you talk a little bit more about the $6.5 billion other asset-backed portfolio? I think there has been a lot of confusion as to whether those are CDO assets or not because of the way that a footnote was worded in your 10-Q and I just think that we would all appreciate a little clarity on what that is?

Erin Callan

It’s either asset-backed loans or securities. So, what is mentioned in the footnote in our Q is a technical reference to CDO technology. It’s not intended to be in common parlance what are CDOs. So as I talked about, it’s things like credit card receivables, aircraft loans, franchise-lending loans, etc., and as I mentioned earlier we only have approximately $600 million of ABS CDOs and that is in the residential line item.

So, it’s truly a category that we intended to design to cover any other asset-backed security that we may have in our portfolio. So, it covers many, many different positions. So, unfortunately the footnote reference to CDOs was a reference of a technology type, not a reference of the assets.

Guy Moszkowski - Merrill Lynch

And then finally, you talked a little bit about what Tier 1 might look like under the new CSE or Basel II basis and that you are going to talk about that more next week. That implies that basically you will be doing your initial Basel II disclosure at that time.

I’ve been led to believe that that’s going to be an industry event when it happens, that basically everybody is going to be disclosing at around the same time. Is that your understanding and therefore should we be assuming that everybody will be disclosing that now with second quarter earnings?

Erin Callan

Yes, everyone will be disclosing in their Q, I can’t tell you that I am sure; I actually don’t think many will disclose it in their earnings release. And what we’ll do next Monday, as I said, again, just in the interest of transparency and giving guidance is we will disclose the range that’s our best estimate.

Again this is the kind of thing takes a lot of work at the end of the quarter. But we think, it will be helpful to give a range next week, but I actually expect you are more likely see people wait until their Q. But it will be in the Qs.


Your next question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

The 20% mezz you said the sales in commercial real estate 20% of it was mezz. Did you comment about breakdown in the commercial book between how much is equity versus mezz versus senior in the remaining book?

Erin Callan

I didn’t comment but just as a guide and again, I’ll get into this in more detail next week, roughly 80% is senior and 20% is mezz.

Glenn Schorr - UBS

And nothing equity?

Erin Callan

No, not in the commercial mortgage line item.

Glenn Schorr - UBS

And I know you’re not commenting on marks on Archstone besides that it has been marked each quarter but just curious, where would the mark show up like in the table on Page 9, would it be in any one of those buckets?

Erin Callan

Yes it will show up on Page 9. It will show up in the commercial mortgage related positions line item.

Glenn Schorr - UBS

And that’s where it’s been if I look back at the ‘07 and first quarter tables?

Erin Callan

Yes, it’s been there consistently.

Glenn Schorr - UBS

In terms of the 15% to 20% reduction in resi, commercial and real estate owned, I think there is an assumption by me and others that if you had it your way you would sell lots more than 20%; you would have reduced it by say 50%. I don’t know if that’s correct or not, but can you talk about like did you want to reduce by 50%, and you’ve got to take what the market gives you?

And then what’s like, what’s normal because there is also an assumption and I don’t think it’s the same in CDO-land, yes, we would like all that crap off our balance sheet, but here I’m assuming that there are some positions that you actually want to hold on to over time.

Erin Callan

Yes, I think your latter point is the correct one, right? So, in all these things you look at selling these assets with a balancing act between what you are selling at today in order to de-risk your concentrated exposure and what’s the P&L give up going forward. So, as I talked about, we’ve already taken $11 billion of accumulated write-downs in the resi asset class. We certainly think where these things have marked they have real value.

So, the objective is how to take down the risk in a measured way that’s meaningful, while preserving the upside that we think is inherent in the asset class where we’ve been a great operator. So, we did not target nor intend to sell more than 20%. It’s not to say we couldn’t have. There was a market, we could have, but it was a deliberate decision in terms of that balancing act of what upside we want to retain and also in fairness to you Glenn, to your question, how much of an impact do you want to have on the market?

The larger you do sales and if you go out and do a portfolio sale of $30 billion of resi mortgages you will create a market event on pricing, right? So, one of the things I want to highlight about this quarter is that is not the strategy that we took. This was a vigilant, day-by-day effort, $10 million of inventory here, $20 there to optimize the pricing outcome to the firm and our shareholders and it was very difficult to do it in that fashion. So we didn’t want to do a portfolio trade and just walk away. There would have been a significant P&L impact for taking that approach.

Glenn Schorr - UBS

And were these lots of realized write-downs? In other words, is most of this produced by sale or is this just markdowns as well? Is there any combination you can talk about?

Erin Callan

The actual realized losses associated with the sale is actually pretty immaterial given the size of the sales. So the losses for the quarter are truly write-downs reflective of the market conditions and the deterioration of prices during the course of the quarter and the better price visibility that we had this quarter given all that activity than we had in prior quarters.

Glenn Schorr - UBS

So in April you had the capital raise and it was a little bit of a reverse inquiry and I think something that you mentioned as not overly critical from a corporate finance perspective. And then in mid-May, you talked about marks being something a lot smaller than the first quarter’s marks and you mentioned May was better.

So it just felt like this was a bigger loss. I think we all braced for the ineffective hedges and the impact of marks and all that stuff, it just seemed to accelerate in May even though May you mentioned was just a better month?

Erin Callan

So the corollary to the write-down number for this quarter, the mark-to-market adjustment of $3.6 gross actually compares apples-to-apples in Q1 of something about $5 billion. So, there definitely was a slowdown in the pace of write-downs on a gross debt basis. But it is all in the hedging in terms of the outcome. And a lot of that came through during the month of April.

We’ve talked about the resi part, the cap structure being affected in March. April had a lot to do with derivatives and cash conversion and diversions that went on during that month. And there is some part of the portfolio, just to be practical that even though it’s marked throughout the quarter, you do your final marking obviously at the end of the quarter on the more difficult to mark collateral. And so that by nature will be back ended in terms of how the losses come through the P&L.


Your next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

On the hard-to-sell asset, are you open to doing something like a BlackRock, UBS transaction or is that just something that is too detrimental to the P&L to do from your perspective?

Erin Callan

Two things, one I would be open to doing that kind of a transaction, if I could keep a piece of the upside, so that would be a critical aspect of it. And two, I wouldn’t want to do it on terms where we gave generous financing to the buyers, so to speak.

So, as we talked about we’ve been very hesitant to do the transactions we’ve done this quarter with financing. We wanted to play to the cash bid. So, it would have to be in a way that either had a very, very good financing terms from our perspective and also where we could retain the upside in a meaningful way.

Prashant Bhatia - Citigroup

And that seems to reflect your confidence in where that pool of assets which is probably down to about $65 billion is just marked right now?

Erin Callan

Exactly, so I don’t want to give away what I think is some material upside there.

Prashant Bhatia - Citigroup

And then as we think about the equity, you’ve raised about $12 billion this year in total, but you’ve only taken $2.8 billion in losses. Obviously you have deleveraged, but should we think about that excess equity as really being held up against this hard to value portfolio or how do you think about that in terms of how much equity to hold against the portfolio?

Erin Callan

No, I’m actually comfortable that we have sufficient equity to cover those assets as we stand. I think the additional equity in some ways, which you may appreciate is a bit of art and not science, it’s about what level of equity do we need as an organization to bolster the balance sheet so we can get back to running our business on a day-today basis and stop distractions and discussions we have related to the questions about our balance sheet.

So, it’s hard to come up with that number. I think we have done a good job in sizing what that confidence number is and that was our objective. So, it’s not to hold against specific positions, it’s designed to end the chatter about Lehman Brothers and let us get back to business.

Prashant Bhatia - Citigroup

So, you can be offensive with this equity; it’s not held up against a pool?

Erin Callan

Exactly, and that is the intention.

Prashant Bhatia - Citigroup

And then just on the equity trading, if you look at the last, four or five quarters and normalize for the private equity and structured gains and losses, it looks like you’re running at about $1.4 billion in revenue. This quarter normalized is about $900. Is there anything other than environment that’s taken that number down or can we get back to normal from your perspective?

Erin Callan

Yes. I think if you look at the volumes that took place during the course of the quarter, March was a very, very quiet month on equity volumes. So, that is what that number is reflecting. As you point out, it reflects the environment; it does not reflect anything unique to our franchise which I think has continued to do quite well.

Prashant Bhatia - Citigroup

And then just finally on the record prime brokerage revenue, just a feel for fixed income versus equity? I do not even know if you look at it that way, but if you do what was the driver there? What were you seeing on both?

Erin Callan

Yes, Prashant. So, I do not have the breakdown between those two businesses yet and I can cover that next week. Let me finish a final point I think the driver, consistent with my earlier point, is our ability to get paid an appropriate cost of capital for the use of our balance sheet. So, it’s really about margins in the business that drove the performance of prime brokerage for the quarter.


Your next question comes from Mike Mayo - Deutsche Bank Securities.

Mike Mayo - Deutsche Bank Securities

Could you just get us from the $3.6 billion gross mark-to-market loss to the $4.9 billion number you gave in your opening comments?

Erin Callan

Yes. So, it’s a combination of $3.6 as we talked about at the gross mark, $500 million of principal losses and $700 million of losses on additional hedging strategies. Actually, I am working off the $3.7 Mike, which is the net. So, it’s $3.7 plus $500 plus $700.

Mike Mayo - Deutsche Bank Securities

And how much were the severance costs?

Erin Callan

Severance costs, about $150 million.

Mike Mayo - Deutsche Bank Securities

And then going back to the capital, so this is all excess capital that you are raising since you are comfortable with your net leverage ratio. On the other hand you want to keep the confidence that you think this capital raise will bring. So, what’s your timing for redeploying the new $6 billion of capital or should we think about you redeploying maybe $3 billion of capital, which is in excess of the loss that you are taking this quarter?

Erin Callan

Yes, I think when you start with thinking about the $3 billion, clearly first and foremost and the reason for raising common equity is to fill the hole in the common equity component of the capital structure and get us back to a more normalized and optimized cap structure as it relates to common versus hybrid relationship, which post loss has gotten as far as 60:40.

So, I think the common was too levered, so it takes us back to a much stronger common equity base versus our hybrid and so I think you should be thinking about the $3 billion. And with the timeframe I think certainly over the next six months we see lots of opportunities based on the environment to put that money to work.

Mike Mayo - Deutsche Bank Securities

How do we know that you’ve taken enough write-downs in your real estate book? That’s the general question but maybe some specifics. What percent have you written down your residential mortgages? You had $11 billion of gross write-downs, what’s that on a percentage basis of the original total?

Erin Callan

I don’t have the original total in front of me, so I can come back to you on that, what that specifically translates in to. I think in terms of the confidence level on write-downs, it is the following two points. One is the aggregate number is very large that we’ve taken since Q3 predictably last year. And so, that gives me confidence in the actual accumulated loss across those portfolios resi and commercial.

I think the other piece though that is very, very important is we were probably the most active seller of assets in the market this quarter across all these asset classes. And as I have talked about earlier, we weren’t selling AAAs. We were selling the entire capital structure and we were selling risk assets.

I think unquestionably, our price visibility we got from these transactions was tremendous and so much more activity for us certainly than we did last quarter. So, I think the confidence level that the remaining inventory can only be higher than it was given all that sales activity, the visibility, the number of clients we dealt with and the resulting impact on our remaining inventory.

Mike Mayo - Deutsche Bank Securities

And then how much was Alt-A reduced and any color you can give on Alt-A like what percent of Alt-A is AAA.

Erin Callan

Yes, I will give that next week Mike. I don’t have the breakout yet on the balance sheet between Alt-A and some of the other asset classes within resis. So, we will give that in full next Monday.


Your next question comes from Jim Mitchell - Buckingham Research.

Jim Mitchell - Buckingham Research

On the hedging, is that the minute you sell down the asset you can close out the associated hedge or is there a timing thing where you still hold onto the hedges while you work through that? I am just trying to think through, as you reduce assets, do you also reduce the basis risk on the hedges?

Erin Callan

Yes, remember we have a dynamic hedging strategy. So, it’s not as simple as this hedge against this position and then what’s the duration of each, so we certainly try to match the duration of the hedges broadly to the assets. We are at 100% hedged because we are in a risk business, and as I said they are dynamic in nature.

So, the fact of the experience on the hedges this quarter really in no way is related particularly to the sell down of the assets, nor do I feel like we end the quarter with an amount of hedges that varies in a meaningful way from the proportion of hedges we had going into the quarter. So, I think we also manage the hedges dynamically with the size of the portfolio. So, it’s not as if we are sitting there with a whole of bunches of hedges on now with the assets gone.

Jim Mitchell - Buckingham Research

No, fair enough, but I think, everyone is concerned about how much basis risk is still left and it would be nice to at least have some color on if that has been reduced along with the?

Erin Callan

Well, I can say it’s fair to say it’s been reduced proportionately with the asset sale.


Your next question comes from David Trone - Fox-Pitt Kelton.

David Trone - Fox-Pitt Kelton

The hedging aberration comment that you made, you seem pretty confident of that. But couldn’t you see peers selling assets at potentially lower prices than you have and so the dynamic could continue and it seems like that would almost be plausible given that, you’ve been aggressive in selling and you’ve created the snowball of repricing downward?

Erin Callan

Yes, on that point, David, I would say the aberration on the derivatives versus cash markets is not necessarily related to the selling, as much it’s related to liquidity. So, I want to be clear on that. So, what we’ve seen happen in the derivatives market is that there is a tremendous amount of liquidity.

On the correlation of the cash market, there are parties who are willing to finance cash assets at this point, from the pullback on balance sheets and lending. And so what’s happened is if you want to express a view on any of these assets classes you express it as an unfunded derivative format, because that’s the easiest way to do it.

So, I think the predominance of the difference is driven by liquidity not by price of changes in the market due to selling and do I expect liquidity to change around the cash markets versus the derivatives markets soon? No, but do we feel good that the amount of the further divergence is pretty limited given that at some point you run out of basis points? Yes.

David Trone - Fox-Pitt Kelton

In the Alt-A segment there was the high profile sale by UBS and could you characterize where you were relative to that price?

Erin Callan

Relative to the UBS prices from their presentation back a month and a half ago?

David Trone - Fox-Pitt Kelton


Erin Callan

Well, what I can tell you is at the time of their presentation, our marks were consistent with theirs. Obviously, there has been price action since then but it was consistent with their marks at that point in time.

David Trone - Fox-Pitt Kelton

How about next week, could you tell us if we’re below that point?

Erin Callan

Well, we never tell you specific marks nor do we tell you marks across asset classes but I can certainly give you a sense of whether there has been deterioration in prices from that point in time.

David Trone - Fox-Pitt Kelton

To your creditor or counterparty comment, you said things are fine. How is that different, obviously it’s different from mid-March. But could you contrast the less obvious nature of the discussions between now versus the tougher period when Bear was collapsing?

Erin Callan

Yes, I think, to be fair the discussions at this point are not about our viability or the fact that we will be here, or the fact that we have sufficient liquidity. I think we put that to bed on a number of different levels through our own actions, obviously to some extent through the Fed’s actions. So, I don’t think there is any question on the part of our any of our counterparties or lenders that they will be repaid by Lehman Brothers.

I think there is a good debate that’s being had about the investment banking sector, its return profile as we move forward in a lower leveraged environment. But we are not having any conversation with counterparties or lenders about whether they feel confident extending funds and credit to us.

David Trone - Fox-Pitt Kelton

Your deleveraging ROE connection, if we go back to the late 1990’s we had an equity boom and you and your peers were doing only about 20 times leverage, but you were putting up 30% ROEs. Right now it’s tough to imagine in an environment like this that there will be another boom ever again, but of course there will be.

Why couldn’t if the next boom that emerges in a few years is centered on something other than credit, why couldn’t you go back to higher ROEs and thus blend cross-cycle to something closer to 20?

Erin Callan

I am not saying that is not possible Jim. What I want to do is to be very careful and conservative about the expectations we set.

But actually, I want to come back to one earlier point for clarification, the question about the commercial mortgage line item. There are some non-consolidated equity pieces in that line item. The amount of them is much less than the first mortgage debt in the real estate held for sale line. So, I just wanted to clarify there is some small amount of non-consolidated equity in that line item.


Your last question comes from Douglas Sipkin – Wachovia.

Douglas Sipkin – Wachovia

I know back when you did the first offering, you had indicated that you could have raised double, triple what you did. So I am just a little curious, why you didn’t take advantage of that at a better price? Especially, knowing that you were embarking on an initiative to shrink the balance sheet and likely would be absorbing some losses along the way?

Erin Callan

Very importantly Doug at the end of March, we did not have the visibility on the loss that we ultimately suffered in the quarter. So, we didn’t have that expectation. Also, as I talked about earlier, the deleveraging itself did not create a meaningful P&L event. So, I want to be clear about that.

So, there were price reductions in the quarter and asset write-downs associated with the environment, but it wasn’t because we were selling assets that we experienced significant losses. So, both of those things were really not particularly relevant at that point at the end of March.

Douglas Sipkin – Wachovia

Can you talk about the particular areas where you are starting to see meaningful pricing power? I know you mentioned parts of fixed income trading. Can you drill down into some more specific places, what areas you really think there are opportunity with capacity coming on?

Erin Callan

As you mentioned, the flow businesses in fixed income there is much, much higher margins to be made on trading those assets classes than we are seeing in a very long time. Interestingly as I mentioned earlier, prime brokerage given the pull back of balance sheet across the board in our industry, the ability to charge more appropriate levels for the use of our own balance sheet has been very constructive during the course of the quarter.

The equity flow businesses also have really demonstrated a great ability to make money throughout the board. We’ve seen a very big change in acquisition finance and our M&A activity in terms of what we can get to the extent we want to go down the path of committed financing and in fact committed financing is not necessarily a quid pro quo for M&A advice. So that’s a big change.

In general, firm relationship loans where we provide balance sheet to our clients as part and parcel of our relationship are being charged differently and more consistent with market levels. So it is really across the board in every asset class and virtually everywhere we do business.

Douglas Sipkin – Wachovia

Can you just walk us through you mentioned obviously the trends of March, April, May can you characterize how much better May was than April and any color on early trends into June?

Erin Callan

Yes, May as I mentioned was one of our best run rate revenue months, so you could pretty much draw a straight line upward from March through May to give you a feel for the change in activity. And I think, you are going to find when others report in our sector that that was consistent across the board. Obviously, we are only one week into June, so I’d hate to make a trend of it, but the first week of June was very strong and consistent with May.


That concludes today’s question and answer session.

Erin Callan

I want to thank everybody for joining us today again on pretty short notice. I’m going to be happy to be back here talking to you a week from today on the 16th with more detail about the quarter. And we appreciate your patience and appreciate your getting up and having the time to talk to us on this call. And also for those who particularly supported us in our capital raise, we look forward to moving into the next step of the paradigm and getting a lot more interest and activity around the business as we proceed.

So, thanks everybody for today and we will be back next Monday talking to you in further detail. Thanks.

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