| LEHMAN BROTHERS HOLDINGS INC Item 1A Risk Factors 12 ITEM 1A RISK FACTORS _________________________________________________________________ You should carefully consider the following risks and all of the other information set forth in this Report, including the Consolidated Financial Statements and the Notes thereto |
| If any of the events or developments described below were actually to occur, our business, financial condition or results of operations could be adversely affected |
| Market Risk As a global investment bank, risk is an inherent part of our business |
| Our businesses are materially affected by conditions in the financial markets, and economic conditions generally, around the world |
| A favorable business environment is characterized by many factors, including a stable geopolitical climate, transparent financial markets, low inflation, low unemployment, strong business profitability and high business and investor confidence |
| Concerns about geopolitical developments, oil prices and natural disasters, among other things, can affect the global financial markets |
| In addition, economic or political pressures in a country or region may cause local market disruptions and currency devaluations, which may also affect markets generally |
| In the event of changes in market conditions, such as interest or foreign exchange rates, stock or real estate valuations or volatility, our businesses could be adversely affected in many ways, including those described below |
| See Part II, Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Market Risk for a further discussion of the market risks to which we are exposed |
| We have been operating in a low interest rate market for the past several years (though, recently, central banks have been raising rates) |
| Increasing or high interest rates and/or widening credit spreads, especially if such changes are rapid, may create a less favorable environment for certain of our businesses |
| In particular, in our mortgage origination and securitization businesses, rising interest rates may cause a decline in the volume of mortgage origination activity, and therefore may also decrease the volume of securitizations |
| Declining real estate values could also reduce our level of new mortgage loan originations and securitizations |
| Our Investment Banking revenues, in the form of financial advisory and debt and equity underwriting fees, are directly related to the number and size of the transactions in which we participate and would therefore be adversely affected by a sustained market downturn |
| A market downturn would likely lead to a decline in the volume of transactions that we execute for our clients and, therefore, to a decline in the revenues we receive from commissions and spreads earned from the trades we execute for our clients |
| In addition, because the fees that we charge for managing our clients &apos portfolios are in many cases based on the value of those portfolios, a market downturn that reduces the value of our clients &apos portfolios would reduce the revenue we receive from our asset management business |
| Even in the absence of a market downturn, below-market investment performance could reduce Investment Management revenues and assets under management |
| We May Incur Losses in Our Capital Markets Business Segment Due to Fluctuations in Market Rates, Prices and Volatility |
| Market risk is inherent in our client-driven market-making transactions in equity and fixed income securities and derivatives and our mortgage origination and loan syndication activities |
| Fluctuations in market rates, prices and volatility can adversely affect the market value of our long or short inventory positions and, to the extent that such positions are not hedged, cause the Firm to incur losses |
| In our client-driven market-making transactions, we maintain substantial inventory positions from time to time, acting as a financial intermediary for our clients, and we hold inventory positions in the normal course of business to allow clients to rebalance their portfolios and diversify risks across market cycles |
| To the extent that we hold long inventory positions, a downturn in the market could result in losses from a decline in the value of those positions |
| On the other hand, to the extent that we have sold inventory short, an upturn in those markets could expose us to losses as we attempt to cover our short positions by acquiring assets in a rising market |
| In our mortgage origination and securitization businesses, we are also subject to risks from decreasing interest rates |
| Most residential mortgages provide that the borrower may repay them early |
| Borrowers often exercise this right when interest rates decline |
| As prepayments increase, the value of mortgages held in inventory prior to securitization generally will decrease, and to the extent that prepayment risk has not been hedged, prepayments may result in a loss |
| We also maintain long and short positions through our proprietary trading activities, and make principal investments in real estate and private equity, which are also subject to market risks |
| The value of these positions can be adversely -12- _________________________________________________________________ LEHMAN BROTHERS HOLDINGS INC affected by changes in market rates, prices and volatility |
| Concentration of risk may reduce revenues or result in losses in our market-making, block trading, underwriting, proprietary trading and lending businesses in the event of unfavorable market movements |
| We have committed substantial amounts of capital to these businesses, which often require us to take large positions in the securities of, or make large loans to, a particular issuer or issuers in a particular industry, country or region |
| Moreover, the trend in all major capital markets is towards larger and more frequent commitments of capital in many of these activities, and we expect this trend to continue |
| In addition to the potentially adverse effects on our businesses described above, market risk could exacerbate other risks that we face |
| For example, if we were to incur substantial market risk losses, our need for liquidity could rise significantly, while our access to liquidity could be impaired |
| In addition, in conjunction with a market downturn, our clients and counterparties could incur substantial losses of their own, thereby weakening their financial condition and increasing our credit risk to them |
| Credit Risk We May Incur Losses Associated with Our Credit Exposures |
| Credit risk represents the possibility a counterparty or an issuer of securities or other financial instruments we hold or a borrower of funds from us will be unable to honor its contractual obligations to us |
| These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons |
| Default risk may also arise from events or circumstances that are difficult to foresee or detect, such as fraud |
| Credit risk may arise, for example, from holding securities of third parties; entering into swap or other derivative contracts under which counterparties have obligations to make payments to us; executing securities, futures, currency or commodity trades that fail to settle at the required time due to non-delivery by the counterparty or systems failure by clearing agents, exchanges, clearing houses or other financial intermediaries; and extending credit to our clients through bridge or margin loans or other arrangements |
| See Part II, Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Risk Management—Credit Risk for a further discussion of the credit risks to which we are exposed |
| Our principal focus has been acting as an intermediary of credit |
| In recent years, we have expanded our activities associated with providing our clients access to credit and liquidity and have significantly expanded our swaps and other derivatives businesses |
| Defaults by Another Large Financial Institution Could Adversely Affect Financial Markets Generally |
| The commercial soundness of many financial institutions may be closely interrelated as a result of credit, trading, clearing or other relationships between the institutions |
| As a result, concerns about, or a default by, one institution could lead to significant market-wide liquidity problems, losses or defaults by other institutions |
| This is sometimes referred to as "e systemic risk "e and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which we interact on a daily basis, and therefore could adversely affect Lehman Brothers |
| Liquidity Risk Liquidity, that is, ready access to funds, is essential to our businesses |
| Financial institutions rely on external borrowings for the vast majority of their funding, and failures in our industry are typically the result of insufficient liquidity |
| We maintain a liquidity pool available to Holdings that is intended to cover all expected cash outflows for one year in a stressed liquidity environment, which assumes, among other things, that during that year we cannot issue unsecured debt |
| See Part II, Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Liquidity Risk Management, for a discussion of our liquidity needs and liquidity management |
| To the extent that a liquidity event lasts for more than one year, or our expectations concerning the market conditions that exist during a liquidity event, or our access to funds, prove to be inaccurate (eg, the level of secured financing "e haircuts "e (the difference between the market and pledge value of the assets) required to fund our assets in a stressed market event is greater than expected, or the amount of drawdowns under our commitments to extend credit in a stressed market environment exceeds our expectations), our ability to fund operations could be significantly impaired |
| Even within the one-year time frame contemplated by our liquidity pool, we depend on continuous access to secured financing in the repurchase and securities lending markets, which could be impaired by factors that are not -13- _________________________________________________________________ LEHMAN BROTHERS HOLDINGS INC specific to Lehman Brothers, such as a severe disruption of the financial markets |
| We Are a Holding Company and Are Dependent on Our Subsidiaries for Funds |
| Since Holdings is primarily a holding company, our cash flow and consequent ability to pay dividends and satisfy our obligations under securities we issue are dependent upon the earnings of our subsidiaries and the distribution of those earnings as dividends or loans or other payments by those subsidiaries to us |
| Several of our principal subsidiaries are subject to various capital adequacy requirements promulgated by the regulatory, banking and exchange authorities of the countries in which they operate and/or to capital targets established by various ratings agencies |
| These regulatory rules, and certain covenants contained in various debt agreements, may restrict our ability to withdraw capital from our subsidiaries by dividends, loans or other payments |
| Further information about these requirements and restrictions is set forth in Note 12 to the Consolidated Financial Statements in Part II, Item 8, of this Report |
| Additionally, our ability to participate as an equity holder in any distribution of assets of any subsidiary upon liquidation is generally subordinate to the claims of creditors of the subsidiary |
| Credit Ratings Our borrowing costs and our access to the debt capital markets depend significantly on our credit ratings |
| A reduction in our credit ratings could increase our borrowing costs, limit our access to the capital markets and trigger additional collateral requirements in derivative contracts and other secured funding arrangements |
| Credit ratings are also important to us when competing in certain markets, such as longer-term over-the-counter derivatives |
| Therefore, a substantial reduction in our credit ratings would reduce our earnings and adversely affect our liquidity and competitive position |
| See Part II, Item 7, Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Liquidity Risk Management and—Credit Ratings, for additional information concerning our credit ratings |
| We face operational risk arising from errors made in the execution, confirmation or settlement of transactions or from transactions not being properly recorded, evaluated or accounted for |
| Derivative contracts, particularly credit derivatives, are not always confirmed by the counterparties on a timely basis; while the transaction remains unconfirmed, we are subject to heightened credit and operational risk and in the event of a default may find it more difficult to enforce the contract |
| Our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies, and the transactions we process have become increasingly complex |
| Consequently, we rely heavily on our financial, accounting and other data processing systems |
| If any of these systems do not operate properly or are disabled, we could suffer financial loss, a disruption of our businesses, liability to clients, regulatory intervention or reputational damage |
| The inability of our systems to accommodate an increasing volume of transactions could also constrain our ability to expand our businesses |
| In recent years, we have substantially upgraded and expanded the capabilities of our data processing systems and other operating technology, and we expect that we will need to continue to upgrade and expand in the future to avoid disruption of, or constraints on, our operations |
| In addition, despite the contingency plans we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located |
| This may include a disruption involving electrical, communications, transportation or other services used by Lehman Brothers or third parties with which we conduct business, terrorist activities or disease pandemics |
| See Managementapstas Discussion and Analysis of Financial Condition and Results of Operations—Risk Management in Part II, Item 7, of this Report for a description of our Risk Management infrastructure and procedures |
| Acquisitions or Joint Ventures Could Present Unforeseen Integration Obstacles or Costs |
| Acquisitions and joint ventures involve a number of risks and present financial, managerial and operational challenges, including difficulty with integrating personnel and financial and other systems, hiring additional management and other critical personnel and increasing the scope, geographic diversity and complexity of our operations |
| In addition, we may not realize the anticipated benefits from an acquisition, and we may be exposed to additional liabilities of any acquired business |
| The volume of litigation against financial services firms and the amount of damages claimed has increased over the past several years |
| We are exposed to potential liability under securities or other laws for materially false or misleading statements made in connection with securities and other transactions, potential liability for the "e fairness opinions "e and other advice we provide to participants in corporate transactions and disputes over the terms and conditions of complex trading arrangements |
| We also face the possibility that counterparties in complex or risky trading transactions will claim that we improperly failed to tell them of the risks or that they were not authorized or permitted to enter into these transactions with us and that their obligations to Lehman Brothers are not enforceable |
| In our Investment Management segment, we are exposed to claims against us for recommending investments that are not consistent with a clientapstas investment objectives or engaging in unauthorized or excessive trading |
| We are also subject to claims arising from disputes with employees for alleged discrimination or harassment, among other things |
| These risks often may be difficult to assess or quantify, and their existence and magnitude often remain unknown for substantial periods of time |
| We incur significant legal expenses every year in defending against litigation, and |