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GLOBAL RISK MANAGEMENT SECOND QUARTER 2008 As of July 21, 2008 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION TABLE OF CONTENTS FIRM OVERVIEW ____________________________________________________ 4 Main trading businesses, products and markets _____________________________________ 4 Summary of Results __________________________________________________________ 5 Business Environment ________________________________________________________ 7 FIRM CONTROL STRUCTURE ________________________________________ 10 Risk Management ___________________________________________________________ 10 Committee Structures ________________________________________________________ 11 GLOBAL RISK MANAGEMENT DIVISION _____________________________ 12 Overview__________________________________________________________________ 12 Mission Statement __________________________________________________________ 13 GRMD Functions ___________________________________________________________ 14 Market Risk Management __________________________________________________ 14 Credit Risk Management ___________________________________________________ 15 Quantitative Risk Management ______________________________________________ 16 Sovereign Risk Management ________________________________________________ 17 Risk Information and Analysis ______________________________________________ 18 Risk Governance _________________________________________________________ 19 IMD (Investment Management Division) Risk Management _______________________ 20 RISK MEASUREMENT _______________________________________________ 21 Overview _______________________________________________________________ 21 Risk Appetite ____________________________________________________________ 22 Risk Equity _____________________________________________________________ 23 VaR (Market Risk)________________________________________________________ 24 Event Risk ______________________________________________________________ 25 Counterparty Credit Risk ___________________________________________________ 26 Stress Testing and Scenario Analysis _________________________________________ 27 LIMIT STRUCTURE__________________________________________________ 28 Overview _______________________________________________________________ 28 VaR Limits______________________________________________________________ 29 Counterparty Credit Limits _________________________________________________ 31 Single Transaction Limit ___________________________________________________ 32 Country Limit ___________________________________________________________ 33 Concentration Limits ______________________________________________________ 34 OTHER _____________________________________________________________ 35 Main Financial and Non Financial Risks in Trading Book _________________________ 35 Valuation _______________________________________________________________ 36 Pricing Models___________________________________________________________ 37 Credit Risk Process _______________________________________________________ 38 REPORTS ___________________________________________________________ 43 2 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Risk Summary for 2Q2008 ____________________________________________________ 43 VaR – Historical Simulation___________________________________________________ 49 Revenue Volatility __________________________________________________________ 50 Fair Value of OTC Derivative Contracts by Maturity _____________________________ 51 Net Credit Exposure for OTC Contracts _______________________________________ 52 Counterparty Credit Risk – Credit Exposure by Rating ___________________________ 53 Counterparty Credit Risk – Credit Exposure by Sector____________________________ 54 Counterparty Credit Risk – Credit Exposure by Region ___________________________ 55 Stress Testing Results 2Q 2008 ______________________________________________ 56 Scenarios _______________________________________________________________ 57 Bull Steepening ________________________________________________________ 57 Bull Flattening_________________________________________________________ 58 Bear Flattening ________________________________________________________ 59 Bear Steepening________________________________________________________ 60 EMG Crisis ___________________________________________________________ 61 Rating/Default and Hedge Fund Risk _______________________________________ 62 HY/LBO/Default Risk___________________________________________________ 63 Equity Crash __________________________________________________________ 64 Parallel Move Down ____________________________________________________ 65 Parallel Move Up_______________________________________________________ 66 Black Monday _________________________________________________________ 67 Oil Supply Crisis _______________________________________________________ 68 Liquidity Crunch _______________________________________________________ 69 Credit Crunch _________________________________________________________ 70 3 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION FIRM OVERVIEW Main trading businesses, products and markets Lehman Brothers is an innovator in global finance, serving the financial needs of corporations, governments and municipalities, institutional clients and high-net-worth individuals worldwide with business activities organized in three segments – Capital Markets, Investment Banking and Investment Management. We provide a full array of services in equity and fixed income sales, trading and research, investment banking, asset management, private investment management and private equity. Our worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by a network of offices in North America, Europe, the Middle East, Latin America and the Asia Pacific region. Our Capital Markets segment is divided into two components: Fixed Income – We make markets in and trade interest rate and credit products, mortgage-related securities, loan products, municipal and public sector instruments, currencies and commodities. We also originate mortgages and we structure and enter into a variety of derivative transactions. We provide research covering economic, quantitative, strategic, credit, relative value, and index and portfolio analyses. Additionally, we provide financing, advice and servicing activities to the hedge fund community, known as prime brokerage services. Equities - We make markets in and trade equities and equity-related products and enter into a variety of derivative transactions. We also provide equity-related research coverage as well as execution and clearing activities for clients. Through our capital markets prime services, we provide financing, advice and servicing activities to the hedge fund community (prime brokerage) as well as provide execution and clearing activities for clients. We also engage in proprietary trading activities as well as principal investing in real estate and private equity. We take an integrated approach to client coverage, organizing bankers into industry, product and geographic groups within our Investment Banking segment. Business activities provided to corporations and governments worldwide can be separated into: Global Finance – We serve our clients’ capital raising needs through underwriting, private placements, leveraged finance and other activities associated with debt and equity products. Advisory Services – We provide business advisory assignments with respect to mergers and acquisitions, divestitures, restructurings, and other corporate activities. The Investment Management business segment consists of: Asset Management – We provide customized investment management services for high net worth clients, mutual funds and other small and middle market institutional investors. Asset Management also serves as general partner for private equity and other alternative investment partnerships and has minority stake investments in certain alternative investment managers. Private Investment Management – We provide investment, wealth advisory and capital markets execution services to high net worth and middle market institutional clients. 4 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Summary of Results The Company reported a net loss for the second quarter of 2008 of $2.8 billion, or a $5.14 loss per common share (diluted), compared with net earnings for the second quarter of 2007 of $1.3 billion, or $2.21 per common share (diluted). Revenues, net of interest expense (“net revenues”) for the second quarter of 2008 were negative $0.7 billion, compared to $5.5 billion in the prior-year period. The pre-tax loss for the second quarter of 2008 was $4.1 billion, compared with pre-tax earnings of $1.9 billion for the prior-year period. For the six months ended May 31, 2008, the Company incurred a net loss of $2.3 billion, or a $4.33 loss per common share (diluted), compared with net earnings for the six months ended May 31, 2007 of $2.4 billion, or a $4.17 per common share (diluted). Net revenues for the six months ended May 31, 2008 were $2.8 billion, compared to $10.6 billion in the prior-year six month period. The pre-tax loss for the six months ended May 31, 2008 was $3.4 billion, compared with pre-tax earnings of $3.6 billion in the prior-year six month period. The losses in the Company’s net revenues and earnings during the second quarter of 2008 were driven by losses within the Capital Markets business segment which more than offset net revenues from the Investment Banking and Investment Management segments. Net revenues were significantly impacted by challenging market conditions that continued to impact the Company’s valuation of certain financial instruments, primarily residential and commercial mortgage-related assets and related economic hedges to those asset classes. The Company also incurred losses on principal investing activities, economic hedging activities and defensive rates and credit trading positions. These losses were partially offset by gains on certain of the Company’s debt liabilities. The impact of these events is reflected within the Company’s Capital Markets business segment and principally within the Fixed Income component. The Company’s Capital Markets business segment reported negative net revenues for the three and six months ended May 31, 2008 of negative $2.4 billion and negative $0.7 billion, respectively, compared to net revenue of $3.6 billion and $7.1 billion for the three and six months ended May 31, 2007, respectively. Capital Markets—Fixed Income net revenues for the three and six months ended May 31, 2008 were negative $3.0 billion and negative $2.7 billion, respectively, compared to $1.9 billion and $4.1 billion in the corresponding 2007 periods. For the three and six months ended May 31, 2008, Capital Markets—Equities reported net revenues of $0.6 billion and $2.0 billion respectively, a decrease of 64% and 33% from $1.7 billion and $3.0 billion for the three and six months ended May 31, 2007, respectively. Investment Banking segment net revenues were $0.9 billion and $1.7 billion in the 2008 three and six months, respectively, down 25% and 14% from the corresponding 2007 periods. Investment Management segment net revenues increased 10% and 24% to $0.8 billion and $1.8 billion in the 2008 three and six months, respectively, compared to the corresponding 2007 periods, reflecting increasing net revenues in both Asset Management and Private Investment Management. Assets under management (“AUM”) at May 31, 2008 were $277 billion, an increase of 5% from levels at May 31, 2007 and a 2% decrease from levels at November 30, 2007. During the second quarter of 2008, the Company reduced assets, including inventory positions related to residential mortgages, commercial mortgage and real estate-related investments, and acquisition finance facilities. At May 31, 2008, the Company’s total assets were approximately $639.4 billion, representing a 19% decrease, or a reduction of $146.6 billion, from total asset levels of $786.0 billion at February 29, 2008. May 31, 2008 total asset balances were 7% lower, or $51.6 billion less than total asset levels reported at November 30, 2007. The combined 5 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION effect of an equity raise as well as the reduction of assets in the second quarter of 2008 resulted in a decrease in the Company’s gross and net leverage ratios to 24.34x and 12.06x at May 31, 2008, respectively, from 30.73x and 16.14x at November 30, 2007. 6 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Business Environment As an investment banking, securities and investment management firm, the Company’s businesses are materially affected by conditions in the global financial markets and worldwide economic conditions. A favorable business environment is generally characterized by, among other factors, high global gross domestic product growth, stable geopolitical conditions, transparent and efficient capital markets, liquid markets with active investors, low inflation, high business and consumer confidence and strong business earnings. These factors provide a positive climate for investment banking activities, for many of the Company’s capital markets trading businesses and for wealth creation, which contributes to growth in the Company’s asset management business During the second quarter of 2008, the Company operated in an unfavorable global business environment. Conditions were characterized by a continued lack of liquidity in the credit markets, significantly depressed volumes in most equity markets, a widening in certain fixed income credit spreads compared to the end of the 2007 fiscal year and declining asset values. Growth in major economies slowed as a result of declining business and consumer confidence. Global inflation rose, amid slowing economic growth. Commodity prices rose significantly during the quarter, with oil and gold reaching record levels, raising costs of industrial production. Consumer spending was challenged by a combination of lower wealth from declining housing values, higher commodity prices impacting levels of disposable income, and falling private sector employment growth. Central banks’ concerns regarding exacerbating inflationary conditions limited their ability to effect monetary policies intended to provide liquidity within the markets. The combination of low levels of liquidity and financial companies de-leveraging their balance sheets resulted in downward pressure on financial asset prices. These global economic conditions, in aggregate, depressed both the valuations of the Company’s inventory positions as well as transactional volumes and market activity levels in which the Company’s Capital Markets and Investment Banking business segments operated during the fiscal quarter. Based upon estimates by the Company’s economists, global economic growth was approximately 2.5% at the end of the second quarter of 2008 compared to 3.5% in fiscal year 2007. The decrease was driven by a slowdown in the Americas and Eurozone. The Company anticipates global economic growth in subsequent fiscal quarters to be less than levels in the second fiscal quarter of 2008. The magnitude of the growth deceleration is largely dependent on how extended and severe the credit dislocation continues to be, results from fiscal and monetary policy actions, accessibility of new sources of liquidity and oil prices leveling or continuing to increase. At the end of the Company’s 2008 second quarter, the global fixed income environment was characterized by tighter spreads compared to the first quarter of 2008. However, spreads were still at wider levels than at the end of the 2007 fiscal year. Global high yield and high grade spread indices tightened 78 basis points and 9 basis points, respectively, at the end of the second quarter compared to the end of the first quarter of 2008 and widened 81 and 43 basis points, respectively, compared to the end of the 2007 fiscal year. At the end of the second quarter of 2008, global equity markets modestly increased from levels at the end of the first quarter of 2008 but were down 6.6% at the end of the second quarter compared to the end of fiscal year 2007. Global corporate activity levels in completed 7 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION M&A transactions for the 2008 second quarter were lower, compared to levels at the end of the first quarter of 2008 and those at the end of the 2007 fiscal year. Equity underwriting levels for the 2008 second quarter were down 25% from the 2007 fourth quarter and fixed income underwriting levels for the 2008 second quarter increased 7% between the benchmark periods. Investment banking activity for the remaining 2008 calendar year is expected to be modest. Global public issuance markets have contracted from 2007 levels. The Company believes full-year 2008 M&A volumes will decline compared to full-year 2007 levels. The anticipated decrease in 2008 investment banking activities is the result of both comparatively lower financial sponsor activity as well as slower economic growth. This is expected to be offset in part by: (i) the weak U.S. dollar attracting cross-border transactions; (ii) companies focusing on core businesses and divesting non-core functions; (iii) selective financing of strategic deals; and (iv) equity or hybrid equity offerings. Real gross domestic product growth (“GDP”) in the U.S. economy, as forecasted by the Company’s economists, expanded by an estimated 1.0% for the 2008 second quarter, compared to GDP growth of 1.0% in the first quarter. This forecast is predicated upon declining consumer spending resulting from increasing unemployment levels and declining wealth measures. Expected relief on consumer spending as a result of fiscal stimulus packages may be annulled from rising commodity prices, particularly oil and grains. Continued slowdowns in home sales and commercial real estate investments suggest inventories may continue to rise and increase levels of construction and price cuts. Growth in industrial production slowed from 2007 levels, reflecting reduced growth in domestic consumer demand, partially offset by demand for U.S. exports. Market indications suggesting declines in business and consumer confidences continue to be present as they were in the prior quarter. In March 2008, the Federal Reserve Bank of New York created the Primary Dealer Credit Facility which was designed to address elevated pressures in short-term funding markets. The U.S. Federal Reserve Board reduced rates twice in the fiscal quarter and is anticipated to hold rates steady over the next several meetings. The Company’s economists expect the terminal funds rate will be within the range of 1.50% and 2.00% by the end of the fourth quarter due to rising energy costs, tightening credit conditions, a continued drop in home prices and weak job markets. Long-term bond yields increased, with the 10-year Treasury note yield ending the fiscal quarter at 4.10%, up approximately 70 basis points from the first quarter of 2008. At the end of the second fiscal quarter, the S&P 500 Index, Dow Jones Industrial Average and NASDAQ composites decreased 8.5%, 7.3%, and 3.1%, respectively, from 2007 second quarter levels. In Eurozone countries and the U.K., economic growth slowed during the second quarter of the 2008 fiscal year as the disruption in the global financial markets and higher oil prices affected spending and consumer confidence. Business activity reflected a decline from the benchmark period as a result of tighter credit conditions and an overall decrease in consumption across all sectors. Labor markets appeared unaffected as unemployment levels modestly declined over the quarter. Measures of core inflation increased during the 2008 second quarter mainly due to elevated pressure in the energy and food markets. The European Central Bank held rates level during the fiscal quarter and the Company’s economists expect a rate increase to occur in the third quarter of the 2008 fiscal year. In April 2008, the Bank of England eased rates and a further rate reduction is anticipated during the remaining quarters of the fiscal year. The Bund and Gilts’ 10-year yields were 8 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION 4.4% and 4.8%, respectively, at the 2008 second quarter-end compared to 3.9% and 4.3%, respectively, at the 2008 first quarter-end. Equity volatility for continental Europe and the U.K. was up compared to levels at the end of the 2008 first quarter. The Company believes that the generally tighter bank and credit conditions, lower forecasted global growth and a stronger Euro will combine to slow 2008 Eurozone and U.K. growth. In Japan, real gross domestic product growth decelerated, unemployment levels modestly decreased and measures of inflation spiked slightly during the 2008 quarter due to increased energy prices. While increasing food prices are causing slight inflation, the rise is expected to taper by the end of the 2008 fiscal year. The Company expects energy prices to have a significant impact on Japan’s economic performance from the second half of the 2008 fiscal year and beyond. The Bank of Japan held its rates steady during the 2008 quarter and is anticipated to continue to do so into the 2008 fiscal year. The yield on the 10-year Japanese government bond increased 25 basis points from the first quarter of calendar year 2008 to 1.6% at the end of the second quarter of calendar year 2008. The Nikkei 225 equity index gained 10.6% over the course of April to mark the largest percentage increase since July 1995. Residential and non-residential construction spending decreased, and the recovery in the corporate sector during the period has yet to have an effect on wages and consumption, thus increasing the risk of a possible recession. The Company expects three trends to emerge in China’s economy in 2008: (i) GDP growth to fall on an annual basis; (ii) inflation to increase over the long-term; and (iii) the central bank to focus more on slowing growth than rising inflation. The Company expects certain larger emerging markets, Brazil, Russia and Mexico, for example, to achieve solid growth during the 2008 calendar year. While Latin America is expected to feel the effects from a decelerating U.S. economy, the Company believes the impact should be less severe than historically as a result of the region’s establishment of new trading relationships with other parts of the world. During 2008, the Company expects India to continue GDP growth absent a significant contraction in the U.S. economy. Any effect from weaker world economic growth should be offset by continued investment and spending within India. 9 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION FIRM CONTROL STRUCTURE Risk Management Many parts of the Firm are all involved in a tightly interwoven control environment for Risk. They include Risk Management, Finance, Operations, Compliance, Audit, Trading Management and Capital Markets senior management. The support functions are high quality and enjoy very strong senior management support and status within the Firm, as their role in keeping the Firm safe is recognized and appreciated. The Firm has established a rigorous independent internal control environment, which ensures the reliability of the mark-to-market and risk management processes. This multi-tier framework includes: • Capital Markets Senior Management - Review of P&L and key risk positions on a daily basis; • Middle Office Operations Function - Calculation of daily P&L on a position by position level basis; • Risk Management Division - Calculation of Value at Risk (“VaR”) on a daily basis, and analytical review of VaR versus actual daily P&L; • Finance via Product Controllers – Analysis of daily P&L and positions, pricing verification, and review of new transactions; • Product Controllers review pricing on a daily basis, as an extension of the detailed P&L review process they perform daily. They also perform a formal monthly price verification procedure for their respective businesses. 10 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Committee Structures The Firm has a robust Committee structure consisting of Management Oversight, Transaction Approval and Divisional and Business Level Committees to oversee risk taking activities and to ensure that controls are appropriately administered and reviewed. The key committees include: Management Oversight Committees • Executive Committee (keyword: EXECC) • Management Committee (keyword: MGMTC) • Capital Markets Committee (keyword: CAPMC) • Conflicts Task Force (keyword: CTF) • Finance Committee (keyword: FINC) • Operating Exposures Committee (keyword: OEC) • Risk Committee (keyword: RISKC) Transaction Approval Committees • Bridge Loan Committee (keyword: BLC) • Commitment Committee (keyword: commitmentcommittee or COMC) • Complex Structured Finance Transactions Committee (keyword: CSFTC) • Fairness Opinion Committee (keyword: FOC) • IMD Product Review Committee (keyword: IMDPRC) • Investment Committee (keyword: IC) • New Products Committee (keyword: NPC) • Strategic Acquisition Review Committee (keyword: SARC) Divisional & Business Level Committees • Complex Derivative Transaction Review Committee (keyword: CDTRC) • Credit Risk Management Committee (keyword: CRMC) • Disclosure Committee (keyword: DISC) • Equity Commitment Committee (keyword: ECC) • High Grade Commitment Committee (keyword: HGCC) • High Yield Commitment Committee (keyword: HYCC) • High Yield New Business Committee (keyword: HYNBC) • Loan Participation Committee (keyword: LPC) • Market Risk Control Commitee (Keyword: MRCC) • MCD New Products Committee (keyword: MCDNPC) • Model Control Committee (keyword: MCC) • Structured Finance Committee (keyword: SFC) • Tax Oversight Committee (keyword: TOCM) • Valuation Committees (keyword: VALC) 11 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION GLOBAL RISK MANAGEMENT DIVISION Overview The Global Risk Management Division (“GRMD”) is an independent function under the leadership of the Global Head of Risk Management. While GRMD partners and works proactively with the businesses before transactions are done in order to determine the least risky deal structure it is independent of the trading areas. The Division consists of seven global functions (market risk management, credit risk management, risk information and analysis,; sovereign risk management; quantitative risk management; risk governance, including operational risk management, IMD risk management) which have been integrated allowing us to leverage our people, our analytics and information flow. GRMD has staff in each of our trading centers, New York, London and Tokyo with additional personnel in key sales regional offices including Hong Kong, Singapore, Korea, Australia, Brazil and India. 12 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Mission Statement The Division’s mission is to protect the franchise by proactively identifying, evaluating, monitoring and controlling Firm market, credit and operational risks. The Division achieves this objective through the development and implementation of a transparent and robust integrated risk management framework and analytics. In collaboration with our business and corporate colleagues, the Division plays an active control and advisory role in the areas of efficient capital allocation, risk diversification and risk mitigation, to optimize financial returns for our shareholders. Risk Management provides Senior Management, Regulators, the Board of Directors and Shareholders with an independent view of the Firm’s risk. The Division leverages industry-leading qualitative approaches to risk evaluation and quantitative approaches to risk measurement in a culture of discipline, teamwork, and innovation. 13 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION GRMD Functions • • • • • • • • • Market Risk Management is responsible for: Ensuring all market risks are identified, understood, measured, monitored and captured by an appropriate metric Active risk exposure consulting with businesses Active consulting role in risk capital allocation / risk-adjusted performance assessment Assisting senior management in the dialogue with rating agencies and regulatory bodies Administering limits and management action triggers Monitoring and reporting of the market risk of trading exposures Aggregating and analyzing market risk (regionally and globally) Communicating large or unusual risk as appropriate Developing market risk measurement methodologies in conjunction with Quantitative Risk Management ƒ VaR ƒ VaR Back Testing ƒ Scenario Analysis ƒ Event Risk 14 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION • • • • • • • Credit Risk Management is responsible for: Counterparty credit analysis and due diligence Assigning and maintaining Internal Risk Ratings (ICR) Establishing Credit Limits for each counterparty by family and legal entity, as well as at the individual product levels Establishing Country Risk limits Preparing Credit Reviews on counterparties which assess the counterparty’s strengths and weaknesses, supporting the ICR recommendation and recommended Credit Limits Monitoring Counterparty credit exposures on a Current (CCE) and Potential basis (MPE) including usage of Credit Limits Monitoring the Credit Portfolio on an ongoing basis which includes ƒ Country updates ƒ Industry reviews ƒ Ongoing review of counterparties ƒ Monthly Hedge Fund performance reviews ƒ Revising and updating risk ratings as appropriate ƒ Understanding portfolio concentrations 15 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION • • Quantitative Risk Management is responsible for: Developing, implementing and maintaining the risk methodologies and systems used to measure market, credit and operational risks, as well as validating the pricing and valuation models used by the business units of the Firm Subgroups ƒ Market Risk Analytics – Develops the quantitative methodologies to measure market risk (VaR, Risk Appetite); provides analyses and consultation on market risk quantification ƒ Credit Risk Analytics – Develops various quantitative methodologies used to measure counterparty credit risk (CCE, EPE, MPE); generates exposure, country risk and ad hoc credit risk reports for senior management; provides transaction level analyses and consultation on credit risk quantification ƒ Operational Risk Analytics – Develops the quantitative methodologies used to measure operational risk; provides analyses and consultation on operational risk quantification ƒ Model Validation – Develops and implements the validation standards for the pricing models used in Firm; collects and archives documentation on the pricing models; reviews and approves the pricing models; participates in Model Review Committees (Fixed Income and Equities) with business units, Quantitative Research, Product Control and Technology 16 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION • • • • • • Sovereign Risk Management is responsible for: Establishing a framework to assess political, economic, and social conditions and events in a foreign country that might adversely affect the Firm’s interests or reputation Monitoring and reporting on crisis events and substantial market shocks in emerging market and selected developed market countries and regions Establish country risk appetite limits and internal country ratings Advising senior management and business heads on emerging market issues Aggregating and analyzing country risk exposures (regionally and globally) Assisting Market and Credit Risk Management with the analysis of major market fluctuations resulting from: default; currency inconvertibility and transfer risk; currency devaluation; and expropriation of assets 17 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION • • • • Risk Information and Analysis is responsible for: Data Integrity ƒ data management and reconciliation of position, indicative and historical time-series data for market and counterparty credit risk Credit Risk Control ƒ design and use of the Internal Ratings System ƒ administration of the Credit Risk Management Committee ƒ generation and dissemination of governance related management reporting Portfolio Risk Management ƒ aggregate Firm-wide and business level reporting of Risk Equity, Risk Appetite, VaR, CCE, MPE, CVA and other risk sensitivities ƒ VaR back-testing, limit maintenance and monitoring and other control issues ƒ Valuation Analysis Risk Policy and Procedures ƒ development, implementation and maintenance of risk documents 18 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION • • • • Risk Governance is responsible for: Management of our Regulatory and Rating Agency information and processes; and Leadership of various Firm-wide and divisional initiatives Coordinating with the other Risk Management Executive Committee members on risk information reporting and improvements and efficiencies Firm-wide Operational Risk Management; ƒ Ensuring all operational risks are identified, understood, measured and monitored ƒ Increasing awareness of operational risk throughout the Firm ƒ Active risk exposure consulting with businesses and support functions ƒ Resolution of operational risk related issues ƒ Assisting senior management in the dialogue with internal and external bodies 19 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION • • • IMD (Investment Management Division) Risk Management is responsible for: Ensuring that the market risk, credit risk and operational risk within the IMD Division is identified, understood, measured and monitored. Ensuring that the Firm’s global risk frameworks are instituted within the IMD Division. Assisting in developing the processes to monitor the alignment of client objectives and expectations with the Firm’s investment processes, specifically: ƒ Processes to identify and monitor risk exposures within and across portfolios to assist in the production of high-quality portfolio returns which result from portfolio managers' intended risk strategies and are not driven by unintentional sources of risk ƒ Processes to ensure the management of all portfolios within welldocumented client risk parameters and according to specified client expectations ƒ Processes to monitor and mitigate any unusual risk situations (market, credit, operational or reputational) affecting either client portfolios or the investment management business as a whole 20 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION RISK MEASUREMENT Overview At the core of our risk management framework are two comprehensive risk measurement models: • Risk Appetite (95% confidence) integrating market, event and counterparty risk; and • Risk Equity (99.5% confidence) encompassing market, event, counterparty, operating and legal risk as well as regulatory capital requirements 21 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Risk Appetite The risk tolerance of the Firm is primarily expressed through a framework called Risk Appetite which is grounded in our financial targets. The Firm’s Risk Committee serves as a primary vehicle for establishing the Firm’s overall Risk Appetite. The Risk Appetite represents the amount of money that the Firm is “prepared to lose” over one year due to market, event and counterparty credit risk. Risk appetite is measured at a 95% level of confidence. The risk appetite framework aims at balancing risk and return. We set risk at a level which ensures that we can achieve minimum financial targets, as well as generate acceptable cross cycle returns. We start with a revenue budget which assumes a “slow” market environment. We model a low case revenue scenario for all of our client/customer flow businesses. This “post slowdown” revenue represents, conceptually, the minimum revenue level we anticipate from our franchise before the impact of potential losses from risk taking. Then we subject ourselves to two constraints: one internal and one external. Internally, we want to make sure we are compensation adequate. We want to set enough money aside to pay for our employees. We do not want to be hiring and firing but instead, we want to protect the franchise for the long-term. Externally, we want to ensure we have enough revenue to produce minimally acceptable cross-cycle returns on tangible equity. Risk is allocated across different businesses as a function of several measures including return on equity, EVA, leverage and balance sheet constraints, return on assets and taking into account the value of a particular business to the overall franchise of the Firm. In order to allocate the Firm’s risk appetite across the divisions we take into consideration: • Budgeted revenue, net income and return on tangible equity – we aim to allocate risk appetite consistent with the performance expectations of each business and their risk/return profiles; • Franchise considerations/past usage – we recognize that certain minimum risk usage is needed to support the franchise. This includes allocating sufficient risk appetite to potentially low ROTE businesses which are important to the overall product suite we deliver to clients; • Outlook for businesses – adjustments are made to take into consideration planned changes in the business mix. Diversification comes from businesses functioning as part of a larger unit: trading desks are part of regional businesses; regional businesses are part of global businesses; global businesses are part of divisions; and divisions are part of the Firm. Diversification also comes from our exposure across different risk types (market, counterparty credit, and event). To the extent there is a meaningful change in the business mix, there could be an increase or decrease in our risk usage. 22 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Risk Equity We use our Risk Equity Model to determine the equity to be allocated to each of our businesses. The components of our Risk Equity Model are: • • • • • Economic equity ƒ Market risk ƒ Event risk ƒ Counterparty credit risk Regulatory-adjusted economic equity Operating risk Legal risk Other corporate asset charges Those components are combined in a single number which we refer to as Risk Equity. Below, a description of each component: • • • • • • • Market risk ƒ Measures the potential mark to market loss on positions from adverse moves in all risk factors. It is computed by historical simulation (similarly to daily VaR) but at a higher confidence level of 99.5% and one-year holding period. Event risk ƒ Measure the potential loss beyond those measured in market risk such as losses associated with a downgrade for high quality bonds, defaults of the high-yield bonds and loans and loss on real-estatebacked loans, etc. Counterparty credit risk ƒ Measures the potential losses across all of the Firm's forward settlement, financing and derivative transactions, due to nonperformance of our trading counterparties. Regulatory capital for regulated entities ƒ Regulated legal entities are required to maintain a minimum level of equity capital. In determining the amount of capital utilized by a business operating in a regulated entity, the after tax economic risk capital is compared to the regulatory equity and the greater of the two is allocated to the business. Operating risk ƒ Measures business risk. Legal risk ƒ Measures the potential loss arising from litigation with investors, customers and employees, net of applicable insurance recoveries. Other corporate assets ƒ The equity associated with other assets in the Firm, for example buildings, are allocated to each business as part of the operating component of equity 23 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION VaR (Market Risk) Risk appetite is our principal risk metric, which we use on a daily basis to measure, report and control our risk on a statistical basis which express the losses we might expect to experience with a given degree of confidence over a one year horizon. Our VaR model, which is the market risk component of risk appetite, is controlled by Risk Management. VaR is an estimate of the potential decline in the value of the Firm’s trading positions due to normal market movements over a one-day holding horizon at a 95% confidence level. The VaR model accounts for general and issuer-specific risk. It also accounts for the nonlinear dependency of certain positions with respect to the underlying risk drivers by actual portfolio revaluation. We adopt a historical simulation approach to VaR calculation, utilizing the most recent four years of market data across all general market risk factors. The correlations amongst general market risk factors are implicitly determined by the actual historical time series. The data are weighted to emphasize the most recent period (the Firm currently uses an exponential decay factor of approximately 10% per month). Individual stock price series are used for the simulation of equities risk wherever those series are available. When there are not enough data on a recently issued stock (e.g. recent IPOs), the Firm employs an interim model using a proxy for the individual stock return: either the closest stock index (when there are fewer than 60 data points) or linear regression model based on the closest index (when there are 60 data points or more). For debt-related instruments, general risk is represented by bond indices constructed for rating-maturity-industry buckets. The specific risk component is simulated based on the characteristics of the empirical distribution of the individual bond residuals with respect to each bucket. All simulated specific risks are assumed to be independent of each other as well as general market risk factors in the VaR model. We have a high degree of granularity in our estimation of risk evidenced by the fact that we use over 20,000 time series. The VaR model, as well as most pricing models (which feed risk factor sensitivities into the VaR model), has been developed internally. 24 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Event Risk Event risk measures potential trading losses associated with large, gap-like market moves or stress market events that usually cannot be adequately captured by VaR model and historical time series of limited length. The following examples illustrate the type of losses covered under the event risk metric: • Downgrade for high grade loans, bonds and convertibles • Defaults for the high yield loans, bonds and convertibles • Defaults for sub-prime mortgage loans • Property value losses on real estate • Dividend yield assumptions for equity derivatives • Gap risk for fund derivatives 25 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Counterparty Credit Risk Counterparty credit risk measures the potential loss to the Firm due to non-performance of our counterparties on forward settlements, financing and OTC derivative transactions. A multitude of risk measures are calculated in the counter party risk arena. Current Credit Exposure (CCE) to counter-party is our potential credit loss arising from its immediate default or non-performance. It equates to the positive mark-to-market value of the trade portfolio. Maximum Potential Exposure (MPE) is a measure of the stressed value of potential credit losses if counter-party defaults sometime in the future. It is calculated over the life of the portfolio of trades, and identified at a tail percentile (95th) amongst all possible scenarios. The average expected magnitude of potential credit exposures is designated as Expected Potential Exposures (EPE). This quantity is also calculated over the life of the trade portfolio as an average over all possible future scenarios. EPE is commonly used as input to the calculation of other key counterparty credit risk measures such as the credit component of Regulatory Capital or the Credit Valuation Adjustments (CVA). At the aggregate level, counterparty credit risk contribution to the Risk Appetite is estimated by constructing a portfolio loss distribution across all counterparties, taking into account both the magnitude of each credit exposure, the probabilities of each counterparty defaulting, as well as the estimated recovery value to each counterparty claim. The Firm adopts a Monte Carlo simulation approach to counterparty credit risk quantification for OTC derivative and long-settlement transactions, by generating future market scenarios with multiple risk drivers and subsequently revaluating the trade portfolios under each possible market scenarios. For financing trades with daily mark-tomarket, a direct historical simulation approach is used. All credit calculations are subject to the proper application of legal netting rules as well as margin and pledge provisions. Exposures are typically aggregated at both the legal entity and the product level. 26 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Stress Testing and Scenario Analysis Stress tests and scenario analyses are performed regularly to evaluate the potential P&L impact on the Firm’s portfolio of abnormal yet plausible market conditions. We employ two types of stress tests: Firm-wide Scenario Analysis We will subject the Firm’s overall portfolio to a number of coherent macro-economic scenarios in which pertinent market factors are shocked by extreme, although plausible amounts. The scenarios which are relevant at any particular time will be driven by the nature of our exposures. To determine the plausible shock-factors to apply to our portfolios we will draw upon our experience of historic events. Although stress events, by their nature, are relatively rare, and history is not bound to repeat itself exactly, we use examples of historical events as a means of judging the magnitudes of plausible shockfactors and the extent of plausible correlation changes. Correlation changes during extreme market events may be very significant, which implies that stress test results may not be deduced merely by taking multiples of VaR. The portfolio of scenarios we apply will evolve over time as we continually strive to establish scenarios that seek out the vulnerabilities in our portfolios. Applying shock factors derived from historical events to our exposures of today will not be adequate, because it will be the case that the market environment today, in terms of the levels of interest rates, the shapes of yield curves and volatility surfaces, etc. may be very different to those extant at the time of the historical event. Likewise, there may have been paradigm shifts since the historical event occurred, such as the development of new instruments, the lengthening of tenors, the advent of new currencies such as the Euro, or the subsequent breaking of currency pegs long after the event, which may mean that blindly applying the shocks which occurred during the historical event to the positions today may well result in implausible market effects. Localized Stress Testing Scenarios designed to explore the specific vulnerabilities of each line of business and region, and of specific legal entities. Such stress testing will include examination of our exposures to idiosyncratic events, such as changes to tax codes, which may give rise to significant valuation changes for our municipals business, or the dividend assumptions used in our equity derivatives valuation models; or changes to the implicit government guarantee backing Agencies positions, etc. A second kind of localized stress scenario which we intend to carry out is what we refer to as a “Dealer-Exit” scenario. A number of our businesses trade highly structured and complex products in which we, along with other competing dealers, tend to warehouse exotic risks which we may not easily trade out of. As a result of these trades the dealer community tends to warehouse one side of these transactions, whilst the end-user clients tend to hold the other side. As a consequence, the forced exit from the market of one of our competitors may give rise to large losses on a mark-to-market basis. We subject both our trading and counterparty portfolio to stress tests. 27 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION LIMIT STRUCTURE Overview Fundamental to risk management is the establishment and maintenance of a sound system of integrated risk limits to control the range of risks inherent in the Firm’s activities. The overall philosophy of the Firm is that we have a zero tolerance level for ignoring limits and internal processes. Disciplinary actions for limit breaches include compensation adjustment or terminations. The foundation of our limit framework is an aggregate risk appetite limit at the Firmwide level, which is then cascaded down to the Divisions and then to the businesses both globally and regionally. These risk appetite limits are supplemented by VaR, counterparty credit, single transaction, country and concentration limits. 28 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION VaR Limits VaR limits pertain to the Firm’s trading and investing activities. VaR limits are set at a Firm-wide level, and cascaded down to the Divisions and Lines of Business within each Division on a global and regional basis. In addition, while the Firm does not manage risk on a legal entity basis, limits are nonetheless applied to the Firm’s regulated legal entities as required. The Firm-wide Divisional VaR limits and the region-wide cross-divisional limits for Europe and Asia are established by the Global Head of Risk Management and the Division/Region Head. Limits set within a Division, which may be either regional or for a global Line of Business, depending upon the business organization, are set by Market Risk Management in conjunction with the Division Heads. Business Managers have the authority to set additional limits, including individual trader limits so long as the Line of Business/Region stays within its limit overall. When a Firm-wide Divisional or Region-wide cross divisional limit is approached, or seems likely to be exceeded, the issue is escalated both within Market Risk Management and the Division/Regional Head, as appropriate. The Division/Regional Head and Global Head of Risk Management are then able to decide the action to be taken. One of three courses may be taken: • Allow the excess to remain for an agreed period of time in support of the specific trading strategy: this action may occur in cases where the excess was anticipated and discussed with Market Risk Management or where the excess is in support of a customer facilitation trade and there is unused risk capacity at the Firm-wide level; • Agree, in some circumstances, to revise the limits if, for example, there has been a change in the business which warrants such a change; or • The decision may be taken to reduce the risk profile back within the limit. Likewise, when an intra-Division or business line limit is approached or breached, the Division Head determines the appropriate course of action, taking into account the advice of Market Risk Management. Market Risk Managers are responsible to report all such limit excesses and any discussions with the trader or business unit manager regarding them to his/her manager in Market Risk Management, who in turn will alert the Global Head of Risk Management, and to the Division head. Provided that the limit for the Division has not been breached, the Division head may re-allocate intra-Divisional limits, subject to the advice of Market Risk Management. In addition, the Global Head of Risk Management is empowered to grant a temporary waiver of an intra-Divisional limit excess. If a temporary waiver is agreed, this becomes the limit used for the duration of the waiver. At the end of the waiver period the limit will revert to the previous level. 29 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION In circumstances where excesses are occurring frequently, Market Risk Management will bring this to the attention of the Global Head of Risk Management. This may result in: • Action to bring risk below limit; • An ad-hoc meeting to review the cause of the limit breaches; • A review of the risk measurement technique; • An adjustment in the business’s allocated risk limits. 30 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Counterparty Credit Limits Counterparty Credit Limits are set for each counterparty group and legal entity based on our internal risk ratings. Credit exposure is aggregated by legal entities across the Firm and netted by product where enforceable netting agreements exist. No diversification benefit is given to any counterparty across products. The largest counterparties by industry, region and product are reviewed on a quarterly basis. All counterparties are formally reviewed on a regular basis – at least annually for BBB+ or weaker counterparties. Within this framework, limits by product and tenor are established for each legal entity within a group. Limits are set based on our potential risk exposure for a product • Money lines are established with the large banks for liquidity management. • Exposures for traded products are measured primarily on an MPE (Maximum Potential Exposure) basis, taking into account netting and collateral where available. • Settlement limits are set where we, due to market convention, have free delivery (FX). Credit also has responsibility for portfolio management of counterparty credit risks. This includes monitoring and reporting large exposures (current credit exposure and maximum potential exposure), managing concentrations across countries, industries and products, ensuring risk rating are current, asset quality portfolio trend analysis. 31 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Single Transaction Limit The Single Transaction Limit framework limits the size of single transactions even if a transaction can be accommodated within the risk appetite limits. We want to limit the maximum loss we could incur to any one name in order to avoid negative publicity and incur decreased confidence in the Firm’s risk controls. The Commitments Committee has the authority to approve transactions within these limits. Executive Committee approval is required in rare circumstances where transactions could exceed these limits. 32 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Country Limit Country Limits are set on a country basis for non-G10 countries. All countries are tiered according to • political and social stability • macro fundamentals/creditworthiness • size and liquidity of markets Limits are set on an Estimated Loss Potential basis. This process limits losses arising from a crisis in a country or a region and encourages prudent risk taking. 33 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Concentration Limits Concentration Limits are set on: • asset classes • industry sector • credit sector • underlying name 34 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION OTHER Main Financial and Non Financial Risks in Trading Book The Firm’s main financial market risks generically are due to changes in the level, shape and slope of the yield curve; changes in basis (cash/futures; on-the-run; off-the-run MBS; OAS; basis); credit spreads; prepayment risk; FX risk; stock price movements; volatility. The main credit risks include spreads widening; downgrades; defaults. The top nonfinancial risks include legal enforceability on netting and collateral and reputational risks. Other non-financial or operational risks in the trading books can arise from a variety of different sources. Operational risks in the trading book can arise from items associated with trade execution and delivery such as a miscommunication or from a data entry or data maintenance error. In addition, operational losses can arise in the natural course of business, when a deadline is missed (e.g., delivery fails). There are also operational risks in the trading books which arise through interaction with counterparties around documentation execution and documentation monitoring. Counterparties may not always return signed and executed documents in a timely manner. For these reasons, Lehman Brothers has a dedicated staff in the Transactions Management Group (TMG) whose responsibilities include Master Agreement preparation, negotiation, and execution. In addition, collateral management associated with the terms of these various agreements that have been executed, can present the Firm with other operational risks. These collateral management risks are aggressively managed by the various product margin groups. For example, we must closely monitor agreement terms such as minimum transfer amounts, thresholds, and cure periods to ensure that margin calls are made in the correct amount and in a timely fashion. Another source of operational risk in the trading book can arise if there is a model error or an inaccurate price used within the model framework. These risks are controlled with a well-defined Model Approval Policy. Finally, as is the case with most financial firms, operational risks in the trading book can also arise as a result of system failures. Again, the Firm’s extensive Business Continuity Plan (BCP) has been designed to thwart any such occurrence. The trading desks have a number of alternative means for booking transactions across a number of different physical locations. We have a well diversified business and do not have large concentrations of risk. Our risk reports capture non-financial risks. We have daily operational risk reports which track and highlight pricing issues, delivery fails, systems malfunctions, and margin disputes. The list of main risks which we have highlighted is always present in some form. Our exposures change due to the ebbs and flows of our business. 35 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Valuation The foundation of our risk management process lies in the discipline instilled by marking our positions to market on a daily basis. The marking process is overseen by the Product Control function, which is part of Finance, and is independent of the Front Office. The goal of marking to market is to record all positions in our books at market. For all liquid products, establishing the market value at the end of the trading day is a straightforward matter, using price feeds from the many widely available independent price sources, such as Reuters or Bloomberg. For products that are less liquid and for which independent price sources are not easily available we impute marks using standard basis relationships, such as spreads, between the value of the position we wish to price and other positions for which prices are easily available. Product Controllers conduct periodic pricetesting, during which independent price sources are used to check the valuations we are using for illiquid positions. In certain cases there may be uncertainty around the market value which could be achieved for a particular position, perhaps because the position we hold is unusually large relative to the size of a normal market trade, in which case we may expect the market price to be affected adversely by the action of unwinding our position, or perhaps because a position is particularly illiquid and there is no regular market available in which to price it. In these cases we adjust the mark to allow for the valuation uncertainty. For structured derivatives transactions, which are custom-made for a client, and for which there are therefore no market prices available, we estimate market using models, the input parameters of which are widely available from independent market sources. Such input parameters may include, for example, implied volatilities of at-the-money options. In certain cases, the model may require input parameters which are not observable in the market, for example the implied correlation between an interest rate and a spot foreign exchange rate. In these cases, the values of the input parameters are taken to be our best estimate of their fair value, and we set the mark very conservatively to account for the fact that our best estimate may not be where the true value lies. In these situations, the Firm would not book any profit at the onset of the transaction but instead value the position conservatively until a more robust price valuation becomes available. This adjustment accounts for the valuation difference arising when we adjust the model parameters to adverse, but nevertheless plausible, levels. Before any trade requiring a model for valuation or risk measurement may be executed, the model must be accepted jointly by traders, Research, and Global Risk Management. For the purpose of expediency, a pricing model can be accepted subject to conditions to be set by the party having non-critical reservations on the model. Models that cater to a small number of new transactions with limited risk exposures need not go through the entire formal acceptance procedure. In such cases, it is essential that the relevant staff in the middle office, financial control and Quantitative Risk Management be informed beforehand, and a quick determination of the exception is made. The financial controller in consultation with the business unit head and Quantitative Risk Management must also decide on the appropriate P&L adjustment for the potential inaccuracy of the model. 36 FOIA CONFIDENTIAL TREATMENT REQUESTED BY LEHMAN BROTHERS HOLDINGS INC. LBEX-DOCID 738522 QUARTERLY GLOBAL RISK MANAGEMENT INFORMATION Pricing Models Pricing models are developed by the quantitative research teams dedicated to each business. Those teams do not report into the specific business they support. That structure creates a fair amount of independence for model conceptualization and development away from sales and trading. Models are extensively tested by research prior to use; sometimes for many months. Various extreme situations are examin