2008-06-09 20:20:31 -

- Fitch Ratings has downgraded the long- and short-term Issuer Default Ratings (IDRs) of Lehman Brothers Holdings Inc. (Lehman) and its subsidiaries as follows:

Lehman Brothers Holdings Inc.

--Long-term IDR to 'A+' from 'AA-';

--Short-term IDR to 'F1' from 'F1+'.

Approximately $145 billion of long-term debt is outstanding including current year maturities of $18.5 billion with $8 billion of commercial paper.

Fitch's ratings action results from increased earnings volatility, changes in its business mix due to contraction in the securitization and structured credit markets and the level of risky assets exposing earnings to challenges in hedge effectiveness. Earnings volatility has increased and is expected to remain elevated in the near term. The level and variability

in future profits are expected to be consistent with companies carrying a high 'A' rating.

Lehman announced a capital raising transaction to offset the negative impact of earnings on capital and leverage. A successful common equity raise should help mitigate potential future erosion from continued asset sales in residential mortgages and corporate and commercial real estate loans. The amount and composition of the capital raise will be evaluated and included in the resolution of the Negative Outlook.

Lehman's Rating Outlook remains negative because profitability is expected to be challenged with continued fixed income volatility. Despite asset sales, Lehman's exposure to higher risk asset categories as a percent of Fitch core capital is higher than peers. Lehman's has been active hedging its exposure in these asset categories. However, its hedging strategy, while generally reducing earnings volatility, has not always been effective.

Fitch may revise the Outlook over the next year pending modifications to business mix and profitability. Lehman's equity sales and trading and investment banking businesses experienced increases in market shares. Additionally, management has reduced overhead and will continue to adjust its business strategy as the environment changes. Fitch believes Lehman will continue to sell riskier assets and reduce its overall risk in specific asset classes, particularly residential and commercial mortgages. However, Fitch is concerned that such sales may remove the most attractive assets, leaving a concentrated level of least desirable or more problematic assets on the balance sheet.

Fitch believes management has made strides in reducing its aggregate leverage and risk profile through asset sales, preferred capital issuance and reduced trading positions. Liquidity has been bolstered to over $40 billion by debt. Capital position has been strengthened this year by $5.9 billion of preferred issuances, including $4 billion mandatory convertible preferred stock, and $2 billion of 30-year subordinated debt. While Fitch recognizes the permanency of the preferred issues, maximum equity credit of such hybrids has been reached in Fitch calculated leverage ratios. While Fitch recognizes the permanency of the preferred issues, maximum equity credit of such hybrids has been reached in Fitch calculated leverage ratios. The cost of carrying this incremental funding will also negatively impact profitability.

Lehman's liquidity position solidly covers its short-term needs and was recently bolstered by the introduction of the Federal Reserve's Primary Dealer Credit Facility, and greater use of its bank entities to fund less liquid assets.

Management has conservatively structured its funding strategy and is currently running with large surpluses of long-term funding sources relative to its level of illiquid assets and other long-term funding requirements. Average life of long-term debt is approximately seven years. Its liquidity pool amply covers cash outflows generated by unsecured debt maturities over the next twelve months. Commercial paper has modestly expanded with minimal indication of credit sensitivity at current levels. Lehman maintains its emphasis on match funding credit sensitive and liquid investments with like sources.

Market risk measures indicate Lehman has increased its risk to market volatility over historic levels. Lehman's disclosed VaR, Fitch stressed VaRs as a percent of tangible equity and the volatility of principal trading revenues reflect the more volatile environment and heightened levels of risk to capital. Positively, position risk has declined visibly through Lehman's disclosure of un-weighted Value at Risk on an average and end of period basis. Risk contribution continues to remain fairly balanced between interest rate/credit and equity based exposures. Principal trading losses in fixed income are expected to result in earnings volatility particularly in the next few quarters.

Earnings volatility increased with Lehman pre-announcing substantive losses for the second quarter as dislocations between cash and derivatives pricing behavior severely limited the effectiveness of hedges. Some of these losses were realized as Lehman sold assets, particularly in sales of residential mortgages and leveraged loans. Two proprietary positions designed to be risk reducing in nature also suffered losses due to unexpected price behaviors during the quarter. Both have been largely sold. The basis risk between the cash and derivatives markets may result in further realized losses since the reduction in basis may be ongoing for some time.

Revenues in investment management and investment banking remain stable. Despite Lehman's improvement in M&A announced market share, Fitch expects revenues to be limited with materially reduced levels of activity in the near term.

Costs are expected to be reduced over the next several quarters with the impact of recent staff reductions. Management is expected to reduce capital investments reducing the run rate of non-compensation expenses. Reductions in compensation may be below Fitch's expectations since pressures for retention bonuses and franchise protection may increase in the near time.

Fitch will issue a detailed list of ratings actions shortly.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Fitch Ratings
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Leslie Bright, 212-908-0622, New York
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