Dec. 13 (Bloomberg) -- Lehman Brothers Holdings Inc., the largest U.S. underwriter of mortgage-backed bonds, said earnings fell for a second straight quarter and losses from the collapse of the subprime market will probably extend into next year.

Fourth-quarter net income declined 12 percent to $886 million, or $1.54 a share, from $1 billion, or $1.72, a year earlier, the New York-based company said today in a statement. A drop in the value of mortgage-related securities and real-estate holdings cut revenue by $830 million. Lehman fell 0.7 percent on the New York Stock Exchange, less than Wall Street rivals.

Lehman's earnings exceeded analysts' estimates after revenue from trading stocks more than doubled, helped by private-equity gains and the firm's investment in hedge fund GLG Partners Inc. The board gave Chief Executive Officer Richard Fuld a $35 million stock award for the year as Lehman, the fourth-largest U.S. securities firm by market value, avoided the losses analysts predict Wall Street rivals Morgan Stanley and Bear Stearns Cos. will report next week.

``We expect the next couple of quarters to be quite tough on fixed income,'' Chief Financial Officer Erin Callan said in an interview. ``Diversification hasn't made us immune to that, it's just mitigated what otherwise would be a significant downside.''

A logjam in the debt markets will also slow other businesses next year, Callan said. Mergers and acquisitions will drop by 20 percent industrywide in 2008, though market share gains will help soften the blow for Lehman, she said.

Shares Decline

Lehman fell 45 cents to $61.37 in composite trading on the New York Stock Exchange at 4 p.m. The stock declined 21 percent this year, compared with Morgan Stanley's 26 percent drop, Bear Stearns's 40 percent slide and Goldman Sachs Group Inc.'s 4.6 percent advance.

``Lehman has seemed to limit its balance-sheet exposure to subprime, keeping the writedowns reasonable,'' said Benjamin Wallace, who helps manage $750 million at Grimes & Co. in Westborough, Massachusetts. ``They're still a big fixed-income player and that business will probably slow down further next year, so the share price isn't rewarding their performance yet.''

All four firms sank today on concern a Federal Reserve plan to provide financial companies with as much as $64 billion is failing to boost lending.

Record Year

Lehman's fourth-quarter revenue fell 3 percent to $4.39 billion, with a record 62 percent coming from non-U.S. businesses. Return on equity decreased to 16.6 percent from 22.3 percent a year earlier. The company has reported two consecutive quarters of declining profits for the first time in five years, though earnings for the full year were a record $4.2 billion.

While fixed-income trading revenue declined 60 percent to $860 million in the quarter, equity trading more than doubled to $1.9 billion.

The GLG transaction contributed about $500 million in revenue for the quarter, risk management head Christopher O'Meara said on a conference call with analysts. That raised concern among analysts including William Tanona at Goldman Sachs that Lehman won't be able to repeat its better-than-expected performance in coming quarters.

``The quality appears less than optimal,'' Tanona, who rates Lehman ``neutral,'' said in a report to investors.

A lower-than-expected tax rate accounted for about 6 cents a share of the earnings beat, according to Merrill Lynch & Co. analyst Guy Moszkowski.

`First Glance'

The earnings performance was ``not as good as it looks at first glance,'' UBS AG analyst Glenn Schorr, who recommends investors buy Lehman shares, said in a report.

Lehman's gross fourth-quarter writedown was $3.5 billion, O'Meara said. Residential mortgages and related assets accounted for $2.2 billion of that figure, and the rest came from commercial mortgages.

Lehman offset the losses with $2 billion it made on hedges, $320 million of gains from the sale of leveraged loans that were previously written down and a $320 million drop in the firm's liabilities, O'Meara said.

Those steps resulted in the $830 million revenue reduction, on top of the $700 million writedown the company reported last quarter. Further writedowns are likely in the first half of next year, CFO Callan said during a conference call with analysts.

Lehman executives said they used bets against ABX indexes, credit-default swaps and total-return swaps and other forms of hedging to protect against declines in mortgage-related assets. While hedging has become more difficult in the last several months because counterparties are hard to find, Lehman is benefiting from having hedged its inventory before markets declined, Callan said during the interview.

`Great Idea'

``You give up profitability when you hedge during positive environments,'' Callan said. ``Sixteen out of 18 months that didn't feel so hot. But in those two out of 18 months, that felt like a great idea.''

Merrill, the third-largest U.S. securities firm, took an $8.4 billion writedown last quarter, and Morgan Stanley last month said it will report at least $3.7 billion of writedowns in the fourth quarter. Bear Stearns is writing down about $2 billion in the third and fourth quarters.

Lehman's investment-banking revenue fell 3 percent to $831 million, and fees from asset management increased 30 percent to $832 million.

The firm advised on 45 takeovers in the fourth quarter valued at $296.3 billion, more than three times what it handled a year earlier, according to data compiled by Bloomberg. It underwrote $24.8 billion of U.S. bonds in the quarter, down from $28.9 billion the previous year.

Employee Ranks

Lehman has eliminated 2,500 mortgage-related jobs and shut its subprime lending unit, BNC Mortgage LLC, in August after U.S. foreclosures rose to a record. BNC, which was making more than $2 billion of home loans a month last year, cut lending to $200 million a month before being closed.

Lehman had 28,556 employees as of Nov. 30, down from 28,783 at the end of the third quarter.

``This firm produced a respectable profit in a very difficult quarter,'' Credit Suisse Group analyst Susan Katzke said in a report today. Katzke, who rates the shares ``outperform,'' cut her profit estimate for 2008 by 50 cents to $7, citing a ``weaker economic outlook.''

Wall Street's biggest losses have come from collateralized debt obligations, which pool asset-backed securities according to varying degrees of default risk. Investors have become wary about even the CDOs that are supposed to have the least risk, driving prices down more than 70 percent. Lehman executives have said they don't own any CDOs that aren't fully hedged.

Level 3

Lehman's so-called Level 3 assets, which are harder to value because market prices have become scarce, increased about $6 billion in the fourth quarter from the previous three months, O'Meara said on the conference call today. In the third quarter, the figure jumped 57 percent to $34.7 billion.

The ratio of Level 3 assets to total inventory rose to about 13 percent from 11 percent in the previous quarter, he said. While some of those were assets shifted from Level 2, where there are more market prices available, some were assets acquired during the period, he said.

The firm's subprime exposure was $5.3 billion at the end of the fourth quarter, O'Meara said, down from $6.3 billion in the previous period.

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net.

Last Updated: December 13, 2007 16:13 EST