10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

Commission File Number 1-11758

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(Exact Name of Registrant as specified in its charter)

 

       

Delaware

(State or other jurisdiction of incorporation or organization)

   1585 Broadway

New York, NY 10036

(Address of principal executive
offices, including zip code)

   36-3145972

(I.R.S. Employer Identification No.)

   (212) 761-4000

(Registrant’s telephone number,
including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer  x

   Accelerated Filer  ¨

Non-Accelerated Filer  ¨

   Smaller reporting company  ¨

(Do not check if a smaller reporting company)

  

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of April 30, 2011, there were 1,544,658,124 shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding.


Table of Contents

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QUARTERLY REPORT ON FORM 10-Q

For the quarter ended March 31, 2011

 

Table of Contents         Page  

Part I—Financial Information

  

Item 1.

  Financial Statements (unaudited)      1   
 

Condensed Consolidated Statements of Financial Condition—March 31, 2011 and December 31, 2010

     1   
 

Condensed Consolidated Statements of Income—Three Months Ended March 31, 2011 and 2010

     3   
 

Condensed Consolidated Statements of Comprehensive Income—Three Months Ended March 31, 2011 and 2010

     4   
 

Condensed Consolidated Statements of Cash Flows—Three Months Ended March 31, 2011 and 2010

     5   
 

Condensed Consolidated Statements of Changes in Total Equity—Three Months Ended March 31, 2011 and 2010

     6   
  Notes to Condensed Consolidated Financial Statements (unaudited)      8   
 

Note 1.      Introduction and Basis of Presentation

     8   
 

Note 2.      Significant Accounting Policies

     10   
 

Note 3.      Fair Value Disclosures

     11   
 

Note 4.      Securities Available for Sale

     30   
 

Note 5.      Collateralized Transactions

     32   
 

Note 6.      Variable Interest Entities and Securitization Activities

     34   
 

Note 7.      Financing Receivables

     42   
 

Note 8.      Goodwill and Net Intangible Assets

     44   
 

Note 9.      Long-Term Borrowings and Other Secured Financings

     45   
 

Note 10.    Derivative Instruments and Hedging Activities

     46   
 

Note 11.    Commitments, Guarantees and Contingencies

     54   
 

Note 12.    Regulatory Requirements

     60   
 

Note 13.    Total Equity

     63   
 

Note 14.    Earnings per Common Share

     63   
 

Note 15.    Interest Income and Interest Expense

     65   
 

Note 16.    Employee Benefit Plans

     65   
 

Note 17.    Income Taxes

     66   
 

Note 18.    Segment and Geographic Information

     67   
 

Note 19.    Equity Method Investments

     69   
 

Note 20.    Discontinued Operations

     70   
 

Note 21.    Subsequent Events

     71   
  Report of Independent Registered Public Accounting Firm      72   

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     73   
 

Introduction

     73   
 

Executive Summary

     74   
 

Business Segments

     82   
 

Accounting Developments

     93   
 

Other Matters

     94   
 

Critical Accounting Policies

     97   
 

Liquidity and Capital Resources

     102   

Item 3.

  Quantitative and Qualitative Disclosures about Market Risk      115   

 

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Item 4.

  Controls and Procedures      127   

Financial Data Supplement (Unaudited)

     128   

Part II—Other Information

  

Item 1.

  Legal Proceedings      131   

Item 1A.

  Risk Factors      133   

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      134   

Item 6.

  Exhibits      134   

 

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AVAILABLE INFORMATION

Morgan Stanley files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Morgan Stanley) file electronically with the SEC. Morgan Stanley’s electronic SEC filings are available to the public at the SEC’s internet site, www.sec.gov.

Morgan Stanley’s internet site is www.morganstanley.com. You can access Morgan Stanley’s Investor Relations webpage at www.morganstanley.com/about/ir. Morgan Stanley makes available free of charge, on or through its Investor Relations webpage, its proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Morgan Stanley also makes available, through its Investor Relations webpage, via a link to the SEC’s internet site, statements of beneficial ownership of Morgan Stanley’s equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

Morgan Stanley has a Corporate Governance webpage. You can access information about Morgan Stanley’s corporate governance at www.morganstanley.com/about/company/governance. Morgan Stanley posts the following on its Corporate Governance webpage:

 

   

Amended and Restated Certificate of Incorporation;

 

   

Amended and Restated Bylaws;

 

   

Charters for its Audit Committee; Internal Audit Subcommittee; Compensation, Management Development and Succession Committee; Nominating and Governance Committee; and Risk Committee;

 

   

Corporate Governance Policies;

 

   

Policy Regarding Communication with the Board of Directors;

 

   

Policy Regarding Director Candidates Recommended by Shareholders;

 

   

Policy Regarding Corporate Political Contributions;

 

   

Policy Regarding Shareholder Rights Plan;

 

   

Code of Ethics and Business Conduct;

 

   

Code of Conduct; and

 

   

Integrity Hotline information.

Morgan Stanley’s Code of Ethics and Business Conduct applies to all directors, officers and employees, including its Chief Executive Officer, Chief Financial Officer and Deputy Chief Financial Officer. Morgan Stanley will post any amendments to the Code of Ethics and Business Conduct and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange LLC (“NYSE”) on its internet site. You can request a copy of these documents, excluding exhibits, at no cost, by contacting Investor Relations, 1585 Broadway, New York, NY 10036 (212-761-4000). The information on Morgan Stanley’s internet site is not incorporated by reference into this report.

 

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Table of Contents

Part I—Financial Information.

 

Item 1. Financial Statements.

MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(dollars in millions, except share data)

(unaudited)

 

     March 31,
2011
     December 31,
2010
 

Assets

     

Cash and due from banks ($310 and $297 at March 31, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities generally not available to the Company)

   $ 8,120      $ 7,341  

Interest bearing deposits with banks

     44,488        40,274  

Cash deposited with clearing organizations or segregated under federal and other regulations or requirements

     21,932        19,180  

Financial instruments owned, at fair value (approximately $132 billion and $130 billion were pledged to various parties at March 31, 2011 and December 31, 2010, respectively):

     

U.S. government and agency securities

     46,626        48,446  

Other sovereign government obligations

     38,878        33,908  

Corporate and other debt ($4,316 and $3,816 at March 31, 2011 and December 31, 2010, respectively related to consolidated variable interest entities, generally not available to the Company)

     88,459        88,154  

Corporate equities ($655 and $625 at March 31, 2011 and December 31, 2010, respectively related to consolidated variable interest entities, generally not available to the Company)

     67,042        68,416  

Derivative and other contracts

     49,913        51,292  

Investments ($1,881 and $1,873 at March 31, 2011 and December 31, 2010, respectively related to consolidated variable interest entities, generally not available to the Company)

     9,068        9,752  

Physical commodities

     8,126        6,778  
                 

Total financial instruments owned, at fair value

     308,112        306,746  

Securities available for sale, at fair value

     27,733        29,649  

Securities received as collateral, at fair value

     13,161        16,537  

Federal funds sold and securities purchased under agreements to resell

     162,923        148,253  

Securities borrowed

     142,937        138,730  

Receivables:

     

Customers

     43,959        35,258  

Brokers, dealers and clearing organizations

     6,131        9,102  

Fees, interest and other

     8,840        9,790  

Loans (net of allowances of $45 and $82 at March 31, 2011 and December 31, 2010, respectively)

     11,882        10,576  

Other investments

     4,719        5,412  

Premises, equipment and software costs (net of accumulated depreciation of $4,259 and $4,476 at March 31, 2011 and December 31, 2010, respectively) ($352 and $321 at March 31, 2011 and December 31, 2010, respectively related to consolidated variable entities, generally not available to the Company)

     6,366        6,154  

Goodwill

     6,743        6,739  

Intangible assets (net of accumulated amortization of $692 and $605 at March 31, 2011 and December 31, 2010, respectively) (includes $144 and $157 at fair value at March 31, 2011 and December 31, 2010, respectively)

     4,581        4,667  

Other assets ($232 and $118 at March 31, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities generally not available to the Company)

     13,558        13,290  
                 

Total assets

   $ 836,185      $ 807,698  
                 

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION—(Continued)

(dollars in millions, except share data)

(unaudited)

 

     March 31,
2011
    December 31,
2010
 

Liabilities and Equity

    

Deposits (includes $2,848 and $3,027 at fair value at March 31, 2011 and December 31, 2010, respectively)

   $ 63,495     $ 63,812  

Commercial paper and other short-term borrowings (includes $1,657 and $1,799 at fair value at March 31, 2011 and December 31, 2010, respectively)

     3,302       3,256  

Financial instruments sold, not yet purchased, at fair value:

    

U.S. government and agency securities

     31,488       27,948  

Other sovereign government obligations

     23,133       22,250  

Corporate and other debt

     10,443       10,918  

Corporate equities

     26,621       19,838  

Derivative and other contracts

     44,585       47,802  
                

Total financial instruments sold, not yet purchased, at fair value

     136,270       128,756  

Obligation to return securities received as collateral, at fair value

     18,069       21,163  

Securities sold under agreements to repurchase (includes $890 and $849 at fair value at March 31, 2011 and December 31, 2010, respectively)

     156,891       147,598  

Securities loaned

     36,084       29,094  

Other secured financings (includes $8,052 and $8,490 at fair value at March 31, 2011 and December 31, 2010, respectively) ($2,812 and $2,656 at March 31, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities and are non-recourse to the Company)

     12,958       10,453  

Payables:

    

Customers

     121,574       123,249  

Brokers, dealers and clearing organizations

     8,278       3,363  

Interest and dividends

     2,659       2,572  

Other liabilities and accrued expenses ($177 and $117 at March 31, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities and are non-recourse to the Company)

     13,961       16,518  

Long-term borrowings (includes $43,575 and $42,709 at fair value at March 31, 2011 and December 31, 2010, respectively)

     196,136       192,457  
                
     769,677       742,291  
                

Commitments and contingent liabilities (see Note 11)

    

Equity

    

Morgan Stanley shareholders’ equity:

    

Preferred stock

     9,597       9,597  

Common stock, $0.01 par value;

    

Shares authorized: 3,500,000,000 at March 31, 2011 and December 31, 2010;

    

Shares issued: 1,603,913,074 at March 31, 2011 and December 31, 2010;

    

Shares outstanding: 1,545,064,012 at March 31, 2011 and 1,512,022,095 at December 31, 2010

     16       16  

Paid-in capital

     12,185       13,521  

Retained earnings

     39,269       38,603  

Employee stock trust

     3,468       3,465  

Accumulated other comprehensive loss

     (426     (467

Common stock held in treasury at cost, $0.01 par value; 58,849,062 shares at March 31, 2011 and 91,890,979 shares at December 31, 2010

     (2,455     (4,059

Common stock issued to employee trust

     (3,468     (3,465
                

Total Morgan Stanley shareholders’ equity

     58,186       57,211  

Noncontrolling interests

     8,322       8,196  
                

Total equity

     66,508       65,407  
                

Total liabilities and equity

   $ 836,185     $ 807,698  
                

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(dollars in millions, except share and per share data)

(unaudited)

 

     Three Months Ended
March 31,
 
     2011     2010  

Revenues:

    

Investment banking

   $ 1,214     $ 1,060  

Principal transactions:

    

Trading

     2,977       3,758  

Investments

     329       369  

Commissions

     1,449       1,260  

Asset management, distribution and administration fees

     2,109       1,963  

Other

     (444     294  
                

Total non-interest revenues

     7,634       8,704  
                

Interest income

     1,854       1,736  

Interest expense

     1,853       1,368  
                

Net interest

     1       368  
                

Net revenues

     7,635       9,072  
                

Non-interest expenses:

    

Compensation and benefits

     4,333       4,416  

Occupancy and equipment

     402       390  

Brokerage, clearing and exchange fees

     405       348  

Information processing and communications

     445       395  

Marketing and business development

     147       134  

Professional services

     428       395  

Other

     603       479  
                

Total non-interest expenses

     6,763       6,557  
                

Income from continuing operations before income taxes

     872       2,515  

Provision for (benefit from) income taxes

     (256     436  
                

Income from continuing operations

     1,128       2,079  
                

Discontinued operations:

    

Loss from discontinued operations

     —          (99

Benefit from income taxes

     (2     (31
                

Net gain (loss) from discontinued operations

     2       (68
                

Net income

   $ 1,130     $ 2,011  

Net income applicable to noncontrolling interests

     162       235  
                

Net income applicable to Morgan Stanley

   $ 968     $ 1,776  
                

Earnings applicable to Morgan Stanley common shareholders

   $ 736     $ 1,411  
                

Amounts applicable to Morgan Stanley:

    

Income from continuing operations

   $ 966     $ 1,844  

Net gain (loss) from discontinued operations

     2       (68
                

Net income applicable to Morgan Stanley

   $ 968     $ 1,776  
                

Earnings (loss) per basic common share:

    

Income from continuing operations

   $ 0.50     $ 1.12  

Net gain (loss) from discontinued operations

     0.01       (0.05
                

Earnings per basic common share

   $ 0.51     $ 1.07  
                

Earnings per diluted common share:

    

Income from continuing operations

   $ 0.50     $ 1.03  

Loss from discontinued operations

     —          (0.04
                

Earnings per diluted common share

   $ 0.50     $ 0.99  
                

Average common shares outstanding:

    

Basic

     1,456,015,979       1,314,608,020  
                

Diluted

     1,472,307,592       1,626,207,327  
                

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in millions)

(unaudited)

 

     Three Months Ended
March 31,
 
         2011             2010      

Net income

   $ 1,130     $ 2,011  

Other comprehensive income (loss), net of tax:

    

Foreign currency translation adjustments(1)

     37        2  

Amortization of cash flow hedges(2)

     1       3  

Net unrealized loss on Securities available for sale(3)

     (36     (20

Pension, postretirement and other related adjustments(4)

     5       4  
                

Comprehensive income

   $ 1,137     $ 2,000  

Net income applicable to noncontrolling interests

     162       235  

Other comprehensive loss applicable to noncontrolling interests

     (34     (12
                

Comprehensive income applicable to Morgan Stanley

   $ 1,009     $ 1,777  
                

 

(1) Amounts are net of provision for (benefit from) income taxes of $(68) million and $89 million for the quarters ended March 31, 2011 and 2010, respectively.
(2) Amounts are net of provision for income taxes of $2 million for both quarters ended March 31, 2011 and 2010.
(3) Amounts are net of benefit from income taxes of $24 million and $14 million for the quarters ended March 31, 2011 and 2010, respectively.
(4) Amounts are net of provision for (benefit from) income taxes of $(4) million and $2 million for the quarters ended March 31, 2011 and 2010, respectively.

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in millions)

(unaudited)

 

     Three Months Ended
March  31,
 
         2011             2010      

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 1,130     $ 2,011  

Adjustments to reconcile net income (loss) to net cash provided by (used for) operating activities:

    

(Gain) loss on equity method investees

     660        (66

Compensation payable in common stock and options

     340       370  

Depreciation and amortization

     379        154  

Loss on business dispositions

     —          932  

Gain on sale of securities available for sale

     (12     —     

Loss on repurchase of long-term debt

     23        —     

Insurance reimbursement

     —          (31

Impairment charges and other-than-temporary impairment charges

     3       10  

Changes in assets and liabilities:

    

Cash deposited with clearing organizations or segregated under federal and other regulations or requirements

     (2,752     1,345  

Financial instruments owned, net of financial instruments sold, not yet purchased

     7,568       (5,073

Securities borrowed

     (4,207     (13,554

Securities loaned

     6,990       5,126  

Receivables, loans and other assets

     (7,417     4,618  

Payables and other liabilities

     1,350        5,494  

Federal funds sold and securities purchased under agreements to resell

     (14,670     4,575  

Securities sold under agreements to repurchase

     9,293       15,190  
                

Net cash provided by (used for) operating activities

     (1,322     21,101  
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Net proceeds from (payments for):

    

Premises, equipment and software costs

     (409     (138

Purchases of securities available for sale

     (3,357     (18,674

Sales and redemptions of securities available for sale

     6,311       —     
                

Net cash provided by (used for) investing activities

     2,545       (18,812
                

CASH FLOWS FROM FINANCING ACTIVITIES

    

Net proceeds from (payments for):

    

Commercial paper and other short-term borrowings

     46        945  

Dividends related to noncontrolling interests

     (7     (7

Derivatives financing activities

     89        (39

Other secured financings

     2,312       1,458  

Deposits

     (317     1,711  

Net proceeds from:

    

Excess tax benefits associated with stock-based awards

     29       2  

Public offerings and other issuances of common stock

     —          1  

Issuance of long-term borrowings

     14,285       7,755  

Payments for:

    

Long-term borrowings

     (13,046     (9,693

Repurchases of common stock for employee tax withholding

     (273     (262

Cash dividends

     (302     (293
                

Net cash provided by financing activities

     2,816        1,578  
                

Effect of exchange rate changes on cash and cash equivalents

     644       (380
                

Effect of cash and cash equivalents related to variable interest entities

     310       —     
                

Net increase in cash and cash equivalents

     4,993       3,487  

Cash and cash equivalents, at beginning of period

     47,615       31,991  
                

Cash and cash equivalents, at end of period

   $ 52,608     $ 35,478  
                

Cash and cash equivalents include:

    

Cash and due from banks

   $ 8,120     $ 5,979  

Interest bearing deposits with banks

     44,488       29,499  
                

Cash and cash equivalents, at end of period

   $ 52,608     $ 35,478  
                

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Cash payments for interest were $1,697 million and $1,178 million for the quarters ended March 31, 2011 and 2010, respectively.

Cash payments for income taxes were $250 million and $169 million for the quarters ended March 31, 2011 and 2010, respectively.

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN TOTAL EQUITY

Three Months Ended March 31, 2011

(dollars in millions)

(unaudited)

 

    Preferred
Stock
    Common
Stock
    Paid-in
Capital
    Retained
Earnings
    Employee
Stock
Trust
    Accumulated
Other
Comprehensive
Income (Loss)
    Common
Stock
Held in
Treasury
at Cost
    Common
Stock
Issued to
Employee
Trust
    Non-
controlling
Interests
    Total
Equity
 

BALANCE AT DECEMBER 31, 2010

  $ 9,597      $ 16      $ 13,521      $ 38,603      $ 3,465      $ (467   $ (4,059   $ (3,465   $ 8,196      $ 65,407   

Net income

    —          —          —          968       —          —          —          —          162       1,130  

Dividends

    —          —          —          (302     —          —          —          —          —          (302

Shares issued under employee plans and related tax effects

    —          —          (1,336     —          3       —          1,877       (3     —          541  

Repurchases of common stock

    —          —          —          —          —          —          (273     —          —          (273

Net change in cash flow hedges

    —          —          —          —          —          1       —          —          —          1  

Pension, postretirement and other related adjustments

    —          —          —          —          —          5       —          —          —          5  

Foreign currency translation adjustments

    —          —          —          —          —          71       —          —          (34     37  

Change in net unrealized losses on securities available for sale

    —          —          —          —          —          (36     —          —          —          (36

Decrease in noncontrolling interests related to dividends of noncontrolling interests

    —          —          —          —          —          —          —          —          (7     (7

Other increases in noncontrolling interests

    —          —          —          —          —          —          —          —          5       5  
                                                                               

BALANCE AT MARCH 31, 2011

  $ 9,597      $ 16      $ 12,185      $ 39,269      $ 3,468      $ (426   $ (2,455   $ (3,468   $ 8,322      $ 66,508   
                                                                               

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN TOTAL EQUITY—(Continued)

 

Three Months Ended March 31, 2010

(dollars in millions)

(unaudited)

 

    Preferred
Stock
    Common
Stock
    Paid-in
Capital
    Retained
Earnings
    Employee
Stock
Trust
    Accumulated
Other
Comprehensive
Income (Loss)
    Common
Stock
Held in
Treasury
at Cost
    Common
Stock
Issued to
Employee
Trust
    Non-
controlling
Interests
    Total
Equity
 

BALANCE AT DECEMBER 31, 2009

  $ 9,597      $ 15      $ 8,619      $ 35,056      $ 4,064      $ (560   $ (6,039   $ (4,064   $ 6,092      $ 52,780   

Net income

    —          —          —          1,776       —          —          —          —          235       2,011  

Dividends

    —          —          —          (293     —          —          —          —          —          (293

Shares issued under employee plans and related tax effects

    —          —          (1,869     —          (292     —          2,223       292       —          354  

Repurchases of common stock

    —          —          —          —          —          —          (262     —          —          (262

Net change in cash flow hedges

    —          —          —          —          —          3       —          —          —          3  

Pension and postretirement adjustments

    —          —          —          —          —          4       —          —          —          4  

Foreign currency translation adjustments

    —          —          —          —          —          14       —          —          (12     2  

Change in net unrealized losses on securities available for sale

    —          —          —          —          —          (20     —          —          —          (20

Increase in noncontrolling interests related to the consolidation of certain real estate partnerships sponsored by the Company

    —          —          —          —          —          —          —          —          468       468  

Decrease in noncontrolling interests related to dividends of noncontrolling interests

    —          —          —          —          —          —          —          —          (7     (7

Other increases in noncontrolling interests

    —          —          —          —          —          —          —          —          139       139  
                                                                               

BALANCE AT MARCH 31, 2010

  $ 9,597      $ 15      $ 6,750      $ 36,539      $ 3,772      $ (559   $ (4,078   $ (3,772   $ 6,915      $ 55,179   
                                                                               

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Introduction and Basis of Presentation.

The Company.    Morgan Stanley, a financial holding company, is a global financial services firm that maintains significant market positions in each of its business segments—Institutional Securities, Global Wealth Management Group and Asset Management. Unless the context otherwise requires, the terms “Morgan Stanley” and the “Company” mean Morgan Stanley and its consolidated subsidiaries.

A summary of the activities of each of the Company’s business segments is as follows:

Institutional Securities provides capital raising; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; corporate lending; sales, trading, financing and market-making activities in equity and fixed income securities and related products, including foreign exchange and commodities; and investment activities.

Global Wealth Management Group, which includes the Company’s 51% interest in Morgan Stanley Smith Barney Holdings LLC (“MSSB”), provides brokerage and investment advisory services to individual investors and small-to-medium sized businesses and institutions covering various investment alternatives; financial and wealth planning services; annuity and other insurance products; credit and other lending products; cash management services; retirement services; and trust and fiduciary services and engages in fixed income principal trading, which primarily facilitates clients’ trading or investments in such securities.

Asset Management provides a broad array of investment strategies that span the risk/return spectrum across geographies, asset classes and public and private markets to a diverse group of clients across the institutional and intermediary channels as well as high net worth clients (see “Discontinued Operations—Retail Asset Management Business” herein).

Discontinued Operations.

Retail Asset Management Business.    On June 1, 2010, the Company completed the sale of substantially all of its retail asset management business (“Retail Asset Management”), including Van Kampen Investments, Inc., to Invesco Ltd. (“Invesco”). The Company received $800 million in cash and approximately 30.9 million shares of Invesco stock upon the sale. The results of Retail Asset Management are reported as discontinued operations within the Asset Management business segment for all periods presented through the date of sale.

The Company recorded the 30.9 million shares as securities available for sale. In the fourth quarter of 2010, the Company sold its investment in Invesco.

Revel Entertainment Group, LLC.    On March 31, 2010, the Board of Directors authorized a plan of disposal by sale for Revel Entertainment Group, LLC (“Revel”), a development stage enterprise and subsidiary of the Company that was primarily associated with a development property in Atlantic City, New Jersey. On February 17, 2011, the Company completed the sale of Revel to a group of investors led by Revel’s chief executive officer. The Company did not retain any stake or ongoing involvement. The sale price approximated the carrying value of Revel and, accordingly, the Company did not recognize any pre-tax gain or loss on the sale. Total assets of Revel included in the Company’s condensed consolidated statement of financial condition at December 31, 2010 approximated $28 million. The results of Revel are reported as discontinued operations within the Institutional Securities business segment for all periods presented through the date of sale. The quarter ended March 31, 2010 included losses of approximately $932 million in connection with such planned disposition. See Note 17 for additional information about an income tax benefit related to Revel.

CityMortgage Bank.    In the third quarter of 2010, the Company completed the disposal of CityMortgage Bank (“CMB”), a Moscow-based mortgage bank. The results of CMB are reported as discontinued operations for all periods presented through the date of disposal within the Institutional Securities business segment.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Other.    In the third quarter of 2010, the Company completed a disposal of a real estate property within the Asset Management business segment. The results of operations are reported as discontinued operations for all periods presented through the date of disposal.

Discover.    On June 30, 2007, the Company completed the spin-off of its business segment Discover Financial Services (“DFS”) to its shareholders. On February 11, 2010, DFS paid the Company $775 million in complete satisfaction of its obligations to the Company regarding the sharing of proceeds from a lawsuit against Visa and MasterCard. The payment was recorded as a gain in discontinued operations for the quarter ended March 31, 2010.

Prior period amounts have been recast for discontinued operations. See Note 20 for additional information on discontinued operations.

Basis of Financial Information.    The condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S.”), which require the Company to make estimates and assumptions regarding the valuations of certain financial instruments, the valuation of goodwill, compensation, deferred tax assets, the outcome of litigation and tax matters, and other matters that affect the condensed consolidated financial statements and related disclosures. The Company believes that the estimates utilized in the preparation of the condensed consolidated financial statements are prudent and reasonable. Actual results could differ materially from these estimates.

Material intercompany balances and transactions have been eliminated.

The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 (the “Form 10-K”). The condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for the fair presentation of the results for the interim period. The results of operations for interim periods are not necessarily indicative of results for the entire year.

Consolidation.    The condensed consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and other entities in which the Company has a controlling financial interest, including certain variable interest entities (“VIE”) (see Note 6). For consolidated subsidiaries that are less than wholly owned, the third-party holdings of equity interests are referred to as noncontrolling interests. The portion of net income attributable to noncontrolling interests for such subsidiaries is presented as Net income (loss) applicable to noncontrolling interests on the condensed consolidated statements of income, and the portion of the shareholders’ equity of such subsidiaries is presented as Noncontrolling interests in the condensed consolidated statements of financial condition and condensed consolidated statements of changes in total equity.

For entities where (1) the total equity investment at risk is sufficient to enable the entity to finance its activities without additional support and (2) the equity holders bear the economic residual risks and returns of the entity and have the power to direct the activities of the entity that most significantly affect its economic performance, the Company consolidates those entities it controls either through a majority voting interest or otherwise. For entities that do not meet these criteria, commonly known as VIEs, the Company consolidates those entities where the Company has the power to make the decisions that most significantly affect the economic performance of the VIE and has the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE, except for certain VIEs that are money market funds, investment companies or are entities qualifying for accounting purposes as investment companies. Generally, the Company consolidates those entities when it absorbs a majority of the expected losses or a majority of the expected residual returns, or both, of the entities.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

For investments in entities in which the Company does not have a controlling financial interest but has significant influence over operating and financial decisions, the Company generally applies the equity method of accounting with net gains and losses recorded within Other revenues. Where the Company has elected to measure certain eligible investments at fair value in accordance with the fair value option, net gains and losses are recorded within Principal transactions—Investments (see Note 3).

Equity and partnership interests held by entities qualifying for accounting purposes as investment companies are carried at fair value.

The Company’s significant regulated U.S. and international subsidiaries include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. International plc (“MSIP”), Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”), Morgan Stanley Bank, N.A. and Morgan Stanley Investment Advisors Inc.

Income Statement Presentation.    The Company, through its subsidiaries and affiliates, provides a wide variety of products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. In connection with the delivery of the various products and services to clients, the Company manages its revenues and related expenses in the aggregate. As such, when assessing the performance of its businesses, primarily in its Institutional Securities business segment, the Company considers its principal trading, investment banking, commissions and interest income, along with the associated interest expense, as one integrated activity.

 

2. Significant Accounting Policies.

For a detailed discussion about the Company’s significant accounting policies, see Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.

During the quarter ended March 31, 2011, other than the following, no other updates were made to the Company’s significant accounting policies.

Financial Instruments and Fair Value.

Fair value for many cash instruments and OTC derivative contracts is derived using pricing models. Pricing models take into account the contract terms (including maturity) as well as multiple inputs, including, where applicable, commodity prices, equity prices, interest rate yield curves, credit curves, correlation, creditworthinness of the counterparty, creditworthiness of the Company, option volatility and currency rates. Where appropriate, valuation adjustments are made to account for various factors such as liquidity risk (bid-ask adjustments), credit quality, model uncertainty and concentration risk. Adjustments for liquidity risk adjust model derived mid-market levels of Level 2 and Level 3 financial instruments for the bid-mid or mid-ask spread required to properly reflect the exit price of a risk position. Bid-mid and mid-ask spreads are marked to levels observed in trade activity, broker quotes or other external third-party data. Where these spreads are unobservable for the particular position in question, spreads are derived from observable levels of similar positions. The Company applies credit-related valuation adjustments to its short-term and long-term borrowings (primarily structured notes) for which the fair value option was elected and to OTC derivatives. The Company considers the impact of changes in its own credit spreads based upon observations of the Company’s secondary bond market spreads when measuring the fair value for short-term and long-term borrowings. For OTC derivatives, the impact of changes in both the Company’s and the counterparty’s credit standing is considered when measuring fair

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

value. In determining the expected exposure, the Company simulates the distribution of the future exposure to a counterparty, then applies market-based default probabilities to the future exposure, leveraging external third-party credit default swap (“CDS”) spread data. Where CDS spread data are unavailable for a specific counterparty, bond market spreads, CDS spread data based on the counterparty’s credit rating or CDS spread data that reference a comparable counterparty may be utilized. The Company also considers collateral held and legally enforceable master netting agreements that mitigate the Company’s exposure to each counterparty. Adjustments for model uncertainty are taken for positions whose underlying models are reliant on significant inputs that are neither directly nor indirectly observable, hence requiring reliance on established theoretical concepts in their derivation. These adjustments are derived by making assessments of the possible degree of variability using statistical approaches and market-based information where possible. The Company generally subjects all valuations and models to a review process initially and on a periodic basis thereafter. The Company may apply a concentration adjustment to certain of its OTC derivatives portfolios to reflect the additional cost of closing out a particularly large risk position. Where possible, these adjustments are based on observable market information but in many instances significant judgment is required to estimate the costs of closing out concentrated risk positions due to the lack of liquidity in the marketplace.

Accounting Developments.

Goodwill Impairment Test.

In December 2010, the Financial Accounting Standards Board (the “FASB”) issued accounting guidance that modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity shall consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance. This guidance became effective for the Company on January 1, 2011. The adoption of this accounting guidance did not have a material impact on the Company’s condensed consolidated financial statements.

 

3. Fair Value Disclosures.

Fair Value Measurements.

A description of the valuation techniques applied to the Company’s major categories of assets and liabilities measured at fair value on a recurring basis follows.

Financial Instruments Owned and Financial Instruments Sold, Not Yet Purchased.

U.S. Government and Agency Securities.

 

   

U.S. Treasury Securities.    U.S. treasury securities are valued using quoted market prices. Valuation adjustments are not applied. Accordingly, U.S. treasury securities are generally categorized in Level 1 of the fair value hierarchy.

 

   

U.S. Agency Securities.    U.S. agency securities are composed of three main categories consisting of agency-issued debt, agency mortgage pass-through pool securities and collateralized mortgage obligations. Non-callable agency-issued debt securities are generally valued using quoted market prices. Callable agency-issued debt securities are valued by benchmarking model-derived prices to quoted market prices and trade data for identical or comparable securities. The fair value of agency mortgage

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

pass-through pool securities is model-driven based on spreads of the comparable To-be-announced (“TBA”) security. Collateralized mortgage obligations are valued using indices, quoted market prices and trade data for identical or comparable securities. Actively traded non-callable agency-issued debt securities are generally categorized in Level 1 of the fair value hierarchy. Callable agency-issued debt securities, agency mortgage pass-through pool securities and collateralized mortgage obligations are generally categorized in Level 2 of the fair value hierarchy.

Other Sovereign Government Obligations.

 

   

Foreign sovereign government obligations are valued using quoted prices in active markets when available. To the extent quoted prices are not available, fair value is determined based on a valuation model that has as inputs interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the bond in terms of issuer, maturity and seniority. These bonds are generally categorized in Level 1 or Level 2 of the fair value hierarchy.

Corporate and Other Debt.

 

   

State and Municipal Securities.    The fair value of state and municipal securities is determined using recently executed transactions, market price quotations and pricing models that factor in, where applicable, interest rates, bond or credit default swap spreads and volatility. These bonds are generally categorized in Level 2 of the fair value hierarchy.

 

   

Residential Mortgage-Backed Securities (“RMBS”), Commercial Mortgage-Backed Securities (“CMBS”) and other Asset-Backed Securities (“ABS”).    RMBS, CMBS and other ABS may be valued based on price or spread data obtained from observed transactions or independent external parties such as vendors or brokers. When position-specific external price data are not observable, the fair value determination may require benchmarking to similar instruments and/or analyzing expected credit losses, default and recovery rates. In evaluating the fair value of each security, the Company considers security collateral-specific attributes, including payment priority, credit enhancement levels, type of collateral, delinquency rates and loss severity. In addition, for RMBS borrowers, Fair Isaac Corporation (“FICO”) scores and the level of documentation for the loan are also considered. Market standard models, such as Intex, Trepp or others, may be deployed to model the specific collateral composition and cash flow structure of each transaction. Key inputs to these models are market spreads, forecasted credit losses, default and prepayment rates for each asset category. Valuation levels of RMBS and CMBS indices are also used as an additional data point for benchmarking purposes or to price outright index positions.

RMBS, CMBS and other ABS are generally categorized in Level 2 of the fair value hierarchy. If external prices or significant spread inputs are unobservable or if the comparability assessment involves significant subjectivity related to property type differences, cash flows, performance and other inputs, then RMBS, CMBS and other ABS are categorized in Level 3 of the fair value hierarchy.

 

   

Corporate Bonds.    The fair value of corporate bonds is determined using recently executed transactions, market price quotations (where observable), bond spreads or credit default swap spreads obtained from independent external parties such as vendors and brokers adjusted for any basis difference between cash and derivative instruments. The spread data used are for the same maturity as the bond. If the spread data do not reference the issuer, then data that reference a comparable issuer are used. When observable price quotations are not available, fair value is determined based on cash flow models with yield curves, bond or single name credit default swap spreads and recovery rates as significant inputs. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy; in instances where prices, spreads or any of the other aforementioned key inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

   

Collateralized Debt Obligations (“CDO”).    The Company holds cash CDOs that typically reference a tranche of an underlying synthetic portfolio of single name credit default swaps. The collateral is usually ABS or other corporate bonds. Credit correlation, a primary input used to determine the fair value of a cash CDO, is usually unobservable and derived using a benchmarking technique. The other model inputs such as credit spreads, including collateral spreads, and interest rates are typically observable. CDOs are categorized in Level 2 of the fair value hierarchy when the credit correlation input is insignificant. In instances where the credit correlation input is deemed to be significant, these instruments are categorized in Level 3 of the fair value hierarchy.

 

   

Corporate Loans and Lending Commitments.    The fair value of corporate loans is determined using recently executed transactions, market price quotations (where observable), implied yields from comparable debt, and market observable credit default swap spread levels obtained from independent external parties such as vendors and brokers adjusted for any basis difference between cash and derivative instruments, along with proprietary valuation models and default recovery analysis where such transactions and quotations are unobservable. The fair value of contingent corporate lending commitments is determined by using executed transactions on comparable loans and the anticipated market price based on pricing indications from syndicate banks and customers. The valuation of loans and lending commitments also takes into account fee income that is considered an attribute of the contract. Corporate loans and lending commitments are categorized in Level 2 of the fair value hierarchy except in instances where prices or significant spread inputs are unobservable, in which case they are categorized in Level 3 of the fair value hierarchy.

 

   

Mortgage Loans.    Mortgage loans are valued using observable prices based on transactional data for identical or comparable instruments, when available. Where observable prices are not available, the Company estimates fair value based on benchmarking to prices and rates observed in the primary market for similar loan or borrower types or based on the present value of expected future cash flows using its best estimates of the key assumptions, including forecasted credit losses, prepayment rates, forward yield curves and discount rates commensurate with the risks involved or a methodology that utilizes the capital structure and credit spreads of recent comparable securitization transactions. Mortgage loans valued based on observable transactional data for identical or comparable instruments are categorized in Level 2 of the fair value hierarchy. Where observable prices are not available, due to the subjectivity involved in the comparability assessment related to mortgage loan vintage, geographical concentration, prepayment speed and projected loss assumptions, mortgage loans are categorized in Level 3 of the fair value hierarchy.

 

   

Auction Rate Securities (“ARS”).    The Company primarily holds investments in Student Loan Auction Rate Securities (“SLARS”) and Municipal Auction Rate Securities (“MARS”) with interest rates that are reset through periodic auctions. SLARS are ABS backed by pools of student loans. MARS are municipal bonds often wrapped by municipal bond insurance. ARS were historically traded and valued as floating rate notes, priced at par due to the auction mechanism. Beginning in fiscal 2008, uncertainties in the credit markets have resulted in auctions failing for certain types of ARS. Once the auctions failed, ARS could no longer be valued using observations of auction market prices. Accordingly, the fair value of ARS is determined using independent external market data where available and an internally developed methodology to discount for the lack of liquidity and non-performance risk.

Inputs that impact the valuation of SLARS are independent external market data, the underlying collateral types, level of seniority in the capital structure, amount of leverage in each structure, credit rating and liquidity considerations. Inputs that impact the valuation of MARS are independent external market data when available, the maximum rate, quality of underlying issuers/insurers and evidence of issuer calls. ARS are generally categorized in Level 2 of the fair value hierarchy as the valuation technique relies on observable external data.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Corporate Equities.

 

   

Exchange-Traded Equity Securities.    Exchange-traded equity securities are generally valued based on quoted prices from the exchange. To the extent these securities are actively traded, valuation adjustments are not applied, and they are categorized in Level 1 of the fair value hierarchy; otherwise, they are categorized in Level 2 or Level 3 of the fair value hierarchy.

Derivative and Other Contracts.

 

   

Listed Derivative Contracts.    Listed derivatives that are actively traded are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Listed derivatives that are not actively traded are valued using the same approaches as those applied to OTC derivatives; they are generally categorized in Level 2 of the fair value hierarchy.

 

   

OTC Derivative Contracts.    OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, equity prices or commodity prices.

Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be either observed or modeled using a series of techniques and model inputs from comparable benchmarks, including closed-form analytic formulas, such as the Black-Scholes option-pricing model, and simulation models or a combination thereof. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swaps, certain option contracts and certain credit default swaps. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. A substantial majority of OTC derivative products valued by the Company using pricing models fall into this category and are categorized in Level 2 of the fair value hierarchy.

Other derivative products, including complex products that have become illiquid, require more judgment in the implementation of the valuation technique applied due to the complexity of the valuation assumptions and the reduced observability of inputs. This includes derivative interests in certain mortgage-related CDO securities, certain types of ABS credit default swaps, basket credit default swaps and CDO-squared positions (a CDO-squared position is a special purpose vehicle that issues interests, or tranches, that are backed by tranches issued by other CDOs) where direct trading activity or quotes are unobservable. These instruments involve significant unobservable inputs and are categorized in Level 3 of the fair value hierarchy.

Derivative interests in complex mortgage-related CDOs and ABS credit default swaps, for which observability of external price data is extremely limited, are valued based on an evaluation of the market and model input parameters sourced from similar positions as indicated by primary and secondary market activity. Each position is evaluated independently taking into consideration the underlying collateral performance and pricing, behavior of the tranche under various cumulative loss and prepayment scenarios, deal structures (e.g., non-amortizing reference obligations, call features, etc.) and liquidity. While these factors may be supported by historical and actual external observations, the determination of their value as it relates to specific positions nevertheless requires significant judgment.

For basket credit default swaps and CDO-squared positions, the correlation input between reference credits is unobservable for each specific swap or position and is benchmarked to standardized proxy baskets for which correlation data are available. The other model inputs such as credit spread, interest rates and recovery rates are observable. In instances where the correlation input is deemed to be significant, these instruments are categorized in Level 3 of the fair value hierarchy; otherwise, these instruments are categorized in Level 2 of the fair value hierarchy.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company trades various derivative structures with commodity underlyings. Depending on the type of structure, the model inputs generally include interest rate yield curves, commodity underlier price curves, implied volatility of the underlying commodities and, in some cases, the implied correlation between these inputs. The fair value of these products is determined using executed trades and broker and consensus data to provide values for the aforementioned inputs. Where these inputs are unobservable, relationships to observable commodities and data points, based on historic and/or implied observations, are employed as a technique to estimate the model input values. Commodity derivatives are generally categorized in Level 2 of the fair value hierarchy; in instances where significant inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.

For further information on derivative instruments and hedging activities, see Note 10.

Investments.

 

   

The Company’s investments include investments in private equity funds, real estate funds, hedge funds and direct investments in equity securities. Direct investments are presented in the fair value hierarchy table as Principal investments and Other. Initially, the transaction price is generally considered by the Company as the exit price and is the Company’s best estimate of fair value.

After initial recognition, in determining the fair value of internally and externally managed funds, the Company considers the net asset value of the fund provided by the fund manager to be the best estimate of fair value. For non-exchange-traded investments either held directly or held within internally managed funds, fair value after initial recognition is based on an assessment of each underlying investment, considering rounds of financing and third-party transactions, discounted cash flow analyses and market-based information, including comparable company transactions, trading multiples and changes in market outlook, among other factors. Exchange-traded direct equity investments are generally valued based on quoted prices from the exchange.

Exchange-traded direct equity investments that are actively traded are categorized in Level 1 of the fair value hierarchy. Non-exchange-traded direct equity investments and investments in private equity and real estate funds are generally categorized in Level 3 of the fair value hierarchy. Investments in hedge funds that are redeemable at the measurement date or in the near future are categorized in Level 2 of the fair value hierarchy; otherwise, they are categorized in Level 3 of the fair value hierarchy.

Physical Commodities.

 

   

The Company trades various physical commodities, including crude oil and refined products, natural gas, base and precious metals and agricultural products. Fair value for physical commodities is determined using observable inputs, including broker quotations and published indices. Physical commodities are categorized in Level 2 of the fair value hierarchy.

Securities Available for Sale.

 

   

Securities available for sale are composed of U.S. government and agency securities, including U.S. Treasury securities, agency-issued debt, agency mortgage pass-through securities and collateralized mortgage obligations. Actively traded U.S. Treasury securities and non-callable agency-issued debt securities are generally categorized in Level 1 of the fair value hierarchy. Callable agency-issued debt securities, agency mortgage pass-through securities and collateralized mortgage obligations are generally categorized in Level 2 of the fair value hierarchy. For further information on securities available for sale, see Note 4.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Commercial Paper and Other Short-term Borrowings/Long-term Borrowings.

 

   

Structured Notes.    The Company issues structured notes that have coupon or repayment terms linked to the performance of debt or equity securities, indices, currencies or commodities. Fair value of structured notes is determined using valuation models for the derivative and debt portions of the notes. These models incorporate observable inputs referencing identical or comparable securities, including prices that the notes are linked to, interest rate yield curves, option volatility and currency, commodity or equity rates. Independent, external and traded prices for the notes are also considered. The impact of the Company’s own credit spreads is also included based on the Company’s observed secondary bond market spreads. Most structured notes are categorized in Level 2 of the fair value hierarchy.

Deposits.

 

   

Time Deposits.    The fair value of certificates of deposit is determined using third-party quotations. These deposits are generally categorized in Level 2 of the fair value hierarchy.

Securities Sold under Agreements to Repurchase.

 

   

In 2010, the fair value option was elected for certain securities sold under agreements to repurchase. The fair value of a repurchase agreement is computed using a standard cash flow discounting methodology. The inputs to the valuation include contractual cash flows and collateral funding spreads, which are estimated using various benchmarks, interest rate yield curves and option volatilities. In instances where the unobservable inputs are deemed significant, repurchase agreements are categorized in Level 3 of the fair value hierarchy; otherwise, they are categorized in Level 2 of the fair value hierarchy.

The following fair value hierarchy tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis at March 31, 2011 and December 31, 2010.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis at March 31, 2011

 

    Quoted
Prices  in
Active
Markets
for
Identical
Assets
(Level 1)
    Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
    Counterparty
and Cash
Collateral
Netting
    Balance at
March 31,
2011
 
    (dollars in millions)  

Assets

         

Financial instruments owned:

         

U.S. government and agency securities:

         

U.S. Treasury securities

  $ 15,174     $ 21     $ —        $ —        $ 15,195  

U.S. agency securities

    4,253       27,121       57       —          31,431  
                                       

Total U.S. government and agency securities

    19,427       27,142       57       —          46,626  

Other sovereign government obligations

    30,494       8,258       126       —          38,878  

Corporate and other debt:

         

State and municipal securities

    —          3,370       4       —          3,374  

Residential mortgage-backed securities

    —          3,572       361       —          3,933  

Commercial mortgage-backed securities

    —          2,782       132       —          2,914  

Asset-backed securities

    —          2,355       —          —          2,355  

Corporate bonds

    —          40,454       1,366       —          41,820   

Collateralized debt obligations

    —          1,961       1,593       —          3,554  

Loans and lending commitments

    —          16,757       11,218       —          27,975  

Other debt

    —          2,369       165       —          2,534  
                                       

Total corporate and other debt

    —          73,620       14,839       —          88,459  

Corporate equities(1)

    64,037       2,503       502       —          67,042  

Derivative and other contracts:

         

Interest rate contracts

    1,578       534,820       5,767       —          542,165  

Credit contracts

    —          85,999       13,012       —          99,011  

Foreign exchange contracts

    —          58,336       389       —          58,725  

Equity contracts

    1,577       38,555       1,043       —          41,175  

Commodity contracts

    6,829       57,540       1,056       —          65,425  

Other

    —          119       143       —          262  

Netting(2)

    (8,337     (677,036     (11,186     (60,291     (756,850
                                       

Total derivative and other contracts

    1,647       98,333       10,224       (60,291     49,913  

Investments:

         

Private equity funds

    —          —          2,006       —          2,006  

Real estate funds

    —          6       1,251       —          1,257  

Hedge funds

    —          666       871       —          1,537  

Principal investments

    269       193       3,057       —          3,519  

Other

    191       160       398       —          749  
                                       

Total investments

    460       1,025       7,583       —          9,068  

Physical commodities

    —          8,126       —          —          8,126  
                                       

Total financial instruments owned

    116,065       219,007       33,331       (60,291     308,112  

Securities available for sale:

         

U.S. government and agency securities

    15,157       12,576       —          —          27,733  

Securities received as collateral

    13,007       154       —          —          13,161  

Intangible assets(3)

    —          —          144       —          144  

Liabilities

         

Deposits

  $ —        $ 2,848     $ —        $ —        $ 2,848  

Commercial paper and other short-term borrowings

    —          1,653       4       —          1,657  

Financial instruments sold, not yet purchased:

         

U.S. government and agency securities:

         

U.S. Treasury securities

    29,260       4       —          —          29,264  

U.S. agency securities

    2,147       77       —          —          2,224  
                                       

Total U.S. government and agency securities

    31,407       81       —          —          31,488  

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

    Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
    Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
    Counterparty
and Cash
Collateral
Netting
    Balance at
March 31,
2011
 
    (dollars in millions)  

Other sovereign government obligations

    19,784       3,349       —          —          23,133  

Corporate and other debt:

         

State and municipal securities

    —          4       —          —          4  

Asset-backed securities

    —          7       —          —          7  

Corporate bonds

    —          9,421       150       —          9,571  

Collateralized debt obligations

    —          —          2       —          2  

Unfunded lending commitments

    —          435       171       —          606  

Other debt

    —          73       180       —          253  
                                       

Total corporate and other debt

    —          9,940       503       —          10,443  

Corporate equities(1)

    25,713       899       9       —          26,621  

Derivative and other contracts:

         

Interest rate contracts

    1,366       508,086       5,825       —          515,277  

Credit contracts

    —          80,208       6,933       —          87,141  

Foreign exchange contracts

    —          60,507       343       —          60,850  

Equity contracts

    1,663       43,003       1,688       —          46,354  

Commodity contracts

    7,477       59,024       726       —          67,227  

Other

    —          581       651       —          1,232  

Netting(2)

    (8,337     (677,036     (11,186     (36,937     (733,496
                                       

Total derivative and other contracts

    2,169       74,373       4,980       (36,937     44,585  
                                       

Total financial instruments sold, not yet purchased

    79,073       88,642       5,492       (36,937     136,270  

Obligation to return securities received as collateral

    17,915       154       —          —          18,069  

Securities sold under agreements to repurchase

    —          538       352       —          890  

Other secured financings

    —          7,447       605       —          8,052  

Long-term borrowings

    21       42,180       1,374       —          43,575  

 

(1) The Company holds or sells short for trading purposes equity securities issued by entities in diverse industries and of varying size.
(2) For positions with the same counterparty that cross over the levels of the fair value hierarchy, both counterparty netting and cash collateral netting are included in the column titled “Counterparty and Cash Collateral Netting.” For contracts with the same counterparty, counterparty netting among positions classified within the same level is included within that level. For further information on derivative instruments and hedging activities, see Note 10.
(3) Amount represents mortgage servicing rights (“MSR”) accounted for at fair value. See Note 6 for further information on MSRs.

Transfers Between Level 1 and Level 2 During the Quarter Ended March 31, 2011.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts.    During the quarter ended March 31, 2011, the Company reclassified approximately $0.6 billion of derivative assets and approximately $0.8 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Assets and Liabilities Measured at Fair Value on a Recurring Basis at December 31, 2010

 

     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
    Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
    Counterparty
and Cash
Collateral
Netting
    Balance at
December 31,
2010
 
     (dollars in millions)  

Assets

          

Financial instruments owned:

          

U.S. government and agency securities:

          

U.S. Treasury securities

   $ 19,226     $ —        $ —        $ —        $ 19,226  

U.S. agency securities

     3,827       25,380       13       —          29,220  
                                        

Total U.S. government and agency securities

     23,053       25,380       13       —          48,446  

Other sovereign government obligations

     25,334       8,501       73       —          33,908  

Corporate and other debt:

          

State and municipal securities

     —          3,229       110       —          3,339  

Residential mortgage-backed securities

     —          3,690       319       —          4,009  

Commercial mortgage-backed securities

     —          2,692       188       —          2,880  

Asset-backed securities

     —          2,322       13       —          2,335  

Corporate bonds

     —          39,569       1,368       —          40,937  

Collateralized debt obligations

     —          2,305       1,659       —          3,964  

Loans and lending commitments

     —          15,308       11,666       —          26,974  

Other debt

     —          3,523       193       —          3,716  
                                        

Total corporate and other debt

     —          72,638       15,516       —          88,154  

Corporate equities(1)

     65,009       2,923       484       —          68,416  

Derivative and other contracts:

          

Interest rate contracts

     3,985       616,016       966       —          620,967  

Credit contracts

     —          95,818       14,316       —          110,134  

Foreign exchange contracts

     1       61,556       431       —          61,988  

Equity contracts

     2,176       36,612       1,058       —          39,846  

Commodity contracts

     5,464       57,528       1,160       —          64,152  

Other

     —          108       135       —          243  

Netting(2)

     (8,551     (761,939     (7,168     (68,380     (846,038
                                        

Total derivative and other contracts

     3,075       105,699       10,898       (68,380     51,292  

Investments:

          

Private equity funds

     —          —          1,986       —          1,986  

Real estate funds

     —          8       1,176       —          1,184  

Hedge funds

     —          736       901       —          1,637  

Principal investments

     286       486       3,131       —          3,903  

Other(3)

     403       79       560       —          1,042  
                                        

Total investments

     689       1,309       7,754       —          9,752  

Physical commodities

     —          6,778       —          —          6,778  
                                        

Total financial instruments owned

     117,160       223,228       34,738       (68,380     306,746  

Securities available for sale:

          

U.S. government and agency securities

     20,792       8,857       —          —          29,649  

Securities received as collateral

     15,646       890       1       —          16,537  

Intangible assets(4)

     —          —          157       —          157  

Liabilities

          

Deposits

   $ —        $ 3,011     $ 16     $ —        $ 3,027  

Commercial paper and other short-term borrowings

     —          1,797       2       —          1,799  

Financial instruments sold, not yet purchased:

          

U.S. government and agency securities:

          

U.S. Treasury securities

     25,225       —          —          —          25,225  

U.S. agency securities

     2,656       67       —          —          2,723  
                                        

Total U.S. government and agency securities

     27,881       67       —          —          27,948  

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
    Significant
Observable
Inputs

(Level 2)
    Significant
Unobservable
Inputs

(Level 3)
    Counterparty
and Cash
Collateral
Netting
    Balance at
December 31,
2010
 
     (dollars in millions)  

Other sovereign government obligations

     19,708       2,542       —          —          22,250  

Corporate and other debt:

          

State and municipal securities

     —          11       —          —          11  

Asset-backed securities

     —          12       —          —          12  

Corporate bonds

     —          9,100       44       —          9,144  

Collateralized debt obligations

     —          2       —          —          2  

Unfunded lending commitments

     —          464       263       —          727  

Other debt

     —          828       194       —          1,022  
                                        

Total corporate and other debt

     —          10,417       501       —          10,918  

Corporate equities(1)

     19,696       127       15       —          19,838  

Derivative and other contracts:

          

Interest rate contracts

     3,883       591,378       542       —          595,803  

Credit contracts

     —          87,904       7,722       —          95,626  

Foreign exchange contracts

     2       64,301       385       —          64,688  

Equity contracts

     2,098       42,242       1,820       —          46,160  

Commodity contracts

     5,871       58,885       972       —          65,728  

Other

     —          520       1,048       —          1,568  

Netting(2)

     (8,551     (761,939     (7,168     (44,113     (821,771
                                        

Total derivative and other contracts

     3,303       83,291       5,321       (44,113     47,802  
                                        

Total financial instruments sold, not yet purchased

     70,588       96,444       5,837       (44,113     128,756  

Obligation to return securities received as collateral

     20,272       890       1       —          21,163  

Securities sold under agreements to repurchase

     —          498       351       —          849  

Other secured financings

     —          7,474       1,016       —          8,490  

Long-term borrowings

     —          41,393       1,316       —          42,709  

 

(1) The Company holds or sells short for trading purposes equity securities issued by entities in diverse industries and of varying size.
(2) For positions with the same counterparty that cross over the levels of the fair value hierarchy, both counterparty netting and cash collateral netting are included in the column titled “Counterparty and Cash Collateral Netting.” For contracts with the same counterparty, counterparty netting among positions classified within the same level is included within that level. For further information on derivative instruments and hedging activities, see Note 10.
(3) In June 2010, the Company voluntarily contributed $25 million to certain other investments in funds that it manages in connection with upcoming rule changes regarding net asset value disclosures for money market funds. Based on current liquidity and fund performance, the Company does not expect to provide additional voluntary support to non-consolidated funds that it manages.
(4) Amount represents MSRs accounted for at fair value. See Note 6 for further information on MSRs.

Transfers Between Level 1 and Level 2 during the Quarter Ended March 31, 2010.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts.    During the quarter ended March 31, 2010, the Company reclassified approximately $1.3 billion of derivative assets and approximately $1.5 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.

Financial instruments owned—Corporate equities.    During the quarter ended March 31, 2010, the Company reclassified approximately $1.0 billion of certain Corporate equities from Level 2 to Level 1 as transactions in these securities occurred with sufficient frequency and volume to constitute an active market.

The following tables present additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the quarters ended March 31, 2011 and 2010, respectively. Level 3 instruments may be hedged with instruments classified in Level 1 and Level 2. As a result, the realized and unrealized gains (losses) for assets and liabilities within the Level 3 category presented in the tables below do not reflect the related

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

realized and unrealized gains (losses) on hedging instruments that have been classified by the Company within the Level 1 and/or Level 2 categories.

Additionally, both observable and unobservable inputs may be used to determine the fair value of positions that the Company has classified within the Level 3 category. As a result, the unrealized gains (losses) during the period for assets and liabilities within the Level 3 category presented in the tables below may include changes in fair value during the period that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.

For assets and liabilities that were transferred into Level 3 during the period, gains (losses) are presented as if the assets or liabilities had been transferred into Level 3 at the beginning of the period; similarly, for assets and liabilities that were transferred out of Level 3 during the period, gains (losses) are presented as if the assets or liabilities had been transferred out at the beginning of the period.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Three Months Ended March 31, 2011

 

    Beginning
Balance at
December 31,
2010
    Total
Realized and
Unrealized
Gains
(Losses)(1)
    Purchases     Sales     Issuances     Settlements     Net Transfers     Ending
Balance at
March 31,
2011
    Unrealized
Gains

(Losses) for
Level 3 Assets/
Liabilities
Outstanding at
March 31,
2011(2)
 
    (dollars in millions)  

Assets

                 

Financial instruments owned:

                 

U.S. agency securities

  $ 13     $ —        $ 103     $ (52   $ —        $ —        $ (7   $ 57     $ —     

Other sovereign government obligations

    73       —          59       —          —          —          (6     126       —     

Corporate and other debt:

                 

State and municipal securities

    110       (1     4       (96     —          —          (13     4       —     

Residential mortgage-backed securities

    319       (58     198       (183     —          (1     86       361       (21

Commercial mortgage-backed securities

    188       16       9       (30     —          —          (51     132       10  

Asset-backed securities

    13       —          12       (19     —          —          (6     —          —     

Corporate bonds

    1,368       33       255       (215     —          —          (75     1,366       55  

Collateralized debt obligations

    1,659       254       355       (595     —          (36     (44     1,593       93  

Loans and lending commitments

    11,666       386       1,023       (643     —          (1,024     (190     11,218       382  

Other debt

    193       (6     1       (22     —          —          (1     165       (16
                                                                       

Total corporate and other debt

    15,516       624       1,857       (1,803     —          (1,061     (294     14,839       503  

Corporate equities

    484       (53     101       (98     —          —          68       502       (18

Net derivatives and other contracts(3):

                 

Interest rate contracts

    424       169       1       —          (663     (114     125       (58     100   

Credit contracts

    6,594       (673     128       —          (152     71       111       6,079       (245

Foreign exchange contracts

    46       (124     —          —          —          127       (3     46       (100

Equity contracts

    (762     75       65       (12     (85     15       59       (645     75  

Commodity contracts

    188       (9     161       —          (132     85       37       330       (4

Other

    (913     209       —          —          (5     205       (4     (508     203  
                                                                       

Total net derivative and other contracts

    5,577       (353     355       (12     (1,037     389       325       5,244       29   

Investments:

                 

Private equity funds

    1,986       107       32       (190     —          —          71       2,006       95  

Real estate funds

    1,176       64       14       (3     —          —          —          1,251       102  

Hedge funds

    901       (9     135       (189     —          —          33       871       (9

Principal investments

    3,131       66       202       (301     —          —          (41     3,057       (85

Other

    560       8       1       (14     —          —          (157     398       3  
                                                                       

Total investments

    7,754       236       384       (697     —          —          (94     7,583       106  

Securities received as collateral

    1       —          —          (1     —          —          —          —          —     

Intangible assets

    157       (15     3       (1     —          —          —          144       (14

Liabilities

                 

Deposits

  $ 16     $ 2     $ —        $ —        $ —        $ (14 )   $ —        $ —        $ —     

Commercial paper and other short-term borrowings

    2       —          —          —          4       (2     —          4       —     

Financial instruments sold, not yet purchased:

                 

Corporate and other debt:

                 

Corporate bonds

    44       1       (27     155       —          —          (21     150       8  

Collateralized debt obligations

    —          1       —          3       —          —          —          2       1  

Unfunded lending commitments

    263       92       —          —          —          —          —          171       92  

Other debt

    194       —          —          —          —          —          (14     180       —     
                                                                       

Total corporate and other debt

    501       94       (27     158       —          —          (35     503       101  

Corporate equities

    15       (1     (8     1       —          —          —          9       —     

Obligation to return securities received as collateral

    1       —          (1     —          —          —          —          —          —     

Securities sold under agreements to repurchase

    351       (2     —          —          —          (1     —          352       (2

Other secured financings

    1,016       (12     —          —          —          (117     (306     605       (12

Long-term borrowings

    1,316       (84     —          —          141       (180     13       1,374       (83

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

(1) Total realized and unrealized gains (losses) are primarily included in Principal transactions—Trading in the condensed consolidated statements of income except for $236 million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.
(2) Amounts represent unrealized gains (losses) for the quarter ended March 31, 2011 related to assets and liabilities still outstanding at March 31, 2011.
(3) Net derivative and other contracts represent Financial instruments owned—Derivative and other contracts net of Financial instruments sold, not yet purchased—Derivative and other contracts. For further information on Derivative instruments and hedging activities, see Note 10.

Financial instruments owned—Corporate and other debt.    During the quarter ended March 31, 2011, the Company reclassified approximately $1.6 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified the corporate loans as external prices and/or spread inputs for these instruments became observable.

The Company also reclassified approximately $1.3 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to corporate loans and were generally due to a reduction in market price quotations for these or comparable instruments, or a lack of available broker quotes, such that unobservable inputs had to be utilized for the fair value measurement of these instruments.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Three Months Ended March 31, 2010

 

     Beginning
Balance at
December 31,
2009
    Total
Realized
and
Unrealized
Gains
(Losses)(1)
    Purchases,
Sales, Other
Settlements
and
Issuances,
net
    Net
Transfers
    Ending
Balance at
March 31,
2010
    Unrealized
Gains (Losses)
for Level 3
Assets/
Liabilities
Outstanding at
March 31,
2010(2)
 
     (dollars in millions)  

Assets

            

Financial instruments owned:

            

U.S. agency securities

   $ 36     $ —        $ (35   $ —        $ 1     $ —     

Other sovereign government obligations

     3       2       76       (1     80       1  

Corporate and other debt:

            

State and municipal securities

     713       (18     (297     —          398       1  

Residential mortgage-backed securities

     818       24       (220     3       625       19  

Commercial mortgage-backed securities

     1,573       109       (860     (43     779       42  

Asset-backed securities

     591       1       (440     (3     149       10  

Corporate bonds

     1,038       (55     128       34       1,145       (48

Collateralized debt obligations

     1,553       133       (171     (3     1,512       121  

Loans and lending commitments

     12,506       155       572       270       13,503       143  

Other debt

     1,662       252       8       (1     1,921       244  
                                                

Total corporate and other debt

     20,454       601       (1,280     257       20,032       532  

Corporate equities

     536       70       (7     (63     536       56  

Net derivative and other contracts:

            

Interest rate contracts

     387       9       7       (19     384       1  

Credit contracts

     8,824       (434     96       (534     7,952       (352

Foreign exchange rate contracts

     254       (285     201       36       206       (308

Equity contracts

     (689     (96     58       26       (701     (88

Commodity contracts

     7       (25     108       —          90       83  

Other

     (437     (147     4       1       (579     (113
                                                

Total net derivative and other contracts(3)

     8,346       (978     474       (490     7,352       (777

Investments

     7,613       56       19       (142     7,546       50  

Securities received as collateral

     23       —          (23     —          —          —     

Intangible assets

     137       38       —          —          175       30  

Liabilities

            

Deposits

   $ 24     $ 1     $ —        $ (8   $ 15     $ 1  

Commercial paper and other short-term borrowings

     —          —          300       —          300       —     

Financial instruments sold, not yet purchased:

            

Corporate and other debt:

            

Asset-backed securities

     4       —          —          —          4       —     

Corporate bonds

     29       (42     (79     25       17       (36

Collateralized debt obligations

     3       —          (3     —          —          —     

Unfunded lending commitments

     252       (32     (71     —          213       (29

Other debt

     431       25       (76     (13     317       24  
                                                

Total corporate and other debt

     719       (49     (229     12       551       (41

Corporate equities

     4       (1     5       3       13       —     

Obligation to return securities received as collateral

     23       —          (23     —          —          —     

Other secured financings

     1,532       (104     175       —          1,811       (104

Long-term borrowings

     6,865       5       45       (177     6,728       5  

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

(1) Total realized and unrealized gains (losses) are primarily included in Principal transactions—Trading in the condensed consolidated statements of income except for $56 million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.
(2) Amounts represent unrealized gains (losses) for the quarter ended March 31, 2010 related to assets and liabilities still outstanding at March 31, 2010.
(3) Net derivative and other contracts represent Financial instruments owned—Derivative and other contracts net of Financial instruments sold, not yet purchased—Derivative and other contracts. For further information on derivative instruments and hedging activities, see Note 10.

Financial instruments owned—Corporate and other debt.    During the quarter ended March 31, 2010, the Company reclassified approximately $0.6 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified the corporate loans as external prices and/or spread inputs for these instruments became observable.

The Company also reclassified approximately $0.9 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to corporate loans and were generally due to a reduction in market price quotations for these or comparable instruments, or a lack of available broker quotes, such that unobservable inputs had to be utilized for the fair value measurement of these instruments. The Company reclassified the corporate loans as external prices and/or spread inputs became unobservable.

Financial instruments owned—Net derivative and other contracts.    The net losses in Net derivative and other contracts were primarily driven by tightening of credit spreads on underlying reference entities of bespoke basket credit default swaps.

Fair Value of Investments that Calculate Net Asset Value.

The Company’s Investments measured at fair value were $9,068 million and $9,752 million at March 31, 2011 and December 31, 2010, respectively. The following table presents information solely about the Company’s investments in private equity funds, real estate funds and hedge funds measured at fair value based on net asset value at March 31, 2011 and December 31, 2010, respectively.

 

     At March 31, 2011      At December 31, 2010  
     Fair
Value
     Unfunded
Commitment
     Fair
Value
     Unfunded
Commitment
 
     (dollars in millions)  

Private equity funds

   $ 1,968      $ 1,111      $ 1,947      $ 1,047  

Real estate funds

     1,225        552        1,154        500  

Hedge funds(1):

           

Long-short equity hedge funds

     877        4        1,046        4  

Fixed income/credit-related hedge funds

     304        —           305        —     

Event-driven hedge funds

     196        —           143        —     

Multi-strategy hedge funds

     161        —           140        —     
                                   

Total

   $ 4,731      $ 1,667      $ 4,735      $ 1,551  
                                   

 

(1) Fixed income/credit-related hedge funds, event-driven hedge funds, and multi-strategy hedge funds are redeemable at least on a six-month period basis primarily with a notice period of 90 days or less. At March 31, 2011, approximately 57% of the fair value amount of long-short equity hedge funds is redeemable at least quarterly, 20% is redeemable every six months and 23% of these funds have a redemption frequency of greater than six months. At December 31, 2010, approximately 49% of the fair value amount of long-short equity hedge funds is redeemable at least quarterly, 24% is redeemable every six months and 27% of these funds have a redemption frequency of greater than six months. The notice period for long-short equity hedge funds is primarily greater than 90 days.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Private Equity Funds.    Amount includes several private equity funds that pursue multiple strategies including leveraged buyouts, venture capital, infrastructure growth capital, distressed investments, and mezzanine capital. In addition, the funds may be structured with a focus on specific domestic or foreign geographic regions. These investments are generally not redeemable with the funds. Instead, the nature of the investments in this category is that distributions are received through the liquidation of the underlying assets of the fund. At March 31, 2011, it is estimated that 6% of the fair value of the funds will be liquidated in the next five years, another 36% of the fair value of the funds will be liquidated between five to 10 years and the remaining 58% of the fair value of the funds have a remaining life of greater than 10 years.

Real Estate Funds.    Amount includes several real estate funds that invest in real estate assets such as commercial office buildings, retail properties, multi-family residential properties, developments or hotels. In addition, the funds may be structured with a focus on specific geographic domestic or foreign regions. These investments are generally not redeemable with the funds. Distributions from each fund will be received as the underlying investments of the funds are liquidated. At March 31, 2011, it is estimated that 19% of the fair value of the funds will be liquidated within the next five years, another 33% of the fair value of the funds will be liquidated between five to 10 years and the remaining 48% of the fair value of the funds have a remaining life of greater than 10 years.

Hedge Funds.    Investments in hedge funds may be subject to initial period lock-up restrictions or gates. A hedge fund lock-up provision is a provision that provides that, during a certain initial period, an investor may not make a withdrawal from the fund. The purpose of a gate is to restrict the level of redemptions that an investor in a particular hedge fund can demand on any redemption date.

 

   

Long-short Equity Hedge Funds.    Amount includes investments in hedge funds that invest, long or short, in equities. Equity value and growth hedge funds purchase stocks perceived to be undervalued and sell stocks perceived to be overvalued. Investments representing approximately 22% of the fair value of the investments in this category cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for 100% of investments subject to lock-up restrictions ranged from one to three years at March 31, 2011. Investments representing approximately 23% of the fair value of the investments in long-short equity hedge funds cannot be redeemed currently because an exit restriction has been imposed by the hedge fund manager. The restriction period for 100% of investments subject to an exit restriction was primarily two years or less at March 31, 2011.

 

   

Fixed Income/Credit-Related Hedge Funds.    Amount includes investments in hedge funds that employ long-short, distressed or relative value strategies in order to benefit from investments in undervalued or overvalued securities that are primarily debt or credit related. At March 31, 2011, investments representing approximately 18% of the fair value of the investments in fixed income/credit-related hedge funds cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for these investments was two years or less at March 31, 2011.

 

   

Event-Driven Hedge Funds.    Amount includes investments in hedge funds that invest in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. This may involve the simultaneous purchase of stock in companies being acquired and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the target company. At March 31, 2011, investments representing approximately 37% of the value of the investments in this category cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for these investments was two years or less at March 31, 2011.

 

   

Multi-strategy Hedge Funds.    Amount includes investments in hedge funds that pursue multiple strategies to realize short- and long-term gains. Management of the hedge funds has the ability to

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

overweight or underweight different strategies to best capitalize on current investment opportunities. At March 31, 2011, investments representing approximately 35% of the fair value of the investments in this category cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for 72% of investments subject to lock-ups was two years or less at March 31, 2011. The remaining restriction period for the other 28% of investments subject to lock-up restrictions was greater than three years at March 31, 2011. Investments representing approximately 23% of the fair value of investments in multi-strategy hedge funds cannot be redeemed currently because of an exit restriction that has been imposed by the hedge fund manager. The restriction period for 100% of investments subject to an exit restriction was indefinite at March 31, 2011.

Fair Value Option.

The Company elected the fair value option for certain eligible instruments that are risk managed on a fair value basis to mitigate income statement volatility caused by measurement basis differences between the elected instruments and their associated risk management transactions or to eliminate complexities of applying certain accounting models. The following tables present net gains (losses) due to changes in fair value for items measured at fair value pursuant to the fair value option election for the quarters ended March 31, 2011 and 2010, respectively.

 

     Principal
Transactions-
Trading
    Interest
Expense
    Gains
(Losses)
Included in
Net
Revenues
 
     (dollars in millions)  

Three Months Ended March 31, 2011

      

Deposits

   $ 13     $ (30   $ (17

Commercial paper and other short-term borrowings

     (5     —          (5

Long-term borrowings

     (1,266     (290     (1,556

Securities sold under agreements to repurchase

     (2     —          (2

Three Months Ended March 31, 2010

      

Deposits

   $ (25   $ (47   $ (72

Commercial paper and other short-term borrowings

     13       —          13  

Long-term borrowings

     (366     (202     (568

In addition to the amounts in the above table, as discussed in Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K, all of the instruments within Financial instruments owned or Financial instruments sold, not yet purchased are measured at fair value, either through the election of the fair value option, or as required by other accounting guidance.

The following tables present information on the Company’s short-term and long-term borrowings (primarily structured notes), loans and unfunded lending commitments for which the fair value option was elected.

Gains (Losses) due to Changes in Instrument Specific Credit Spreads

 

     Three Months Ended
March  31,
 
     2011     2010  
     (dollars in millions)  

Short-term and long-term borrowings(1)

   $ (189   $ 54  

Loans(2)

     140       316  

Unfunded lending commitments(3)

     10       (21

 

(1) The change in the fair value of short-term and long-term borrowings (primarily structured notes) includes an adjustment to reflect the credit quality of the Company based upon observations of the Company’s secondary bond market spreads.
(2) Instrument-specific credit gains were determined by excluding the non-credit components of gains and losses, such as those due to changes in interest rates.
(3) Gains (losses) were generally determined based on the differential between estimated expected client yields and contractual yields at each respective period end.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Amount by Which Contractual Principal Amount Exceeds Fair Value

 

     At
March 31,
2011
     At
December 31,
2010
 
     (dollars in billions)  

Short-term and long-term borrowings(1)

   $ 1.1      $ 0.6  

Loans(2)

     23.6        24.3  

Loans 90 or more days past due and/or on non-accrual status(2)(3)

     21.2        21.2  

 

(1) These amounts do not include structured notes where the repayment of the initial principal amount fluctuates based on changes in the reference price or index.
(2) The majority of this difference between principal and fair value amounts emanates from the Company’s distressed debt trading business, which purchases distressed debt at amounts well below par.
(3) The aggregate fair value of loans that were in non-accrual status, which includes all loans 90 or more days past due, was $2.7 billion and $2.2 billion at March 31, 2011 and December 31, 2010, respectively. The aggregate fair value of loans that were 90 or more days past due was $2.0 billion at both March 31, 2011 and December 31, 2010.

The tables above exclude non-recourse debt from consolidated VIEs, liabilities related to failed sales and other liabilities that have specified assets attributable to them.

Assets and Liabilities Measured at Fair Value on a Non-recurring Basis

Certain assets were measured at fair value on a non-recurring basis and are not included in the tables above. These assets may include loans, equity method investments, premises and equipment, intangible assets and real estate investments.

The following tables present, by caption on the condensed consolidated statements of financial condition, the fair value hierarchy for those assets measured at fair value on a non-recurring basis for which the Company recognized a non-recurring fair value adjustment for the quarters ended March 31, 2011 and 2010, respectively.

Three Months Ended March 31, 2011.

 

            Fair Value Measurements Using:         
     Carrying
Value at
March
31, 2011
     Quoted Prices
in Active
Markets for
Identical
Assets

(Level 1)
     Significant
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
     Total Gains (Losses)
for the
Three Months
Ended March 31,
2011(1)
 
     (dollars in millions)  

Loans(2)

   $ 559       $ —         $ 46       $ 513       $ 16   

Other investments(3)

     77         —           —           77         (9

Intangible assets(4)

     —           —           —           —           (3
                                            

Total

   $ 636      $ —         $ 46      $ 590      $ 4  
                                            

 

(1) Losses are recorded within Other expenses in the condensed consolidated statement of income except for fair value adjustments related to Loans and losses related to Other investments, which are included in Other revenues.
(2) Non-recurring change in fair value for loans held for investment was calculated based upon the fair value of the underlying collateral. The fair value of the collateral was determined using internal expected recovery models. The non-recurring change in fair value for mortgage loans held for sale is based upon a valuation model incorporating market observable inputs.
(3) Losses recorded were determined primarily using discounted cash flow models.
(4) Losses primarily related to investment management contracts, including contracts associated with FrontPoint, and were determined primarily using discounted cash flow models.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

There were no liabilities measured at fair value on a non-recurring basis during the quarter ended March 31, 2011.

Three Months Ended March 31, 2010.

 

            Fair Value Measurements Using:         
     Carrying
Value at
March 31,
2010
     Quoted Prices
in Active
Markets for
Identical
Assets

(Level 1)
     Significant
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs

(Level 3)
     Total Losses
for the
Three Months
Ended
March 31,
2010(1)
 
     (dollars in millions)  

Loans(2)

   $ 634      $  —         $ —         $ 634      $ (3

Other investments(3)

     17        —           —           17        (5

Intangible assets(4)

     5        —           —           5        (10
                                            

Total

   $ 656