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 June 30, 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 July 31, 2011, there were 1,927,916,237 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 June 30, 2011

 

Table of Contents    Page  

Part I—Financial Information

  

Item 1.

  Financial Statements (unaudited)      1   
 

Condensed Consolidated Statements of Financial Condition—June 30, 2011 and December 31, 2010

     1   
 

Condensed Consolidated Statements of Income—Three and Six Months Ended June 30, 2011 and 2010

     3   
 

Condensed Consolidated Statements of Comprehensive Income—Three and Six Months Ended June  30, 2011 and 2010

     4   
 

Condensed Consolidated Statements of Cash Flows—Six Months Ended June 30, 2011 and 2010

     5   
 

Condensed Consolidated Statements of Changes in Total Equity—Six Months Ended June  30, 2011 and 2010

     6   
  Notes to Condensed Consolidated Financial Statements (unaudited)      8   
  Report of Independent Registered Public Accounting Firm      82   

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      83   
 

Introduction

     83   
 

Executive Summary

     84   
 

Business Segments

     95   
 

Accounting Developments

     109   
 

Other Matters

     110   
 

Critical Accounting Policies

     114   
 

Liquidity and Capital Resources

     119   

Item 3.

  Quantitative and Qualitative Disclosures about Market Risk      132   

Item 4.

  Controls and Procedures      143   
  Financial Data Supplement (Unaudited)      144   

Part II—Other Information

  

Item 1.

  Legal Proceedings      150   

Item 1A.

  Risk Factors      151   

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      156   

Item 6.

  Exhibits      156   

 

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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; Compensation, Management Development and Succession Committee; Nominating and Governance Committee; Operations and Technology 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)

 

     June 30,
2011
     December 31,
2010
 

Assets

     

Cash and due from banks ($254 and $297 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities generally not available to the Company)

   $ 9,066       $ 7,341   

Interest bearing deposits with banks

     41,681         40,274   

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

     25,504         19,180   

Financial instruments owned, at fair value (approximately $122,209 and $129,969 were pledged to various parties at June 30, 2011 and December 31, 2010, respectively):

     

U.S. government and agency securities

     35,676         48,446   

Other sovereign government obligations

     39,172         33,908   

Corporate and other debt ($4,005 and $3,816 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)

     89,159         88,154   

Corporate equities ($100 and $625 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)

     66,053         68,416   

Derivative and other contracts

     46,167         51,292   

Investments ($2,012 and $1,873 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)

     9,020         9,752   

Physical commodities

     9,551         6,778   
                 

Total financial instruments owned, at fair value

     294,798         306,746   

Securities available for sale, at fair value

     24,306         29,649   

Securities received as collateral, at fair value

     15,862         16,537   

Federal funds sold and securities purchased under agreements to resell

     180,990         148,253   

Securities borrowed

     132,092         138,730   

Receivables:

     

Customers

     39,142         35,258   

Brokers, dealers and clearing organizations

     9,439         9,102   

Fees, interest and other

     9,911         9,790   

Loans (net of allowances of $36 and $82 at June 30, 2011 and December 31, 2010, respectively)

     12,476         10,576   

Other investments

     4,831         5,412   

Premises, equipment and software costs (net of accumulated depreciation of $4,524 and $4,476 at June 30, 2011 and December 31, 2010, respectively) ($310 and $321 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)

     6,399         6,154   

Goodwill

     6,744         6,739   

Intangible assets (net of accumulated amortization of $779 and $605 at June 30, 2011 and December 31, 2010, respectively) (includes $133 and $157 at fair value at June 30, 2011 and December 31, 2010, respectively)

     4,474         4,667   

Other assets ($371 and $118 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)

     13,032         13,290   
                 

Total assets

   $ 830,747       $ 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)

 

     June 30,
2011
    December 31,
2010
 

Liabilities and Equity

    

Deposits (includes $2,830 and $3,027 at fair value at June 30, 2011 and December 31, 2010, respectively)

   $ 65,525      $ 63,812   

Commercial paper and other short-term borrowings (includes $1,710 and $1,799 at fair value at June 30, 2011 and December 31, 2010, respectively)

     3,566        3,256   

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

    

U.S. government and agency securities

     27,520        27,948   

Other sovereign government obligations

     22,479        22,250   

Corporate and other debt

     9,166        10,918   

Corporate equities

     27,618        19,838   

Derivative and other contracts

     41,113        47,802   
  

 

 

   

 

 

 

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

     127,896        128,756   

Obligation to return securities received as collateral, at fair value

     20,741        21,163   

Securities sold under agreements to repurchase (includes $358 and $849 at fair value at June 30, 2011 and December 31, 2010, respectively )

     133,707        147,598   

Securities loaned

     35,375        29,094   

Other secured financings (includes $16,632 and $8,490 at fair value at June 30, 2011 and December 31, 2010, respectively) ($3,157 and $2,656 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities and are non-recourse to the Company)

     22,476        10,453   

Payables:

    

Customers

     133,372        123,249   

Brokers, dealers and clearing organizations

     5,178        3,363   

Interest and dividends

     3,066        2,572   

Other liabilities and accrued expenses ($132 and $117 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities and are non-recourse to the Company)

     15,596        16,518   

Long-term borrowings (includes $43,434 and $42,709 at fair value at June 30, 2011 and December 31, 2010, respectively)

     196,106        192,457   
  

 

 

   

 

 

 
     762,604        742,291   
  

 

 

   

 

 

 

Commitments and contingent liabilities (see Note 11)

    

Equity

    

Morgan Stanley shareholders’ equity:

    

Preferred stock

     1,508        9,597   

Common stock, $0.01 par value;

    

Shares authorized: 3,500,000,000 at June 30, 2011 and December 31, 2010;

    

Shares issued: 1,989,377,171 at June 30, 2011 and 1,603,913,074 at December 31, 2010;

    

Shares outstanding: 1,929,032,583 at June 30, 2011 and 1,512,022,095 and December 31, 2010

     20        16   

Paid-in capital

     22,346        13,521   

Retained earnings

     38,637        38,603   

Employee stock trust

     3,385        3,465   

Accumulated other comprehensive loss

     (320     (467

Common stock held in treasury, at cost, $0.01 par value; 60,344,588 shares at June 30, 2011 and 91,890,979 shares at December 31, 2010

     (2,484     (4,059

Common stock issued to employee trust

     (3,385     (3,465
  

 

 

   

 

 

 

Total Morgan Stanley shareholders’ equity

     59,707        57,211   

Noncontrolling interests

     8,436        8,196   
  

 

 

   

 

 

 

Total equity

     68,143        65,407   
  

 

 

   

 

 

 

Total liabilities and equity

   $ 830,747      $ 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
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Revenues:

        

Investment banking

   $ 1,695      $ 1,080      $ 2,909      $ 2,140   

Principal transactions:

        

Trading

     3,485        3,353        6,462        7,111   

Investments

     402        (52     731        317   

Commissions

     1,291        1,308        2,740        2,568   

Asset management, distribution and administration fees

     2,206        1,974        4,315        3,937   

Other

     275        159        (169     453   
                                

Total non-interest revenues

     9,354        7,822        16,988        16,526   
                                

Interest income

     1,957        1,747        3,811        3,483   

Interest expense

     2,029        1,606        3,882        2,974   
                                

Net interest

     (72     141        (71     509   
                                

Net revenues

     9,282        7,963        16,917        17,035   
                                

Non-interest expenses:

        

Compensation and benefits

     4,675        3,886        9,008        8,302   

Occupancy and equipment

     401        401        803        791   

Brokerage, clearing and exchange fees

     416        371        821        719   

Information processing and communications

     448        416        893        811   

Marketing and business development

     154        153        301        287   

Professional services

     494        496        922        891   

Other

     750        537        1,353        1,016   
                                

Total non-interest expenses

     7,338        6,260        14,101        12,817   
                                

Income from continuing operations before income taxes

     1,944        1,703        2,816        4,218   

Provision for income taxes

     542        240        286        676   
                                

Income from continuing operations

     1,402        1,463        2,530        3,542   
                                

Discontinued operations:

        

Gain from discontinued operations

     5        866        6        767   

Provision for income taxes

     1        345        —          314   
                                

Net gain from discontinued operations

     4        521        6        453   
                                

Net income

   $ 1,406      $ 1,984      $ 2,536      $ 3,995   

Net income applicable to noncontrolling interests

     213        24        375        259   
                                

Net income applicable to Morgan Stanley

   $ 1,193      $ 1,960      $ 2,161      $ 3,736   
                                

Earnings (loss) applicable to Morgan Stanley common shareholders

   $ (558   $ 1,578      $ 188      $ 2,990   
                                

Amounts applicable to Morgan Stanley:

        

Income from continuing operations

   $ 1,189      $ 1,439      $ 2,155      $ 3,283   

Net gain from discontinued operations

     4        521        6        453   
                                

Net income applicable to Morgan Stanley

   $ 1,193      $ 1,960      $ 2,161      $ 3,736   
                                

Earnings (loss) per basic common share:

        

Income (loss) from continuing operations

   $ (0.38   $ 0.84      $ 0.12      $ 1.96   

Net gain from discontinued operations

     —          0.36        0.01        0.31   
                                

Earnings (loss) per basic common share

   $ (0.38   $ 1.20      $ 0.13      $ 2.27   
                                

Earnings (loss) per diluted common share:

        

Income (loss) from continuing operations

   $ (0.38   $ 0.80      $ 0.12      $ 1.82   

Net gain from discontinued operations

     —          0.29        0.01        0.26   
                                

Earnings (loss) per diluted common share

   $ (0.38   $ 1.09      $ 0.13      $ 2.08   
                                

Average common shares outstanding:

        

Basic

     1,464,295,984        1,317,686,493        1,460,155,981        1,316,147,257   
                                

Diluted

     1,464,295,984        1,748,208,948        1,477,572,132        1,687,528,753   
                                

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
June 30,
     Six Months Ended
June 30,
 
         2011              2010          2011      2010  

Net income

   $ 1,406       $ 1,984       $ 2,536       $ 3,995   

Other comprehensive income, net of tax:

           

Foreign currency translation adjustments(1)

     94         35         131         37   

Amortization of cash flow hedges(2)

     3         2         4         5   

Net unrealized gain on Securities available for sale(3)

     50         107         14         87   

Pension, postretirement and other related adjustments(4)

     2         105         7         109   
  

 

 

    

 

 

    

 

 

    

 

 

 

Comprehensive income

   $ 1,555       $ 2,233       $ 2,692       $ 4,233   

Net income applicable to noncontrolling interests

     213         24         375         259   

Other comprehensive income applicable to noncontrolling interests

     43         44         9         32   
  

 

 

    

 

 

    

 

 

    

 

 

 

Comprehensive income applicable to Morgan Stanley

   $ 1,299       $ 2,165       $ 2,308       $ 3,942   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Amounts are net of provision for (benefit from) income taxes of $(68) million and $(19) million for the quarters ended June 30, 2011 and 2010, respectively, and $(136) million and $70 million for the six months ended June 30, 2011 and 2010, respectively.
(2) Amounts are net of provision for income taxes of $2 million for the quarter ended June 30, 2010, and $2 million and $3 million for the six months ended June 30, 2011 and 2010, respectively.
(3) Amounts are net of provision for income taxes of $34 million and $90 million for the quarters ended June 30, 2011 and 2010, respectively, and $10 million and $76 million for the six months ended June 30, 2011 and 2010, respectively.
(4) Amounts are net of provision for income taxes of $4 million and $66 million for the quarters ended June 30, 2011 and 2010, respectively, and $68 million for the six months ended June 30, 2010.

See Notes to Condensed Consolidated Financial Statements.

 

 

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MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in millions)

(unaudited)

 

     Six Months Ended
June 30,
 
         2011             2010      

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 2,536      $ 3,995   

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

    

(Gain) loss on equity method investees

     725        (78

Compensation payable in common stock and options

     728        671   

Depreciation and amortization

     759        1,191   

Gain on business dispositions

     —          (514

Gain on sale of securities available for sale

     (94     —     

Loss on repurchase of long-term debt

     31        —     

Insurance reimbursement

     —          (88

Loss on assets held for sale

     —          951   

Impairment charges and other-than-temporary impairment charges

     3        27   

Changes in assets and liabilities:

    

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

     (6,324     1,782   

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

     22,984        7,242   

Securities borrowed

     6,638        (11,358

Securities loaned

     6,281        278   

Receivables, loans and other assets

     (6,271     343   

Payables and other liabilities

     13,458        872   

Federal funds sold and securities purchased under agreements to resell

     (32,737     (1,654

Securities sold under agreements to repurchase

     (13,891     25,733   
  

 

 

   

 

 

 

Net cash provided by (used for) operating activities

     (5,174     29,393   
  

 

 

   

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

    

Net proceeds from (payments for):

    

Premises, equipment and software costs

     (725     (436

Business acquisitions, net of cash acquired

     —          (1,028

Business dispositions, net of cash disposed

     —          800   

Japanese securities joint venture with MUFG

     —          283   

Purchases of securities available for sale

     (8,632     (19,233

Sales and redemptions of securities available for sale

     14,245        —     
  

 

 

   

 

 

 

Net cash provided by (used for) investing activities

     4,888        (19,614
  

 

 

   

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

    

Net proceeds from (payments for):

    

Commercial paper and other short-term borrowings

     310        1,457   

Dividends related to noncontrolling interests

     (153     (14

Derivatives financing activities

     146        (64

Other secured financings

     3,176        (367

Deposits

     1,713        (847

Net proceeds from:

    

Excess tax benefits associated with stock-based awards

     29        3   

Public offerings and other issuances of common stock

     —          2   

Issuance of long-term borrowings

     22,596        13,757   

Payments for:

    

Long-term borrowings

     (24,192     (17,570

Repurchases of common stock for employee tax withholding

     (283     (275

Cash dividends

     (594     (582
  

 

 

   

 

 

 

Net cash provided by (used for) financing activities

     2,748        (4,500
  

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     416        (923
  

 

 

   

 

 

 

Effect of cash and cash equivalents related to variable interest entities

     254        —     
  

 

 

   

 

 

 

Net increase in cash and cash equivalents

     3,132        4,356   

Cash and cash equivalents, at beginning of period

     47,615        31,991   
  

 

 

   

 

 

 

Cash and cash equivalents, at end of period

   $ 50,747      $ 36,347   
  

 

 

   

 

 

 

Cash and cash equivalents include:

    

Cash and due from banks

   $ 9,066      $ 8,770   

Interest bearing deposits with banks

     41,681        27,577   
  

 

 

   

 

 

 

Cash and cash equivalents, at end of period

   $ 50,747      $ 36,347   
  

 

 

   

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Cash payments for interest were $3,144 million and $3,302 million for the six months ended June 30, 2011 and 2010, respectively.

Cash payments for income taxes were $530 million and $236 million for the six months ended June 30, 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

Six Months Ended June 30, 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

    —          —          —          2,161        —          —          —          —          375        2,536   

Dividends

    —          —          —          (401     —          —          —          —          —          (401

Shares issued under employee plans and related tax effects

    —          —          (1,072     —          (80     —          1,858        80        —          786   

Repurchases of common stock

    —          —          —          —          —          —          (283     —          —          (283

Net change in cash flow hedges

    —          —          —          —          —          4        —          —          —          4   

Pension, postretirement and other related adjustments

    —          —          —          —          —          7        —          —          —          7   

Foreign currency translation adjustments

    —          —          —          —          —          122        —          —          9        131   

Change in net unrealized gains on securities available for sale

    —          —          —          —          —          14        —          —          —          14   

Other increase in equity method investments

    —          —          86        —          —          —          —          —          —          86   

MUFG stock conversion

    (8,089     4        9,811        (1,726     —          —          —          —          —          —     

Decrease in noncontrolling interests related to dividends of noncontrolling interests

    —          —          —          —          —          —          —          —          (153     (153

Other increases in noncontrolling interests

    —          —          —          —          —          —          —          —          9        9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE AT JUNE 30, 2011

  $ 1,508      $ 20      $ 22,346      $ 38,637      $ 3,385      $ (320   $ (2,484   $ (3,385   $ 8,436      $ 68,143   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

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

Six Months Ended June 30, 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

    —          —          —          3,736        —          —          —          —          259        3,995   

Dividends

    —          —          —          (582     —          —          —          —          —          (582

Shares issued under employee plans and related tax effects

    —          —          (1,687     —          (398     —          2,210        398        —          523   

Repurchases of common stock

    —          —          —          —          —          —          (275     —          —          (275

Net change in cash flow hedges

    —          —          —          —          —          5        —          —          —          5   

Pension and postretirement adjustments

    —          —          —          —          —          109        —          —          —          109   

Foreign currency translation adjustments

    —          —          —          —          —          5        —          —          32        37   

Gain on Japanese securities joint venture with MUFG

    —          —          717        —          —          —          —          —          —          717   

Change in net unrealized gains on securities available for sale

    —          —          —          —          —          87        —          —          —          87   

Increase in noncontrolling interests related to Japanese securities joint venture with MUFG

    —          —          —          —          —          —          —          —          1,130        1,130   

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

    —          —          —          —          —          —          —          —          (14     (14

Other increases in noncontrolling interests

    —          —          —          —          —          —          —          —          179        179   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

BALANCE AT JUNE 30, 2010

  $ 9,597      $ 15      $ 7,649      $ 38,210      $ 3,666      $ (354   $ (4,104   $ (3,666   $ 8,146      $ 59,159   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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 three and six months ended June 30, 2010 included losses of approximately $19 million and $951 million, respectively, 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 six months ended June 30, 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.

At June 30, 2011, the Company recorded approximately $5.6 billion in Financial instruments owned—Corporate and other debt, $3.4 billion of physical commodities within Financial instruments owned—Physical commodities, and $9.0 billion of financing obligations within Other secured financing in the condensed consolidated statements of financial condition in connection with certain physical commodities swap transactions. Prior to June 30, 2011, the Company accounted for these types of transfers of assets as sales and purchases instead of financings. There was no impact on the Company’s results of operations in any period presented as a result of this change. The Company did not restate the balances in connection with such transactions at December 31, 2010 as amounts did not materially affect the Company’s condensed consolidated statement of financial condition.

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 in 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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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.

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. LLC (“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., Morgan Stanley Private Bank, National Association 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 six months ended June 30, 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

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 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.

Allowance for Loan Losses.

The Company places loans on nonaccrual status if principal or interest is past due for a period of 90 days or more or payment of principal or interest is in doubt unless the obligation is well secured and in the process of collection. Payments received on nonaccrual loans held for investment are applied to principal if there is doubt regarding the ultimate collectability of principal (cost recovery method). If collection of the principal of nonaccrual loans held for investment is not in doubt, interest income is recognized on a cash basis. If neither principal nor interest collection is in doubt, loans are on accrual status and interest income is recognized using the effective interest method.

Condensed Consolidated Statements of Cash Flows.

For purposes of the condensed consolidated statements of cash flows, cash and cash equivalents consist of Cash and due from banks and Interest bearing deposits with banks, which are highly liquid investments with original maturities of three months or less and readily convertible to known amounts of cash, and are held for investment purposes. At June 30, 2011, Mitsubishi UFJ Financial Group, Inc. (“MUFG”) and the Company converted MUFG’s outstanding Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock (“Series B Preferred Stock”) in the Company with a face value of $7.8 billion (carrying value $8.1 billion) into the Company’s common stock. As a result of the adjustment to the conversion ratio, pursuant to the transaction agreement, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the quarter and six months ended June 30, 2011 (see Note 13). In addition, in the six months ended June 30, 2010, the Company’s significant non-cash activities include assets acquired of approximately $0.4 billion and assumed liabilities of approximately $0.1 billion in connection with a business acquisition and approximately $0.6 billion of equity securities received in connection with the sale of Retail Asset Management.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

   

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.

 

   

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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

   

Mortgage Loans.    Mortgage loans are valued using observable prices based on transactional data or third party pricing 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 market 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.

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,

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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.

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 and hedge funds (which include investments made in connection with certain employee deferred compensation plans) as well as 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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

After initial recognition, in determining the fair value of internally and externally managed funds, the Company generally 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 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.

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.

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.

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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 June 30, 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 June 30, 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
June 30,
2011
 
    (dollars in millions)  

Assets

         

Financial instruments owned:

         

U.S. government and agency securities:

         

U.S. Treasury securities

  $ 13,062      $ 21      $ —        $ —        $ 13,083   

U.S. agency securities

    2,499        20,092        2        —          22,593   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total U.S. government and agency securities

    15,561        20,113        2        —          35,676   

Other sovereign government obligations

    30,743        8,297        132        —          39,172   

Corporate and other debt:

         

State and municipal securities

    —          3,166        —          —          3,166   

Residential mortgage-backed securities

    —          3,025        509        —          3,534   

Commercial mortgage-backed securities

    —          2,586        136        —          2,722   

Asset-backed securities

    —          1,639        298        —          1,937   

Corporate bonds

    —          36,972        1,179        —          38,151   

Collateralized debt obligations

    —          1,932        1,650        —          3,582   

Loans and lending commitments

    —          17,055        10,420        —          27,475   

Other debt

    —          8,429        163        —          8,592   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    —          74,804        14,355        —          89,159   

Corporate equities(1)

    62,535        3,057        461        —          66,053   

Derivative and other contracts:

         

Interest rate contracts

    1,660        578,414        4,919        —          584,993   

Credit contracts

    —          96,664        15,622        —          112,286   

Foreign exchange contracts

    —          55,956        517        —          56,473   

Equity contracts

    1,900        38,839        1,240        —          41,979   

Commodity contracts

    5,638        42,934        1,297        —          49,869   

Other

    —          233        312        —          545   

Netting(2)

    (8,020     (720,762     (11,253     (59,943     (799,978
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total derivative and other contracts

    1,178        92,278        12,654        (59,943     46,167   

Investments:

         

Private equity funds

    —          —          2,160        —          2,160   

Real estate funds

    —          7        1,290        —          1,297   

Hedge funds

    —          436        827        —          1,263   

Principal investments

    213        228        3,120        —          3,561   

Other

    188        26        525        —          739   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

    401        697        7,922        —          9,020   

Physical commodities

    —          8,878        673        —          9,551   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total financial instruments owned

    110,418        208,124        36,199        (59,943     294,798   

Securities available for sale:

         

U.S. government and agency securities

    9,378        14,928        —          —          24,306   

Securities received as collateral

    15,778        84        —          —          15,862   

Intangible assets(3)

    —          —          133        —          133   

Liabilities

         

Deposits

  $ —        $ 2,830      $ —        $ —        $ 2,830   

Commercial paper and other short-term borrowings

    —          1,687        23        —          1,710   

Financial instruments sold, not yet purchased:

         

U.S. government and agency securities:

         

U.S. Treasury securities

    25,315        —          —          —          25,315   

U.S. agency securities

    2,191        14        —          —          2,205   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total U.S. government and agency securities

    27,506        14        —          —          27,520   

Other sovereign government obligations

    19,903        2,576        —          —          22,479   

 

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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
June 30,
2011
 
    (dollars in millions)  

Corporate and other debt:

         

State and municipal securities

    —          4        —          —          4   

Residential mortgage-backed securities

    —          —          41        —          41   

Commercial mortgage-backed securities

    —          18        —          —          18   

Corporate bonds

    —          7,962        35        —          7,997   

Unfunded lending commitments

    —          669        240        —          909   

Other debt

    —          19        178        —          197   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    —          8,672        494        —          9,166   

Corporate equities(1)

    26,563        1,054        1        —          27,618   

Derivative and other contracts:

         

Interest rate contracts

    1,560        551,231        4,602        —          557,393   

Credit contracts

    —          93,508        8,230        —          101,738   

Foreign exchange contracts

    —          57,275        473        —          57,748   

Equity contracts

    1,758        43,459        2,901        —          48,118   

Commodity contracts

    6,196        43,852        981        —          51,029   

Other

    —          612        709        —          1,321   

Netting(2)

    (8,020     (720,762     (11,253     (36,199     (776,234
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total derivative and other contracts

    1,494        69,175        6,643        (36,199     41,113   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total financial instruments sold, not yet purchased

    75,466        81,491        7,138        (36,199     127,896   

Obligation to return securities received as collateral

    20,657        84        —          —          20,741   

Securities sold under agreements to repurchase

    —          —          358        —          358   

Other secured financings

    —          15,890        742        —          16,632   

Long-term borrowings

    12        42,171        1,251        —          43,434   

 

(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 June 30, 2011.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts.    During the quarter ended June 30, 2011, the Company reclassified approximately $0.9 billion of derivative assets and approximately $1.3 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.

Transfers Between Level 1 and Level 2 During the Six Months Ended June 30, 2011.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts.    During the six months ended June 30, 2011, the Company reclassified approximately $1.1 billion of derivative assets and approximately $0.9 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   

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   

 

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Table of Contents

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)  

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 June 30, 2010.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts.    During the quarter ended June 30, 2010, the Company reclassified approximately $1.5 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 June 30, 2010, the Company reclassified approximately $0.5 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. During the quarter ended June 30, 2010, the Company reclassified approximately $1.0 billion of certain Corporate equities from Level 1 to Level 2 as transactions in these securities did not occur with sufficient frequency and volume to constitute an active market.

Transfers Between Level 1 and Level 2 During the Six Months Ended June 30, 2010.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts.    During the six months ended June 30, 2010, the Company reclassified approximately $1.8 billion of derivative assets and approximately $1.9 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)

 

Financial instruments owned—Corporate equities.    During the six months ended June 30, 2010, the Company reclassified approximately $1.1 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.

Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis.

The following tables present additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter and six months ended June 30, 2011 and for the quarter and six months ended June 30, 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 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 June 30, 2011

 

    Beginning
Balance at
March 31,
2011
    Total
Realized and
Unrealized
Gains
(Losses)(1)
    Purchases     Sales     Issuances     Settlements     Net Transfers     Ending
Balance at
June 30,
2011
    Unrealized
Gains
(Losses) for
Level 3 Assets/
Liabilities
Outstanding at
June 30,
2011(2)
 
    (dollars in millions)  

Assets

                 

Financial instruments owned:

                 

U.S. agency securities

  $ 57      $ 1      $ 29      $ (72   $ —        $ —        $ (13   $ 2      $ —     

Other sovereign government obligations

    126        9        —          (4     —          —          1        132        9   

Corporate and other debt:

                 

State and municipal securities

    4        —          21        (25     —          —          —          —          —     

Residential mortgage-backed securities

    361        (10     101        (54     —          —          111        509        —     

Commercial mortgage-backed securities

    132        (21     81        (10     —          —          (46     136        (1

Asset-backed securities

    —          259        4        —          —          —          35        298        259   

Corporate bonds

    1,366        (93     216        (353     —          —          43        1,179        (57

Collateralized debt obligations

    1,593        17        357        (352     —          (19     54        1,650        14   

Loans and lending commitments

    11,218        (168     1,898        (676     —          (1,285     (567     10,420        (236

Other debt

    165        5        6        (13     —          —          —          163        1   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    14,839        (11     2,684        (1,483     —          (1,304     (370     14,355        (20

Corporate equities

    502        11        127        (144     —          —          (35     461        24   

Net derivative and other contracts(3):

                 

Interest rate contracts

    (58     472        22        —          (45     (62     (12     317        376   

Credit contracts

    6,079        1,002        1,089        —          (109     (737     68        7,392        958   

Foreign exchange contracts

    46        (34     2        —          —          30        —          44        (39

Equity contracts

    (645     58        77        (7     (1,163     52        (33     (1,661     60   

Commodity contracts

    330        (129     330        —          (146     (99     30        316        (139

Other

    (508     (74     2        —          (112     296        (1     (397     (81
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total net derivative and other contracts

    5,244        1,295        1,522        (7     (1,575     (520     52        6,011        1,135   

Investments:

                 

Private equity funds

    2,006        153        91        (90     —          —          —          2,160        129   

Real estate funds

    1,251        81        17        (59     —          —          —          1,290        148   

Hedge funds

    871        (17     20        (120     —          —          73        827        (17

Principal investments

    3,057        182        75        (108     —          —          (86     3,120        (15

Other

    398        2        2        (3     —          —          126        525        (2
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

    7,583        401        205        (380     —          —          113        7,922        243   

Physical commodities

    —          (48     721        —          —          —          —          673        (48

Intangible assets

    144        (11     1        —          —          (1     —          133        (11

Liabilities

                 

Commercial paper and other short-term borrowings

  $ 4      $ 7      $ —        $ —        $ 29      $ (3   $ —        $ 23      $ 7   

Financial instruments sold, not yet purchased:

                 

Corporate and other debt:

                 

Residential mortgage-backed securities

    —          (13     (13     41        —          —          —          41        (13

Corporate bonds

    150        49        (324     336        —          —          (78     35        60   

Collateralized debt obligations

    2        —          (1     —          —          —          (1     —          —     

Unfunded lending commitments

    171        (69     —          —          —          —          —          240        (69

Other debt

    180        13        —          13        —          —          (2     178        13   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    503        (20     (338     390        —          —          (81     494        (9

Corporate equities

    9        13        (8     12        —          —          1        1        3   

Securities sold under agreements to repurchase

    352        (5     —          —          1        —          —          358        (5

Other secured financings

    605        (9     —          —          145        (17     —          742        (9

Long-term borrowings

    1,374        38        —          —          215        (175     (125     1,251        20   

 

(1) Total realized and unrealized gains (losses) are primarily included in Principal transactions—Trading in the condensed consolidated statements of income except for $401 million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.
(2) Amounts represent unrealized gains (losses) for the quarter ended June 30, 2011 related to assets and liabilities still outstanding at June 30, 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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Financial instruments owned—Corporate and other debt.    During the quarter ended June 30, 2011, the Company reclassified approximately $1.2 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 $0.8 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 Six Months Ended June 30, 2011

 

    Beginning
Balance at
December 31,
2010
    Total
Realized
and
Unrealized
Gains
(Losses)(1)
    Purchases     Sales     Issuances     Settlements     Net
Transfers
    Ending
Balance at
June 30,
2011
    Unrealized
Gains
(Losses) for
Level 3 Assets/
Liabilities
Outstanding at
June 30,
2011(2)
 
    (dollars in millions)  

Assets

                 

Financial instruments owned:

                 

U.S. agency securities

  $ 13      $ —        $ 34      $ (40   $ —        $ —        $ (5   $ 2      $ —     

Other sovereign government obligations

    73        8        56        —          —          —          (5     132        8   

Corporate and other debt:

                 

State and municipal securities

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

Residential mortgage-backed securities

    319        (62     279        (193     —          (1     167        509        (71

Commercial mortgage-backed securities

    188        (19     96        (30     —          —          (99     136        (18

Asset-backed securities

    13        259        13        (17     —          —          30        298        258   

Corporate bonds

    1,368        (26     273        (409     —          34        (61     1,179        42   

Collateralized debt obligations

    1,659        273        641        (862     —          (55     (6     1,650        70   

Loans and lending commitments

    11,666        213        2,321        (537     —          (2,038     (1,205     10,420        212   

Other debt

    193        —          5        (33     —          —          (2     163        (9
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    15,516        637        3,628        (2,177     —          (2,060     (1,189     14,355        484   

Corporate equities

    484        (207     219        (176     —          —          141        461        1   

Net derivative and other contracts(3):

                 

Interest rate contracts

    424        702        19        —          (704     (192     68        317        600   

Credit contracts

    6,594        388        1,148        —          (197     (614     73        7,392        772   

Foreign exchange contracts

    46        (159     1        —          —          159        (3     44        (130

Equity contracts

    (762     105        119        —          (1,236     98        15        (1,661     96   

Commodity contracts

    188        165        455        —          (321     (281     110        316        153   

Other

    (913     117        2        —          (116     428        85        (397     110   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total net derivative and other contracts

    5,577        1,318        1,744        —          (2,574     (402     348        6,011        1,601   

Investments:

                 

Private equity funds

    1,986        260        88        (245     —          —          71        2,160        209   

Real estate funds

    1,176        145        31        (62     —          —          —          1,290        255   

Hedge funds

    901        (25     15        (172     —          —          108        827        (25

Principal investments

    3,131        242        (26     (195     —          —          (32     3,120        (105

Other

    560        51        (4     (11     —          —          (71     525        41   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

    7,754        673        104        (685     —          —          76        7,922        375   

Physical commodities

    —          (48     721        —          —          —          —          673        (48

Securities received as collateral

    1        —          —          (1     —          —          —          —          —     

Intangible assets

    157        (26     5        (1     (1     (1     —          133        (26

Liabilities

                 

Deposits

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

Commercial paper and other short-term borrowings

    2        7        —          —          29        (1     —          23        7   

Financial instruments sold, not yet purchased:

                 

Corporate and other debt:

                 

Residential mortgage-backed securities

    —          (13     (12     40        —          —          —          41        (13

Commercial mortgage-backed securities

    —          1        —          1        —          —          —          —          —     

Corporate bonds

    44        40        (367     426        —          —          (28     35        30   

Unfunded lending commitments

    263        23        —          —          —          —          —          240        23   

Other debt

    194        4        (10     14        —          —          (16     178        4   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    501        55        (389     481        —          —          (44     494        44   

Corporate equities

    15        5        (19     6        —          —          4        1        3   

Obligation to return securities received as collateral

    1        —          (1     —          —          —          —          —          —     

Securities sold under agreements to repurchase

    351        (6     1        —          —          —          —          358        (8

Other secured financings

    1,016        (12     —          —          142        (122     (306     742        (12

Long-term borrowings

    1,316        (28     —          —          388        (342     (139     1,251        (22

 

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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 $673 million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.
(2) Amounts represent unrealized gains (losses) for the six months ended June 30, 2011 related to assets and liabilities still outstanding at June 30, 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 six months ended June 30, 2011, the Company reclassified approximately $1.8 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified these corporate loans as external prices and/or spread inputs for these instruments became observable.

The Company also reclassified approximately $0.6 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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Table of Contents

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 June 30, 2010

 

    Beginning
Balance at
March 31,
2010
    Total
Realized
and
Unrealized
Gains
(Losses)(1)
    Purchases,
Sales, Other
Settlements
and
Issuances, net
    Net
Transfers
    Ending
Balance at
June 30,
2010
    Unrealized
Gains (Losses)
for Level 3
Assets/
Liabilities
Outstanding at
June 30,
2010(2)
 
    (dollars in millions)  

Assets

           

Financial instruments owned:

           

U.S. agency securities

  $ 1      $ —        $ (5   $ 5      $ 1      $ —     

Other sovereign government obligations

    80        (1     70        (76     73        —     

Corporate and other debt:

           

State and municipal securities

    398        19        (180     (16     221        1   

Residential mortgage-backed securities

    625        (37     (97     (15     476        (42

Commercial mortgage-backed securities

    779        23        133        (322     613        13   

Asset-backed securities

    149        8        (75     19        101        6   

Corporate bonds

    1,145        86        154        (41     1,344        79   

Collateralized debt obligations

    1,512        (25     40        (14     1,513        42   

Loans and lending commitments

    13,503        (40     152        (868     12,747        (64

Other debt

    1,921        (61     (28     (22     1,810        (68
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    20,032        (27     99        (1,279     18,825        (33

Corporate equities

    536        (33     (183     26        346        (1

Net derivative and other contracts(3):

           

Interest rate contracts

    384        310        (132     (46     516        311   

Credit contracts

    7,952        315        265        (431     8,101        499   

Foreign exchange rate contracts

    206        (1     (134     —          71        (2

Equity contracts

    (701     (137     (191     31        (998     (129

Commodity contracts

    90        (152     53        23        14        (126

Other

    (579     (402     (40     (18     (1,039     (352
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total net derivative and other contracts

    7,352        (67     (179     (441     6,665        201   

Investments:

           

Private equity funds

    1,634        82        123        —          1,839        21   

Real estate funds

    1,751        4        (115     3        1,643        109   

Hedge funds

    1,027        (29     5        (93     910        (29

Principal investments

    2,700        (132     7        —          2,575        (83

Other

    434        64        (60     6        444        3   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

    7,546        (11     (40     (84     7,411        21   

Intangible assets

    175        (15     (21     —          139        (27

Liabilities

           

Deposits

  $ 15      $ 1      $ —        $ —        $ 14      $ —     

Commercial paper and other short-term borrowings

    300        —          (293     —          7        —     

Financial instruments sold, not yet purchased:

           

Corporate and other debt:

           

Residential mortgage-backed securities

    —          (6     (4     —          2        (5

Asset-backed securities

    4        —          (4     —          —          —     

Corporate bonds

    17        14        80        (3     80        19   

Unfunded lending commitments

    213        (110     12        —          335        (110

Other debt

    317        15        (81     —          221        13   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    551        (87     3        (3     638        (83

Corporate equities

    13        1        (4     (3     5        —     

Other secured financings

    1,811        69        5        163        1,910        69   

Long-term borrowings

    6,728        92        20        (147     6,509        92   

 

(1) Total realized and unrealized gains (losses) are primarily included in Principal transactions—Trading in the condensed consolidated statements of income except for $(11) million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.
(2) Amounts represent unrealized gains (losses) for the quarter ended June 30, 2010 related to assets and liabilities still outstanding at June 30, 2010.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(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 June 30, 2010, the Company reclassified approximately $1.9 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 $0.6 billion of certain Corporate and other debt from Level 2 to Level 3. The Company reclassified corporate loans as external prices and/or spread inputs became unobservable.

 

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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 Six Months Ended June 30, 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
June 30,
2010
    Unrealized
Gains (Losses)
for Level 3
Assets/
Liabilities
Outstanding at
June 30,
2010(2)
 
    (dollars in millions)  

Assets

           

Financial instruments owned:

           

U.S. agency securities

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

Other sovereign government obligations

    3        (1     63        8        73        (1

Corporate and other debt:

           

State and municipal securities

    713        (56     (436     —          221        (58

Residential mortgage-backed securities

    818        12        (392     38        476        (6

Commercial mortgage-backed securities

    1,573        128        (774     (314     613        28   

Asset-backed securities

    591        3        (491     (2     101        9   

Corporate bonds

    1,038        (44     256        94        1,344        (53

Collateralized debt obligations

    1,553        122        (171     9        1,513        60   

Loans and lending commitments

    12,506        76        629        (464     12,747        126   

Other debt

    1,662        185        (14     (23     1,810        160   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    20,454        426        (1,393     (662     18,825        266   

Corporate equities

    536        67        (161     (96     346        21   

Net derivative and other contracts(3):

           

Interest rate contracts

    387        300        (146     (25     516        302   

Credit contracts

    8,824        (163     383        (943     8,101        340   

Foreign exchange rate contracts

    254        (102     (123     42        71        (308

Equity contracts

    (689     (208     (184     83        (998     (161

Commodity contracts

    7        (68     14        61        14        66   

Other

    (437     (575     (12     (15     (1,039     (511
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total net derivative and other contracts

    8,346        (816     (68     (797     6,665        (272

Investments:

           

Private equity funds

    1,628        139        72        —          1,839        116   

Real estate funds

    1,087        186        350        20        1,643        289   

Hedge funds

    1,678        (218     (270     (280     910        (220

Principal investments

    2,642        (105     38        —          2,575        (87

Other

    578        47        (180     (1     444        (3
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investments

    7,613        49        10        (261     7,411        95   

Securities received as collateral

    23        —          (23     —          —          —     

Intangible assets

    137        24        (22     —          139        4   

Liabilities

           

Deposits

  $ 24      $ 2      $ —        $ (8   $ 14      $ 2   

Commercial paper and other short-term borrowings

    —          —          7        —          7        —     

Financial instruments sold, not yet purchased:

           

Corporate and other debt:

           

Residential mortgage-backed securities

    —          (1     1        —          2        (1

Commercial mortgage-backed securities

    —          1        1        —          —          —     

Asset-backed securities

    4        —          (4     —          —          —     

Corporate bonds

    29        (1     22        28        80        8   

Collateralized debt obligations

    3        —          (3     —          —          —     

Unfunded lending commitments

    252        (140     (57     —          335        (138

Other debt

    431        20        (175     (15     221        20   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total corporate and other debt

    719        (121     (215     13        638        (111

Corporate equities

    4        (1     (7     7        5        1   

Obligation to return securities received as collateral

    23        —          (23     —          —          —     

Other secured financings

    1,532        (67     222        89        1,910        (80

Long-term borrowings

    6,865        99        (26     (231     6,509        99   

 

(1) Total realized and unrealized gains (losses) are primarily included in Principal transactions—Trading in the condensed consolidated statements of income except for $49 million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.
(2) Amounts represent unrealized gains (losses) for the six months ended June 30, 2010 related to assets and liabilities still outstanding at June 30, 2010.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(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 six months ended June 30, 2010, the Company reclassified approximately $1.4 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 $0.8 billion of certain Corporate and other debt from Level 2 to Level 3. The Company reclassified corporate loans as external prices and/or spread inputs became unobservable.

Fair Value of Investments that Calculate Net Asset Value.

The Company’s Investments measured at fair value were $9,020 million and $9,752 million at June 30, 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 June 30, 2011 and December 31, 2010, respectively.

 

     At June 30, 2011      At December 31, 2010  
     Fair
Value
     Unfunded
Commitment
     Fair
Value
     Unfunded
Commitment
 
     (dollars in millions)  

Private equity funds

   $ 2,119       $ 1,019       $ 1,947       $ 1,047   

Real estate funds

     1,262         538         1,154         500   

Hedge funds(1):

           

Long-short equity hedge funds

     571         5         1,046         4   

Fixed income/credit-related hedge funds

     123         —           305         —     

Event-driven hedge funds

     183         —           143         —     

Multi-strategy hedge funds

     385         —           140         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 4,643       $ 1,562       $ 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 June 30, 2011, approximately 40% of the fair value amount of long-short equity hedge funds is redeemable at least quarterly, 32% is redeemable every six months and 28% 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.

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 June 30, 2011, it is estimated that 7% of the fair value of the funds will be liquidated in the next five years, another 32% of the fair value of the funds will be liquidated between five to 10 years and the remaining 61% 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

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 June 30, 2011, it is estimated that 18% of the fair value of the funds will be liquidated within the next five years, another 35% of the fair value of the funds will be liquidated between five to 10 years and the remaining 47% 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 12% 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 these investments subject to lock-up restrictions ranged from one to three years at June 30, 2011. Investments representing approximately 26% 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 these investments subject to an exit restriction was primarily two years or less at June 30, 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 June 30, 2011, investments representing approximately 36% 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 subject to lock-up restrictions was one year or less at June 30, 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 June 30, 2011, investments representing approximately 34% 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 primarily one year or less at June 30, 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 overweight or underweight different strategies to best capitalize on current investment opportunities. At June 30, 2011, investments representing approximately 76% 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 these investments subject to lock-up restrictions was primarily three years or less at June 30, 2011. Investments representing approximately 9% 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 these investments subject to an exit restriction was indefinite at June 30, 2011.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 and six months ended June 30, 2011 and 2010, respectively.

 

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

Three Months Ended June 30, 2011

      

Deposits

   $ 18      $ (30   $ (12

Commercial paper and other short-term borrowings

     49        —          49   

Securities sold under agreements to repurchase

     2        —          2   

Long-term borrowings

     (42     (270     (312

Six Months Ended June 30, 2011

      

Deposits

   $ 31      $ (60   $ (29

Commercial paper and other short-term borrowings

     44        —          44   

Securities sold under agreements to repurchase

     —          —          —     

Long-term borrowings

     (1,308     (560     (1,868

Three Months Ended June 30, 2010

      

Deposits

   $ 10      $ (45   $ (35

Commercial paper and other short-term borrowings

     55        —          55   

Long-term borrowings

     2,409        (285     2,124   

Six Months Ended June 30, 2010

      

Deposits

   $ (15   $ (93   $ (108

Commercial paper and other short-term borrowings

     68        —          68   

Long-term borrowings

     2,527        (484     2,043   

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 changes in overall fair value of the short-term and long-term borrowings (primarily structured notes) are attributable to changes in foreign currency exchange rates, interest rates, movements in the reference price or index for structured notes and (as presented in the table below) an adjustment to reflect the change in credit quality of the Company.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 Risk

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2011             2010             2011             2010      
    

(dollars in millions)

 

Short-term and long-term borrowings(1)

   $ 244      $ 750      $ 55      $ 803   

Loans(2)

     (146     (348     (108     (1

Unfunded lending commitments(3)

     (223     (94     (213     (164

 

(1) The change in the fair value of short-term and long-term borrowings (primarily structured notes) includes an adjustment to reflect the change in 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.

Amount by Which Contractual Principal Amount Exceeds Fair Value

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in billions)  

Short-term and long-term borrowings(1)

   $ 0.9       $ 0.6   

Loans(2)

     24.5         24.3   

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

     21.4         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 $2.3 billion and $2.2 billion at June 30, 2011 and December 31, 2010, respectively. The aggregate fair value of loans that were 90 or more days past due was $1.8 billion and $2.0 billion at June 30, 2011 and December 31, 2010, respectively.

The tables above exclude non-recourse debt from consolidated VIEs, liabilities related to failed sales, pledged commodities 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.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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 and six months ended June 30, 2011 and 2010, respectively.

Three and Six Months Ended June 30, 2011.

 

            Fair Value Measurements Using:               
     Carrying
Value At
June 30,
2011(1)
     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 June
30, 2011(2)
    Total
Gains (Losses)
for the Six
Months
Ended June 30,
2011(2)
 
     (dollars in millions)  

Loans(3)

   $ 183       $ —         $ 92       $ 91       $ 3      $ 18   

Other investments(4)

     84         —           —           84         (20     (28

Intangible assets(5)

     —           —           —           —           —          (3
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 267       $ —         $ 92       $ 175       $ (17   $ (13
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Carrying values relate only to those assets that had fair value adjustments during the quarter ended June 30, 2011. These amounts do not include assets that had fair value adjustments during the six months ended June 30, 2011, unless the assets also had a fair value adjustment during the quarter ended June 30, 2011.
(2) 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.
(3) 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.
(4) Losses recorded were determined primarily using discounted cash flow models.
(5) Losses primarily related to investment management contracts and were determined primarily using discounted cash flow models.

There were no liabilities measured at fair value on a non-recurring basis during the quarter and six months ended June 30, 2011.

Three and Six Months Ended June 30, 2010.

 

            Fair Value Measurements Using:               
     Carrying
Value At
June 30,
2010(1)
     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

June 30,
2010(2)
    Total Losses
for the

Six Months
Ended

June 30,
2010(2)
 
     (dollars in millions)  

Loans(3)

   $ 622       $ —         $ —         $ 622       $ (25   $ (28

Other investments(4)

     —           —           —           —           —          (5

Intangible assets(5)

     3         —           —           3         (17     (27
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 625       $ —         $ —         $ 625       $ (42   $ (60
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Carrying values relate only to those assets that had fair value adjustments during the quarter ended June 30, 2010. These amounts do not include assets that had fair value adjustments during the six months ended June 30, 2010, unless the assets also had a fair value adjustment during the quarter ended June 30, 2010.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

(2) 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.
(3) Non-recurring change in fair value for loans held for investment were calculated based upon the fair value of the underlying collateral. The fair value of the collateral was determined using internal expected recovery models.
(4) Losses recorded were determined primarily using discounted cash flow models.
(5) Losses primarily related to investment management contracts and were determined using discounted cash flow models.

In addition to the losses included in the table above, the Company incurred a loss of approximately $951 million in connection with the planned disposition of Revel, which was included in discontinued operations. The loss primarily related to premises and equipment and was included in discontinued operations (see Note 1). The fair value of Revel, net of estimated costs to sell, included in Premises, equipment and software costs was approximately $240 million at June 30, 2010 and was classified in Level 3. Fair value was determined using discounted cash flow models.

There were no liabilities measured at fair value on a non-recurring basis during the quarter and six months ended June 30, 2010.

Financial Instruments Not Measured at Fair Value.

Some of the Company’s financial instruments are not measured at fair value on a recurring basis but nevertheless are recorded at amounts that approximate fair value due to their liquid or short-term nature. Such financial assets and financial liabilities include: Cash and due from banks, Interest bearing deposits with banks, Cash deposited with clearing organizations or segregated under federal and other regulations or requirements, Federal funds sold and Securities purchased under agreements to resell, Securities borrowed, certain Securities sold under agreements to repurchase, Securities loaned, Receivables—Customers, Receivables—Brokers, dealers and clearing organizations, Payables—Customers, Payables—Brokers, dealers and clearing organizations, certain Commercial paper and other short-term borrowings, certain Deposits and certain Other secured financings.

The Company’s long-term borrowings are recorded at amortized amounts unless elected under the fair value option or designated as a hedged item in a fair value hedge. For long-term borrowings not measured at fair value, the fair value of the Company’s long-term borrowings was estimated using either quoted market prices or discounted cash flow analyses based on the Company’s current borrowing rates for similar types of borrowing arrangements. At June 30, 2011, the carrying value of the Company’s long-term borrowings not measured at fair value was approximately $1.0 billion higher than fair value. At December 31, 2010, the carrying value of the Company’s long-term borrowings not measured at fair value was approximately $1.8 billion higher than fair value.

 

4. Securities Available for Sale.

The following table presents information about the Company’s available for sale (“AFS”) securities:

 

    At June 30, 2011  
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Other-than-
Temporary
Impairment
    Fair Value  
    (dollars in millions)  

Debt securities available for sale:

         

U.S. government and agency securities:

         

U.S. Treasury securities

  $ 9,233      $ 148      $ 3      $ —        $ 9,378   

U.S. agency securities

    14,986        6        64        —          14,928   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total U.S. government and agency securities

  $ 24,219      $ 154      $ 67      $ —        $ 24,306   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

    At December 31, 2010  
    Amortized
Cost
    Gross
Unrealized
Gains
    Gross
Unrealized
Losses
    Other-than-
Temporary
Impairment
    Fair Value  
    (dollars in millions)  

Debt securities available for sale:

         

U.S. government and agency securities:

         

U.S. Treasury securities

  $ 18,812      $ 199      $ 34      $ —        $ 18,977   

U.S. agency securities

    10,774        16        118        —          10,672   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total U.S. government and agency securities

  $ 29,586      $ 215      $ 152      $ —        $ 29,649   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The table below presents the fair value of investments in debt securities available for sale that have been in an unrealized loss position:

 

    Less than 12 Months     12 Months or Longer     Total  

At June 30, 2011

 

Fair Value

   

Gross
Unrealized
Losses

   

Fair Value

   

Gross
Unrealized
Losses

   

Fair Value

   

Gross
Unrealized
Losses

 
    (dollars in millions)  

Debt securities available for sale:

           

U.S. government and agency securities:

           

U.S. Treasury securities

  $ 619      $ 3      $ —        $ —        $ 619      $ 3   

U.S. agency securities

    11,023        64        —          —          11,023        64   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total U.S. government and agency securities

  $ 11,642      $ 67      $ —        $ —        $ 11,642      $ 67   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    Less than 12 Months     12 Months or Longer     Total  

At December 31, 2010

 

Fair Value

   

Gross
Unrealized
Losses

   

Fair Value

   

Gross
Unrealized
Losses

   

Fair Value

   

Gross
Unrealized
Losses

 
    (dollars in millions)  

Debt securities available for sale:

           

U.S. government and agency securities:

           

U.S. Treasury securities

  $ 1,960      $ 34      $ —        $ —        $ 1,960      $ 34   

U.S. agency securities

    7,736        118        —          —          7,736        118   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total U.S. government and agency securities

  $ 9,696      $ 152      $ —        $ —        $ 9,696      $ 152   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross unrealized losses are recorded in Accumulated other comprehensive income.

The Company does not intend to sell these securities or expect to be required to sell these securities prior to recovery of the amortized cost basis. In addition, the Company does not expect these securities to experience a credit loss given the explicit and implicit guarantee provided by the U.S. government. The Company believes that the debt securities with an unrealized loss in Accumulated other comprehensive income were not other-than-temporarily impaired at June 30, 2011 and December 31, 2010.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table presents the amortized cost and fair value of debt securities available for sale by contractual maturity dates at June 30, 2011.

 

    Amortized Cost     Fair Value     Annualized
Average Yield
 
    (dollars in millions)        

U.S. government and agency securities:

     

U.S. Treasury securities:

     

Due within 1 year

  $ 304      $ 304        0.4

After 1 year but through 5 years

    8,830        8,975        1.4

After 5 years

    99        99        1.7
 

 

 

   

 

 

   

Total

  $ 9,233      $ 9,378     
 

 

 

   

 

 

   

U.S. agency securities:

     

After 5 years

    14,986        14,928        1.3
 

 

 

   

 

 

   

Total U.S. government and agency securities:

  $ 24,219      $ 24,306        1.4
 

 

 

   

 

 

   

The following table presents information pertaining to sales of debt securities available for sale:

 

     Three Months Ended
June 30, 2011
     Six Months Ended
June 30, 2011
 
     (dollars in millions)  

Gross realized gains

   $ 84       $ 96   
  

 

 

    

 

 

 

Gross realized losses

   $ 2       $ 2   
  

 

 

    

 

 

 

Proceeds of sales of debt securities available for sale

   $ 7,021       $ 13,142   
  

 

 

    

 

 

 

Gross realized gains and losses are recognized in Other revenues in the condensed consolidated statements of income. There were no sales of AFS securities during the three and six months ended June 30, 2010.

 

5. Collateralized Transactions.

The Company enters into reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions to, among other things, acquire securities to cover short positions and settle other securities obligations, to accommodate customers’ needs and to finance the Company’s inventory positions. The Company’s policy is generally to take possession of Securities received as collateral, Securities purchased under agreements to resell and Securities borrowed. The Company manages credit exposure arising from reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions by, in appropriate circumstances, entering into master netting agreements and collateral arrangements with counterparties that provide the Company, in the event of a customer default, the right to liquidate collateral and the right to offset a counterparty’s rights and obligations. The Company also monitors the fair value of the underlying securities as compared with the related receivable or payable, including accrued interest, and, as necessary, requests additional collateral to ensure such transactions are adequately collateralized. Where deemed appropriate, the Company’s agreements with third parties specify its rights to request additional collateral.

The Company also engages in securities financing transactions for customers through margin lending. Under these agreements and transactions, the Company either receives or provides collateral, including U.S. government and agency securities, other sovereign government obligations, corporate and other debt, and corporate equities. Customer receivables generated from margin lending activity are collateralized by customer-

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

owned securities held by the Company. The Company monitors required margin levels and established credit limits daily and, pursuant to such guidelines, requires customers to deposit additional collateral, or reduce positions, when necessary. Margin loans are extended on a demand basis and are not committed facilities. Factors considered in the review of margin loans are the amount of the loan, the intended purpose, the degree of leverage being employed in the account, and overall evaluation of the portfolio to ensure proper diversification or, in the case of concentrated positions, appropriate liquidity of the underlying collateral or potential hedging strategies to reduce risk. Additionally, transactions relating to concentrated or restricted positions require a review of any legal impediments to liquidation of the underlying collateral. Underlying collateral for margin loans is reviewed with respect to the liquidity of the proposed collateral positions, valuation of securities, historic trading range, volatility analysis and an evaluation of industry concentrations. For these transactions, adherence to the Company’s collateral policies significantly limits the Company’s credit exposure in the event of customer default. The Company may request additional margin collateral from customers, if appropriate, and, if necessary, may sell securities that have not been paid for or purchase securities sold but not delivered from customers. At June 30, 2011 and December 31, 2010, there were approximately $20.7 billion and $18.0 billion, respectively, of customer margin loans outstanding.

Other secured financings include the liabilities related to transfers of financial assets that are accounted for as financings rather than sales, consolidated VIEs where the Company is deemed to be the primary beneficiary, and certain equity-linked notes and other secured borrowings. These liabilities are generally payable from the cash flows of the related assets accounted for as Financial instruments owned (see Note 6).

The Company pledges its financial instruments owned to collateralize repurchase agreements and other securities financings. Pledged financial instruments that can be sold or repledged by the secured party are identified as Financial instruments owned (pledged to various parties) in the condensed consolidated statements of financial condition. The carrying value and classification of financial instruments owned by the Company that have been loaned or pledged to counterparties where those counterparties do not have the right to sell or repledge the collateral were as follows:

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in millions)  

Financial instruments owned:

     

U.S. government and agency securities

   $ 7,222       $ 11,513   

Other sovereign government obligations

     6,547         8,741   

Corporate and other debt

     14,257         12,333   

Corporate equities

     23,546         21,919   
  

 

 

    

 

 

 

Total

   $ 51,572       $ 54,506   
  

 

 

    

 

 

 

The Company receives collateral in the form of securities in connection with reverse repurchase agreements, securities borrowed and derivative transactions, and customer margin loans. In many cases, the Company is permitted to sell or repledge these securities held as collateral and use the securities to secure repurchase agreements, to enter into securities lending and derivative transactions or for delivery to counterparties to cover short positions. The Company additionally receives securities as collateral in connection with certain securities-for-securities transactions in which the Company is the lender. In instances where the Company is permitted to sell or repledge these securities, the Company reports the fair value of the collateral received and the related obligation to return the collateral in the condensed consolidated statements of financial condition. At June 30, 2011 and December 31, 2010, the fair value of financial instruments received as collateral where the Company is permitted to sell or repledge the securities was $585 billion and $537 billion, respectively, and the fair value of the portion that had been sold or repledged was $416 billion and $390 billion, respectively.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

At June 30, 2011 and December 31, 2010, cash and securities deposited with clearing organizations or segregated under federal and other regulations or requirements were as follows:

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in millions)  

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

   $ 25,504       $ 19,180   

Securities(1)

     12,175         18,935   
  

 

 

    

 

 

 

Total

   $ 37,679       $ 38,115   
  

 

 

    

 

 

 

 

(1) Securities deposited with clearing organizations or segregated under federal and other regulations or requirements are sourced from Federal funds sold and securities purchased under agreements to resell and Financial instruments owned in the condensed consolidated statements of financial condition.

 

6. Variable Interest Entities and Securitization Activities.

The Company is involved with various SPEs in the normal course of business. In most cases, these entities are deemed to be VIEs.

The Company applies accounting guidance for consolidation of VIEs to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Excluding entities subject to the Deferral (as defined in Note 2 to the consolidated financial statements included in the Form 10-K), the primary beneficiary of a VIE is the party that both (1) has the power to direct the activities of a VIE that most significantly affect the VIE’s economic performance and (2) has an obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. The Company consolidates entities of which it is the primary beneficiary.

The Company’s variable interests in VIEs include debt and equity interests, commitments, guarantees, derivative instruments and certain fees. The Company’s involvement with VIEs arises primarily from:

 

   

Interests purchased in connection with market-making and retained interests held as a result of securitization activities, including re-securitization transactions.

 

   

Guarantees issued and residual interests retained in connection with municipal bond securitizations.

 

   

Servicing residential and commercial mortgage loans held by VIEs.

 

   

Loans and investments made to VIEs that hold debt, equity, real estate or other assets.

 

   

Derivatives entered into with VIEs.

 

   

Structuring of credit-linked notes (“CLN”) or other asset-repackaged notes designed to meet the investment objectives of clients.

 

   

Other structured transactions designed to provide tax-efficient yields to the Company or its clients.

The Company determines whether it is the primary beneficiary of a VIE upon its initial involvement with the VIE and reassesses whether it is the primary beneficiary on an ongoing basis as long as it has any continuing involvement with the VIE. This determination is based upon an analysis of the design of the VIE, including the VIE’s structure and activities, the power to make significant economic decisions held by the Company and by other parties, and the variable interests owned by the Company and other parties.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The power to make the most significant economic decisions may take a number of different forms in different types of VIEs. The Company considers servicing or collateral management decisions as representing the power to make the most significant economic decisions in transactions such as securitizations or CDOs. As a result, the Company does not consolidate securitizations or CDOs for which it does not act as the servicer or collateral manager unless it holds certain other rights to replace the servicer or collateral manager or to require the liquidation of the entity. If the Company serves as servicer or collateral manager, or has certain other rights described in the previous sentence, the Company analyzes the interests in the VIE that it holds and consolidates only those VIEs for which it holds a potentially significant interest, generally based on the fair value of interests held by the Company relative to the fair value of the assets of the VIE.

The structure of securitization vehicles and CDOs are driven by several parties, including loan seller(s) in securitization transactions, the collateral manager in a CDO, one or more rating agencies, a financial guarantor in some transactions and the underwriter(s) of the transactions, who serve to reflect specific investor demand. In addition, subordinate investors, such as the “B-piece” buyer in commercial mortgage backed securitizations or equity investors in CDOs, can influence whether specific loans are excluded from a CMBS transaction or investment criteria in a CDO.

For many transactions, such as re-securitization transactions, CLNs and other asset-repackaged notes, there are no significant economic decisions made on an ongoing basis. In these cases, the Company focuses its analysis on decisions made prior to the initial closing of the transaction and at the termination of the transaction. Based upon factors, which include an analysis of the nature of the assets, including whether the assets were issued in a transaction sponsored by the Company and the extent of the information available to the Company and to investors, the number, nature and involvement of investors, other rights held by the Company and investors, the standardization of the legal documentation and the level of the continuing involvement by the Company, including the amount and type of interests owned by the Company and by other investors, the Company concluded in most of these transactions that decisions made prior to the initial closing were shared between the Company and the initial investors. The Company focused its control decision on any right held by the Company or investors related to the termination of the VIE. Most re-securitization transactions, CLNs and other asset-repackaged notes have no such termination rights.

Except for consolidated VIEs included in other structured financings in the tables below, the Company accounts for the assets held by the entities primarily in Financial instruments owned and the liabilities of the entities as Other secured financings in the condensed consolidated statements of financial condition. For consolidated VIEs included in other structured financings, the Company accounts for the assets held by the entities primarily in Premises, equipment and software costs, and Other assets in the condensed consolidated statements of financial condition. Except for consolidated VIEs included in other structured financings, the assets and liabilities are measured at fair value, with changes in fair value reflected in earnings.

The assets owned by many consolidated VIEs cannot be removed unilaterally by the Company and are not generally available to the Company. The related liabilities issued by many consolidated VIEs are non-recourse to the Company. In certain other consolidated VIEs, the Company has the unilateral right to remove assets or provides additional recourse through derivatives such as total return swaps, guarantees or other forms of involvement.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following tables present information at June 30, 2011 and December 31, 2010 about VIEs that the Company consolidates. Consolidated VIE assets and liabilities are presented after intercompany eliminations and include assets financed on a non-recourse basis.

 

     At June 30, 2011  
     Mortgage and
Asset-backed
Securitizations
     Collateralized
Debt
Obligations
     Managed
Real Estate
Partnerships
     Other
Structured
Financings
     Other  
     (dollars in millions)  

VIE assets

   $ 3,071       $ 133       $ 2,184       $ 851       $ 2,643   

VIE liabilities

   $ 2,185       $ 99       $ 111       $ 2,571       $ 880   

 

     At December 31, 2010  
     Mortgage and
Asset-Backed
Securitizations
     Collateralized
Debt
Obligations
     Managed
Real Estate
Partnerships
     Other
Structured
Financings
     Other  
     (dollars in millions)  

VIE assets

   $ 3,362       $ 129       $ 2,032       $ 643       $ 2,584   

VIE liabilities

   $ 2,544       $ 68       $ 108       $ 2,571       $ 1,219   

In general, the Company’s exposure to loss in consolidated VIEs is limited to losses that would be absorbed on the VIE’s assets recognized in its financial statements, net of losses absorbed by third-party holders of the VIE’s liabilities. At June 30, 2011 and December 31, 2010, managed real estate partnerships reflected noncontrolling interests in the Company’s condensed consolidated financial statements of $1,627 million and $1,508 million, respectively. The Company also had additional maximum exposure to losses of approximately $471 million and $884 million at June 30, 2011 and December 31, 2010, respectively. This additional exposure related primarily to certain derivatives (e.g., instead of purchasing senior securities, the Company has sold credit protection to synthetic CDOs through credit derivatives that are typically related to the most senior tranche of the CDO) and commitments, guarantees and other forms of involvement.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following tables present information about certain non-consolidated VIEs in which the Company had variable interests at June 30, 2011 and December 31, 2010. The tables include all VIEs in which the Company has determined that its maximum exposure to loss is greater than specific thresholds or meets certain other criteria. Most of the VIEs included in the tables below are sponsored by unrelated parties; the Company’s involvement generally is the result of the Company’s secondary market-making activities.

 

    At June 30, 2011  
    Mortgage and
Asset-Backed
Securitizations
    Collateralized
Debt
Obligations
    Municipal
Tender
Option
Bonds
    Other
Structured
Financings
    Other  
    (dollars in millions)  

VIE assets that the Company does not consolidate (unpaid principal balance)(1)

  $ 199,668      $ 26,919      $ 6,901      $ 2,015      $ 5,345   

Maximum exposure to loss:

         

Debt and equity interests(2)

  $ 6,833      $ 1,788      $ —        $ 1,016      $ 1,178   

Derivative and other contracts

    75        847        4,491        —          1,424   

Commitments, guarantees and other

    —          308        —          797        363   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total maximum exposure to loss

  $ 6,908      $ 2,943      $ 4,491      $ 1,813      $ 2,965   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Carrying value of exposure to loss—Assets:

         

Debt and equity interests(2)

  $ 6,833      $ 1,788      $ —        $ 709      $ 1,178   

Derivative and other contracts

    94        659        —          —          401   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total carrying value of exposure to loss—Assets

  $ 6,927      $ 2,447      $ —        $ 709      $ 1,579   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Carrying value of exposure to loss—Liabilities:

         

Derivative and other contracts

  $ 19      $ 119      $ —        $ —        $ 49   

Commitments, guarantees and other

    —          —          —          16        337   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total carrying value of exposure to loss—Liabilities

  $ 19      $ 119      $ —        $ 16      $ 386   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Mortgage and asset-backed securitizations include VIE assets as follows: $25.3 billion of residential mortgages; $132.9 billion of commercial mortgages; $25.0 billion of U.S. agency collateralized mortgage obligations; and $16.5 billion of other consumer or commercial loans.
(2) Mortgage and asset-backed securitizations include VIE debt and equity interests as follows: $1.5 billion of residential mortgages; $1.8 billion of commercial mortgages; $2.3 billion of U.S. agency collateralized mortgage obligations; and $1.2 billion of other consumer or commercial loans.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

    At December 31, 2010  
    Mortgage and
Asset-Backed
Securitizations
    Collateralized
Debt
Obligations
    Municipal
Tender
Option
Bonds
    Other
Structured
Financings
    Other  
    (dollars in millions)  

VIE assets that the Company does not consolidate (unpaid principal balance)(1)

  $ 172,711      $ 38,332      $ 7,431      $ 2,037      $ 11,262   

Maximum exposure to loss:

         

Debt and equity interests(2)

  $ 8,129      $ 1,330      $ 78      $ 1,062      $ 2,678   

Derivative and other contracts

    113        942        4,709        —          2,079   

Commitments, guarantees and other

    —          —          —          791        446   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total maximum exposure to loss

  $ 8,242      $ 2,272      $ 4,787      $ 1,853      $ 5,203   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Carrying value of exposure to loss—Assets:

         

Debt and equity interests(2)

  $ 8,129      $ 1,330      $ 78      $ 779      $ 2,678   

Derivative and other contracts

    113        753        —          —          551   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total carrying value of exposure to loss—Assets

  $ 8,242      $ 2,083      $ 78      $ 779      $ 3,229   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Carrying value of exposure to loss—Liabilities:

         

Derivative and other contracts

  $ 15      $ 123      $ —        $ —        $ 23   

Commitments, guarantees and other

    —          —          —          44        261   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total carrying value of exposure to loss—Liabilities

  $ 15      $ 123      $ —        $ 44      $ 284   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Mortgage and asset-backed securitizations include VIE assets as follows: $34.9 billion of residential mortgages; $94.0 billion of commercial mortgages; $28.8 billion of U.S. agency collateralized mortgage obligations; and $15.0 billion of other consumer or commercial loans.
(2) Mortgage and asset-backed securitizations include VIE debt and equity interests as follows: $1.9 billion of residential mortgages; $2.1 billion of commercial mortgages; $3.0 billion of U.S. agency collateralized mortgage obligations; and $1.1 billion of other consumer or commercial loans.

The Company’s maximum exposure to loss often differs from the carrying value of the VIE’s assets. The maximum exposure to loss is dependent on the nature of the Company’s variable interest in the VIEs and is limited to the notional amounts of certain liquidity facilities, other credit support, total return swaps, written put options, and the fair value of certain other derivatives and investments the Company has made in the VIEs. Liabilities issued by VIEs generally are non-recourse to the Company. Where notional amounts are utilized in quantifying maximum exposure related to derivatives, such amounts do not reflect fair value writedowns already recorded by the Company.

The Company’s maximum exposure to loss does not include the offsetting benefit of any financial instruments that the Company may utilize to hedge these risks associated with the Company’s variable interests. In addition, the Company’s maximum exposure to loss is not reduced by the amount of collateral held as part of a transaction with the VIE or any party to the VIE directly against a specific exposure to loss.

Securitization transactions generally involve VIEs. Primarily as a result of its secondary market-making activities, the Company owned additional securities issued by securitization SPEs for which the maximum exposure to loss is less than specific thresholds. These additional securities totaled $5.0 billion at June 30, 2011. These securities were either retained in connection with transfers of assets by the Company or acquired in

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

connection with secondary market-making activities. Securities issued by securitization SPEs consist of $1.8 billion of securities backed primarily by residential mortgage loans, $1.0 billion of securities backed by U.S. agency collateralized mortgage obligations, $0.9 billion of securities backed by commercial mortgage loans, $0.8 billion of securities backed by collateralized debt obligations or collateralized loan obligations and $0.5 billion backed by other consumer loans, such as credit card receivables, automobile loans and student loans. The Company’s primary risk exposure is to the securities issued by the SPE owned by the Company, with the risk highest on the most subordinate class of beneficial interests. These securities generally are included in Financial instruments owned—Corporate and other debt and are measured at fair value. The Company does not provide additional support in these transactions through contractual facilities, such as liquidity facilities, guarantees or similar derivatives. The Company’s maximum exposure to loss generally equals the fair value of the securities owned.

The Company’s transactions with VIEs primarily includes securitizations, municipal tender option bond trusts, credit protection purchased through CLNs, other structured financings, collateralized loan and debt obligations, equity-linked notes, managed real estate partnerships and asset management investment funds. The Company’s continuing involvement in VIEs that it does not consolidate can include ownership of retained interests in Company-sponsored transactions, interests purchased in the secondary market (both for Company-sponsored transactions and transactions sponsored by third parties), derivatives with securitization SPEs (primarily interest rate derivatives in commercial mortgage and residential mortgage securitizations and credit derivatives in which the Company has purchased protection in synthetic CDOs), and as servicer in residential mortgage securitizations in the U.S. and Europe and commercial mortgage securitizations in Europe. Such activities are further described in Note 7 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.

Transfers of Assets with Continuing Involvement.

The following tables present information at June 30, 2011 regarding transactions with SPEs in which the Company, acting as principal, transferred financial assets with continuing involvement and received sales treatment.

 

     At June 30, 2011  
     Residential
Mortgage
Loans
     Commercial
Mortgage
Loans
     U.S. Agency
Collateralized
Mortgage
Obligations
     Credit-
Linked
Notes
and

Other
 
     (dollars in millions)  

SPE assets (unpaid principal balance)(1)

   $ 44,788       $ 86,427       $ 33,188       $ 17,913   

Retained interests (fair value):

           

Investment grade

   $ 37       $ 89       $ 1,710       $ 3   

Non-investment grade

     233         59         —           1,474   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total retained interests (fair value)

   $ 270       $ 148       $ 1,710       $ 1,477   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interests purchased in the secondary market (fair value):

           

Investment grade

   $ 75       $ 286       $ 133       $ 425   

Non-investment grade

     266         144         —           24   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interests purchased in the secondary market (fair value)

   $ 341       $ 430       $ 133       $ 449   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative assets (fair value)

   $ 40       $ 1,123       $ —         $ 166   

Derivative liabilities (fair value)

   $ 38       $ —         $ —         $ 274   

 

(1) Amounts include assets transferred by unrelated transferors.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     At June 30, 2011  
     Level 1      Level 2      Level 3      Total  
     (dollars in millions)  

Retained interests (fair value):

           

Investment grade

   $ —         $ 1,832       $ 7       $ 1,839   

Non-investment grade

     —           120         1,646         1,766   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total retained interests (fair value)

   $ —         $ 1,952       $ 1,653       $ 3,605   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interests purchased in the secondary market (fair value):

           

Investment grade

   $ —         $ 911       $ 8       $ 919   

Non-investment grade

     —           255         179         434   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interests purchased in the secondary market (fair value)

   $ —         $ 1,166       $ 187       $ 1,353   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative assets (fair value)

   $ —         $ 815       $ 514       $ 1,329   

Derivative liabilities (fair value)

   $ —         $ 274       $ 38       $ 312   

The following tables present information at December 31, 2010 regarding transactions with SPEs in which the Company, acting as principal, transferred assets with continuing involvement and received sales treatment.

 

     At December 31, 2010  
     Residential
Mortgage
Loans
     Commercial
Mortgage
Loans
     U.S. Agency
Collateralized
Mortgage
Obligations
     Credit-
Linked
Notes
and

Other
 
     (dollars in millions)  

SPE assets (unpaid principal balance)(1)

   $ 48,947       $ 85,974       $ 29,748       $ 11,462   

Retained interests (fair value):

           

Investment grade

   $ 46       $ 64       $ 2,636       $ 8   

Non-investment grade

     206         81         —           2,327   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total retained interests (fair value)

   $ 252       $ 145       $ 2,636       $ 2,335   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interests purchased in the secondary market (fair value):

           

Investment grade

   $ 118       $ 643       $ 155       $ 21   

Non-investment grade

     205         55         —           11   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interests purchased in the secondary market (fair value)

   $ 323       $ 698       $ 155       $ 32   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative assets (fair value)

   $ 75       $ 955       $ —         $ 78   

Derivative liabilities (fair value)

   $ 29       $ 80       $ —         $ 314   

 

(1) Amounts include assets transferred by unrelated transferors.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     At December 31, 2010  
     Level 1      Level 2      Level 3      Total  
     (dollars in millions)  

Retained interests (fair value):

           

Investment grade

   $ —         $ 2,732       $ 22       $ 2,754   

Non-investment grade

     —           241         2,373         2,614   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total retained interests (fair value)

   $ —         $ 2,973       $ 2,395       $ 5,368   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interests purchased in the secondary market (fair value):

           

Investment grade

   $ —         $ 929       $ 8       $ 937   

Non-investment grade

     —           255         16         271   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interests purchased in the secondary market (fair value)

   $ —         $ 1,184       $ 24       $ 1,208   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative assets (fair value)

   $ —         $ 887       $ 221       $ 1,108   

Derivative liabilities (fair value)

   $ —         $ 360       $ 63       $ 423   

Transferred assets are carried at fair value prior to securitization, and any changes in fair value are recognized in the condensed consolidated statements of income. The Company may act as underwriter of the beneficial interests issued by securitization vehicles. Investment banking underwriting net revenues are recognized in connection with these transactions. The Company may retain interests in the securitized financial assets as one or more tranches of the securitization. These retained interests are included in the condensed consolidated statements of financial condition at fair value. Any changes in the fair value of such retained interests are recognized in the condensed consolidated statements of income.

Net gains on sales of assets in securitization transactions at the time of the sale were not material in the six months ended June 30, 2011 and 2010.

During the six months ended June 30, 2011 and 2010, the Company received proceeds from new securitization transactions of $15.0 billion and $10.0 billion, respectively. During the six months ended June 30, 2011 and 2010, the Company received proceeds from cash flows from retained interests in securitization transactions of $3.9 billion and $2.8 billion, respectively.

The Company has provided, or otherwise agreed to be responsible for, representations and warranties regarding certain assets transferred in securitization transactions sponsored by the Company (see Note 11).

Failed Sales.

In order to be treated as a sale of assets for accounting purposes, a transaction must meet all of the criteria stipulated in the accounting guidance for the transfer of financial assets. If the transfer fails to meet these criteria, that transfer of financial assets is treated as a failed sale. In such case, the Company continues to recognize the assets in Financial instruments owned, and the Company recognizes the associated liabilities in Other secured financings in the condensed consolidated statements of financial condition.

The assets transferred to many unconsolidated VIEs in transactions accounted for as failed sales cannot be removed unilaterally by the Company and are not generally available to the Company. The related liabilities issued by many unconsolidated VIEs are non-recourse to the Company. In certain other failed sale transactions, the Company has the unilateral right to remove assets or provide additional recourse through derivatives such as total return swaps, guarantees or other forms of involvement.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table presents information about the carrying value of assets and liabilities resulting from transfers of financial assets treated by the Company as secured financings:

 

     At June 30, 2011      At December 31, 2010  
     Carrying Value of      Carrying Value of  
     Assets      Liabilities        Assets        Liabilities  
     (dollars in millions)  

Commercial mortgage loans

   $ 115       $ 115       $ 128       $ 124   

Credit-linked notes

     451         405         784         781   

Equity-linked transactions

     1,661         1,621         1,618         1,583   

Other

     113         113         62         61   

Mortgage Servicing Activities.

Mortgage Servicing Rights.    The Company may retain servicing rights to certain mortgage loans that are sold. These transactions create an asset referred to as MSRs, which totaled approximately $133 million and $157 million at June 30, 2011 and December 31, 2010, respectively, and are included within Intangible assets and carried at fair value in the condensed consolidated statements of financial condition.

SPE Mortgage Servicing Activities.    The Company services residential mortgage loans in the U.S. and Europe and commercial mortgage loans in Europe owned by SPEs, including SPEs sponsored by the Company and SPEs not sponsored by the Company. The Company generally holds retained interests in Company-sponsored SPEs. In some cases, as part of its market-making activities, the Company may own some beneficial interests issued by both Company-sponsored and non-Company sponsored SPEs.

The Company provides no credit support as part of its servicing activities. The Company is required to make servicing advances to the extent that it believes that such advances will be reimbursed. Reimbursement of servicing advances is a senior obligation of the SPE, senior to the most senior beneficial interests outstanding. Outstanding advances are included in Other assets and are recorded at cost. Advances at June 30, 2011 and December 31, 2010 totaled approximately $1.4 billion and $1.5 billion, respectively, net of allowance of $6 million and $10 million at June 30, 2011 and December 31, 2010, respectively.

The following tables present information about the Company’s mortgage servicing activities for SPEs to which the Company transferred loans at June 30, 2011 and December 31, 2010:

 

     At June 30, 2011  
     Residential
Mortgage
Unconsolidated
SPEs
    Residential
Mortgage
Consolidated
SPEs
    Commercial
Mortgage
Unconsolidated
SPEs
     Commercial
Mortgage
Consolidated
SPEs
 
     (dollars in millions)  

Assets serviced (unpaid principal balance)

   $ 9,902      $ 2,221      $ 6,893       $ 1,993   

Amounts past due 90 days or greater (unpaid principal balance)(1)

   $ 3,375      $ 408      $ —         $ —     

Percentage of amounts past due 90 days or greater(1)

     34.1     18.4     —           —     

Credit losses

   $ 206      $ 13      $ —         $ —     

 

(1) Amount includes loans that are at least 90 days contractually delinquent, loans for which the borrower has filed for bankruptcy, loans in foreclosure and real estate owned.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     At December 31, 2010  
     Residential
Mortgage
Unconsolidated
SPEs
    Residential
Mortgage
Consolidated
SPEs
    Commercial
Mortgage
Unconsolidated
SPEs
     Commercial
Mortgage
Consolidated
SPEs
 
     (dollars in millions)  

Assets serviced (unpaid principal balance)

   $ 10,616      $ 2,357      $ 7,108       $ 2,097   

Amounts past due 90 days or greater (unpaid principal balance)(1)

   $ 3,861      $ 446      $ —         $ —     

Percentage of amounts past due 90 days or greater(1)

     36.4     18.9     —           —     

Credit losses

   $ 1,098      $ 35      $ —         $ —     

 

(1) Amount includes loans that are at least 90 days contractually delinquent, loans for which the borrower has filed for bankruptcy, loans in foreclosure and real estate owned.

The Company also serviced residential and commercial mortgage loans for SPEs sponsored by unrelated parties with unpaid principal balances totaling $12 billion and $13 billion at June 30, 2011 and December 31, 2010, respectively.

 

7. Financing Receivables.

Loans held for investment.

The Company’s loans held for investment are recorded at amortized cost and classified as Loans in the condensed consolidated statements of financial condition.

The Company’s loans held for investment at June 30, 2011 and December 31, 2010 included the following:

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in millions)  

Commercial and industrial

   $ 4,183       $ 4,054   

Consumer loans

     4,395         3,974   

Residential real estate loans

     3,320         1,915   

Wholesale real estate loans

     468         468   
  

 

 

    

 

 

 

Total loans held for investment(1)

   $ 12,366       $ 10,411   
  

 

 

    

 

 

 

 

(1) Amounts are net of allowances of $36 million and $82 million at June 30, 2011 and December 31, 2010, respectively.

The above table does not include loans held for sale of $110 million and $165 million at June 30, 2011 and December 31, 2010.

The Company’s Credit Risk Management Department evaluates new obligors before credit transactions are initially approved, and at least annually thereafter for consumer and industrial loans. For corporate and commercial loans, credit evaluations typically involve the evaluation of financial statements, assessment of leverage, liquidity, capital strength, asset composition and quality, market capitalization and access to capital markets, cash flow projections and debt service requirements, and the adequacy of collateral, if applicable. The Company’s Credit Risk Management Department will also evaluate strategy, market position, industry dynamics, obligor’s management and other factors that could affect the obligor’s risk profile. For residential real estate and consumer loans, the initial credit evaluation includes, but is not limited to review of the obligor’s income, net

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

worth, liquidity, collateral, loan-to-value ratio, and credit bureau information. Subsequent credit monitoring for residential real estate loans is performed at the portfolio level and for consumer loans collateral, values are monitored on an ongoing basis.

At June 30, 2011, the Company collectively evaluated for impairment gross commercial and industrial loans, consumer loans, residential real estate loans and wholesale real estate loans of $3,993 million, $4,325 million, $3,321 million and $335 million, respectively. The Company individually evaluated for impairment gross commercial and industrial loans, consumer and wholesale real estate loans of $212 million, $71 million and $145 million, respectively. Commercial and industrial loans of approximately $70 million and wholesale real estate loans of approximately $72 million were impaired at June 30, 2011. Approximately 99% of the Company’s loan portfolio was current at June 30, 2011.

At December 31, 2010, the Company collectively evaluated for impairment gross commercial and industrial loans, consumer loans, residential real estate loans and wholesale real estate loans of $3,791 million, $3,890 million, $1,915 million and $90 million, respectively. The Company individually evaluated for impairment gross commercial and industrial loans, consumer and wholesale real estate loans of $307 million, $85 million and $415 million, respectively. Commercial and industrial loans of approximately $170 million and wholesale real estate loans of approximately $108 million were impaired at December 31, 2010. Approximately 99% of the Company’s loan portfolio was current at December 31, 2010.

The Company assigned an internal grade of “doubtful” to certain commercial asset-backed and wholesale real estate loans totaling $145 million and $500 million at June 30, 2011 and December 31, 2010, respectively. Doubtful loans can be classified as current if the borrower is making payments in accordance with the loan agreement. The Company assigned an internal grade of “pass” to the majority of the remaining loans.

For a description of the Company’s loan portfolio and credit quality indicators utilized in its credit monitoring process, see Note 8 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.

Employee Loans.

Employee loans are granted primarily in conjunction with a program established in the Global Wealth Management Group business segment to retain and recruit certain employees. These loans are recorded in Receivables—Fees, interest and other in the condensed consolidated statements of financial condition. These loans are full recourse, require periodic payments and have repayment terms ranging from four to 12 years. The Company establishes a reserve for loan amounts it does not consider recoverable from terminated employees, which is recorded in Compensation and benefits expense. At June 30, 2011, the Company had $5,502 million of employee loans, net of an allowance of approximately $112 million. At December 31, 2010, the Company had $5,831 million of employee loans, net of an allowance of approximately $111 million.

Collateralized Transactions.

In certain instances, the Company enters into reverse repurchase agreements and securities borrowed transactions to acquire securities to cover short positions, to settle other securities obligations and to accommodate customers’ needs. The Company also engages in securities financing transactions for customers through margin lending (see Note 5).

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Servicing Advances.

As part of its servicing activities, the Company is required to make servicing advances to the extent that it believes that such advances will be reimbursed (see Note 6).

 

8. Goodwill and Net Intangible Assets.

The Company tests goodwill for impairment on an annual basis and on an interim basis when certain events or circumstances exist. The Company tests for impairment at the reporting unit level, which is generally at the level of or one level below its business segments. Goodwill impairment is determined by comparing the estimated fair value of a reporting unit with its respective book value. If the estimated fair value exceeds the book value, goodwill at the reporting unit level is not deemed to be impaired. If the estimated fair value is below book value, however, further analysis is required to determine the amount of the impairment. Additionally, if the book value of a reporting unit is zero or a negative value and it is determined that it is more likely than not the goodwill is impaired, further analysis is required.

The estimated fair values of the reporting units are generally determined utilizing methodologies that incorporate price-to-book, price-to-earnings and assets under management multiples of certain comparable companies. The Company also utilizes a discounted cash flow methodology for certain reporting units.

Due to the volatility in the equity markets, the economic outlook and the Company’s common shares trading below book value during the quarters ended December 31, 2010 and June 30, 2011, the Company performed additional impairment testing at December 31, 2010 and June 30, 2011, which did not result in any goodwill impairment. Adverse market or economic events could result in impairment charges in future periods.

Goodwill.

Changes in the carrying amount of the Company’s goodwill, net of accumulated impairment losses for the six months ended June 30, 2011, were as follows:

 

     Institutional
Securities
     Global
Wealth
Management
Group
     Asset
Management
     Total  
     (dollars in millions)  

Goodwill at December 31, 2010(1)

   $ 383       $ 5,616       $ 740       $ 6,739   

Foreign currency translation adjustments and other

     5         —           —           5   
  

 

 

    

 

 

    

 

 

    

 

 

 

Goodwill at June 30, 2011(1)

   $ 388       $ 5,616       $ 740       $ 6,744   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) The amount of the Company’s goodwill before accumulated impairments of $700 million at June 30, 2011 and December 31, 2010, was $7,444 million and $7,439 million, respectively.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Net Intangible Assets.

Changes in the carrying amount of the Company’s intangible assets for the six months ended June 30, 2011 were as follows:

 

     Institutional
Securities
    Global Wealth
Management
Group
    Asset Management     Total  
     (dollars in millions)  

Amortizable net intangible assets at December 31, 2010

   $ 262      $ 3,963      $ 5      $ 4,230   

Mortgage servicing rights (see Note 6)

     151        6        —          157   

Indefinite-lived intangible assets

     —          280        —          280   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net intangible assets at December 31, 2010

   $ 413      $ 4,249      $ 5      $ 4,667   
  

 

 

   

 

 

   

 

 

   

 

 

 

Amortizable net intangible assets at December 31, 2010

   $ 262      $ 3,963      $ 5      $ 4,230   

Foreign currency translation adjustments and other

     9        —          —          9   

Amortization expense

     (12     (162     —          (174

Impairment losses

     —          —          (3     (3

Intangible assets disposed of during the period

     (1     —          —          (1
  

 

 

   

 

 

   

 

 

   

 

 

 

Amortizable net intangible assets at June 30, 2011

     258        3,801        2        4,061   

Mortgage servicing rights (see Note 6)

     122        11        —          133   

Indefinite-lived intangible assets

     —          280        —          280   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net intangible assets at June 30, 2011

   $ 380      $ 4,092      $ 2      $ 4,474   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

9. Long-Term Borrowings and Other Secured Financings.

The Company’s long-term borrowings included the following components:

 

     At June 30,
2011
     At December 31,
2010
 
     (dollars in millions)  

Senior debt

   $ 187,350       $ 183,514   

Subordinated debt

     3,930         4,126   

Junior subordinated debentures

     4,826         4,817   
  

 

 

    

 

 

 

Total

   $ 196,106       $ 192,457   
  

 

 

    

 

 

 

During the six months ended June 30, 2011, the Company issued notes with a principal amount of approximately $23 billion. During the six months ended June 30, 2011, approximately $24 billion of notes were repaid.

The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.1 years and 5.2 years at June 30, 2011 and December 31, 2010, respectively.

FDIC’s Temporary Liquidity Guarantee Program.

At June 30, 2011 and December 31, 2010, the Company had long-term debt outstanding of $18.3 billion and $21.3 billion, respectively, under the Temporary Liquidity Guarantee Program (“TLGP”). The issuance of debt under the TLGP expired on December 31, 2010, but the existing long-term debt outstanding is guaranteed

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

until June 30, 2012. These borrowings are senior unsecured debt obligations of the Company and guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) under the TLGP. The FDIC has concluded that the guarantee is backed by the full faith and credit of the U.S. government.

Other Secured Financings.

Other secured financings include the liabilities related to transfers of financial assets that are accounted for as financings rather than sales, consolidated VIEs where the Company is deemed to be the primary beneficiary, pledged commodities, certain equity-linked notes and other secured borrowings. See Note 6 for further information on other secured financings related to variable interest entities and securitization activities.

The Company’s other secured financings consisted of the following:

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in millions)  

Secured financings with original maturities greater than one year

   $ 19,730       $ 7,398   

Secured financings with original maturities one year or less

     492         506   

Failed sales(1)

     2,254         2,549   
  

 

 

    

 

 

 

Total(2)

   $ 22,476       $ 10,453   
  

 

 

    

 

 

 

 

(1) For more information on failed sales, see Note 6.
(2) Amounts include $16,632 million at fair value at June 30, 2011 and $8,490 million at fair value at December 31, 2010.

 

10. Derivative Instruments and Hedging Activities.

The Company trades, makes markets and takes proprietary positions globally in listed futures, OTC swaps, forwards, options and other derivatives referencing, among other things, interest rates, currencies, investment grade and non-investment grade corporate credits, loans, bonds, U.S. and other sovereign securities, emerging market bonds and loans, credit indices, asset-backed security indices, property indices, mortgage-related and other asset-backed securities, and real estate loan products. The Company uses these instruments for trading, foreign currency exposure management and asset and liability management.

The Company manages its trading positions by employing a variety of risk mitigation strategies. These strategies include diversification of risk exposures and hedging. Hedging activities consist of the purchase or sale of positions in related securities and financial instruments, including a variety of derivative products (e.g., futures, forwards, swaps and options). The Company manages the market risk associated with its trading activities on a Company-wide basis, on a worldwide trading division level and on an individual product basis.

The Company’s derivative products consist of the following:

 

     At June 30, 2011      At December 31, 2010  
     Assets      Liabilities      Assets      Liabilities  
     (dollars in millions)  

Exchange traded derivative products

   $ 3,657       $ 4,789       $ 6,099       $ 8,553   

OTC derivative products

     42,510         36,324         45,193         39,249   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 46,167       $ 41,113       $ 51,292       $ 47,802   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company incurs credit risk as a dealer in OTC derivatives. Credit risk with respect to derivative instruments arises from the failure of a counterparty to perform according to the terms of the contract. The Company’s exposure to credit risk at any point in time is represented by the fair value of the derivative contracts reported as assets. The fair value of a derivative represents the amount at which the derivative could be exchanged in an orderly transaction between market participants and is further described in Notes 2 and 3.

In connection with its derivative activities, the Company generally enters into master netting agreements and collateral arrangements with counterparties. These agreements provide the Company with the ability to offset a counterparty’s rights and obligations, request additional collateral when necessary or liquidate the collateral in the event of counterparty default.

The tables below present a summary by counterparty credit rating and remaining contract maturity of the fair value of OTC derivatives in a gain position at June 30, 2011 and December 31, 2010, respectively. Fair value is presented in the final column, net of collateral received (principally cash and U.S. government and agency securities):

OTC Derivative Products—Financial Instruments Owned at June 30, 2011(1)

 

    Years to Maturity     Cross-Maturity
and
Cash Collateral
Netting(3)
    Net Exposure
Post-Cash
Collateral
    Net  Exposure
Post-Collateral
 

Credit Rating(2)

  Less
than 1
    1 - 3     3 - 5     Over 5        
    (dollars in millions)  

AAA

  $ 618      $ 1,652      $ 1,050      $ 8,745      $ (5,854   $ 6,211      $ 5,968   

AA

    5,791        5,286        4,841        17,979        (24,792     9,105        7,152   

A

    5,113        6,163        5,942        25,338        (31,535     11,021        9,561   

BBB

    3,102        3,340        2,303        6,716        (8,272     7,189        5,906   

Non-investment grade

    2,877        3,050        2,592        5,451        (4,986     8,984        6,840   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 17,501      $ 19,491      $ 16,728      $ 64,229      $ (75,439   $ 42,510      $ 35,427   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Fair values shown represent the Company’s net exposure to counterparties related to the Company’s OTC derivative products. The table does not include listed derivatives and the effect of any related hedges utilized by the Company. The table also excludes fair values corresponding to other credit exposures, such as those arising from the Company’s lending activities.
(2) Obligor credit ratings are determined by the Company’s Credit Risk Management Department.
(3) Amounts represent the netting of receivable balances with payable balances for the same counterparty across maturity categories. Receivable and payable balances with the same counterparty in the same maturity category are netted within such maturity category, where appropriate. Cash collateral received is netted on a counterparty basis, provided legal right of offset exists.

OTC Derivative Products—Financial Instruments Owned at December 31, 2010(1)

 

    Years to Maturity     Cross-Maturity
and
Cash Collateral
Netting(3)
    Net Exposure
Post-Cash
Collateral
    Net Exposure
Post-Collateral
 

Credit Rating(2)

  Less
than 1
    1 - 3     3 - 5     Over 5        
    (dollars in millions)  

AAA

  $ 802      $ 2,005      $ 1,242      $ 8,823      $ (5,906   $ 6,966      $ 6,683   

AA

    6,601        6,760        5,589        17,844        (27,801     8,993        7,877   

A

    8,655        8,710        6,507        26,492        (36,397     13,967        12,383   

BBB

    2,982        4,109        2,124        7,347        (9,034     7,528        6,001   

Non-investment grade

    2,628        3,231        1,779        4,456        (4,355     7,739        5,348   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 21,668      $ 24,815      $ 17,241      $ 64,962      $ (83,493   $ 45,193      $ 38,292   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

(1) Fair values shown represent the Company’s net exposure to counterparties related to the Company’s OTC derivative products. The table does not include listed derivatives and the effect of any related hedges utilized by the Company. The table also excludes fair values corresponding to other credit exposures, such as those arising from the Company’s lending activities.
(2) Obligor credit ratings are determined by the Company’s Credit Risk Management Department.
(3) Amounts represent the netting of receivable balances with payable balances for the same counterparty across maturity categories. Receivable and payable balances with the same counterparty in the same maturity category are netted within such maturity category, where appropriate. Cash collateral received is netted on a counterparty basis, provided legal right of offset exists.

Hedge Accounting.

The Company applies hedge accounting using various derivative financial instruments to hedge interest rate and foreign exchange risk arising from assets and liabilities not held at fair value as part of asset and liability management and foreign currency exposure management.

The Company’s hedges are designated and qualify for accounting purposes as one of the following types of hedges: hedges of exposure to changes in fair value of assets and liabilities being hedged (fair value hedges) and hedges of net investments in foreign operations whose functional currency is different from the reporting currency of the parent company (net investment hedges).

For all hedges where hedge accounting is being applied, effectiveness testing and other procedures to ensure the ongoing validity of the hedges are performed at least monthly.

Fair Value Hedges—Interest Rate Risk.    The Company’s designated fair value hedges consisted primarily of interest rate swaps designated as fair value hedges of changes in the benchmark interest rate of fixed rate senior long-term borrowings. The Company uses regression analysis to perform an ongoing prospective and retrospective assessment of the effectiveness of these hedging relationships (i.e., the Company applies the “long-haul” method of hedge accounting). A hedging relationship is deemed effective if the fair values of the hedging instrument (derivative) and the hedged item (debt liability) change inversely within a range of 80% to 125%. The Company considers the impact of valuation adjustments related to the Company’s own credit spreads and counterparty credit spreads to determine whether they would cause the hedging relationship to be ineffective.

For qualifying fair value hedges of benchmark interest rates, the changes in the fair value of the derivative and the changes in the fair value of the hedged liability provide offset of one another and, together with any resulting ineffectiveness, are recorded in Interest expense. When a derivative is de-designated as a hedge, any basis adjustment remaining on the hedged liability is amortized to Interest expense over the remaining life of the liability using the effective interest method.

Net Investment Hedges.    The Company may utilize forward foreign exchange contracts to manage the currency exposure relating to its net investments in non-U.S. dollar functional currency operations. No hedge ineffectiveness is recognized in earnings since the notional amounts of the hedging instruments equal the portion of the investments being hedged and the currencies being exchanged are the functional currencies of the parent and investee. The gain or loss from revaluing hedges of net investments in foreign operations at the spot rate is deferred and reported within Accumulated other comprehensive income (loss) in Total Equity, net of tax effects. The forward points on the hedging instruments are recorded in Interest income.

 

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Table of Contents

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following tables summarize the fair value of derivative instruments designated as accounting hedges and the fair value of derivative instruments not designated as accounting hedges by type of derivative contract on a gross basis. Fair values of derivative contracts in an asset position are included in Financial instruments owned—Derivative and other contracts. Fair values of derivative contracts in a liability position are reflected in Financial instruments sold, not yet purchased—Derivative and other contracts.

 

     Assets at
June 30, 2011
     Liabilities at
June 30, 2011
 
     Fair Value     Notional      Fair Value     Notional  
     (dollars in millions)  

Derivatives designated as accounting hedges:

         

Interest rate contracts

   $ 5,428      $ 75,854       $ 102      $ 6,557   

Foreign exchange contracts

     45        4,384         308        15,380   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives designated as accounting hedges

     5,473        80,238         410        21,937   
  

 

 

   

 

 

    

 

 

   

 

 

 

Derivatives not designated as accounting hedges(1):

         

Interest rate contracts

     579,565        22,275,274         557,291        22,708,028   

Credit contracts

     112,286        2,978,200         101,738        2,764,644   

Foreign exchange contracts

     56,428        1,859,885         57,440        1,876,327   

Equity contracts

     41,979        681,867         48,118        698,855   

Commodity contracts

     49,869        438,036         51,029        420,623   

Other

     545        15,609         1,321        29,134   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives not designated as accounting hedges

     840,672        28,248,871         816,937        28,497,611   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives

   $ 846,145      $ 28,329,109       $ 817,347      $ 28,519,548   

Cash collateral netting

     (53,779     —           (30,035     —     

Counterparty netting

     (746,199     —           (746,199     —     
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives

   $ 46,167      $ 28,329,109       $ 41,113      $ 28,519,548   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(1) Notional amounts include net notionals related to long and short futures contracts of $88 billion and $71 billion, respectively. The variation margin on these futures contracts (excluded from the table above) of $293 million and $23 million is included in Receivables—Brokers, dealers and clearing organizations and Payables—Brokers, dealers and clearing organizations, respectively, on the condensed consolidated statements of financial condition.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     Assets at
December 31, 2010
     Liabilities at
December 31, 2010
 
     Fair Value     Notional      Fair Value     Notional  
     (dollars in millions)  

Derivatives designated as accounting hedges:

         

Interest rate contracts

   $ 5,250      $ 68,212       $ 177      $ 7,989   

Foreign exchange contracts

     64        5,119         420        14,408   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives designated as accounting hedges

     5,314        73,331         597        22,397   
  

 

 

   

 

 

    

 

 

   

 

 

 

Derivatives not designated as accounting hedges(1):

         

Interest rate contracts

     615,717        16,305,214         595,626        16,267,730   

Credit contracts

     110,134        2,398,676         95,626        2,239,211   

Foreign exchange contracts

     61,924        1,418,488         64,268        1,431,651   

Equity contracts

     39,846        571,767         46,160        568,399   

Commodity contracts

     64,152        420,534         65,728        414,535   

Other

     243        6,635         1,568        16,910   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives not designated as accounting hedges

     892,016        21,121,314         868,976        20,938,436   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives

   $ 897,330      $ 21,194,645       $ 869,573      $ 20,960,833   

Cash collateral netting

     (61,856     —           (37,589     —     

Counterparty netting

     (784,182     —           (784,182     —     
  

 

 

   

 

 

    

 

 

   

 

 

 

Total derivatives

   $ 51,292      $ 21,194,645       $ 47,802      $ 20,960,833   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(1) Notional amounts include net notionals related to long and short futures contracts of $71 billion and $76 billion, respectively. The variation margin on these futures contracts (excluded from the table above) of $387 million and $1 million is included in Receivables—Brokers, dealers and clearing organizations and Payables—Brokers, dealers and clearing organizations, respectively, on the condensed consolidated statements of financial condition.

The following tables summarize the gains or losses reported on derivative instruments designated and qualifying as accounting hedges for the quarters and six months ended June 30, 2011 and 2010, respectively.

Derivatives Designated as Fair Value Hedges.

The following table presents gains (losses) reported on derivative instruments and the related hedge item as well as the hedge ineffectiveness included in Interest expense in the condensed consolidated statements of income from interest rate contracts:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 

Product Type

   2011     2010     2011      2010  
     (dollars in millions)  

Gain recognized on derivatives

   $ 1,165      $ 1,732      $ 70       $ 2,453   

Gain (loss) recognized on borrowings

     (1,013     (1,579     245         (2,145
  

 

 

   

 

 

   

 

 

    

 

 

 

Total

   $ 152      $ 153      $ 315       $ 308   
  

 

 

   

 

 

   

 

 

    

 

 

 

 

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Table of Contents

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Derivatives Designated as Net Investment Hedges.

 

     Gains (Losses) Recognized in OCI (effective portion)  
     Three Months Ended
June 30,
     Six Months Ended
June  30,
 

Product Type

       2011             2010              2011             2010      
     (dollars in millions)  

Foreign exchange contracts(1)

   $ (157   $ 152       $ (283   $ 372   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

   $ (157   $ 152       $ (283   $ 372   
  

 

 

   

 

 

    

 

 

   

 

 

 

 

(1) Losses of $62 million and $109 million were recognized in income related to amounts excluded from hedge effectiveness testing during the quarter and six months ended June 30, 2011, respectively. Losses of $33 million and $69 million were recognized in income related to amounts excluded from hedge effectiveness testing during the quarter and six months ended June 30, 2010, respectively.

The table below summarizes gains (losses) on derivative instruments not designated as accounting hedges for the quarters and six months ended June 30, 2011 and 2010, respectively:

 

     Gains (Losses) Recognized in
Income(1)(2)
 
         Three Months Ended    
June 30,
    Six Months Ended
June 30,
 

Product Type

       2011             2010             2011             2010      
     (dollars in millions)  

Interest rate contracts

   $ 4,410      $ 381      $ 5,281      $ 997   

Credit contracts

     1,551        1,240        753        574   

Foreign exchange contracts

     (3,329     283        (3,584     193   

Equity contracts

     38        3,307        (942     2,829   

Commodity contracts

     721        630        449        1,181   

Other contracts

     (14     (466     222        (521
  

 

 

   

 

 

   

 

 

   

 

 

 

Total derivative instruments

   $ 3,377      $ 5,375      $ 2,179      $ 5,253   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Gains (losses) on derivative contracts not designated as hedges are primarily included in Principal transactions—Trading.
(2) Gains (losses) associated with derivative contracts that have physically settled are excluded from the table above. Gains (losses) on these contracts are reflected with the associated cash instruments, which are also included in Principal transactions—Trading.

The Company also has certain embedded derivatives that have been bifurcated from the related structured borrowings. Such derivatives are classified in Long-term borrowings and had a net fair value of $98 million and $109 million at June 30, 2011 and December 31, 2010, respectively, and a notional of $4,085 million and $4,256 million at June 30, 2011 and December 31, 2010, respectively. The Company recognized gains of $21 million and $2 million related to changes in the fair value of its bifurcated embedded derivatives for the quarter and six months ended June 30, 2011, respectively. The Company recognized gains of $27 million and $40 million related to changes in the fair value of its bifurcated embedded derivatives for the quarter and six months ended June 30, 2010, respectively.

At June 30, 2011 and December 31, 2010, the amount of payables associated with cash collateral received that was netted against derivative assets was $53.8 billion and $61.9 billion, respectively, and the amount of receivables in respect of cash collateral paid that was netted against derivative liabilities was $30.0 billion and $37.6 billion, respectively. Cash collateral receivables and payables of $413 million and $114 million, respectively, at June 30, 2011 and $435 million and $37 million, respectively, at December 31, 2010, were not offset against certain contracts that did not meet the definition of a derivative.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Credit-Risk-Related Contingencies.

In connection with certain OTC trading agreements, the Company may be required to provide additional collateral or immediately settle any outstanding liability balances with certain counterparties in the event of a credit ratings downgrade. At June 30, 2011 and December 31, 2010, the aggregate fair value of derivative contracts that contain credit-risk-related contingent features that are in a net liability position totaled $29,003 million and $32,567 million, respectively, for which the Company has posted collateral of $22,813 million and $26,904 million, respectively, in the normal course of business. At June 30, 2011 and December 31, 2010, the amount of additional collateral or termination payments that could be called by counterparties under the terms of such agreements in the event of a one-notch downgrade of the Company’s long-term credit rating was approximately $600 million and $873 million, respectively. Additional collateral or termination payments of approximately $1,393 million and $1,537 million could be called by counterparties in the event of a two-notch downgrade at June 30, 2011 and December 31, 2010, respectively. Of these amounts, $1,419 million and $1,766 million at June 30, 2011 and December 31, 2010, respectively, related to bilateral arrangements between the Company and other parties where upon the downgrade of one party, the downgraded party must deliver incremental collateral to the other party. These bilateral downgrade arrangements are a risk management tool used extensively by the Company as credit exposures are reduced if counterparties are downgraded.

Credit Derivatives and Other Credit Contracts.

The Company enters into credit derivatives, principally through credit default swaps, under which it receives or provides protection against the risk of default on a set of debt obligations issued by a specified reference entity or entities. A majority of the Company’s counterparties are banks, broker-dealers, insurance and other financial institutions, and monoline insurers.

The tables below summarize the notional and fair value of protection sold and protection purchased through credit default swaps at June 30, 2011 and December 31, 2010:

 

     At June 30, 2011  
     Maximum Potential Payout/Notional  
     Protection Sold      Protection Purchased  
     Notional      Fair Value
(Asset)/Liability
     Notional      Fair Value
(Asset)/Liability
 
     (dollars in millions)  

Single name credit default swaps

   $ 1,436,109       $ 9,117       $ 1,418,219       $ (13,149

Index and basket credit default swaps

     1,079,299         9,178         871,907         (6,263

Tranched index and basket credit default swaps

     345,218         5,071         592,092         (14,502
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,860,626       $ 23,366       $ 2,882,218       $ (33,914
  

 

 

    

 

 

    

 

 

    

 

 

 

 

     At December 31, 2010  
     Maximum Potential Payout/Notional  
     Protection Sold      Protection Purchased  
     Notional      Fair Value
(Asset)/Liability
     Notional      Fair Value
(Asset)/Liability
 
     (dollars in millions)  

Single name credit default swaps

   $ 1,329,150       $ 10,681       $ 1,316,610       $ (18,481

Index and basket credit default swaps

     683,593         10,380         500,781         (6,764

Tranched index and basket credit default swaps

     281,508         4,171         526,245         (14,496
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 2,294,251       $ 25,232       $ 2,343,636       $ (39,741
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The table below summarizes the credit ratings and maturities of protection sold through credit default swaps and other credit contracts at June 30, 2011:

 

    Protection Sold  
    Maximum Potential Payout/Notional     Fair Value
(Asset)/
Liability(1)(2)
 
    Years to Maturity    

Credit Ratings of the Reference Obligation

  Less than 1     1-3     3-5     Over 5     Total    
    (dollars in millions)  

Single name credit default swaps:

           

AAA

  $ 1,075      $ 5,545      $ 14,478      $ 14,145      $ 35,243      $ 39   

AA

    11,311        34,590        32,304        33,033        111,238        2,320   

A

    52,328        146,630        71,601        47,812        318,371        (2,147

BBB

    107,487        257,970        126,778        95,095        587,330        (3,552

Non-investment grade

    85,074        157,045        77,972        63,836        383,927        12,457   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    257,275        601,780        323,133        253,921        1,436,109        9,117   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Index and basket credit default swaps(3):

           

AAA

    14,551        75,588        31,969        26,337        148,445        (1,331

AA

    1,376        16,966        13,369        14,794        46,505        54   

A

    2,716        19,436        55,561        16,670        94,383        241   

BBB

    10,028        164,816        295,689        49,603        520,136        (2,329

Non-investment grade

    132,446        202,300        120,248        160,054        615,048        17,614   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    161,117        479,106        516,836        267,458        1,424,517        14,249   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total credit default swaps sold

  $ 418,392      $ 1,080,886      $ 839,969      $ 521,379      $ 2,860,626      $ 23,366   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other credit contracts(4)(5)

  $ 808      $ 1,534      $ 684      $ 3,157      $ 6,183      $ (136
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total credit derivatives and other credit contracts

  $ 419,200      $ 1,082,420      $ 840,653      $ 524,536      $ 2,866,809      $ 23,230   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Fair value amounts are shown on a gross basis prior to cash collateral or counterparty netting.
(2) Fair value amounts of certain credit default swaps where the Company sold protection have an asset carrying value because credit spreads of the underlying reference entity or entities tightened during the terms of the contracts.
(3) Credit ratings are calculated internally.
(4) Other credit contracts include CLNs, CDOs and credit default swaps that are considered hybrid instruments.
(5) Fair value amount shown represents the fair value of the hybrid instruments.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The table below summarizes the credit ratings and maturities of protection sold through credit default swaps and other credit contracts at December 31, 2010:

 

    Protection Sold  
    Maximum Potential Payout/Notional     Fair Value
(Asset)/
Liability(1)(2)
 
    Years to Maturity    

Credit Ratings of the Reference Obligation

  Less than 1     1-3     3-5     Over 5     Total    
    (dollars in millions)  

Single name credit default swaps:

           

AAA

  $ 2,747      $ 7,232      $ 13,927      $ 22,648      $ 46,554      $ 3,193   

AA

    13,364        44,700        35,030        33,538        126,632        4,260   

A

    47,756        131,464        79,900        50,227        309,347        (940

BBB

    74,961        191,046        115,460        76,544        458,011        (2,816

Non-investment grade

    70,691        173,778        84,605        59,532        388,606        6,984   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    209,519        548,220        328,922        242,489        1,329,150        10,681   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Index and basket credit default swaps(3):

           

AAA

    17,437        67,165        26,172        26,966        137,740        (1,569

AA

    974        3,012        695        18,236        22,917        305   

A

    447        9,432        44,104        4,902        58,885        2,291   

BBB

    24,311        80,314        176,252        69,218        350,095        (278

Non-investment grade

    53,771        139,875        95,796        106,022        395,464        13,802   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    96,940        299,798        343,019        225,344        965,101        14,551   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total credit default swaps sold

  $ 306,459      $ 848,018      $ 671,941      $ 467,833      $ 2,294,251      $ 25,232   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Other credit contracts(4)(5)

  $ 61      $ 1,416      $ 822      $ 3,856      $ 6,155      $ (1,198
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total credit derivatives and other credit contracts

  $ 306,520      $ 849,434      $ 672,763      $ 471,689      $ 2,300,406      $ 24,034   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Fair value amounts are shown on a gross basis prior to cash collateral or counterparty netting.
(2) Fair value amounts of certain credit default swaps where the Company sold protection have an asset carrying value because credit spreads of the underlying reference entity or entities tightened during the terms of the contracts.
(3) Credit ratings are calculated internally.
(4) Other credit contracts include CLNs, CDOs and credit default swaps that are considered hybrid instruments.
(5) Fair value amount shown represents the fair value of the hybrid instruments.

Single Name Credit Default Swaps.    A credit default swap protects the buyer against the loss of principal on a bond or loan in case of a default by the issuer. The protection buyer pays a periodic premium (generally quarterly) over the life of the contract and is protected for the period. The Company in turn will have to perform under a credit default swap if a credit event as defined under the contract occurs. Typical credit events include bankruptcy, dissolution or insolvency of the referenced entity, failure to pay and restructuring of the obligations of the referenced entity. In order to provide an indication of the current payment status or performance risk of the credit default swaps, the external credit ratings of the underlying reference entity of the credit default swaps are disclosed.

Index and Basket Credit Default Swaps.    Index and basket credit default swaps are credit default swaps that reference multiple names through underlying baskets or portfolios of single name credit default swaps. Generally, in the event of a default on one of the underlying names, the Company will have to pay a pro rata portion of the total notional amount of the credit default index or basket contract. In order to provide an indication of the current payment status or performance risk of these credit default swaps, the weighted average external credit ratings of the underlying reference entities comprising the basket or index were calculated and disclosed.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The Company also enters into index and basket credit default swaps where the credit protection provided is based upon the application of tranching techniques. In tranched transactions, the credit risk of an index or basket is separated into various portions of the capital structure, with different levels of subordination. The most junior tranches cover initial defaults, and once losses exceed the notional of the tranche, they are passed on to the next most senior tranche in the capital structure.

When external credit ratings are not available, credit ratings were determined based upon an internal methodology.

Credit Protection Sold through CLNs and CDOs.    The Company has invested in CLNs and CDOs, which are hybrid instruments containing embedded derivatives, in which credit protection has been sold to the issuer of the note. If there is a credit event of a reference entity underlying the instrument, the principal balance of the note may not be repaid in full to the Company.

Purchased Credit Protection with Identical Underlying Reference Obligations.    For single name credit default swaps and non-tranched index and basket credit default swaps, the Company has purchased protection with a notional amount of approximately $2.3 trillion and $1.8 trillion at June 30, 2011 and December 31, 2010, compared with a notional amount of approximately $2.5 trillion and $2.0 trillion, at June 30, 2011 and December 31, 2010, respectively, of credit protection sold with identical underlying reference obligations. In order to identify purchased protection with the same underlying reference obligations, the notional amount for individual reference obligations within non-tranched indices and baskets was determined on a pro rata basis and matched off against single name and non-tranched index and basket credit default swaps where credit protection was sold with identical underlying reference obligations.

The purchase of credit protection does not represent the sole manner in which the Company risk manages its exposure to credit derivatives. The Company manages its exposure to these derivative contracts through a variety of risk mitigation strategies, which include managing the credit and correlation risk across single name, non-tranched indices and baskets, tranched indices and baskets, and cash positions. Aggregate market risk limits have been established for credit derivatives, and market risk measures are routinely monitored against these limits. The Company may also recover amounts on the underlying reference obligation delivered to the Company under credit default swaps where credit protection was sold.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

11. Commitments, Guarantees and Contingencies.

Commitments.

The Company’s commitments associated with outstanding letters of credit and other financial guarantees obtained to satisfy collateral requirements, investment activities, corporate lending and financing arrangements, mortgage lending and margin lending at June 30, 2011 are summarized below by period of expiration. Since commitments associated with these instruments may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

 

     Years to Maturity      Total at
June 30, 2011
 
     Less
than 1
     1-3      3-5      Over 5     
     (dollars in millions)  

Letters of credit and other financial guarantees obtained to satisfy collateral requirements

   $ 1,220       $ 2       $ 11       $ —         $ 1,233   

Investment activities

     1,255         359         87         262         1,963   

Primary lending commitments—investment grade(1)

     14,074         20,494         18,138         508         53,214   

Primary lending commitments—non-investment grade

     3,023         4,545         7,824         3,121         18,513   

Secondary lending commitments(2)

     53         250         56         130         489   

Commitments for secured lending transactions

     278         322         231         —           831   

Forward starting reverse repurchase agreements(3)

     69,474         —           —           —           69,474   

Commercial and residential mortgage-related commitments

     583         14         103         588         1,288   

Underwriting commitments

     76         —           —           —           76   

Other commitments

     235         212         2         —           449   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 90,271       $ 26,198       $ 26,452       $ 4,609       $ 147,530   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) This amount includes commitments to asset-backed commercial paper conduits of $275 million at June 30, 2011, of which $138 million have maturities of less than one year and $137 million of which have maturities of one to three years.
(2) These commitments are recorded at fair value within Financial instruments owned and Financial instruments sold, not yet purchased in the condensed consolidated statements of financial condition (see Note 3).
(3) The Company enters into forward starting securities purchased under agreements to resell (agreements that have a trade date at or prior to June 30, 2011 and settle subsequent to period-end) that are primarily secured by collateral from U.S. government agency securities and other sovereign government obligations. These agreements primarily settle within three business days and at June 30, 2011, $67.5 billion settled within three business days.

For further description of these commitments, refer to Note 13 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.

The Company sponsors several non-consolidated investment funds for third-party investors where the Company typically acts as general partner of, and investment advisor to, these funds and typically commits to invest a minority of the capital of such funds, with subscribing third-party investors contributing the majority. The Company’s employees, including its senior officers, as well as the Company’s directors, may participate on the same terms and conditions as other investors in certain of these funds that the Company forms primarily for client investment, except that the Company may waive or lower applicable fees and charges for its employees. The Company has contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to these investment funds.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Guarantees.

The table below summarizes certain information regarding the Company’s obligations under guarantee arrangements at June 30, 2011:

 

    Maximum Potential Payout/Notional     Carrying
Amount
(Asset)/
Liability
   

Collateral/
Recourse

 
    Years to Maturity     Total      

Type of Guarantee

  Less than 1     1-3     3-5     Over 5        
    (dollars in millions)  

Credit derivative contracts(1)

  $ 418,392      $ 1,080,886      $ 839,969      $ 521,379      $ 2,860,626      $ 23,366      $ —     

Other credit contracts

    808        1,534        684        3,157        6,183        (136     —     

Non-credit derivative contracts(1)

    1,286,082        941,485        371,512        330,187        2,929,266        76,136        —     

Standby letters of credit and other financial guarantees issued(2)(3)

    7,247        1,588        567        5,648        15,050        (58     12,081   

Market value guarantees

    —          —          159        669        828        16        91   

Liquidity facilities

    4,570        504        758        71        5,903        —          6,806   

Whole loan sales representations and warranties

    —          —          —          24,674        24,674        49        —     

Securitization representations and warranties

    —          —          —          87,948        87,948        25        —     

General partner guarantees

    208        1        56        283        548        72        —     

 

(1) Carrying amount of derivative contracts are shown on a gross basis prior to cash collateral or counterparty netting. For further information on derivative contracts, see Note 10.
(2) Approximately $2.3 billion of standby letters of credit are also reflected in the “Commitments” table in primary and secondary lending commitments. Standby letters of credit are recorded at fair value within Financial instruments owned or Financial instruments sold, not yet purchased in the condensed consolidated statements of financial condition.
(3) Amounts include guarantees issued by consolidated real estate funds sponsored by the Company of approximately $362 million. These guarantees relate to obligations of the fund’s investee entities, including guarantees related to capital expenditures and principal and interest debt payments. Accrued losses under these guarantees of approximately $82 million are reflected as a reduction of the carrying value of the related fund investments, which are reflected in Financial instruments owned—Investments on the condensed consolidated statement of financial condition.

For further description of these guarantees, refer to Note 13 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.

The Company has obligations under certain guarantee arrangements, including contracts and indemnification agreements that contingently require a guarantor to make payments to the guaranteed party based on changes in an underlying measure (such as an interest or foreign exchange rate, security or commodity price, an index or the occurrence or non-occurrence of a specified event) related to an asset, liability or equity security of a guaranteed party. Also included as guarantees are contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity’s failure to perform under an agreement, as well as indirect guarantees of the indebtedness of others.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Other Guarantees and Indemnities.

In the normal course of business, the Company provides guarantees and indemnifications in a variety of commercial transactions. These provisions generally are standard contractual terms. Certain of these guarantees and indemnifications are described below.

 

   

Trust Preferred Securities.    The Company has established Morgan Stanley Capital Trusts for the limited purpose of issuing trust preferred securities to third parties and lending the proceeds to the Company in exchange for junior subordinated debentures. The Company has directly guaranteed the repayment of the trust preferred securities to the holders thereof to the extent that the Company has made payments to a Morgan Stanley Capital Trust on the junior subordinated debentures. In the event that the Company does not make payments to a Morgan Stanley Capital Trust, holders of such series of trust preferred securities would not be able to rely upon the guarantee for payment of those amounts. The Company has not recorded any liability in the condensed consolidated financial statements for these guarantees and believes that the occurrence of any events (i.e., non-performance on the part of the paying agent) that would trigger payments under these contracts is remote. See Note 15 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K for details on the Company’s junior subordinated debentures.

 

   

Indemnities.    The Company provides standard indemnities to counterparties for certain contingent exposures and taxes, including U.S. and foreign withholding taxes, on interest and other payments made on derivatives, securities and stock lending transactions, certain annuity products and other financial arrangements. These indemnity payments could be required based on a change in the tax laws or change in interpretation of applicable tax rulings or a change in factual circumstances. Certain contracts contain provisions that enable the Company to terminate the agreement upon the occurrence of such events. The maximum potential amount of future payments that the Company could be required to make under these indemnifications cannot be estimated.

 

   

Exchange/Clearinghouse Member Guarantees.    The Company is a member of various U.S. and non-U.S. exchanges and clearinghouses that trade and clear securities and/or derivative contracts. Associated with its membership, the Company may be required to pay a proportionate share of the financial obligations of another member who may default on its obligations to the exchange or the clearinghouse. While the rules governing different exchange or clearinghouse memberships vary, in general the Company’s guarantee obligations would arise only if the exchange or clearinghouse had previously exhausted its resources. The maximum potential payout under these membership agreements cannot be estimated. The Company has not recorded any contingent liability in the condensed consolidated financial statements for these agreements and believes that any potential requirement to make payments under these agreements is remote.

 

   

Merger and Acquisition Guarantees.    The Company may, from time to time, in its role as investment banking advisor be required to provide guarantees in connection with certain European merger and acquisition transactions. If required by the regulating authorities, the Company provides a guarantee that the acquirer in the merger and acquisition transaction has or will have sufficient funds to complete the transaction and would then be required to make the acquisition payments in the event the acquirer’s funds are insufficient at the completion date of the transaction. These arrangements generally cover the time frame from the transaction offer date to its closing date and, therefore, are generally short term in nature. The maximum potential amount of future payments that the Company could be required to make cannot be estimated. The Company believes the likelihood of any payment by the Company under these arrangements is remote given the level of the Company’s due diligence associated with its role as investment banking advisor.

 

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Guarantees on Morgan Stanley Stable Value Program.    On September 30, 2009, the Company entered into an agreement with the investment manager for the Stable Value Program (“SVP”), a fund within the Company’s 401(k) plan, and certain other third parties. Under the agreement, the Company contributed $20 million to the SVP on October 15, 2009 and recorded the contribution in Compensation and benefits expense. Additionally, the Company may have a future obligation to make a payment of $40 million to the SVP following the third anniversary of the agreement, after which the SVP would be wound down over a period of time. The future obligation is contingent upon whether the market-to-book value ratio of the portion of the SVP that is subject to certain book-value stabilizing contracts has fallen below a specific threshold and the Company and the other parties to the agreement all decline to make payments to restore the SVP to such threshold as of the third anniversary of the agreement. The Company has not recorded a liability for this guarantee in the condensed consolidated financial statements.

In the ordinary course of business, the Company guarantees the debt and/or certain trading obligations (including obligations associated with derivatives, foreign exchange contracts and the settlement of physical commodities) of certain subsidiaries. These guarantees generally are entity or product specific and are required by investors or trading counterparties. The activities of the subsidiaries covered by these guarantees (including any related debt or trading obligations) are included in the Company’s condensed consolidated financial statements.

Contingencies.

Legal.    In the normal course of business, the Company has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities as a global diversified financial services institution. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or are in financial distress. These actions have included, but are not limited to, residential mortgage and credit crisis related matters and a Foreign Corrupt Practices Act related matter in China. Recently, the level of litigation activity focused on residential mortgage and credit crisis related matters has increased materially in the financial services industry. As a result, the Company expects that it may become the subject of increased claims for damages and other relief regarding residential mortgages and related securities in the future and, while the Company has identified below any individual proceedings where the Company believes a material loss to be reasonably possible and reasonably estimable, there can be no assurance that material losses will not be incurred from claims that have not yet been notified to the Company or are not yet determined to be probable or possible and reasonably estimable losses.

The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding the Company’s business, including, among other matters, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief.

The Company contests liability and/or the amount of damages as appropriate in each pending matter. Where available information indicates that it is probable a liability had been incurred at the date of the condensed consolidated financial statements and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is not always possible to reasonably estimate the size of the possible loss or range of loss.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

For certain legal proceedings, the Company cannot reasonably estimate such losses, particularly for proceedings that are in their early stages of development or where plaintiffs seek substantial or indeterminate damages. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, determination of issues related to class certification and the calculation of damages, and by addressing novel or unsettled legal questions relevant to the proceedings in question, before a loss or additional loss or range of loss or additional loss can be reasonably estimated for any proceeding.

For certain other legal proceedings, the Company can estimate reasonably possible losses, additional losses, ranges of loss or ranges of additional loss in excess of amounts accrued, but does not believe, based on current knowledge and after consultation with counsel, that such losses will have a material adverse effect on the Company’s condensed consolidated financial statements as a whole, other than the matters referred to in the next three paragraphs.

On September 25, 2009, the Company was named as a defendant in a lawsuit styled Citibank, N.A. v. Morgan Stanley & Co. International, PLC, which is pending in the United States District Court for the Southern District of New York (“SDNY”). The lawsuit relates to a credit default swap referencing the Capmark VI CDO (“Capmark”), which was structured by Citibank, N.A. (“Citi N.A.”). At issue is whether, as part of the swap agreement, Citi N.A. was obligated to obtain the Company’s prior written consent before it exercised a right to liquidate Capmark upon the occurrence of certain contractually-defined credit events. Citi N.A. is seeking approximately $245 million in compensatory damages plus interest and costs. On May 12, 2010, the court granted Citi N.A.’s motion for judgment on the pleadings on its claim for breach of contract. On October 8, 2010, the court issued an order denying Citi N.A.’s motion for judgment on the pleadings as to the Company’s counterclaim for reformation and granting Citi N.A.’s motion for judgment on the pleadings as to the Company’s counterclaim for estoppel. On May 25, 2011, the court denied the Company’s motion for summary judgment and granted Citi N.A.’s cross motion for summary judgment. On June 27, 2011, the court entered a judgment in favor of Citi N.A. for $269 million plus post-judgment interest and the Company filed a notice of appeal to the United States Court of Appeals for the Second Circuit. Based on currently available information, the Company believes it could incur a loss of up to approximately $269 million plus post-judgment interest.

On August 25, 2008, the Company and two ratings agencies were named as defendants in a purported class action related to securities issued by a structured investment vehicle called Cheyne Finance (the “Cheyne SIV”). The case is styled Abu Dhabi Commercial Bank, et al. v. Morgan Stanley & Co. Inc., et al. and is pending in the SDNY. The complaint alleges, among other things, that the ratings assigned to the securities issued by the Cheyne SIV were false and misleading because the ratings did not accurately reflect the risks associated with the subprime residential mortgage backed securities held by the Cheyne SIV. On September 2, 2009, the court dismissed all of the claims against the Company except for plaintiffs’ claims for common law fraud. On June 15, 2010, the court denied plaintiffs’ motion for class certification. On July 20, 2010, the court granted plaintiffs leave to replead their aiding and abetting common law fraud claims against the Company, and those claims were added in an amended complaint filed on August 5, 2010. Since the filing of the initial complaint, various additional plaintiffs have been added to the case. The deadline for new plaintiffs to join the case expired on March 11, 2011. There are currently 15 plaintiffs asserting individual claims related to approximately $983 million of securities issued by the Cheyne SIV. Plaintiffs have not provided information quantifying the amount of compensatory damages they are seeking and are also seeking unspecified punitive damages. Based on currently available information, the Company believes that the defendants could incur a loss up to the amount of plaintiffs’ claimed compensatory damages, once specified, related to their alleged purchase of approximately $983 million of securities issued by the Cheyne SIV plus pre- and post-judgment interest, fees and costs.

On July 15, 2010, China Development Industrial Bank (“CDIB”) filed a complaint against the Company, which is styled China Development Industrial Bank v. Morgan Stanley & Co. Incorporated et al. and is pending in the

 

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Supreme Court of the State of New York, New York County. The complaint relates to a $275 million credit default swap referencing the super senior portion of the STACK 2006-1 CDO. The complaint asserts claims for common law fraud, fraudulent inducement and fraudulent concealment and alleges that the Company misrepresented the risks of the STACK 2006-1 CDO to CDIB, and that the Company knew that the assets backing the CDO were of poor quality when it entered into the credit default swap with CDIB. The complaint seeks compensatory damages related to the approximately $228 million that CDIB alleges it has already lost under the credit default swap, rescission of CDIB’s obligation to pay an additional $12 million, punitive damages, equitable relief, fees and costs. On February 28, 2011, the court presiding over this action denied the Company’s motion to dismiss the complaint. On March 21, 2011, the Company appealed the order denying its motion to dismiss the complaint. On July 7, 2011, the appellate court affirmed the lower court’s decision denying the motion to dismiss. Based on currently available information, the Company believes it could incur a loss of up to approximately $240 million plus pre- and post-judgment interest, fees and costs.

On December 6, 2010, MBIA Insurance Corporation (“MBIA”) filed a complaint against the Company related to MBIA’s contract to insure approximately $223 million of residential mortgage backed securities related to a second lien residential mortgage backed securitization sponsored by the Company in June 2007. The complaint is styled MBIA Insurance Corporation v. Morgan Stanley, et al. and is pending in New York Supreme Court, Westchester County. The complaint asserts claims for fraud, breach of contract and unjust enrichment and alleges, among other things, that the Company misled MBIA regarding the quality of the loans contained in the securitization, that loans contained in the securitization breached various representations and warranties and that the loans have been serviced inadequately. The complaint seeks, among other relief, compensatory and punitive damages, an order requiring the Company to comply with the loan breach remedy procedures in the transaction documents and/or to indemnify MBIA for losses resulting from the Company’s alleged breach of the transaction documents, as well as costs, interests and fees. On May 26, 2011, the court presiding over this case partially denied the Company’s motion to dismiss the complaint. On June 28, 2011, the Company filed a notice appealing that decision to the Appellate Division of the New York Supreme Court, First Department. Based on currently available information, the Company believes it could incur a loss of up to approximately $223 million plus pre- and post-judgment interest, fees and costs.

 

12. Regulatory Requirements.

Morgan Stanley.    The Company is a financial holding company under the Bank Holding Company Act of 1956 and is subject to the regulation and oversight of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Federal Reserve establishes capital requirements for the Company, including well-capitalized standards, and evaluates the Company’s compliance with such capital requirements. The Office of the Comptroller of the Currency establishes similar capital requirements and standards for the Company’s national bank subsidiaries.

The Company calculates its capital ratios and Risk Weighted Assets (“RWA”) in accordance with the capital adequacy standards for financial holding companies adopted by the Federal Reserve. These standards are based upon a framework described in the “International Convergence of Capital Measurement and Capital Standards,” July 1988, as amended, also referred to as Basel I. In December 2007, the U.S. banking regulators published final regulation incorporating the Basel II Accord, which requires internationally active banking organizations, as well as certain of their U.S. bank subsidiaries, to implement Basel II standards over the next several years. The timeline set out in December 2007 for the implementation of Basel II in the U.S. may be impacted by the developments concerning Basel III described below. Starting July 2010, the Company has been reporting on a parallel basis under the current regulatory capital regime (Basel I) and Basel II. During the parallel run period, the Company continues to be subject to Basel I but simultaneously calculates its risks under Basel II. The Company reports the capital ratios under both of these standards to the regulators. There will be at least four

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

quarters of parallel reporting before the Company enters the three-year transitional period to implement Basel II standards. In addition, under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the generally applicable capital standards, which are currently based on Basel I standards, but may themselves change over time, will serve as a permanent floor to minimum capital requirements calculated under the Basel II standard the Company is currently required to implement, as well as future capital standards.

In December 2009, the Basel Committee of Banking Supervision (the “Basel Committee”) released proposals on risk-based capital, leverage and liquidity standards, known as Basel III. The proposal described new standards to raise the quality of capital and strengthen counterparty credit risk capital requirements; introduced a leverage ratio as a supplemental measure to the risk-based ratio and introduced a countercyclical buffer. The Basel III proposals complement an earlier proposal for revisions to the Market Risk Framework that increases capital requirements for securitizations within the Company’s trading book. The Basel Committee published final rules in December 2010, which were ratified at the G-20 Leaders Summit in November 2010. The U.S. regulators will require implementation of Basel III subject to an extended phase-in period. The Basel Committee is also working with the Financial Stability Board to develop additional requirements for systemically important financial institutions, which could include capital surcharges.

At June 30, 2011, the Company was in compliance with Basel I capital requirements with ratios of Tier 1 capital to RWAs of 16.7% and total capital to RWAs of 18.3% (6% and 10% being well-capitalized for regulatory purposes, respectively). In addition, financial holding companies are subject to a Tier 1 leverage ratio as defined by the Federal Reserve. The Company calculated its Tier 1 leverage ratio as Tier 1 capital divided by adjusted average total assets (which reflects adjustments for disallowed goodwill, certain intangible assets, deferred tax assets and financial and non-financial equity investments). The adjusted average total assets are derived using weekly balances for the calendar quarter.

The following table summarizes the capital measures for the Company:

 

     June 30, 2011     December 31, 2010  
     Balance        Ratio         Balance          Ratio    
     (dollars in millions)  

Tier 1 capital

   $ 51,007         16.7   $ 52,880         16.1

Total capital

     55,758         18.3     54,477         16.5

RWAs

     304,759         —          329,560         —     

Adjusted average assets

     848,329         —          802,283         —     

Tier 1 leverage

     —           6.0     —           6.6

Tier 1 capital ratio increased in the six month period due to a decrease of RWAs. Tier 1 leverage decreased in the six month period due to an increase of adjusted average assets and a decrease in Tier 1 capital.

The Company’s Significant U.S. Bank Operating Subsidiaries.    The Company’s domestic bank operating subsidiaries are subject to various regulatory capital requirements as administered by U.S. federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional, discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s U.S. bank operating subsidiaries’ financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company’s U.S. bank operating subsidiaries must meet specific capital guidelines that involve quantitative measures of the Company’s U.S. bank operating subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.

At June 30, 2011, the Company’s U.S. bank operating subsidiaries met all capital adequacy requirements to which they are subject and exceeded all regulatory mandated and targeted minimum regulatory capital requirements to be well-capitalized. There are no conditions or events that management believes have changed the Company’s U.S. bank operating subsidiaries’ category.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The table below sets forth the Company’s significant U.S. bank operating subsidiaries’ capital.

 

     June 30, 2011     December 31, 2010  
       Amount          Ratio         Amount          Ratio    
     (dollars in millions)  

Total capital (to RWAs):

          

Morgan Stanley Bank, N.A.

   $ 9,968         17.7   $ 9,568         18.6

Morgan Stanley Private Bank, National Association

   $ 1,069         40.8   $ 909         37.4

Tier I capital (to RWAs):

          

Morgan Stanley Bank, N.A.

   $ 8,462         15.1   $ 8,065         15.7

Morgan Stanley Private Bank, National Association

   $ 1,067         40.8   $ 909         37.4

Leverage ratio:

          

Morgan Stanley Bank, N.A.

   $ 8,462         12.3   $ 8,069         12.1

Morgan Stanley Private Bank, National Association

   $ 1,067         14.2   $ 909         12.4

Under regulatory capital requirements adopted by the U.S. federal banking agencies, U.S. depository institutions, in order to be considered well-capitalized, must maintain a ratio of total capital to RWAs of 10%, a capital ratio of Tier 1 capital to RWAs of 6%, and a ratio of Tier 1 capital to average book assets (leverage ratio) of 5%. Each U.S. depository institution subsidiary of the Company must be well-capitalized in order for the Company to continue to qualify as a financial holding company and to continue to engage in the broadest range of financial activities permitted to financial holding companies. At June 30, 2011 and December 31, 2010, the Company’s three U.S. depository institutions maintained capital at levels in excess of the universally mandated well-capitalized levels. These subsidiary depository institutions maintain capital at levels sufficiently in excess of the “well-capitalized” requirements to address any additional capital needs and requirements identified by the federal banking regulators.

MS&Co. and Other Broker-Dealers.    MS&Co. is a registered broker-dealer and registered futures commission merchant and, accordingly, is subject to the minimum net capital requirements of the U.S. Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority, Inc. and the U.S. Commodity Futures Trading Commission. MS&Co. has consistently operated with capital in excess of its regulatory capital requirements. MS&Co.’s net capital totaled $6,474 million and $7,463 million at June 30, 2011 and December 31, 2010, respectively, which exceeded the amount required by $5,309 million and $6,355 million, respectively. MS&Co. is required to hold tentative net capital in excess of $1 billion and net capital in excess of $500 million in accordance with the market and credit risk standards of Appendix E of SEC Rule 15c3-1. MS&Co. is also required to notify the SEC in the event that its tentative net capital is less than $5 billion. At June 30, 2011, MS&Co. had tentative net capital in excess of the minimum and the notification requirements.

Morgan Stanley Smith Barney LLC is a registered broker-dealer and registered futures commission merchant and, accordingly, is subject to the minimum net capital requirements of the SEC, the Financial Industry Regulatory Authority, Inc. and the U.S. Commodity Futures Trading Commission. Morgan Stanley Smith Barney LLC has consistently operated with capital in excess of its regulatory capital requirements. Morgan Stanley Smith Barney LLC clears certain customer activity directly and introduces other business to MS&Co. and Citigroup, Inc. MSIP, a London-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Authority, and MSMS, a Tokyo-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Agency. MSIP and MSMS have consistently operated in excess of their respective regulatory capital requirements.

Other Regulated Subsidiaries.    Certain other U.S. and non-U.S. subsidiaries are subject to various securities, commodities and banking regulations, and capital adequacy requirements promulgated by the regulatory and

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

exchange authorities of the countries in which they operate. These subsidiaries have consistently operated in excess of their local capital adequacy requirements.

Morgan Stanley Derivative Products Inc. (“MSDP”), a derivative products subsidiary rated Aa3 by Moody’s and AAA by Standard & Poor’s Ratings Services, a Division of the McGraw-Hill Companies Inc. (“S&P”), maintains certain operating restrictions that have been reviewed by Moody’s and S&P. On December 17, 2010, MSDP was downgraded from an Aa2 rating to an Aa3 rating by Moody’s but maintained its AAA rating by S&P. While MSDP has made substantial effort to address Moody’s comments, MSDP’s counterparty rating remains on review for possible downgrade while Moody’s continues to evaluate MSDP’s capital adequacy. The recent downgrade did not significantly impact the Company’s results of operations or financial condition. MSDP is operated such that creditors of the Company should not expect to have any claims on the assets of MSDP, unless and until the obligations to its own creditors are satisfied in full. Creditors of MSDP should not expect to have any claims on the assets of the Company or any of its affiliates, other than the respective assets of MSDP.

 

13. Total Equity.

Common Equity Offerings.    During the quarters and six months ended June 30, 2011 and 2010, the Company did not purchase any of its common stock as part of its share repurchase program. At June 30, 2011, the Company had approximately $1.6 billion remaining under its current share repurchase authorization. Share repurchases by the Company are subject to regulatory approval.

MUFG Stock Conversion.

As previously disclosed, on April 21, 2011, MUFG and the Company announced that they had entered into an agreement to convert MUFG’s outstanding Series B Preferred Stock in the Company into the Company’s common stock. On June 30, 2011 the Company and MUFG completed the conversion, whereby MUFG exchanged the Series B Preferred Stock with a face value of $7.8 billion (carrying value $8.1 billion) and a 10% dividend for 385,464,097 shares of the Company’s common stock, including approximately 75 million shares resulting from the adjustment to the conversion ratio pursuant to the transaction agreement. As a result of the adjustment to the conversion ratio, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the quarter and six months ended June 30, 2011. As a result of the conversion, MUFG did not receive the previously declared dividend that would otherwise have been payable on July 15, 2011 in respect of the Series B Preferred Stock.

Noncontrolling Interest.

Changes in the Company’s Ownership Interest in Subsidiaries.

The following table presents the effect on the Company’s shareholders’ equity from changes in ownership of subsidiaries resulting from transactions with noncontrolling interests.

 

     Six Months Ended June 30,  
         2011              2010      
     (dollars in millions)  

Net income applicable to Morgan Stanley

   $ 2,161       $ 3,736   

Transfers from the noncontrolling interests:

     

Increase in paid-in capital in connection with the MUFG transaction

     —           717   
  

 

 

    

 

 

 

Net transfers from noncontrolling interests

     —           717   
  

 

 

    

 

 

 

Change from net income applicable to Morgan Stanley and transfers from noncontrolling interests

   $ 2,161       $ 4,453   
  

 

 

    

 

 

 

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In connection with the transaction between the Company and MUFG to form a joint venture in Japan, the Company recorded an after-tax gain of $717 million from the sale of a noncontrolling interest in its Japanese institutional securities business. This gain was recorded in Paid-in capital in the Company’s condensed consolidated statements of financial condition at June 30, 2010 and changes in total equity for the six months ended June 30, 2010. See “Other Matters—Japanese Securities Joint Venture” in Part I, Item 2 herein for further information.

 

14. Earnings per Common Share.

Basic earnings per common share (“EPS”) is computed by dividing income available to Morgan Stanley common shareholders by the weighted average number of common shares outstanding for the period. Common shares outstanding include common stock and vested restricted stock units (“RSUs”) where recipients have satisfied either the explicit vesting terms or retirement eligibility requirements. Diluted EPS reflects the assumed conversion of all dilutive securities. The Company calculates EPS using the two-class method and determines whether instruments granted in share-based payment transactions are participating securities (see Note 2 to the consolidated financial statements for the year ended December 31, 2010 in the Form 10-K). The following table presents the calculation of basic and diluted EPS (in millions, except for per share data):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2011             2010             2011             2010      

Basic EPS:

        

Income from continuing operations

   $ 1,402      $ 1,463      $ 2,530      $ 3,542   

Net gain from discontinued operations

     4        521        6        453   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     1,406        1,984        2,536        3,995   

Net income applicable to noncontrolling interests

     213        24        375        259   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

     1,193        1,960        2,161        3,736   

Less: Preferred dividends (Series A Preferred Stock)

     (11     (11     (22     (22

Less: Preferred dividends (Series B Preferred Stock)

     —          (196     (196     (392

Less: MUFG stock conversion

     (1,726       (1,726  

Less: Preferred dividends (Series C Preferred Stock)

     (13     (13     (26     (26

Less: Allocation of earnings to participating RSUs(1):

        

From continuing operations

     (1     (38     (3     (91

From discontinued operations

     —          (16     —          (14

Less: Allocation of undistributed earnings to Equity Units(2):

        

From continuing operations

     —          (67     —          (165

From discontinued operations

     —          (41     —          (36
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) applicable to Morgan Stanley common shareholders

   $ (558   $ 1,578      $ 188      $ 2,990   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares outstanding

     1,464        1,318        1,460        1,316   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) per basic common share:

        

Income (loss) from continuing operations

   $ (0.38   $ 0.84      $ 0.12      $ 1.96   

Net gain from discontinued operations

     —          0.36        0.01        0.31   
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) per basic common share

   $ (0.38   $ 1.20      $ 0.13      $ 2.27   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
         2011             2010              2011              2010      

Diluted EPS:

          

Earnings (loss) applicable to Morgan Stanley common shareholders

   $ (558   $ 1,578       $ 188       $ 2,990   

Impact on income of assumed conversions:

          

Assumed conversion of Equity Units(2)

          

From continuing operations

     —          91         —           91   

From discontinued operations

     —          41         —           41   

Preferred stock dividends (Series B Preferred Stock)

     —          196         —           392   
  

 

 

   

 

 

    

 

 

    

 

 

 

Earnings (loss) applicable to common shareholders plus assumed conversions

   $ (558   $ 1,906       $ 188       $ 3,514   
  

 

 

   

 

 

    

 

 

    

 

 

 

Weighted average common shares outstanding

     1,464        1,318         1,460         1,316   

Effect of dilutive securities:

          

Stock options and RSUs(1)

     —          4         17         4   

Series B Preferred Stock

     —          310         —           310   

Equity Units(2)

     —          116         —           58   
  

 

 

   

 

 

    

 

 

    

 

 

 

Weighted average common shares outstanding and common stock equivalents

     1,464        1,748         1,477         1,688   
  

 

 

   

 

 

    

 

 

    

 

 

 

Earnings (loss) per diluted common share:

          

Income (loss) from continuing operations

   $ (0.38   $ 0.80       $ 0.12       $ 1.82   

Net income from discontinued operations

     —          0.29         0.01         0.26   
  

 

 

   

 

 

    

 

 

    

 

 

 

Earnings (loss) per diluted common share

   $ (0.38   $ 1.09       $ 0.13       $ 2.08   
  

 

 

   

 

 

    

 

 

    

 

 

 

 

(1) RSUs that are considered participating securities participate in all of the earnings of the Company in the computation of basic EPS, and therefore, such RSUs are not included as incremental shares in the diluted calculation.
(2) See Note 15 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K for further information on Equity Units.

The following securities were considered antidilutive and, therefore, were excluded from the computation of diluted EPS:

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 

Number of Antidilutive Securities Outstanding at End of Period:

       2011              2010              2011              2010      
     (shares in millions)  

RSUs and Performance-based stock units

     36         45         25         45   

Stock options

     59         70         59         70   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     95         115         84         115   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

15. Interest Income and Interest Expense.

Details of Interest income and Interest expense were as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2011             2010             2011             2010      
     (dollars in millions)  

Interest income(1):

        

Financial instruments owned(2)

   $ 926      $ 1,059      $ 1,845      $ 2,190   

Securities available for sale

     96        55        191        65   

Loans

     83        70        159        140   

Interest bearing deposits with banks

     43        42        77        83   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed

     330        175        605        325   

Other

     479        346        934        680   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest income

   $ 1,957      $ 1,747      $ 3,811      $ 3,483   
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest expense(1):

        

Deposits

   $ 60      $ 78      $ 126      $ 160   

Commercial paper and other short-term borrowings

     11        3        18        6   

Long-term debt

     1,292        1,154        2,604        2,233   

Securities sold under agreements to repurchase and Securities loaned

     682        423        1,155        708   

Other

     (16     (52     (21     (133
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Interest expense

   $ 2,029      $ 1,606      $ 3,882      $ 2,974   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest

   $ (72   $ 141      $ (71   $ 509   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Interest income and expense are recorded within the condensed consolidated statements of income depending on the nature of the instrument and related market conventions. When interest is included as a component of the instrument’s fair value, interest is included within Principal transactions—Trading revenues or Principal transactions—Investments revenues. Otherwise, it is included within Interest income or Interest expense.
(2) Interest expense on Financial instruments sold, not yet purchased is reported as a reduction to Interest income.

 

16. Employee Benefit Plans.

The Company sponsors various pension plans for the majority of its U.S. and non-U.S. employees. The Company provides certain other postretirement benefits, primarily health care and life insurance, to eligible U.S. employees. The Company also provides certain postemployment benefits to certain former employees or inactive employees prior to retirement.

Effective January 1, 2011, the Morgan Stanley Employees Retirement Plan (the “Pension Plan”) for U.S. participants ceased accruals of benefits under the Pension Plan. Any benefits earned by participants under the Pension Plan at December 31, 2010 were preserved and will be payable in the future based on the Pension Plan’s provisions.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The components of the Company’s net periodic benefit expense for its pension and postretirement plans were as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
       2011         2010         2011         2010    
     (dollars in millions)  

Service cost, benefits earned during the period

   $ 8      $ 26      $ 16      $ 52   

Interest cost on projected benefit obligation

     41        41        83        82   

Expected return on plan assets

     (33     (32     (66     (64

Net amortization of prior service costs

     (4     (2     (8     (4

Net amortization of actuarial loss

     5        7        10        14   

Curtailment gain

     —          (51     —          (51
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit expense

   $ 17      $ (11   $ 35      $ 29   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

17. Income Taxes.

The Company is under continuous examination by the Internal Revenue Service (the “IRS”) and other tax authorities in certain countries, such as Japan and the United Kingdom (the “U.K.”), and states in which the Company has significant business operations, such as New York. The Company is currently in the early stages of an IRS audit for tax years 2006 – 2008. During 2012, the Company expects to reach a conclusion with the IRS on issues covering tax years 1999 – 2005. During 2011, the Company expects to commence an audit with New York State and New York City covering tax years 2007 – 2009. Also during 2011, the Company expects to reach a conclusion with the U.K. tax authorities on substantially all issues through tax year 2008, including those in appeals. During 2012, the Company expects to reach a conclusion with the Japanese tax authorities on substantially all issues covering tax years 2007 – 2008. The Company periodically evaluates the likelihood of assessments in each taxing jurisdiction resulting from current and subsequent years’ examinations.

The Company believes that the resolution of tax matters will not have a material effect on the condensed consolidated statements of financial condition of the Company, although a resolution could have a material impact on the Company’s condensed consolidated statements of income for a particular future period and on the Company’s effective income tax rate for any period in which such resolution occurs. The Company has established a liability for unrecognized tax benefits that the Company believes is adequate in relation to the potential for additional assessments. Once established, the Company adjusts unrecognized tax benefits only when more information is available or when an event occurs necessitating a change.

It is reasonably possible that significant changes in the gross balance of unrecognized tax benefits may occur within the next 12 months. At this time, however, it is not possible to reasonably estimate the expected change to the total amount of unrecognized tax benefits and impact on the effective tax rate over the next 12 months.

The Company’s effective tax rate from continuing operations for the six months ended June 30, 2011 included a $447 million net tax benefit from the remeasurement of a deferred tax asset and the reversal of a related valuation allowance. The deferred tax asset and valuation allowance were recognized in income from discontinued operations during 2010 in connection with the recognition of a $1.2 billion loss due to writedowns and related costs following the Company’s commitment to a plan to dispose of Revel. The Company recorded the valuation allowance because the Company did not believe it was more likely than not that it would have sufficient future net capital gain to realize the benefit of the expected capital loss to be recognized upon the disposal of Revel. During the quarter ended March 31, 2011, the disposal of Revel was restructured as a tax-free like kind exchange and the disposal was completed. The restructured transaction changed the character of the future taxable loss to

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

ordinary. The Company reversed the valuation allowance because the Company believes it is more likely than not that it will have sufficient future ordinary taxable income to recognize the recorded deferred tax asset. In accordance with the applicable accounting literature, this reversal of a previously established valuation allowance due to a change in circumstances was recognized in income from continuing operations during the quarter ended March 31, 2011.

 

18. Segment and Geographic Information.

Segment Information.

The Company structures its segments primarily based upon the nature of the financial products and services provided to customers and the Company’s management organization. The Company provides a wide range of financial products and services to its customers in each of its business segments: Institutional Securities, Global Wealth Management Group and Asset Management. For further discussion of the Company’s business segments, see Note 1.

Revenues and expenses directly associated with each respective segment are included in determining its operating results. Other revenues and expenses that are not directly attributable to a particular segment are allocated based upon the Company’s allocation methodologies, generally based on each segment’s respective net revenues, non-interest expenses or other relevant measures.

As a result of treating certain intersegment transactions as transactions with external parties, the Company includes an Intersegment Eliminations category to reconcile the business segment results to the Company’s consolidated results. Intersegment eliminations also reflect the effect of fees paid by the Institutional Securities business segment to the Global Wealth Management Group business segment related to the bank deposit program.

Selected financial information for the Company’s segments is presented below:

 

Three Months Ended June 30, 2011

   Institutional
Securities
    Global Wealth
Management
Group
     Asset
Management
    Intersegment
Eliminations
    Total  
     (dollars in millions)  

Total non-interest revenues

   $ 5,599      $ 3,128       $ 655      $ (28   $ 9,354   

Net interest

     (410     348         (10     —          (72
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net revenues(1)

   $ 5,189      $ 3,476       $ 645      $ (28   $ 9,282   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

   $ 1,457      $ 322       $ 165      $ —        $ 1,944   

Provision for income taxes

     350        138         54        —          542   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Income from continuing operations

     1,107        184         111        —          1,402   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Discontinued operations(2):

           

Gain from discontinued operations

     1        —           4        —          5   

Provision from income taxes

     —          —           1        —          1   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net gain on discontinued operations

     1        —           3        —          4   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net income

     1,108        184         114        —          1,406   

Net income applicable to noncontrolling interests

     117        4         92        —          213   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

   $ 991      $ 180       $ 22      $ —        $ 1,193   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Three Months Ended June 30, 2010

  Institutional
Securities
    Global Wealth
Management
Group
    Asset
Management
    Intersegment
Eliminations
    Total  
    (dollars in millions)  

Total non-interest revenues

  $ 4,640      $ 2,786      $ 432      $ (36   $ 7,822   

Net interest

    (125     288        (22     —          141   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues(1)

  $ 4,515      $ 3,074      $ 410      $ (36   $ 7,963   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations before income taxes

  $ 1,595      $ 207      $ (86   $ (13   $ 1,703   

Provision for (benefit from) income taxes

    220        61        (39     (2     240   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations

    1,375        146        (47     (11     1,463   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discontinued operations(2):

         

Gain (loss) from discontinued operations

    (50     —          901        15        866   

Provision for (benefit from) income taxes

    (23     —          360        8        345   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net gain (loss) on discontinued operations

    (27     —          541        7        521   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

    1,348        146        494        (4     1,984   

Net income (loss) applicable to noncontrolling interests

    (9     36        (3     —          24   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) applicable to Morgan Stanley

  $ 1,357      $ 110      $ 497      $ (4   $ 1,960   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

Six Months Ended June 30, 2011

  Institutional
Securities
    Global Wealth
Management
Group
    Asset
Management
    Intersegment
Eliminations
    Total  
    (dollars in millions)  

Total non-interest revenues

  $ 9,524      $ 6,223      $ 1,289      $ (48   $ 16,988   

Net interest

    (743     690        (18     —          (71
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues(1)

  $ 8,781      $ 6,913      $ 1,271      $ (48   $ 16,917   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

  $ 1,854      $ 670      $ 292      $ —        $ 2,816   

Provision for (benefit from) income taxes

    (28     229        85        —          286   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations

    1,882        441        207        —          2,530   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discontinued operations(2):

         

Gain (loss) from discontinued operations

    (4     —          9        1        6   

Provision for (benefit from) income taxes

    (2     —          1        1        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net gain (loss) on discontinued operations

    (2     —          8        —          6   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

    1,880        441        215        —          2,536   

Net income applicable to noncontrolling interests

    178        78        119        —          375   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

  $ 1,702      $ 363      $ 96      $ —        $ 2,161   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Six Months Ended June 30, 2010

  Institutional
Securities
    Global Wealth
Management
Group
    Asset
Management
    Discover     Intersegment
Eliminations
    Total  
    (dollars in millions)  

Total non-interest revenues

  $ 9,867      $ 5,700      $ 1,104      $ —        $ (145   $ 16,526   

Net interest

    (14     479        (41     —          85        509   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues(1)

  $ 9,853      $ 6,179      $ 1,063      $ —        $ (60   $ 17,035   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations before income taxes

  $ 3,660      $ 485      $ 88      $ —        $ (15   $ 4,218   

Provision for (benefit from) income taxes

    550        125        4        —          (3     676   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations

    3,110        360        84        —          (12     3,542   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Discontinued operations(2):

           

Gain (loss) from discontinued operations

    (985     —          965        775        12        767   

Provision for (benefit from) income taxes

    (22     —          330        —          6        314   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net gain (loss) from discontinued operations(3)

    (963     —          635        775        6        453   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

    2,147        360        719        775        (6     3,995   

Net income (loss) applicable to noncontrolling interests

    (5     151        113        —          —          259   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) applicable to Morgan Stanley

  $ 2,152      $ 209      $ 606      $ 775      $ (6   $ 3,736   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) In certain management fee arrangements, the Company is entitled to receive performance-based fees (also referred to as incentive fees) when the return on assets under management exceeds certain benchmark returns or other performance targets. In such arrangements, performance fee revenue is accrued (or reversed) quarterly based on measuring account fund performance to date versus the performance benchmark stated in the investment management agreement. The amount of performance-based fee revenue at risk of reversing if fund performance falls below stated investment management agreement benchmarks was approximately $262 million at June 30, 2011 and approximately $208 million at December 31, 2010 (see Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K).
(2) See Note 1 for discussion of discontinued operations.
(3) Amounts for the three months ended June 30, 2010 included a gain of $514 million related to the Company’s sale of Retail Asset Management within the Asset Management business segment. Amounts for the six months ended June 30, 2010 included a loss of $951 million related to the planned disposition of Revel included within the Institutional Securities business segment and a gain of $775 million related to the legal settlement with DFS.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Net Interest

   Institutional
Securities
    Global Wealth
Management
Group
     Asset
Management
    Intersegment
Eliminations
    Total  
     (dollars in millions)  

Three Months Ended June 30, 2011

           

Interest income

   $ 1,573      $ 466       $ 3      $ (85   $ 1,957   

Interest expense

     1,983        118         13        (85     2,029   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest

   $ (410     348         (10     —          (72
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Three Months Ended June 30, 2010

           

Interest income

   $ 1,359      $ 387       $ 3      $ (2   $ 1,747   

Interest expense

     1,484        99         25        (2     1,606   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest

   $ (125   $ 288       $ (22   $ —          $141   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2011

           

Interest income

   $ 3,053      $ 920         $7      $ (169   $ 3,811   

Interest expense

     3,796        230         25        (169     3,882   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest

   $ (743   $ 690       $ (18   $ —        $ (71
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Six Months Ended June 30, 2010

           

Interest income

   $ 2,755      $ 726       $ 9      $ (7   $ 3,483   

Interest expense

     2,769        247         50        (92     2,974   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest

   $ (14   $ 479       $ (41   $ 85      $ 509   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

 

Total Assets(1)

   Institutional
Securities
     Global Wealth
Management
Group
     Asset
Management
     Total  
     (dollars in millions)  

At June 30, 2011

   $ 719,637       $ 103,665       $ 7,445       $ 830,747   
  

 

 

    

 

 

    

 

 

    

 

 

 

At December 31, 2010

   $ 698,453       $ 101,058       $ 8,187       $ 807,698   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Corporate assets have been fully allocated to the Company’s business segments.

Geographic Information.

The Company operates in both U.S. and non-U.S. markets. The Company’s non-U.S. business activities are principally conducted through European and Asian locations. The net revenues disclosed in the following table reflect the regional view of the Company’s consolidated net revenues on a managed basis, based on the following methodology:

 

   

Institutional Securities: advisory and equity underwriting—client location, debt underwriting—revenue recording location, sales and trading—trading desk location.

 

   

Global Wealth Management Group: global representative coverage location.

 

   

Asset Management: client location, except for Merchant Banking and Real Estate Investing businesses, which are based on asset location.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 

Net revenues

  

    2011    

    

    2010    

    

    2011    

    

    2010    

 
     (dollars in millions)  

Americas

   $ 6,629       $ 5,673       $ 12,119       $ 11,873   

Europe, Middle East, and Africa

     1,572         1,720         3,276         3,726   

Asia

     1,081         570         1,522         1,436   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net revenues

   $ 9,282       $ 7,963       $ 16,917       $ 17,035   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

19. Equity Method Investments.

The Company records investments accounted for under the equity method of accounting (see Note 1) in Other investments in the condensed consolidated statements of financial condition. See Note 24 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K for further information.

Huaxin Securities Joint Venture.

In June 2011, the Company and Huaxin Securities Co., Ltd. (“Huaxin Securities”) (also known as China Fortune Securities Co., Ltd.) jointly announced the operational commencement of their securities joint venture in China. The establishment of the joint venture was approved by China Securities Regulatory Commission (“CSRC”) on December 31, 2010 and was subject to receipt of a business license from the State Administration for Industry & Commerce of the People’s Republic of China, which was obtained in May 2011. Final CSRC approval for the commencement of business operations was obtained in June 2011. In the quarter ended June 30, 2011, the Company recorded initial costs of $130 million related to the formation of this new Chinese securities joint venture in Other expenses in the condensed consolidated statement of income.

The joint venture, Morgan Stanley Huaxin Securities Company Limited, is registered and principally located in Shanghai. Huaxin Securities holds a two-thirds interest in the joint venture while the Company owns a one-third interest. The establishment of the joint venture allows the Company to further build on its established onshore businesses in China. The joint venture’s business includes underwriting and sponsorship of shares in the domestic China market (including A shares and foreign investment shares), as well as underwriting, sponsorship and principal trading of bonds (including government and corporate bonds).

Japanese Securities Joint Venture.

On May 1, 2010, the Company and MUFG formed a joint venture in Japan of their respective investment banking and securities businesses. MUFG and the Company have integrated their respective Japanese securities companies by forming two joint venture companies. MUFG contributed the investment banking, wholesale and retail securities businesses conducted in Japan by Mitsubishi UFJ Securities Co., Ltd. into MUMSS. The Company contributed the investment banking operations conducted in Japan by its subsidiary, Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”), formerly known as Morgan Stanley Japan Securities Co., Ltd., into MUMSS (MSMS, together with MUMSS, the “Joint Venture”). The Company owns a 40% economic interest in the Joint Venture and MUFG owns a 60% economic interest in the Joint Venture. The Company holds a 40% voting interest and MUFG holds a 60% voting interest in MUMSS, while the Company holds a 51% voting interest and MUFG holds a 49% voting interest in MSMS. The Company continues to consolidate MSMS in its condensed consolidated financial statements and, commencing on May 1, 2010, accounted for its interest in MUMSS as an equity method investment within the Institutional Securities business segment.

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

During the three and six months ended June 30, 2011, the Company recorded losses of $17 million and $672 million, respectively, arising from the Company’s 40% stake in MUMSS, recorded within Other revenues in the condensed consolidated statements of income. In order to enhance the risk management at MUMSS, during the six months ended June 30, 2011, the Company entered into a transaction with MUMSS whereby the risk associated with the fixed income trading positions that previously caused the majority of the aforementioned MUMSS losses were transferred to MSMS. In return for entering into the transaction, the Company received total consideration of $659 million, which represented the estimated fair value of the transaction.

MUFG is responsible for ensuring that MUMSS remains adequately capitalized, and the Company is not obligated to contribute additional capital to MUMSS. Because of the losses incurred by MUMSS, MUFG contributed approximately $370 million of capital to MUMSS on April 22, 2011. The MUFG capital injection improved the capital base and restored the capital adequacy ratio of MUMSS. As a result of the capital injection, during the quarter ended June 30, 2011, the Company recorded an increase of approximately $148 million in the carrying amount of the equity method investment in MUMSS, reflecting the Company’s 40% share of the increase in the net asset value of MUMSS, and an increase in the Company’s Paid-in capital of approximately $86 million (after-tax).

During the quarter ended June 30, 2011, the Company performed an impairment review of its equity method investment in MUMSS in view of the deterioration in the financial performance of MUMSS and the earthquake in Japan on March 11, 2011. The Company recorded no other-than-temporary impairment loss at June 30, 2011. Adverse market or economic events, as well as further deterioration of post-earthquake economic performance could result in impairment charges of this investment in future periods.

FrontPoint.

On March 1, 2011, the Company and the principals of FrontPoint Partners LLC (“FrontPoint”) completed a transaction, whereby FrontPoint senior management and portfolio managers own a majority equity stake in FrontPoint, and the Company retains a minority stake. FrontPoint has replaced the Company’s affiliates as the investment advisor and general partner of the FrontPoint funds. Beginning March 1, 2011, the Company accounts for its interest in FrontPoint as an equity method investment within the Asset Management business segment. The Company recorded a loss of approximately $20 million related to the writedown of the minority stake investment in FrontPoint for the quarter ended June 30, 2011. The loss was included in Other revenues in the condensed consolidated statement of income.

 

20. Discontinued Operations.

See Note 1 for a discussion of the Company’s discontinued operations.

The table below provides information regarding amounts included in discontinued operations:

 

       Three Months Ended
June 30,
     Six Months Ended
June 30,
 
       2011      2010      2011      2010  
      

(dollars in millions)

 

Pre-tax gain (loss) on discontinued operations(1):

             

Revel(2)

     $ —         $ (25    $ (10    $ (963

Retail Asset Management

       4         916         9         982   

DFS(3)

       —           —           —           775   

CMB

       —           (18      6         (16

Other

       1         (7      1         (11
    

 

 

    

 

 

    

 

 

    

 

 

 
     $ 5       $ 866       $ 6       $ 767   
    

 

 

    

 

 

    

 

 

    

 

 

 

 

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

 

(1) Amounts included eliminations of intersegment activity.
(2) Amount included a loss of approximately $951 million in the six months ended June 30, 2010 in connection with the planned disposition of Revel.
(3) Amount relates to the legal settlement with DFS.

Net revenues included in discontinued operations for the quarter ended June 30, 2011 was $5 million related to Retail Asset Management. Net revenues included in discontinued operations for the six months ended June 30, 2011 included $6 million related to CMB and $5 million related to Retail Asset Management. Net revenues included in discontinued operations for the quarter ended June 30, 2010 included $1,019 million related to Retail Asset Management and a net loss of $2 million related to CMB. Net revenues included in discontinued operations for the six months ended June 30, 2010 included $1,204 million related to Retail Asset Management and $4 million related to CMB.

 

21. Subsequent Events.

Common Dividend.

On July 19, 2011, the Company announced that its Board of Directors declared a quarterly dividend per common share of $0.05. The dividend is payable on August 15, 2011 to common shareholders of record on July 29, 2011.

Long-Term Borrowings.

Subsequent to June 30, 2011 and through July 31, 2011, the Company’s long-term borrowings (net of repayments) increased by approximately $1.5 billion.

U.K. Bank Levy.

In July 2011, the U.K. Government enacted legislation imposing a bank levy on relevant liabilities and equities on the consolidated balance sheets of “U.K. Banking Groups,” as defined under the bank levy legislations at December 31, 2011. The Company continues to evaluate the impact of this legislation and expects to incur a charge of approximately $125 million for the full year. Due to the charge being determined on relevant liabilities and equities at December 31, 2011, the final charge may differ from this estimate. The levy is not deductible for U.K. Corporation Tax purposes. The Company will start to accrue this charge in the third quarter of 2011.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Morgan Stanley:

We have reviewed the accompanying condensed consolidated statement of financial condition of Morgan Stanley and subsidiaries (the “Company”) as of June 30, 2011, the related condensed consolidated statements of income and comprehensive income for the three-month and six-month periods ended June 30, 2011 and 2010, and the condensed consolidated statements of cash flows and changes in total equity for the six-month periods ended June 30, 2011 and 2010. These condensed consolidated financial statements are the responsibility of the management of the Company.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition of the Company as of December 31, 2010, and the consolidated statements of income, comprehensive income, cash flows and changes in total equity for the year then ended (not presented herein) included in the Company’s Annual Report on Form 10-K; and in our report dated February 28, 2011, which report contains an explanatory paragraph concerning the Company changing its fiscal year end from November 30 to December 31, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial condition as of December 31, 2010 is fairly stated, in all material respects, in relation to the consolidated statement of financial condition from which it has been derived.

/s/ Deloitte & Touche LLP

New York, New York

August 8, 2011

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Introduction.

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. 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. 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 Note 1 to the condensed consolidated financial statements for a discussion of the Company’s discontinued operations.

The results of operations in the past have been, and in the future may continue to be, materially affected by many factors, including the effect of political and economic conditions and geopolitical events; the effect of market conditions, particularly in the global equity, fixed income and credit markets, including corporate and mortgage (commercial and residential) lending and commercial real estate investments; the impact of current, pending and future legislation (including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)), regulation (including capital requirements), and legal actions in the United States of America (“U.S.”) and worldwide; the level and volatility of equity, fixed income, and commodity prices and interest rates, currency values and other market indices; the availability and cost of both credit and capital as well as the credit ratings assigned to the Company’s unsecured short-term and long-term debt; investor sentiment and confidence in the financial markets; the performance of the Company’s acquisitions, joint ventures, strategic alliances or other strategic arrangements (including MSSB and with Mitsubishi UFJ Financial Group, Inc. (“MUFG”)); the Company’s reputation; inflation, natural disasters, and acts of war or terrorism; the actions and initiatives of current and potential competitors and technological changes; or a combination of these or other factors. In addition, legislative, legal and regulatory developments related to the Company’s businesses are likely to increase costs, thereby affecting results of operations. These factors also may have an impact on the Company’s ability to achieve its strategic objectives. For a further discussion of these and other important factors that could affect the Company’s business, see “Competition” and “Supervision and Regulation” in Part I, Item 1, and “Risk Factors” in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 (the “Form 10-K”) and “Other Matters” in Part I, Item 2 and “Risk Factors” in Part II, Item 1A herein.

The discussion of the Company’s results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may

 

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cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect the Company’s future results, please see “Forward-Looking Statements” immediately preceding Part I, Item 1, “Competition” and “Supervision and Regulation” in Part I, Item 1, “Risk Factors” in Part I, Item 1A and “Executive Summary—Significant Items” in Part II, Item 7 of the Form 10-K and “Other Matters” herein.

Executive Summary.

Financial Information and Statistical Data (dollars in millions, except where noted and per share amounts).

 

    Three Months Ended
June 30,
    Six Months Ended
June 30,
 
        2011             2010         2011     2010  

Net revenues:

       

Institutional Securities

  $ 5,189      $ 4,515      $ 8,781      $ 9,853   

Global Wealth Management Group

    3,476        3,074        6,913        6,179   

Asset Management

    645        410        1,271        1,063   

Intersegment Eliminations

    (28     (36     (48     (60
 

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated net revenues

  $ 9,282      $ 7,963      $ 16,917      $ 17,035   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net income

    1,406        1,984        2,536        3,995   

Net income applicable to noncontrolling interests

    213        24        375        259   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

  $ 1,193      $ 1,960      $ 2,161      $ 3,736   
 

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations applicable to Morgan Stanley:

       

Institutional Securities

  $ 990      $ 1,384      $ 1,704      $ 3,115   

Global Wealth Management Group

    180        110        363        209   

Asset Management

    19        (44     88        (29

Intersegment Eliminations

    —          (11     —          (12
 

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations applicable to
Morgan Stanley

  $ 1,189      $ 1,439      $ 2,155      $ 3,283   
 

 

 

   

 

 

   

 

 

   

 

 

 

Amounts applicable to Morgan Stanley:

       

Income from continuing operations applicable to Morgan Stanley

  $ 1,189      $ 1,439      $ 2,155      $ 3,283   

Net gain from discontinued operations applicable to Morgan Stanley

    4        521        6        453   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

  $ 1,193      $ 1,960      $ 2,161      $ 3,736   
 

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) applicable to Morgan Stanley common shareholders

  $ (558   $ 1,578      $ 188      $ 2,990   
 

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) per basic common share:

       

Income from continuing operations

  $ (0.38   $ 0.84      $ 0.12      $ 1.96   

Net gain from discontinued operations(1)

    —          0.36        0.01        0.31   
 

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) per basic common share(2)

  $ (0.38   $ 1.20      $ 0.13      $ 2.27   
 

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) per diluted common share:

       

Income (loss) from continuing operations

  $ (0.38   $ 0.80      $ 0.12      $ 1.82   

Net gain from discontinued operations(1)

    —          0.29        0.01        0.26   
 

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) per diluted common share(2)

  $ (0.38   $ 1.09      $ 0.13      $ 2.08   
 

 

 

   

 

 

   

 

 

   

 

 

 

Regional net revenues(3):

       

Americas

  $ 6,629      $ 5,673      $ 12,119      $ 11,873   

Europe, Middle East and Africa

    1,572        1,720        3,276        3,726   

Asia

    1,081        570        1,522        1,436   
 

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues

  $ 9,282      $ 7,963      $ 16,917      $ 17,035   
 

 

 

   

 

 

   

 

 

   

 

 

 

 

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Financial Information and Statistical Data (dollars in millions, except where noted and per share amounts)—(Continued).

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Average common equity (dollars in billions)(4):

        

Institutional Securities

   $ 22.1      $ 17.8      $ 21.2      $ 17.6   

Global Wealth Management Group

     7.1        6.8        7.0        6.8   

Asset Management

     2.0        2.0        2.0        2.1   

Parent capital

     18.4        13.0        18.7        12.2   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total from continuing operations

     49.6        39.6        48.9        38.7   

Discontinued operations

     —          0.4        —          0.4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Consolidated average common equity

   $ 49.6      $ 40.0      $ 48.9      $ 39.1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Return on average common equity(4):

        

Consolidated

     N/M        17     1     17

Institutional Securities(4)

     N/M        29     N/M        34

Global Wealth Management Group

     N/M        6     4     6

Asset Management

     N/M        N/M        N/M        N/M   

Book value per common share(5)

   $ 30.17      $ 29.65      $ 30.17      $ 29.65   

Tangible common equity(6)

   $ 51,339      $ 34,267      $ 51,339      $ 34,267   

Tangible book value per common share(7)

   $ 26.61      $ 24.53      $ 26.61      $ 24.53   

Effective income tax rate provision from continuing operations(8)

     27.9     14.1     10.2     16.0

Worldwide employees

     62,964        61,958        62,964        61,958   

Average liquidity (dollars in billions)(9):

        

Parent company liquidity

   $ 76      $ 60      $ 76      $ 62   

Bank and other subsidiary liquidity

     96        92        96        91   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total liquidity

   $ 172      $ 152      $ 172      $ 153   
  

 

 

   

 

 

   

 

 

   

 

 

 

Capital ratios at June 30, 2011 and 2010(10):

        

Total capital ratio

     18.3     17.0     18.3     17.0

Tier 1 capital ratio

     16.7     16.5     16.7     16.5

Tier 1 leverage ratio

     6.0     6.6     6.0     6.6

Tier 1 common ratio(10)

     14.6     9.2     14.6     9.2

Consolidated assets under management or supervision
(dollars in billions)(11):

        

Asset Management(12)

   $ 296      $ 244      $ 296      $ 244   

Global Wealth Management Group

     516        403        516        403   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 812      $ 647      $ 812      $ 647   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Financial Information and Statistical Data (dollars in millions, except where noted and per share amounts)—(Continued).

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Institutional Securities:

        

Pre-tax profit margin(13)

     28     35     21     37

Global Wealth Management Group:

        

Global representatives

     17,638        18,087        17,638        18,087   

Annualized net revenue per global representative
(dollars in thousands)(14)

   $ 785      $ 679      $ 776      $ 682   

Assets by client segment (dollars in billions):

        

$10 million or more

   $ 539      $ 440      $ 539      $ 440   

$1 million to $10 million

     735        627        735        627   
  

 

 

   

 

 

   

 

 

   

 

 

 

Subtotal $1 million or more

     1,274        1,067        1,274        1,067   
  

 

 

   

 

 

   

 

 

   

 

 

 

$100,000 to $1 million

     397        389        397        389   

Less than $100,000

     38        44        38        44   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total client assets

   $ 1,709      $ 1,500      $ 1,709      $ 1,500   
  

 

 

   

 

 

   

 

 

   

 

 

 

Fee-based assets as a percentage of total client assets

     30     26     30     26

Client assets per global representative(15)

   $ 97      $ 83      $ 97      $ 83   

Global retail net new assets (dollars in billions)

   $ 2.9      $ (5.5   $ 14.3      $ 3.8   

Global fee-based asset flows (dollars in billions)

   $ 9.7      $ 6.3      $ 27.5      $ 15.4   

Global retail locations

     804        881        804        881   

Bank deposits (dollars in billions)(16)

   $ 110      $ 110      $ 110      $ 110   

Pre-tax profit margin(13)

     9     7     10     8

Asset Management:

        

Assets under management or supervision (dollars in billions)

   $ 296      $ 244      $ 296      $ 244   

Pre-tax profit margin(13)

     26     N/M        23     8

 

N/M—Not Meaningful.
(1) See Note 1 to the condensed consolidated financial statements for information on discontinued operations.
(2) For the calculation of basic and diluted earnings per share (“EPS”), see Note 14 to the condensed consolidated financial statements.
(3) In the quarter and six months ended June 30, 2011, regional net revenues, primarily in the Americas, included positive revenue due to the widening of the Company’s credit spreads and other credit factors, which resulted in the decrease in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes. For a discussion of the Company’s methodology used to allocate revenues among the regions, see Note 18 to the condensed consolidated financial statements.
(4) The computation of average common equity for each business segment is determined using the Company’s Required Capital framework (“Required Capital Framework”), an internal capital adequacy measure (see “Liquidity and Capital Resources—Required Capital” herein). The Required Capital Framework will evolve over time in response to changes in the business and regulatory environment and to incorporate enhancements in modeling techniques. During 2011, the Company will continue to evaluate the framework with respect to the impact of future regulatory requirements, as appropriate (see “Regulatory Requirements” herein for further information on Basel III). The return on average common equity uses income from continuing operations applicable to Morgan Stanley less preferred dividends as a percentage of average common equity. For the quarter and six months ended June 30, 2011, the negative adjustment related to the MUFG conversion was included in the calculation of the return on average common equity. Excluding this negative adjustment, the return on average common equity for the quarter and six months ended June 30, 2011 would have been 18% and 14%, respectively, for the Institutional Securities business segment; 10% and 10%, respectively, for the Global Wealth Management Group business segment; and 4% and 8%, respectively, for the Asset Management business segment. See “Liquidity and Capital Resource—Required Capital” herein for more information on the calculation of the average common equity by segment. The effective tax rates used in the computation of business segment return on average common equity were determined on a separate entity basis. Excluding the effect of the discrete tax benefit in the quarter and six months ended June 30, 2010, the return on average common equity for the Institutional Securities business segment would have been 22% and 26%, respectively (see “Executive Summary—Overview of the Quarter and Six Months Ended June 30, 2011 Financial Results” herein).
(5) Book value per common share equals common shareholders’ equity of $58,199 million at June 30, 2011 and $41,415 million at June 30, 2010, divided by common shares outstanding of 1,929 million at June 30, 2011 and 1,397 million at June 30, 2010.

 

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(6) Tangible common equity is a non-Generally Accepted Accounting Principle (“GAAP”) financial measure that the Company considers to be a useful measure that the Company and investors use to assess capital adequacy. For a discussion of tangible common equity, see “Liquidity and Capital Resources—The Balance Sheet” herein.
(7) Tangible book value per common share is a non-GAAP financial measure that the Company considers to be a useful measure that the Company and investors use to assess capital adequacy. Tangible book value per common share equals tangible common equity divided by period-end common shares outstanding.
(8) For a discussion of the effective income tax rate, see “Executive Summary—Overview of the Quarter and Six Months Ended June 30, 2011 Financial Results” herein.
(9) For a discussion of average liquidity, see “Liquidity and Capital Resources—Liquidity Management—Global Liquidity Reserve” herein.
(10) Tier 1 common ratio is a non-GAAP financial measure that the Company considers to be a useful measure that the Company and investors use to assess capital adequacy. For a discussion of total capital ratio, Tier 1 capital ratio and Tier 1 leverage ratio, see “Liquidity and Capital Resources—Regulatory Requirements” herein. For a discussion of Tier 1 common ratio, see “Liquidity and Capital Resources—The Balance Sheet” herein.
(11) Revenues and expenses associated with these assets are included in the Company’s Asset Management and Global Wealth Management Group business segments.
(12) Amounts exclude the Asset Management business segment’s proportionate share of assets managed by entities in which it owns a minority stake.
(13) Pre-tax profit margin is a non-GAAP financial measure that the Company considers to be a useful measure that the Company and investors use to assess operating performance. Percentages represent income from continuing operations before income taxes as a percentage of net revenues.
(14) Annualized net revenues per global representative for the quarter and six months ended June 30, 2011 and 2010 equals Global Wealth Management Group’s net revenues divided by the quarterly weighted average global representative headcount for the quarter and six months ended June 30, 2011 and 2010, respectively.
(15) Client assets per global representative equal total period-end client assets divided by period-end global representative headcount.
(16) Approximately $56 billion and $52 billion of the bank deposit balances at June 30, 2011 and 2010, respectively, are held at Company-affiliated depositories with the remainder held at Citigroup, Inc. (“Citi”) affiliated depositories. These deposit balances are held at certain of the Company’s Federal Deposit Insurance Corporation (the “FDIC”) insured depository institutions for the benefit of the Company’s clients through their accounts.

Global Market and Economic Conditions.

During the six months ended June 30, 2011, global market and economic conditions were negatively impacted by concern about a sovereign debt crisis in Europe and the U.S. federal debt ceiling. Global economic conditions in the quarter ended June 30, 2011 were more challenging than the quarter ended March 31, 2011, which was affected by the natural disaster in Japan, political unrest in the Middle East and military operations in Libya. In the second quarter of 2011, global equity markets were strong in April, but pulled back in May and June as investors reacted to slowing global economic growth.

In the U.S., major equity market indices ended the first six months of 2011 higher compared with the beginning of the year primarily due to better than expected corporate earnings. However, the volatile second quarter of 2011 left the Dow Jones Industrial Average relatively flat and both the NASDAQ Composite and Standard & Poor’s 500-stock index were slightly lower from the beginning of the quarter. Negative market and economic developments in the second quarter of 2011 included the slowing pace of economic recovery, the increase in the unemployment rate and the continued sovereign debt crisis within the European region. Certain sectors of the residential real estate market and investments in commercial real estate projects remained challenged in the second quarter. Growth in consumer spending declined in recent months from the already modest pace in the first quarter. Inflation rose in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions associated with the natural disaster in Japan. Concerns about crude oil supplies contributed to a rise in oil prices in the beginning of the second quarter of 2011 and prices then fell sharply in May and June as investors feared the economic recovery was in jeopardy. The U.S. federal debt ceiling, deficit reductions, balanced budgets, and underfunded public pension liabilities remained critical focus items at the federal, state and local levels of government during the first six months of 2011. The unemployment rate, which declined in the first quarter to 8.8% from 9.4% at December 31, 2010, rose during the second quarter to 9.2% at June 30, 2011. The Federal Open Market Committee (“FOMC”) of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) kept key interest rates at historically low levels, and at June 30, 2011, the federal funds target rate was between zero and 0.25%, and the discount rate was 0.75%. FOMC completed its quantitative easing policies, in which the FOMC purchased securities with the objective of improving economic conditions by increasing the money supply and its $600 billion bond-buying program, commonly referred to as “quantitative easing 2” on June 30, 2011.

 

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In Europe, equity market indices in the United Kingdom (“U.K.”) and France were relatively unchanged during the second quarter, while Germany’s DAX index was 5% higher compared with the beginning of the second quarter. During the first six months of 2011, U.K.’s FTSE 100 index was slightly higher while Germany and France’s indices were 6.3% and 4.5% higher respectively. Results in the European equity markets were affected by adverse economic developments, including investor concerns about the sovereign debt crisis, especially in Greece, Portugal, Ireland, Spain and Italy. The euro area unemployment rate remained relatively unchanged at approximately 10% at June 30, 2011. In April 2011, the European Central Bank (“ECB”) increased its benchmark interest rate by 0.25% from 1.00% to 1.25%. In July 2011, it increased such rate by another 0.25% to 1.50% and signaled further ECB rate increases in coming months. The Bank of England’s (“BOE”) benchmark interest rate was kept at 0.50%. The BOE continued to pursue quantitative easing policies, in which the BOE purchased securities, including U.K. Government Gilts, with the objective of improving economic conditions by increasing the money supply.

In Asia, major stock markets closed out the second quarter lower compared with the beginning of the quarter and the year. Japan’s economy picked up in the second quarter as supply constraints from the March natural disaster eased. In July 2011, the Bank of Japan kept its benchmark interest rate steady at a range of zero to 0.1% and refrained from loosening monetary policy further. The Nikkei 225 Index was relatively flat in the second quarter, and was 6% lower during the first six months of 2011. China’s gross domestic product growth moderated slightly during the second quarter of 2011 as Chinese policy makers tightened monetary policy to combat inflation. The People’s Bank of China (“PBOC”) raised benchmark interest rates by 0.25% twice during the first six months of 2011. In early July 2011, PBOC raised the benchmark interest rates by another 0.25%, which takes the one-year yuan lending rate from 2010 year-end’s 5.81% to 6.56% and one-year yuan deposit rate from 2010 year-end’s 2.75% to 3.5%. The Shanghai Composite Index and the Hang Seng Index decreased 6% and 5%, respectively, during the second quarter and decreased 2% and 3%, respectively, during the first six months of 2011.

Overview of the Quarter and Six Months Ended June 30, 2011 Financial Results.

Consolidated Results. The Company recorded net income applicable to Morgan Stanley of $1,193 million on net revenues of $9,282 million during the quarter ended June 30, 2011, compared with $1,960 million of net income applicable to Morgan Stanley and net revenues of $7,963 million in the prior year period. Net revenues in the current quarter included gains of $244 million due to the widening of the Company’s credit spreads and other credit factors on certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected, compared with gains of approximately $750 million in the quarter ended June 30, 2010. Non-interest expenses increased 17% to $7,338 million in the quarter ended June 30, 2011. Compensation and benefits expense increased 20% quarter over quarter, primarily due to increased compensation costs in the Institutional Securities business segment due to higher net revenues. Non-compensation expenses increased 12%, primarily due to an increase in Other expenses in the Institutional Securities business segment related to business activity and ongoing investments in technology. Diluted EPS and diluted EPS from continuing operations were both $(0.38) in the quarter ended June 30, 2011 compared with $1.09 and $0.80, respectively in the prior year period. The earnings per share calculation for the current quarter included a negative adjustment of approximately $1.7 billion, or $1.02 per diluted share (calculated using 1.79 billion diluted average shares outstanding under the if-converted method), related to the conversion of MUFG’s outstanding Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock (“Series B Preferred Stock”) in the Company into the Company’s common stock.

For the six months ended June 30, 2011, the Company recorded net income applicable to Morgan Stanley of $2,161 million compared with net income applicable to Morgan Stanley of $3,736 million a year ago. Net revenues were $16,917 million in the six months ended June 30, 2011, compared to $17,035 million in the prior year period. Non-interest expenses increased 10% to $14,101 million from the prior year period. Diluted EPS were $0.13 in the six months ended June 30, 2011 compared with $2.08 a year ago. Diluted EPS from continuing operations were $0.12 in the six months ended June 30, 2011 compared with $1.82 a year ago.

 

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The Company’s effective income tax rate from continuing operations was 27.9% and 10.2% for the quarter and six months ended June 30, 2011, respectively. The effective tax rate for the six months ended June 30, 2011 included a net tax benefit of $447 million, or $0.30 per diluted share, from the remeasurement of a deferred tax asset and the reversal of a related valuation allowance. The deferred tax asset and valuation allowance were recognized in income from discontinued operations during 2010 in connection with the recognition of a $1.2 billion loss due to writedowns and related costs following the Company’s commitment to a plan to dispose of Revel Entertainment Group, LLC (“Revel”). Excluding this discrete tax benefit, the annual effective tax rate for the six months ended June 30, 2011 would have been 26.0%. For further discussion of the discrete tax benefit, see “Executive Summary—Significant Items—Income Tax Benefit” herein.

The Company’s effective income tax rate from continuing operations was 14.1% and 16.0% for the quarter and six months ended June 30, 2010, respectively. The effective tax rate for the quarter and six months ended June 30, 2010 included a net tax benefit of $345 million, or $0.20 per diluted share, associated with the remeasurement of net unrecognized tax benefits and related interest based on new information regarding the status of federal and state examinations. The results for the six months ended June 30, 2010 also included a net tax benefit of $382 million, or $0.20 per diluted share, related to the reversal of U.S. deferred tax liabilities associated with prior years’ undistributed earnings of certain non-U.S. subsidiaries that were determined to be indefinitely reinvested abroad. Excluding the benefits noted above, the annual effective tax rate for the quarter and six months ended June 30, 2010 would have been 34.4% and 33.3%, respectively.

Institutional Securities. Income from continuing operations before income taxes was $1,457 million in the quarter ended June 30, 2011 compared with $1,595 million in the prior year period. Net revenues were $5,189 million in the quarter ended June 30, 2011 compared with $4,515 million in the prior year period. Investment banking revenues for the quarter ended June 30, 2011 increased 66% from the comparable period in 2010, reflecting higher revenues in all categories—equity and fixed income underwriting transactions and advisory fees. Equity sales and trading revenues increased 31% to $1,853 million in the quarter ended June 30, 2011, primarily reflecting higher revenues in derivatives and equity financing. Results in the quarter ended June 30, 2011 included positive revenue of $52 million due to the widening of the Company’s credit spreads and other credit factors resulting from the decrease in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected compared with positive revenue of $129 million in the quarter ended June 30, 2010. Fixed income and commodities sales and trading revenues decreased 10% to $2,093 million in the quarter ended June 30, 2011 from the comparable period of 2010, reflecting decreased revenues in commodities, partially offset by gains on monoline insurers (“Monolines”) and higher revenues in credit. Results in the quarter ended June 30, 2011 included positive revenue of $192 million due to the widening of the Company’s credit spreads and other credit factors resulting from the decrease in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected compared with positive revenues of $602 million in the quarter ended June 30, 2010. Principal transaction net investment gains of $150 million were recognized in the quarter ended June 30, 2011 compared with net investment losses of $68 million in the prior year period. Other revenues of $130 million were recognized in the quarter ended June 30, 2011 compared with other revenues of $51 million in the quarter ended June 30, 2010. Non-interest expenses increased 28% in the quarter ended June 30, 2011, primarily due to higher compensation expenses and higher non-compensation expenses. Compensation and benefits expenses increased 37% in the quarter ended June 30, 2011, primarily due to higher net revenues. Non-compensation expenses increased 16% in the quarter ended June 30, 2011 from a year ago, primarily due to an increase in Other expenses, which include the initial costs of $130 million associated with the new Chinese securities joint venture, Morgan Stanley Huaxin Securities Company Limited, which closed in the second quarter of 2011. In addition, the Institutional Securities business segment incurred higher non-compensation expenses in the quarter ended June 30, 2011 resulting from higher levels of business activity and ongoing investments in technology.

 

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Global Wealth Management Group.    Income from continuing operations before income taxes was $322 million in the quarter ended June 30, 2011 compared with $207 million in the prior year period. Net revenues were $3,476 million in the quarter ended June 30, 2011 compared with $3,074 million in the prior year period. Investment banking revenues increased 9% in the quarter ended June 30, 2011, primarily due to higher equity underwriting and unit investment trusts activity, partially offset by lower fixed income underwriting activity. Principal transactions trading revenues increased 16% in the quarter ended June 30, 2011 primarily due to gains related to investments associated with certain employee deferred compensation plans and higher revenues from municipal securities and structured notes, partially offset by lower revenues from corporate equity and government securities. Asset management, distribution and administration fees increased 13% in the quarter ended June 30, 2011, primarily due to higher fee-based revenues. Other revenues increased 101% in the quarter ended June 30, 2011, primarily due to gains on sales of securities available for sale. Net interest increased 21% in the quarter ended June 30, 2011, primarily resulting from an increase in Interest income due to interest on the securities available for sale portfolio and mortgages. Non-interest expenses increased 10% in the quarter ended June 30, 2011, due to increased compensation and non-compensation expenses.

Asset Management.    Income from continuing operations before income taxes was $165 million in the quarter ended June 30, 2011 compared with a loss of $86 million in the prior year period. Net revenues were $645 million in the quarter ended June 30, 2011 compared with $410 million in the prior year period. Principal transactions net investment gains were $247 million in the quarter ended June 30, 2011 compared with gains of $16 million in the quarter ended June 30, 2010, primarily related to net investment gains associated with the Real Estate Investing business, as a result of valuation gains within certain consolidated real estate funds sponsored by the Company, as well as net gains on Merchant Banking and Traditional Asset Management investments. Asset management, distribution and administration fees increased 8% in the quarter ended June 30, 2011, primarily reflecting higher performance fees and fund management and administration fees, due to an increase in average assets under management. Non-interest expenses decreased 3% to $480 million in the quarter ended June 30, 2011, primarily reflecting a decrease in non-compensation expenses.

Significant Items.

Japanese Securities Joint Venture.    During the three and six months ended June 30, 2011, the Company recorded a pre-tax loss of $17 million and $672 million, respectively, within Other revenues in the condensed consolidated statement of income, arising from the Company’s 40% stake in Mitsubishi UFJ Morgan Stanley Securities Co., Ltd. (“MUMSS”) (see Note 19 to the condensed consolidated financial statements). See “Other Matters—Japanese Securities Joint Venture” herein for further information.

MUFG Stock Conversion.    As previously disclosed, on April 21, 2011, MUFG and the Company announced that they had entered into an agreement to convert MUFG’s outstanding Series B Preferred Stock in the Company into the Company’s common stock. On June 30, 2011 the Company and MUFG completed the conversion, whereby MUFG exchanged the Series B Preferred Stock with a face value of $7.8 billion (carrying value $8.1 billion) and a 10% dividend for 385,464,097 shares of the Company’s common stock, including approximately 75 million shares resulting from the adjustment to the conversion ratio pursuant to the transaction agreement. As a result of the adjustment to the conversion ratio, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the quarter and six months ended June 30, 2011. As a result of the conversion, MUFG did not receive the previously declared dividend that would otherwise have been payable on July 15, 2011 in respect of the Series B Preferred Stock.

Monoline Insurers.    The quarter and six months ended June 30, 2011 included gains of $471 million and $153 million, respectively, related to the Company’s Monoline counterparty credit exposures, principally MBIA Insurance Corporation (“MBIA”), compared with losses of $186 million and $330 million, respectively, in the prior year comparative periods.

 

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Monolines provide credit enhancement to capital markets transactions. The current credit environment continues to affect the ability of such financial guarantors to provide enhancement to existing capital market transactions. The Company’s direct exposure to Monolines is limited to bonds that are insured by Monolines and to derivative contracts with a Monoline as counterparty. The Company’s exposure to Monolines at June 30, 2011 includes $1.7 billion of insured municipal bond securities, $145 million of mortgage and asset-backed securities enhanced by financial guarantees, and positive net derivative counterparty exposure of $1.6 billion (gross counterparty exposure of approximately $4.8 billion net of cumulative credit valuation adjustments and counterparty hedges), which was primarily related to MBIA.

At June 30, 2011 and December 31, 2010, the Company’s positive net derivative counterparty exposure to MBIA was as follows:

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in billions)  

Gross counterparty exposure(1)

   $ 4.4       $ 4.2   

Less: Credit valuation adjustments(2)

     1.3         2.1   
  

 

 

    

 

 

 

Subtotal

     3.1         2.1   

Less: Counterparty hedges(3)

     1.6         3.0   
  

 

 

    

Positive net derivative counterparty exposure(4)(5)

   $ 1.5         N/A   
  

 

 

    

 

(1) Gross counterparty exposure is defined as the fair value of derivative contracts with MBIA before consideration of credit valuation adjustments.
(2) Credit valuation adjustments is defined as the change in the fair value of derivative contracts with MBIA attributable to MBIA’s credit spreads.
(3) Counterparty hedges is defined as the notional value less current fair value of single name credit default swaps on MBIA the Company uses to mitigate credit exposure to MBIA.
(4) Positive net derivative counterparty exposure is defined as the net long position for MBIA and represents the potential loss to the Company over a period of time in an event of 100% default of a MBIA, assuming zero recovery.
(5) N/A—Not Applicable. At December 31, 2010, the aggregate value of credit valuation adjustments and hedges exceeded the amount of gross counterparty exposure by $0.9 billion.

The increase in positive net derivative counterparty exposure from December 31, 2010 is primarily due to a reduction in counterparty hedges and a reduction of the credit valuation adjustment from the tightening of MBIA spreads.

The Company’s hedging program primarily includes the use of single name credit default swaps that mitigate credit exposure to the Monolines and is conducted as part of the Company’s overall market risk management. The Company’s hedging program for Monoline counterparty exposure continues to be costly and difficult to effect because of the basis risk (risk associated with imperfect hedging) between the Monoline counterparty exposure and counterparty hedges as well as costs the Company incurs from premiums paid on counterparty hedges. The Company proactively manages its Monoline exposure; however, as market conditions continue to evolve, significant additional gains or losses could be incurred. See “Qualitative and Quantitative Disclosures about Market Risk—Risk Management—Market Risk” in Part II, Item 7A of the Form 10-K.

 

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Corporate Lending.    The Company recorded the following amounts primarily associated with loans and lending commitments carried at fair value within the Institutional Securities business segment (see “Business Segments—Institutional Securities—Sales and Trading Revenues” herein):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011(1)     2010(1)     2011(1)     2010(1)  
     (dollars in billions)  

Losses on loans and lending commitments

   $ (0.2   $ (0.4   $ —        $ (0.2

Gains (losses) on hedges

     (0.1     0.1        (0.2     (0.1
  

 

 

   

 

 

   

 

 

   

 

 

 

Total losses

   $ (0.3   $ (0.3   $ (0.2   $ (0.3
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Amounts include realized and unrealized gains (losses).

Income Tax Benefit.    The Company’s effective tax rate from continuing operations for the six months ended June 30, 2011 included a $447 million net tax benefit from the remeasurement of a deferred tax asset and the reversal of a related valuation allowance. The deferred tax asset and valuation allowance were recognized in income from discontinued operations during 2010 in connection with the recognition of a $1.2 billion loss due to writedowns and related costs following the Company’s commitment to a plan to dispose of Revel. The Company recorded the valuation allowance because the Company did not believe it was more likely than not that it would have sufficient future net capital gain to realize the benefit of the expected capital loss to be recognized upon the disposal of Revel. During the quarter ended March 31, 2011, the disposal of Revel was restructured as a tax-free like kind exchange and the disposal was completed. The restructured transaction changed the character of the future taxable loss to ordinary. The Company reversed the valuation allowance because the Company believes it is more likely than not that it will have sufficient future ordinary taxable income to recognize the recorded deferred tax asset. In accordance with the applicable accounting literature, this reversal of a previously established valuation allowance due to a change in circumstances was recognized in income from continuing operations during the quarter ended March 31, 2011.

The Company’s effective tax rate from continuing operations for the quarter and six months ended June 30, 2010 included a net tax benefit of $345 million and $727 million, respectively. The quarter and six months ended June 30, 2010 included a tax benefit of $345 million associated with the remeasurement of net unrecognized tax benefits and related interest based on new information regarding the status of federal and state examinations. The six months ended June 30, 2010 also included a tax benefit of $382 million related to the reversal of U.S. deferred tax liabilities associated with prior-years’ undistributed earnings of certain non-U.S. subsidiaries that were determined to be indefinitely reinvested abroad.

Morgan Stanley Debt.    Net revenues reflected gains of $244 million and $55 million in the quarter and six months ended June 30, 2011, respectively, and $750 million and $803 million in the quarter and six months ended June 30, 2010, respectively from the widening of the Company’s credit spreads and other credit factors on certain long-term and short-term borrowings, primarily structured notes that are accounted for at fair value.

During the quarter and six months ended June 30, 2011, net revenues included losses on economic hedges related to the Company’s long-term debt (see “Business Segments—Institutional Securities—Sales and Trading Revenues” herein).

 

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Real Estate Investments.    The Company recorded gains (losses) in the following business segments related to real estate investments. These amounts exclude investments associated with certain deferred compensation and employee co-investment plans.

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
         2011              2010          2011      2010  
    

(dollars in billions)

 

Institutional Securities

           

Continuing operations(1)

   $ 0.1       $ —         $ 0.6       $ —     

Discontinued operations(2)

     —           —           —           (0.9
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Institutional Securities

     0.1         —           0.6         (0.9

Asset Management:

           

Continuing operations(3)

     0.2         —           0.2         0.1   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Asset Management

     0.2         —           0.2         0.1   

Amounts applicable to noncontrolling interests

     0.1         —           0.2         0.1   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 0.2       $ —         $ 0.6       $ (0.9
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Amounts include a tax benefit related to Revel (see “Income Tax Benefit” herein), and net realized and unrealized gains from the Company’s limited partnership investments in real estate funds.
(2) On March 31, 2010, the Company’s Board of Directors authorized a plan of disposal by sale for Revel. The results of Revel, including the estimated loss from the planned disposal, are reported as discontinued operations for all periods presented within the Institutional Securities business segment. On February 17, 2011, the Company completed the sale of Revel to a group of investors led by Revel’s chief executive officer (see Note 1 to the condensed consolidated financial statements).
(3) Gains related to net realized and unrealized gains from real estate limited partnership investments in the Company’s Real Estate Investing business and are reflected in Principal transactions—Investments in the condensed consolidated statements of income. Amounts also include net gains associated with the Company’s investment in Infrastructure funds.

Huaxin Securities Joint Venture.    In June 2011, the Company and Huaxin Securities Co., Ltd. (“Huaxin Securities”) (also known as China Fortune Securities Co., Ltd.) jointly announced the operational commencement of their securities joint venture in China. The establishment of the joint venture was approved by China Securities Regulatory Commission (“CSRC”) on December 31, 2010 and was subject to receipt of a business license from the State Administration for Industry & Commerce of the People’s Republic of China, which was obtained in May 2011. Final CSRC approval for the commencement of business operations was obtained in June 2011. In the quarter ended June 30, 2011, the Company recorded initial costs of $130 million related to the formation of this new Chinese securities joint venture in Other expenses in the condensed consolidated statement of income.

The joint venture, Morgan Stanley Huaxin Securities Company Limited, is registered and principally located in Shanghai. Huaxin Securities holds a two-thirds interest in the joint venture while the Company owns a one-third interest. The establishment of the joint venture allows the Company to further build on its established onshore businesses in China. The joint venture’s business includes underwriting and sponsorship of shares in the domestic China market (including A shares and foreign investment shares), as well as underwriting, sponsorship and principal trading of bonds (including government and corporate bonds).

FrontPoint.    The Company recorded a loss of approximately $20 million related to the writedown of its minority stake investment in FrontPoint Partners LLC (“FrontPoint”) for the quarter ended June 30, 2011. The loss was included in Other revenues in the condensed consolidated statement of income. Beginning March 1, 2011, the Company accounts for its interest in FrontPoint as an equity method investment within the Asset Management business segment (see Note 19 to the condensed consolidated financial statements).

Settlement with DFS.    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

 

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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 in the condensed consolidated statement of income for the six months ended June 30, 2010.

Gain on Sale of Noncontrolling Interest.    In connection with the transaction between the Company and MUFG to form a joint venture in Japan, the Company recorded an after-tax gain of $717 million from the sale of a noncontrolling interest in its Japanese institutional securities business. This gain was recorded in Paid-in capital in the Company’s condensed consolidated statements of financial condition at June 30, 2010 and changes in total equity for the six months ended June 30, 2010. See “Other Matters—Japanese Securities Joint Venture” herein for further information.

Gain on Sale of Retail Asset Management.    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. (“Van Kampen”), to Invesco Ltd. (“Invesco”). The Company received $800 million in cash and approximately 30.9 million shares of Invesco stock upon sale, resulting in a cumulative after-tax gain of $673 million, of which $514 million was recorded in the quarter ended June 30, 2010. The remaining gain of $159 million, representing tax basis benefits, was recorded primarily in the quarter ended December 31, 2009. The results of Retail Asset Management are reported as discontinued operations within the Asset Management business segment for all periods presented. The Company recorded the 30.9 million shares as securities available for sale and subsequently sold the shares in the fourth quarter of 2010.

U.K. Tax.    During the quarter ended June 30, 2010, the Company recognized a charge of $361 million in Compensation and benefits expense relating to the U.K. government’s payroll tax on discretionary above-based compensation.

Employee Benefit Plans.    On June 1, 2010, the Morgan Stanley Employees Retirement Plan (the “Pension Plan”) for U.S. participants was amended to cease future benefit accruals after December 31, 2010. Any benefits earned by participants under the Pension Plan at December 31, 2010 were preserved and payable based on the Pension Plan’s provisions. As a result, the Company recorded a curtailment gain that reduced Compensation and benefits expense by approximately $51 million in the condensed consolidated statement of income for the quarter ended June 30, 2010. Additionally, the Company remeasured the obligation and assets of the Pension Plan at May 31, 2010 due to such cessation of accruals for benefits, and recognized a gain of $166 million ($102 million after-tax) in the condensed consolidated statements of comprehensive income for the quarter and six months ended June 30, 2010, after reflecting the $51 million reduction in Compensation and benefits expense (see Note 16 to the condensed consolidated financial statements).

 

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Business Segments.

Substantially all of the Company’s operating revenues and operating expenses can be directly attributed to its business segments. Certain revenues and expenses have been allocated to each business segment, generally in proportion to its respective revenues or other relevant measures.

As a result of treating certain intersegment transactions as transactions with external parties, the Company includes an Intersegment Eliminations category to reconcile the business segment results to the Company’s consolidated results. Intersegment Eliminations also reflect the effect of fees paid by the Institutional Securities business segment to the Global Wealth Management Group business segment related to the bank deposit program. The Company did not recognize any Intersegment Elimination gains or losses in the quarter and six months ended June 30, 2011, and losses from continuing operations before income taxes recorded in Intersegment Eliminations were $13 million and $15 million in the quarter and six months ended June 30, 2010, respectively.

Net Revenues Discussion.

Principal Transactions—Trading.    Principal transactions—Trading revenues include revenues from customers’ purchases and sales of financial instruments in which the Company acts as principal and gains and losses on the Company’s positions, as well as proprietary trading activities for its own account. Principal transactions—Trading revenues also includes the realized gains and losses from sales of cash instruments and derivative settlements, and unrealized gains and losses from ongoing fair value changes of the Company’s positions related to market-making activities. In many markets, the realized and unrealized gains and losses from the purchase and sale transactions will include any spreads between bids and offers. Fees received on loans carried at fair value and dividends from equity securities are also recorded in this line item since they relate to market-making positions. Commissions received for purchasing and selling listed equity securities and options are recorded separately in the Commissions line item. Other cash and derivative instruments typically do not have fees associated with them.

 

Principal Transactions—Investments. The Company’s investments generally are held for long-term appreciation and generally are subject to significant sales restrictions. Estimates of the fair value of the investments may involve significant judgment and may fluctuate significantly over time in light of business, market, economic and financial conditions generally or in relation to specific transactions. In some cases, such investments are required or are a necessary part of offering other products. The revenues recorded are the result of realized gains and losses from sales and unrealized gains and losses from ongoing fair value changes of the Company’s holdings as well as from investments associated with certain employee deferred compensation plans. Typically, there are no fee revenues from these investments. The sales restrictions on the investments relate primarily to redemption and withdrawal restrictions on investments in real estate funds, hedge funds and private equity funds, which includes investments made in connection with certain employee deferred compensation plans (see Note 3 to the condensed consolidated financial statements). Restrictions on interests in exchanges and clearinghouses generally include a requirement to hold those interests for the period of time that the Company is clearing trades on that exchange or clearinghouse. Additionally, there are certain principal investments related to assets held by consolidated real estate funds, which are primarily related to holders of non-controlling interests.

Commissions.    Commission revenues primarily arise from agency transactions in listed and over-the-counter (“OTC”) equity securities and sales of mutual funds, futures, insurance products and options.

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees include fees associated with the management and supervision of assets, account services and administration, performance-based fees relating to certain funds, separately managed accounts, shareholder servicing, and the distribution of certain open-ended mutual funds.

 

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Net Interest.    Interest income and Interest expense are a function of the level and mix of total assets and liabilities, including financial instruments owned and financial instruments sold, not yet purchased, securities available for sale, reverse repurchase and repurchase agreements, loans, trading strategies, customer activity in the Company’s prime brokerage business, and the prevailing level, term structure and volatility of interest rates. Certain Securities purchased under agreements to resell (“reverse repurchase agreements”) and Securities sold under agreements to repurchase (“repurchase agreements”) and Securities borrowed and Securities loaned transactions may be entered into with different customers using the same underlying securities, thereby generating a spread between the interest revenue on the reverse repurchase agreements or securities borrowed transactions and the interest expense on the repurchase agreements or securities loaned transactions.

Market Making.

As a market maker, the Company stands ready to buy, sell or otherwise transact with customers under a variety of market conditions and provide firm or indicative prices in response to customer requests. The Company’s liquidity obligations can be explicit and obligatory in some cases, and in others, customers expect the Company to be willing to transact with them. In order to most effectively fulfill its market-making function, the Company engages in activities, across all of its trading businesses, that include, but are not limited to, (i) taking positions in anticipation of, and in response to customer demand to buy or sell, and—depending on the liquidity of the relevant market and the size of the position—holding those positions for a period of time; (ii) managing and assuming basis risk (risk associated with imperfect hedging) between customized customer risks and the standardized products available in the market to hedge those risks; (iii) building, maintaining, and re-balancing inventory, through trades with other market participants, and engaging in accumulation activities to accommodate anticipated customer demand; (iv) trading in the market to remain current on pricing and trends; and (v) engaging in arbitrage activities to provide efficiency and liquidity for markets. Interest income and expense are also impacted by market-making activities as debt securities held by the Company earn interest and securities are loaned, borrowed, sold with agreement to repurchase and purchased with agreement to resell.

 

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INSTITUTIONAL SECURITIES

INCOME STATEMENT INFORMATION

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2011             2010             2011             2010      
     (dollars in millions)  

Revenues:

        

Investment banking

   $ 1,473      $ 885      $ 2,481      $ 1,772   

Principal transactions:

        

Trading

     3,209        3,116        5,855        6,534   

Investments

     150        (68     293        106   

Commissions

     603        617        1,273        1,197   

Asset management, distribution and administration fees

     34        39        65        65   

Other

     130        51        (443     193   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest revenues

     5,599        4,640        9,524        9,867   
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest income

     1,573        1,359        3,053        2,755   

Interest expense

     1,983        1,484        3,796        2,769   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest

     (410     (125     (743     (14
  

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues

     5,189        4,515        8,781        9,853   
  

 

 

   

 

 

   

 

 

   

 

 

 

Compensation and benefits

     2,240        1,637        4,193        3,806   

Non-compensation expenses

     1,492        1,283        2,734        2,387   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest expenses

     3,732        2,920        6,927        6,193   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

     1,457        1,595        1,854        3,660   

Provision for (benefit from) income taxes

     350        220        (28     550   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income from continuing operations

     1,107        1,375        1,882        3,110   
  

 

 

   

 

 

   

 

 

   

 

 

 

Discontinued operations:

        

Income (loss) from discontinued operations

     1        (50     (4     (985

Provision for (benefit from) income taxes

     —          (23     (2     (22
  

 

 

   

 

 

   

 

 

   

 

 

 

Net gain (losses) on discontinued operations

     1        (27     (2     (963
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     1,108        1,348        1,880        2,147   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) applicable to noncontrolling interests

     117        (9     178        (5
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

   $ 991      $ 1,357      $ 1,702      $ 2,152   
  

 

 

   

 

 

   

 

 

   

 

 

 

Amounts applicable to Morgan Stanley:

        

Income from continuing operations

   $ 990      $ 1,384      $ 1,704      $ 3,115   

Net gain (losses) from discontinued operations

     1        (27     (2     (963
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

   $ 991      $ 1,357      $ 1,702      $ 2,152   
  

 

 

   

 

 

   

 

 

   

 

 

 

On February 17, 2011, the Company completed the sale of Revel. 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. 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 six months ended June 30, 2010 included losses of approximately $1.2 billion in connection with writedowns and related costs of such planned disposition. For further information on Revel, see “Executive Summary—Significant Items—Income Tax Benefit” herein and Note 28 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.

 

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Investment Banking.

Investment banking revenues were as follows:

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
         2011              2010              2011              2010      
     (dollars in millions)  

Advisory revenues

   $ 533       $ 288       $ 918       $ 615   

Underwriting revenues:

           

Equity underwriting revenues

     419         269         704         533   

Fixed income underwriting revenues

     521         328         859         624   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total underwriting revenues

     940         597         1,563         1,157   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment banking revenues

   $ 1,473       $ 885       $ 2,481       $ 1,772   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table presents the Company’s volumes of announced and completed mergers and acquisitions, equity and equity-related offerings and fixed income offerings:

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011(1)      2010(1)      2011(1)      2010(1)  
     (dollars in billions)  

Announced mergers and acquisitions(2)

   $ 106       $ 115       $ 267       $ 180   

Completed mergers and acquisitions(2)

     173         107         411         170   

Equity and equity-related offerings(3)

     16         11         29         22   

Fixed income offerings(4)

     53         48         119         113   

 

(1) Source: Thomson Reuters, data at July 20, 2011. Announced and completed mergers and acquisitions volumes are based on full credit to each of the advisors in a transaction. Equity and equity-related offerings and fixed income offerings are based on full credit for single book managers and equal credit for joint book managers. Transaction volumes may not be indicative of net revenues in a given period. In addition, transaction volumes for prior periods may vary from amounts previously reported due to the subsequent withdrawal or a change in the value of a transaction.
(2) Amounts include transactions of $100 million or more and exclude terminated transactions.
(3) Amounts include Rule 144A and public common stock offerings, convertible offerings and rights offerings.
(4) Amounts include non-convertible preferred stock, mortgage-backed securities, asset-backed securities and taxable municipal debt. Amounts also include publicly registered and Rule 144A issues. Amounts exclude leveraged loans and self-led issuances.

Investment banking revenues for the quarter ended June 30, 2011 increased 66% from the comparable period in 2010, reflecting higher revenues in all categories—equity and fixed income underwriting transactions and advisory fees. Overall, underwriting revenues of $940 million increased 57% from the quarter ended June 30, 2010. Equity underwriting revenues increased 56% to $419 million, reflecting revenue growth across all regions. Fixed income underwriting revenues increased 59% to $521 million, primarily due to higher loan syndication fees and an increase in non-investment grade bond issuances. Advisory revenues from merger, acquisition and restructuring transactions were $533 million, an increase of 85% from the comparable period of 2010, reflecting higher revenues across all regions.

Investment banking revenues for the six months ended June 30, 2011 increased 40% from the comparable period in 2010, reflecting higher revenues from equity and fixed income underwriting transactions and higher advisory revenues.

Sales and Trading Revenues.    Sales and trading revenues are composed of Principal transactions—Trading revenues; Commissions; Asset management, distribution and administration fees; and Net interest revenues (expenses). In assessing the profitability of its sales and trading activities, the Company views these net revenues in the aggregate. In addition, decisions relating to principal transactions are based on an overall review of aggregate revenues and costs associated with each transaction or series of transactions. This review includes,

 

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among other things, an assessment of the potential gain or loss associated with a transaction, including any associated commissions, dividends, the interest income or expense associated with financing or hedging the Company’s positions, and other related expenses. See Note 10 to the condensed consolidated financial statements for further information related to gains (losses) on derivative instruments.

Effective March 31, 2011, the Institutional Securities business segment’s “fixed income” business has been renamed the “fixed income and commodities” business. The interest rate, credit and currency business has been renamed the “fixed income” business. These name changes did not affect current or previously reported results for these businesses.

Total sales and trading revenues decreased 6% in the quarter ended June 30, 2011 from the comparable period of 2010, reflecting lower fixed income sales and trading revenues and higher losses in other sales and trading revenues, partially offset by higher equity sales and trading revenues.

Sales and trading revenues were as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
       2011         2010(1)         2011         2010(1)    
     (dollars in millions)  

Equity

   $ 1,853      $ 1,415      $ 3,555      $ 2,834   

Fixed income and commodities

     2,093        2,332        3,863        5,049   

Other(2)

     (510     (100     (968     (101
  

 

 

   

 

 

   

 

 

   

 

 

 

Total sales and trading revenues

   $ 3,436      $ 3,647      $ 6,450      $ 7,782   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) All prior-period amounts have been reclassified to conform to the current period’s presentation.
(2) Other sales and trading net revenues include net gains (losses) from loans and lending commitments and related hedges associated with the Company’s lending activities. Other sales and trading net revenues also included losses on economic hedges related to the Company’s long-term debt and net losses associated with costs related to the amount of liquidity (“negative carry”) in the Company’s domestic subsidiary banks, Morgan Stanley Bank, N.A. and Morgan Stanley Private Bank, National Association (formerly, Morgan Stanley Trust FSB) (the “Subsidiary Banks”).

Equity.    Equity sales and trading revenues increased 31% to $1,853 million in the quarter ended June 30, 2011 from the comparable period of 2010. The increase primarily reflected higher revenues in derivatives and equity financing driven by strong client activity and to a lesser extent structured transactions. Prime Brokerage net revenues also increased from the prior year quarter primarily reflecting higher average client balances. Results in equity sales and trading revenues also included positive revenue of $52 million in the quarter ended June 30, 2011 due to the widening of the Company’s credit spreads and other credit factors, resulting in a decrease in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected compared with positive revenue of $129 million in the quarter ended June 30, 2010.

In the quarter ended June 30, 2011, equity sales and trading revenues also reflected unrealized losses of $6 million related to changes in the fair value of net derivative contracts attributable to the widening of counterparties’ credit default swap spreads and other credit factors compared with unrealized losses of $60 million in the quarter ended June 30, 2010. The Company also recorded unrealized gains of $69 million in the quarter ended June 30, 2011 related to changes in the fair value of net derivative contracts attributable to the widening of the Company’s credit default swap spreads and other credit factors compared with unrealized gains of $80 million in the quarter ended June 30, 2010. The unrealized gains and losses on credit default swap spreads do not reflect any gains or losses on related hedging instruments.

Fixed Income and Commodities.    Fixed income and commodities sales and trading revenues decreased 10% to $2,093 million in the quarter ended June 30, 2011 from the comparable period of 2010. Fixed income product revenues in the quarter ended June 30, 2011 increased 32%, primarily reflecting higher results in credit products due to higher revenues related to structured transactions, partially offset by lower revenues from unfavorable positioning in interest rate products. Fixed income product net revenues in the quarter ended June 30, 2011 were

 

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positively impacted by gains of $471 million from Monolines compared with losses of $186 million in the quarter ended June 30, 2010 (see “Executive Summary—Significant Items—Monoline Insurers” herein for further information). Commodity net revenues decreased 83% in the quarter ended June 30, 2011, primarily due to lower levels of client activity across all sectors. Results in the quarter ended June 30, 2011 included positive revenue of $192 million due to the widening of the Company’s credit spreads and other credit factors, resulting in a decrease in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected compared with positive revenues of $602 million in the quarter ended June 30, 2010.

In the quarter ended June 30, 2011, fixed income and commodities sales and trading revenues reflected net unrealized gains of $129 million related to changes in the fair value of net derivative contracts attributable to the tightening of counterparties’ credit default swap spreads and other credit factors compared with unrealized losses of $820 million in the quarter ended June 30, 2010 due to the widening of such spreads and other credit factors. The Company also recorded unrealized gains of $138 million in the quarter ended June 30, 2011 related to changes in the fair value of net derivative contracts attributable to the widening of the Company’s credit default swap spreads and other credit factors compared with gains of $919 million in the quarter ended June 30, 2010. The unrealized gains and losses on credit default swap spreads do not reflect any gains or losses on related hedging instruments.

Other.    In addition to the equity and fixed income and commodities sales and trading revenues discussed above, sales and trading revenues included other trading revenues, consisting of certain activities associated with the Company’s lending activities, losses on economic hedges related to the Company’s long-term debt and negative carry in the Subsidiary Banks. In the quarter ended June 30, 2011, other sales and trading revenues reflected a net loss of $510 million compared with a net loss of $100 million in the quarter ended June 30, 2010. Results in the quarter ended June 30, 2011 included net losses related to negative carry in the Subsidiary Banks and net losses of $252 million associated with loans and lending commitments (mark-to-market valuations and realized losses of $173 million and losses on related hedges of $79 million). The results in the current quarter also reflected net losses on economic hedges related to the Company’s long-term debt compared with net gains in the prior year quarter. Results for the prior year quarter included net losses of $277 million (mark-to-market valuations and realized losses of $388 million, partially offset by gains on related hedges of $111 million) associated with loans and lending commitments. The valuation of these commitments could change in future periods depending on, among other things, the extent that they are renegotiated or repriced or if the associated acquisition transaction does not occur.

Sales and Trading Revenues in the Six Months Ended June 30, 2011.    Total sales and trading revenues decreased 17% in the six months ended June 30, 2011 from the comparable period of 2010, reflecting lower fixed income and commodities sales and trading revenues and higher losses in other sales and trading revenues, partially offset by higher equity sales and trading revenues. Equity sales and trading revenues increased 25% primarily due to higher revenues in the derivatives and cash businesses and higher revenues from prime brokerage. The results in equity sales and trading revenues in the six months ended June 30, 2011 also included positive revenues of $22 million due to the widening of the Company’s debt-related credit spreads and other credit factors compared with positive revenues of $177 million in the six months ended June 30, 2010. Fixed income and commodities sales and trading revenues decreased 23% primarily due to lower revenues in credit, currency and commodity products. The decrease in fixed income and commodities sales and trading revenues in the six months ended June 30, 2011 were also due to the inclusion of positive revenues of only $33 million due to the widening of the Company’s debt-related credit spreads and other credit factors compared with positive revenues of $604 million in the six months ended June 30, 2010. In the six months ended June 30, 2011, other sales and trading losses were $968 million compared with losses of $101 million in the six months ended June 30, 2010. Results in the six months ended June 30, 2011 included net losses on economic hedges related to the Company’s long-term debt and higher net losses related to negative carry in the Subsidiary Banks, partially offset by lower losses related to certain activities associated with the Company’s corporate lending activities.

 

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Principal Transactions—Investments.    Principal transaction net investment gains of $150 million and $293 million were recognized in the quarter and six months ended June 30, 2011 compared with net investment losses of $68 million and net investment gains of $106 million in the quarter and six months ended June 30, 2010, respectively. The gains in the quarter ended June 30, 2011 primarily reflected higher equity valuations compared with lower equity valuations in the quarter ended June 30, 2010. The gains in the six months ended June 30, 2011 and June 30, 2010 were primarily due to principal investments in real estate funds and investments associated with certain employee deferred compensation plans.

Other.    Other revenues of $130 million and other losses of $443 million were recognized in the quarter and six months ended June 30, 2011, respectively, compared with other revenues of $51 million and $193 million in the quarter and six months ended June 30, 2010, respectively. The increase in the quarter ended June 30, 2011 was primarily due to higher revenues from equity method investments. The results in the quarter and six months ended June 30, 2011 included pre-tax losses of $17 million and $672 million, respectively, arising from the Company’s 40% stake in MUMSS (see “Executive Summary—Significant Items—Japanese Securities Joint Venture” herein).

Non-interest Expenses.    Non-interest expenses increased 28% and 12% in the quarter and six months ended June 30, 2011, respectively. The increase in both periods was primarily due to higher compensation expenses and higher non-compensation expenses. Compensation and benefits expenses increased 37% in the quarter ended June 30, 2011 primarily due to higher net revenues. Compensation and benefits expenses increased 10% in the six months ended June 30, 2011 primarily due to higher net revenues, excluding gains due to the widening of the Company’s credit spreads and other credit factors on long-term and short-term borrowings carried at fair value and a pre-tax loss of $672 million arising from the Company’s 40% stake in MUMSS (see “Executive Summary—Significant Items—Japanese Securities Joint Venture” herein). Brokerage, clearing and exchange fees increased 10% and 12% in the quarter and six months ended June 30, 2011, respectively, primarily due to higher levels of business activity. Information processing and communications expense increased 12% in both periods, primarily due to ongoing investments in technology. Professional services expense decreased 9% and 10% in the quarter and six months ended June 30, 2011, respectively, primarily due to lower legal fees and consulting expenses. Other expenses increased 82% and 72% in the quarter and six months ended June 30, 2011, respectively, primarily due to the initial costs of $130 million associated with Morgan Stanley Huaxin Securities Company Limited.

 

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GLOBAL WEALTH MANAGEMENT GROUP

INCOME STATEMENT INFORMATION

 

     Three Months Ended
June 30,
     Six Months Ended
June  30,
 
         2011              2010              2011              2010      
     (dollars in millions)  

Revenues:

           

Investment banking

   $ 219       $ 201       $ 423       $ 374   

Principal transactions:

           

Trading

     289         249         623         591   

Investments

     5         —           9         6   

Commissions

     689         692         1,468         1,374   

Asset management, distribution and administration fees

     1,781         1,572         3,464         3,200   

Other

     145         72         236         155   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total non-interest revenues

     3,128         2,786         6,223         5,700   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest income

     466         387         920         726   

Interest expense

     118         99         230         247   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest

     348         288         690         479   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net revenues

     3,476         3,074         6,913         6,179   
  

 

 

    

 

 

    

 

 

    

 

 

 

Compensation and benefits

     2,150         1,966         4,275         3,938   

Non-compensation expenses

     1,004         901         1,968         1,756   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total non-interest expenses

     3,154         2,867         6,243         5,694   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income from continuing operations before income taxes

     322         207         670         485   

Provision for income taxes

     138         61         229         125   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income from continuing operations

     184         146         441         360   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

     184         146         441         360   

Net income applicable to noncontrolling interests

     4         36         78         151   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income applicable to Morgan Stanley

   $ 180       $ 110       $ 363       $ 209   
  

 

 

    

 

 

    

 

 

    

 

 

 

Global Wealth Management Group’s net revenues are composed of Transactional, Asset management, Net interest and Other revenues. Transactional revenues include investment banking, Principal transactionsTrading and Commissions. Asset management revenues include asset management, distribution and administration fees and fees related to the bank deposit program. Net interest revenues include net interest revenues related to the bank deposit program, interest on securities available for sale and all other net interest revenues.

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
         2011              2010              2011              2010      
     (dollars in millions)  

Revenues:

           

Transactional

   $ 1,197       $ 1,142       $ 2,514       $ 2,339   

Asset management

     1,781         1,572         3,464         3,200   

Net interest

     348         288         690         479   

Other

     150         72         245         161   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net revenues

   $ 3,476       $ 3,074       $ 6,913       $ 6,179   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Transactional.

Investment Banking.    Investment banking revenues increased 9% and 13% in the quarter and six months ended June 30, 2011, respectively, from the comparable period of 2010, primarily due to higher equity underwriting and unit investment trusts activity, partially offset by lower fixed income underwriting activity.

Principal Transactions—Trading.    Principal transactions—Trading revenues increased 16% and 5% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to gains related to investments associated with certain employee deferred compensation plans, higher revenues from municipal securities and structured notes, partially offset by lower revenues from corporate equity and government securities.

Commissions.    Commission revenues increased 7% in the six months ended June 30, 2011, from the comparable periods of 2010, primarily due to higher client activity.

Asset Management.

Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees increased 13% and 8% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to higher fee-based revenues. Revenues for the six months ended June 30, 2011 were partially offset by the change in classification of the bank deposit program. From June 2009 until April 1, 2010, revenues in the bank deposit program were primarily included in Asset management, distribution and administration fees. Beginning on April 1, 2010, revenues in the bank deposit program held at the Company’s U.S. depository institutions were recorded as Interest income due to renegotiations of the revenue sharing agreement as part of the Global Wealth Management Group business segment’s retail banking strategy. The Global Wealth Management Group business segment will continue to earn referral fees for deposits placed with Citi depository institutions, and these fees will continue to be recorded in Asset management, distribution and administration fees until the legacy Smith Barney deposits are migrated to the Company’s U.S. depository institutions. The referral fees for deposits were $61 million and $65 million for the quarters ended June 30, 2011 and 2010, respectively, and $126 million and $166 million for the six months ended June 30, 2011 and 2010, respectively.

Balances in the bank deposit program increased to $110.4 billion at June 30, 2011 from $109.5 billion at June 30, 2010. The unlimited FDIC program expired on June 30, 2010 for deposits held by the Company’s depository institutions. Deposits held by Company-affiliated FDIC-insured depository institutions were $55.9 billion of the $110.4 billion deposits at June 30, 2011.

Client assets in fee-based accounts increased to $509 billion and represented 30% of total client assets at June 30, 2011, compared with $396 billion and 26% at June 30, 2010, respectively. Total client asset balances increased to $1,709 billion at June 30, 2011 from $1,500 billion at June 30, 2010, primarily due to improved market conditions and an increase in net new assets. Net new assets for the quarter ended June 30, 2011 were an inflow of $2.9 billion compared with an outflow of $5.5 billion for the quarter ended June 30, 2010. Client asset balances in households with assets greater than $1 million increased to $1,274 billion at June 30, 2011 from $1,067 billion at June 30, 2010. Global fee-based asset net flows increased to $9.7 billion for the quarter ended June 30, 2011 from $6.3 billion for the quarter ended June 30, 2010.

Net Interest.

Net interest increased 21% and 44% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily resulting from an increase in Interest income due to interest on the securities available for sale portfolio and mortgages. The increase in Interest income for the six months ended June 30, 2011 was also due to a change in classification of the bank deposit program noted above.

 

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Other.

Principal Transactions—Investments.    Principal transaction net investment gains were $5 million and $9 million in the quarter and six months ended June 30, 2011, respectively, compared with net investment gains of $0 and $6 million in the quarter and six months ended June 30, 2010, respectively. The increase primarily reflected gains related to investments associated with certain employee deferred compensation plans compared with such investments in the prior year period.

Other.    Other revenues were $145 million and $236 million in the quarter and six months ended June 30, 2011, respectively, an increase of 101% and 52% from the quarter and six months ended June 30, 2010, respectively. The increase was primarily due to gains on sales of securities available for sale.

Non-interest Expenses.    Non-interest expenses increased 10% in the quarter and six months ended June 30, 2011 from the comparable periods of 2010. Compensation and benefits expense increased 9% in the quarter and six months ended June 30, 2011, from the comparable periods of 2010, primarily reflecting higher net revenues, higher expenses associated with certain employee deferred compensation plans and higher amortization of deferred compensation awards. In addition, the quarter and six months ended June 30, 2010 included a pension credit (see “Executive Summary—Significant Items—Employee Benefit Plans” herein). Non-compensation expenses increased 11% and 12% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010. In the quarter and six months ended June 30, 2011, marketing and business development expense increased 17% and 29%, respectively, from the comparable periods of 2010, primarily due to higher costs associated with conferences and seminars. Professional services expense increased 18% and 25% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to increased technology consulting costs and sub-advisory fees. Brokerage, clearing and exchange fees increased 18% and 20% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to higher volumes. Information processing and communications expense increased 9% and 12% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to higher telecommunications and data storage costs. Other expenses increased 14% and 10% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to a $45 million increase in the FDIC assessment on deposits and higher bad debt expense. The six months ended June 30, 2011 was also impacted by higher litigation costs, as well as costs associated with printing, taxes, licenses and fees.

 

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ASSET MANAGEMENT

INCOME STATEMENT INFORMATION

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
         2011             2010             2011             2010      
     (dollars in millions)  

Revenues:

        

Investment banking

   $ 3      $ 7      $ 5      $ 7   

Principal transactions:

        

Trading

     (11     (10     (12     (11

Investments

     247        16        429        205   

Asset management, distribution and administration fees

     413        383        822        797   

Other

     3        36        45        106   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest revenues

     655        432        1,289        1,104   
  

 

 

   

 

 

   

 

 

   

 

 

 

Interest income

     3        3        7        9   

Interest expense

     13        25        25        50   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest

     (10     (22     (18     (41
  

 

 

   

 

 

   

 

 

   

 

 

 

Net revenues

     645        410        1,271        1,063   
  

 

 

   

 

 

   

 

 

   

 

 

 

Compensation and benefits

     285        282        540        557   

Non-compensation expenses

     195        214        439        418   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total non-interest expenses

     480        496        979        975   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations before income taxes

     165        (86     292        88   

Provision for (benefit from) income taxes

     54        (39     85        4   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from continuing operations

     111        (47     207        84   
  

 

 

   

 

 

   

 

 

   

 

 

 

Discontinued operations:

        

Gain from discontinued operations

     4        901        9        965   

Provision for income taxes

     1        360        1        330   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net gain from discontinued operations

     3        541        8        635   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     114        494        215        719   

Net income (loss) applicable to noncontrolling interests

     92        (3     119        113   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

   $ 22      $ 497      $ 96      $ 606   
  

 

 

   

 

 

   

 

 

   

 

 

 

Amounts applicable to Morgan Stanley:

        

Income (loss) from continuing operations

   $ 19      $ (44   $ 88      $ (29

Net gain from discontinued operations

     3        541        8        635   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income applicable to Morgan Stanley

   $ 22      $ 497      $ 96      $ 606   
  

 

 

   

 

 

   

 

 

   

 

 

 

On March 1, 2011, the Company and the principals of FrontPoint completed a transaction whereby FrontPoint senior management and portfolio managers own a majority equity stake in FrontPoint and the Company retained a minority stake. FrontPoint has replaced the Company’s affiliates as the investment advisor and general partner of the FrontPoint funds. The investment in FrontPoint is accounted for under the equity method of accounting. Prior to March 1, 2011, the Company consolidated FrontPoint. The Company recorded a loss of approximately $20 million related to the writedown of the minority stake investment in FrontPoint for the quarter ended June 30, 2011. The loss was included in Other revenues in the condensed consolidated statements of income.

On June 1, 2010, the Company completed the sale of Retail Asset Management, including Van Kampen, to Invesco. The Company recorded a cumulative after-tax gain of $673 million, of which $514 million was recorded in the quarter ended June 30, 2010. The remaining gain of $159 million, representing tax basis benefits, was

 

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recorded primarily in the quarter ended December 31, 2009. The results of Retail Asset Management are reported as discontinued operations within the Asset Management business segment for all periods presented.

Beginning in the quarter ended March 31, 2011, the Asset Management business segment was reorganized into three businesses: Traditional Asset Management, Real Estate Investing and Merchant Banking. Traditional Asset Management includes Long-only, which is comprised of Equity and Fixed Income, Liquidity and the Alternative Investment Products fund-of-funds businesses. Real Estate Investing was previously reported as part of Merchant Banking. Merchant Banking includes the Private Equity and Infrastructure business and hedge fund stake investments. The Company’s equity investment in FrontPoint, subsequent to the restructuring of that business, is included in Merchant Banking. The results of the FrontPoint business for all periods prior to the restructuring are also included in Merchant Banking.

Statistical Data.

The Asset Management business segment’s period-end and average assets under management or supervision were as follows:

 

     At
June 30,
     Average For The
Three Months Ended
June 30,
     Average For The
Six Months Ended
June 30,
 
       2011          2010(1)          2011          2010(1)          2011          2010(1)    
     (dollars in billions)  

Assets under management or supervision by asset class:

                 

Traditional Asset Management:

                 

Equity

   $ 119       $ 87       $ 119       $ 93       $ 116       $ 92   

Fixed income

     61         59         62         60         62         60   

Liquidity

     72         50         68         51         62         53   

Alternatives(2)

     18         17         18         17         18         17   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Traditional Asset Management

     270         213         267         221         258         222   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Real Estate Investing

     17         15         17         15         16         15   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Merchant Banking:

                 

Private Equity

     9         9         9         9         9         9   

FrontPoint(3)

     —           7         —           7         2         7   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Merchant Banking

     9         16         9         16         11         16   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total assets under management or supervision

   $ 296       $ 244       $ 293       $ 252       $ 285       $ 253   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Share of minority stake assets(3)(4)

   $ 7       $ 7       $ 7       $ 7       $ 7       $ 7   

 

(1) All prior-period amounts have been reclassified to conform to the current period’s presentation.
(2) The alternatives asset class includes a range of investment products such as hedge funds, funds of hedge funds and funds of private equity funds.
(3) On March 1, 2011, the Company and the principals of FrontPoint completed a transaction whereby FrontPoint senior management and portfolio managers own a majority equity stake in FrontPoint and the Company retains a minority stake. At June 30, 2011, the assets under management attributed to FrontPoint are represented within the share of minority stake assets.
(4) Amounts represent the Asset Management business segment’s proportional share of assets managed by entities in which it owns a minority stake.

 

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Activity in the Asset Management business segment’s assets under management or supervision during the quarters and six months ended June 30, 2011 and 2010 was as follows:

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
       2011         2010(1)         2011         2010(1)    
     (dollars in billions)  

Balance at beginning of period

   $ 276      $ 255      $ 272      $ 260   

Net flows by asset class:

        

Traditional Asset Management:

        

Equity

     1        (1     4        (1

Fixed income(2)

     (2     (1     (3     1   

Liquidity

     17        —          18        (9

Alternatives(3)

     —          1        —          —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Traditional Asset Management

     16        (1     19        (9
  

 

 

   

 

 

   

 

 

   

 

 

 

Real Estate Investing

     —          —          —          1   
  

 

 

   

 

 

   

 

 

   

 

 

 

Merchant Banking:

        

Private equity

     —          —          —          —     

FrontPoint(4)

     —          —          (2     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Merchant Banking

     —          —          (2     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net flows

     16        (1     17        (8

Net market appreciation (depreciation)

     4        (10     11        (8

Decrease due to FrontPoint transaction

     —          —          (4     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net increase (decrease)

     20        (11     24        (16
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 296      $ 244      $ 296      $ 244   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) All prior-period amounts have been reclassified to conform to the current presentation.
(2) Fixed income outflows for the quarter ended June 30, 2011 includes $1.3 billion due to the revised treatment of assets under management previously reported as a net flow.
(3) The alternatives asset class includes a range of investment products such as hedge funds, funds of hedge funds and funds of private equity funds.
(4) The amount for the six months ended June 30, 2011 includes two months of net flows related to FrontPoint, whereas the comparable period in 2010 includes six months of net flows related to FrontPoint. The amount for the quarter ended June 30, 2011 does not include net flows related to FrontPoint, whereas the quarter ended June 30, 2010 includes three months of net flows related to FrontPoint.

Principal Transactions—Investments.    The Company recorded principal transactions net investment gains of $247 million and $429 million in the quarter and six months ended June 30, 2011, respectively, compared with gains of $16 million and $205 million in the quarter and six months ended June 30, 2010, respectively. The increase in both periods was primarily related to net investment gains associated with the Company’s Real Estate Investing business, as a result of valuation gains within certain consolidated real estate funds sponsored by the Company, as well as net gains on the Company’s Merchant Banking and Traditional Asset Management investments.

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees increased 8% and 3% in the quarter and six months ended June 30, 2011, respectively, primarily reflecting higher performance fees and fund management and administration fees. The higher fund management and administration fees were driven by an increase in average assets under management.

The Company’s assets under management increased $52 billion from $244 billion at June 30, 2010 to $296 billion at June 30, 2011 reflecting market appreciation and net customer inflows. The Company recorded net customer inflows of $15.7 billion and $17.1 billion in the quarter and six months ended June 30, 2011, respectively, compared with net outflows of $1.2 billion and $8.0 billion in the quarter and six months ended

 

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June 30, 2010, respectively. The increase in flows for the quarter and six months ended June 30, 2011 reflected the sweep of MSSB client cash balances of approximately $18.5 billion into Morgan Stanley managed liquidity funds.

Other.    Other revenues decreased 92% and 58% in the quarter and six months ended June 30, 2011, respectively, primarily reflecting a loss of approximately $20 million related to the writedown of the Company’s minority stake investment in FrontPoint (see “Executive Summary—Significant Items—FrontPoint” herein). The results also included lower revenues associated with the Company’s minority stake investments in Avenue Capital Group, a New York-based investment manager, and Lansdowne Partners, a London-based investment manager.

Non-interest Expenses.    Non-interest expenses decreased 3% in the quarter ended June 30, 2011 compared with the quarter ended June 30, 2010, primarily reflecting a decrease in Non-compensation expenses. Non-compensation expenses decreased 9% in the quarter ended June 30, 2011 compared with the prior year quarter primarily due to the absence of FrontPoint in the current quarter. Non-compensation expenses increased 5% in the six months ended June 30, 2011 compared with the prior year period due to indemnification losses related to the FrontPoint transaction and higher distribution expenses.

 

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Accounting Developments.

Reconsideration of Effective Control for Repurchase Agreements.

In April 2011, the FASB issued accounting guidance that removes the requirement to consider whether sufficient collateral is held when determining whether to account for repurchase agreements and other agreements that both entitle and obligate the transferor to repurchase or redeem financial assets before their maturity as sales or as secured financings. The guidance is effective for the Company prospectively for transactions beginning on January 1, 2012. The Company does not believe the adoption of this accounting guidance will have a material impact on the Company’s condensed consolidated financial statements.

Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.

In May 2011, the FASB issued an accounting update that clarifies the existing fair value measurement guidance and changes certain principles or requirements for measuring fair value or disclosing information about fair value measurements. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurement in accordance with U.S. GAAP and International Financial Reporting Standards. The guidance is effective for the Company prospectively beginning on January 1, 2012. The Company is currently evaluating the impact of adopting this accounting guidance on the Company’s condensed consolidated financial statements.

 

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Other Matters.

Real Estate.

The Company acts as the general partner for various real estate funds and also invests in certain of these funds as a limited partner. The Company’s real estate investments at June 30, 2011 and December 31, 2010 are described below. Such amounts exclude investments associated with certain employee deferred compensation and co-investment plans.

At June 30, 2011 and December 31, 2010, the condensed consolidated statements of financial condition included amounts representing real estate investment assets of consolidated subsidiaries of approximately $2.0 billion and $1.9 billion, respectively, including noncontrolling interests of approximately $1.6 billion and $1.5 billion, respectively, for a net amount of $0.4 billion. This net presentation is a non-GAAP financial measure that the Company considers to be the most useful measure for the Company and investors to use in assessing the Company’s net exposure. In addition, the Company has contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to real estate investments of $1.0 billion at June 30, 2011 (see Note 11 to the condensed consolidated financial statements).

In addition to the Company’s real estate investments, the Company engages in various real estate-related activities, including origination of loans secured by commercial and residential properties. The Company also securitizes and trades in a wide range of commercial and residential real estate and real estate-related whole loans, mortgages and other real estate. In connection with these activities, the Company has provided, or otherwise agreed to be responsible for, representations and warranties. Under certain circumstances, the Company may be required to repurchase such assets or make other payments related to such assets if such representations and warranties were breached. The Company continues to monitor its real estate-related activities in order to manage its exposures and potential liability from these markets and businesses. See “Legal Proceedings—Residential Mortgage and Credit Crisis Related Matters” in Part II, Item 1, herein and see Note 11 to the condensed consolidated financial statements.

See “Executive Summary—Significant Items—Real Estate Investments” herein for further information.

Japanese Securities Joint Venture.

On May 1, 2010, the Company and MUFG formed a joint venture in Japan of their respective investment banking and securities businesses. MUFG and the Company have integrated their respective Japanese securities companies by forming two joint venture companies. MUFG contributed the investment banking, wholesale and retail securities businesses conducted in Japan by Mitsubishi UFJ Securities Co., Ltd. into MUMSS. The Company contributed the investment banking operations conducted in Japan by its subsidiary, Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”), formerly known as Morgan Stanley Japan Securities Co., Ltd., into MUMSS (MSMS, together with MUMSS, the “Joint Venture”). The Company owns a 40% economic interest in the Joint Venture and MUFG owns a 60% economic interest in the Joint Venture. The Company holds a 40% voting interest and MUFG holds a 60% voting interest in MUMSS, while the Company holds a 51% voting interest and MUFG holds a 49% voting interest in MSMS. The Company continues to consolidate MSMS in its condensed consolidated financial statements and, commencing on May 1, 2010, accounted for its interest in MUMSS as an equity method investment within the Institutional Securities business segment.

During the three and six months ended June 30, 2011, the Company recorded losses of $17 million and $672 million, respectively, arising from the Company’s 40% stake in MUMSS, recorded within Other revenues in the condensed consolidated statements of income. In order to enhance the risk management at MUMSS, during the six months ended June 30, 2011, the Company entered into a transaction with MUMSS whereby the risk associated with the fixed income trading positions that previously caused the majority of the aforementioned MUMSS losses were transferred to MSMS. In return for entering into the transaction, the Company received total consideration of $659 million, which represented the estimated fair value of the transaction.

 

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MUFG is responsible for ensuring that MUMSS remains adequately capitalized, and the Company is not obligated to contribute additional capital to MUMSS. Because of the losses incurred by MUMSS, MUFG contributed approximately $370 million of capital to MUMSS on April 22, 2011. The MUFG capital injection improved the capital base and restored the capital adequacy ratio of MUMSS. As a result of the capital injection, during the quarter ended June 30, 2011, the Company recorded an increase of approximately $148 million in the carrying amount of the equity method investment in MUMSS, reflecting the Company’s 40% share of the increase in the net asset value of MUMSS, and an increase in the Company’s Paid-in capital of approximately $86 million (after-tax).

During the quarter ended June 30, 2011, the Company performed an impairment review of its equity method investment in MUMSS in view of the deterioration in the financial performance of MUMSS and the earthquake in Japan on March 11, 2011. The Company recorded no other-than-temporary impairment loss at June 30, 2011. Adverse market or economic events, as well as further deterioration of post-earthquake economic performance could result in impairment charges of this investment in future periods.

See Note 19 to the condensed consolidated financial statements and “Executive SummarySignificant Items” herein for further information.

Institutional Securities.

Sales and Trading Activities-Commodities.    The Company invests and makes markets in various types of commodities and commodity-related assets or instruments, not in the sense of a traditional market maker as exists in the equity markets in which one would be expected to quote a two-sided market for all relevant products. Rather, the Company conducts these activities as a commodity merchant that provides liquidity to the markets by providing liquidity to clients, customers and counterparties. In connection with the provision of market-making related services, the Company conducts activities that include, but are not limited to: (i) taking positions in anticipation of, and in response to, customer demand to buy or sell, and—depending on the liquidity of the relevant market and the size of the position—holding those positions for a period of time; (ii) managing and assuming basis risk between customized customer risks and the standardized products available in the market to hedge those risks; (iii) building, maintaining, and re-balancing inventory, through trades with other market participants, and engaging in accumulation activities to accommodate anticipated customer demand; (iv) trading in the market to remain current on pricing and trends; and (v) engaging in arbitrage activities to provide efficiency and liquidity for markets.

Revenue streams are generated by each of these market-making related activities either individually or in combination with one or more of the other activities as part of an overall portfolio of positions assumed by traders in physical and financial markets. Transaction price spreads to existing market levels together with market movement on the portfolio of managed market risk generate revenue. To a lesser extent, there are also revenue streams from service fees, lease fees, and investment appreciation or depreciation.

Within the commodity sector, the types of other parties that make markets in the same commodities vary by asset class. Further, within each of the commodity asset groups, the types of other parties that make markets vary based on the type of physical or financial instruments in which positions are taken. For example, depending upon the relevant market segment, other parties that make markets in the same commodities or commodity-related instruments include subsidiaries of bank holding companies and foreign banks, major oil companies, energy merchant companies, and non-regulated U.S.-based and foreign owned commodity trading companies.

The Company’s other energy related activities include the production, storage and transportation of several commodities, including crude oil, oil products, natural gas, electric power, emission credits, coal, freight, liquefied natural gas and related products. For example, the Company is an electricity power marketer in the U.S. and owns electricity generating facilities in the U.S. and Europe.

 

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The Company conducts its other energy related activities through several subsidiaries, including Morgan Stanley Capital Group Inc., and also participates in these activities through investments in certain non-consolidated entities.

Similar to its market-making activities, revenue streams are generated by each of these other energy-related activities either individually or in combination with one or more of the other activities as part of an overall portfolio of positions assumed by traders in physical and financial markets.

U.K. Bank Levy.

In July 2011, the U.K. Government enacted legislation imposing a bank levy on relevant liabilities and equities on the consolidated balance sheets of “U.K. Banking Groups,” as defined under the bank levy legislations at December 31, 2011. The Company continues to evaluate the impact of this legislation and expects to incur a charge of approximately $125 million for the full year. Due to the charge being determined on relevant liabilities and equities at December 31, 2011, the final charge may differ from this estimate. The levy is not deductible for U.K. Corporation Tax purposes. The Company will start to accrue this charge in the third quarter of 2011.

Regulatory Outlook.

On July 21, 2010, President Obama signed the Dodd-Frank Act into law. While certain portions of the Dodd-Frank Act were effective immediately, other portions will be effective only following extended transition and implementation periods. At this time, it is difficult to assess fully the impact that the Dodd-Frank Act will have on the Company and on the financial services industry in general. Implementation of the Dodd-Frank Act will be accomplished through numerous rulemakings by multiple governmental agencies. The Dodd-Frank Act also mandates the preparation of studies on a wide range of issues, which could lead to additional legislation or regulatory changes.

In addition, legislative and regulatory initiatives continue outside the U.S. which may also affect the Company’s business and operations. For example, the Basel Committee on Banking Supervision (the “Basel Committee”) has issued new capital, leverage and liquidity standards, known as “Basel III,” which U.S. banking regulators are expected to introduce in the U.S. The Financial Stability Board and the Basel Committee are also developing standards designed to apply to systemically important financial institutions, such as the Company. In addition, initiatives are under way in the European Union and Japan, among other jurisdictions, that would require centralized clearing, reporting and recordkeeping with respect to various kinds of financial transactions and other regulatory requirements that are in some cases similar to those required under the Dodd-Frank Act.

It is likely that the year 2011 and subsequent years will see further material changes in the way major financial institutions are regulated in both the U.S. and other markets in which the Company operates, though it is difficult to predict which further reform initiatives will become law, how such reforms will be implemented or the exact impact they will have on the Company’s business, financial condition, results of operations and cash flows for a particular future period.

Other than the following, no other updates were made to the Company’s supervision and regulation disclosure. For a further discussion regarding the regulatory outlook for the Company, please refer to “Supervision and Regulation” in Part I, Item 1 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory Outlook” in Part II, Item 7, included in the Form 10-K.

Scope of Permitted Activities.    The Bank Holding Company Act of 1956, as amended (the “BHC Act”) provides a two-year period from September 21, 2008, the date that the Company became a bank holding company, for the Company to conform its activities to the BHC Act, subject to three one-year extensions that may be granted by the Federal Reserve upon approval of the Company's application. The Company has received the first of these extensions with respect to certain activities relating to its real estate and other funds businesses. Although conformance activities continue with respect to these businesses, the Company is in the process of seeking a second extension, and it is possible that the Company will be required, in 2012, to seek

 

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Federal Reserve approval for the third additional year permitted by the BHC Act. The Federal Reserve may grant an extension, one year at a time, if it finds that the extension will not be detrimental to the public interest. Based on the real estate and other investments and businesses which are required to be sold, there would be no material adverse impact on the Company's condensed consolidated financial statements.

In addition, the Company is engaged in discussions with the Federal Reserve regarding its commodities activities, as the BHC Act also grandfathers any “activities related to the trading, sale or investment in commodities and underlying physical properties,” provided that the Company was engaged in “any of such activities as of September 30, 1997 in the United States” and provided that certain other conditions that are within the Company’s reasonable control are satisfied. If the Federal Reserve were to determine that any of the Company’s commodities activities did not qualify for the BHC Act grandfather exemption, then the Company would likely be required to divest any such activities that did not otherwise conform to the BHC Act by the end of any extensions of the grace period. At this time the Company does not believe, based on its interpretation of applicable law, that any such required divestment would have a material adverse impact on its condensed consolidated financial statements.

 

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Critical Accounting Policies.

The Company’s condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the U.S., which require the Company to make estimates and assumptions (see Note 1 to the condensed consolidated financial statements). The Company believes that of its significant accounting policies (see Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K and Note 2 to the condensed consolidated financial statements), the following involve a higher degree of judgment and complexity.

Fair Value.

Financial Instruments Measured at Fair Value.    A significant number of the Company’s financial instruments are carried at fair value. The Company makes estimates regarding valuation of assets and liabilities measured at fair value in preparing the condensed consolidated financial statements. These assets and liabilities include but are not limited to:

 

   

Financial instruments owned and Financial instruments sold, not yet purchased;

 

   

Securities available for sale;

 

   

Securities received as collateral and Obligation to return securities received as collateral;

 

   

Certain Commercial paper and other short-term borrowings, primarily structured notes;

 

   

Certain Deposits;

 

   

Certain Securities sold under agreements to repurchase;

 

   

Certain Other secured financings; and

 

   

Certain Long-term borrowings, primarily structured notes.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.

In determining fair value, the Company uses various valuation approaches. A hierarchy for inputs is used in measuring fair value that maximizes the use of observable prices and inputs and minimizes the use of unobservable prices and inputs by requiring that the relevant observable inputs be used when available. The hierarchy is broken down into three levels, wherein Level 1 uses observable prices in active markets, and Level 3 consists of valuation techniques that incorporate significant unobservable inputs, and, therefore require the greatest use of judgment. In periods of market disruption, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3. In addition, a downturn in market conditions could lead to declines in the valuation of many instruments. For further information on the fair value definition, Level 1, Level 2, Level 3 and related valuation techniques, see Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in Form 10-K and Notes 2 and 3 to the condensed consolidated financial statements.

Level 3 Assets and Liabilities.    The Company’s Level 3 assets before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $36.3 billion and $34.9 billion at June 30, 2011 and December 31, 2010, respectively, and represented approximately 12% and 10% at June 30, 2011 and December 31, 2010, respectively, of the assets measured at fair value (4% of total assets at June 30, 2011 and December 31, 2010). Level 3 liabilities before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $9.5 billion and $8.5 billion at June 30, 2011 and December 31, 2010, respectively, and represented approximately 4% of the Company’s liabilities measured at fair value.

Transfers In/Out of Level 3 During the Quarter Ended June 30, 2011.    During the quarter ended June 30, 2011, the Company reclassified approximately $1.2 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.

 

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The Company also reclassified approximately $0.8 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.

Assets and Liabilities Measured at Fair Value on a Non-recurring Basis.    Certain of the Company’s assets were measured at fair value on a non-recurring basis, primarily relating to loans, other investments, goodwill and intangible assets. The Company incurs losses or gains for any adjustments of these assets to fair value. A downturn in market conditions could result in impairment charges in future periods.

For assets and liabilities measured at fair value on a non-recurring basis, fair value is determined by using various valuation approaches. The same hierarchy as described above, which maximizes the use of observable inputs and minimizes the use of unobservable inputs by generally requiring that the observable inputs be used when available, is used in measuring fair value for these items.

For further information on financial assets and liabilities that are measured at fair value on a non-recurring basis, see Note 3 to the condensed consolidated financial statements.

Fair Value Control Processes.    The Company employs control processes to validate the fair value of its financial instruments, including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and that the assumptions are reasonable. These control processes include reviews of the pricing model’s theoretical soundness and appropriateness by Company personnel with relevant expertise who are independent from the trading desks. Additionally, groups independent from the trading divisions within Finance, Market Risk Department and Credit Risk Management Department participate in the review and validation of the fair values generated from pricing models, as appropriate. Where a pricing model is used to determine fair value, recently executed comparable transactions and other observable market data are considered for purposes of validating assumptions underlying the model.

Consistent with market practice, the Company has individually negotiated agreements with certain counterparties to exchange collateral (“margining”) based on the level of fair values of the derivative contracts they have executed. Through this margining process, one party or each party to a derivative contract provides the other party with information about the fair value of the derivative contract to calculate the amount of collateral required. This sharing of fair value information provides additional support of the Company’s recorded fair value for the relevant OTC derivative products. For certain OTC derivative products, the Company, along with other market participants, contributes derivative pricing information to aggregation services that synthesize the data and make it accessible to subscribers. This information is then used to evaluate the fair value of these OTC derivative products. For more information regarding the Company’s risk management practices, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.

Goodwill and Intangible Assets.

Goodwill.    The Company tests goodwill for impairment on an annual basis and on an interim basis when certain events or circumstances exist. The Company tests for impairment at the reporting unit level, which is generally at the level of or one level below its business segments. Goodwill no longer retains its association with a particular acquisition once it has been assigned to a reporting unit. As such, all of the activities of a reporting unit, whether acquired or organically developed, are available to support the value of the goodwill. Goodwill impairment is determined by comparing the estimated fair value of a reporting unit with its respective book value. If the estimated fair value exceeds the book value, goodwill at the reporting unit level is not deemed to be impaired. If the estimated fair value is below book value, however, further analysis is required to determine the amount of the

 

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impairment. Additionally, if the book value of a reporting unit is zero or a negative value and it is determined that it is more likely than not the goodwill is impaired, further analysis is required. The estimated fair values of the reporting units are derived based on valuation techniques the Company believes market participants would use for each of the reporting units. The estimated fair values are generally determined utilizing methodologies that incorporate price-to-book, price-to-earnings and assets under management multiples of certain comparable companies. The Company also utilizes a discounted cash flow methodology for certain reporting units.

Intangible Assets.    Amortizable intangible assets are amortized over their estimated useful lives and reviewed for impairment on an interim basis when certain events or circumstances exist. For amortizable intangible assets, an impairment exists when the carrying amount of the intangible asset exceeds its fair value. An impairment loss will be recognized only if the carrying amount of the intangible asset is not recoverable and exceeds its fair value. The carrying amount of the intangible asset is not recoverable if it exceeds the sum of the expected undiscounted cash flows.

Indefinite-lived intangible assets are not amortized but are reviewed annually (or more frequently when certain events or circumstances exist) for impairment. For indefinite-lived intangible assets, an impairment exists when the carrying amount exceeds its fair value.

For both goodwill and intangible assets, to the extent an impairment loss is recognized, the loss establishes the new cost basis of the asset. Subsequent reversal of impairment losses is not permitted. For amortizable intangible assets, the new cost basis is amortized over the remaining useful life of that asset. Adverse market or economic events could result in impairment charges in future periods.

See Note 3 and Note 8 to the condensed consolidated financial statements for additional information about goodwill and intangible assets.

Legal, Regulatory and Tax Contingencies.

In the normal course of business, the Company has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities as a global diversified financial services institution.

Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding the Company’s business, including, among other matters, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief.

Accruals for litigation and regulatory proceedings are generally determined on a case-by-case basis. Where available information indicates that it is probable a liability had been incurred at the date of the condensed consolidated financial statements and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. For certain legal proceedings, the Company can estimate possible losses, additional losses, ranges of loss or ranges of additional loss in excess of amounts accrued. For certain other legal proceedings, the Company cannot reasonably estimate such losses, particularly for proceedings that are in their early stages of development or where plaintiffs seek substantial or indeterminate damages. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, and by addressing novel or unsettled legal questions relevant to the proceedings in question, before a loss or additional loss or range of loss or additional loss can be reasonably estimated for any proceeding.

 

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The Company is subject to the income and indirect tax laws of the U.S., its states and municipalities and those of the foreign jurisdictions in which the Company has significant business operations. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. The Company must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes and the expense for indirect taxes and must also make estimates about when in the future certain items affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be settled with the taxing authority upon examination or audit. The Company periodically evaluates the likelihood of assessments in each taxing jurisdiction resulting from current and subsequent years’ examinations, and unrecognized tax benefits are established as appropriate. The Company establishes a liability for unrecognized tax benefits related to potential losses that may arise from tax audits in accordance with the guidance on accounting for unrecognized tax benefits. Once established, unrecognized tax benefits are adjusted when there is more information available or when an event occurs requiring a change.

Significant judgment is required in making these estimates, and the actual cost of a legal claim, tax assessment or regulatory fine/penalty may ultimately be materially different from the recorded reserves, if any. See Notes 11 and 17 to the condensed consolidated financial statements for additional information on legal proceedings and tax examinations.

Special Purpose Entities and Variable Interest Entities.

The Company’s involvement with special purpose entities (“SPE”) consists primarily of the following:

 

   

Transferring financial assets into SPEs;

 

   

Acting as an underwriter of beneficial interests issued by securitization vehicles;

 

   

Holding one or more classes of securities issued by, or making loans to or investments in, SPEs that hold debt, equity, real estate or other assets;

 

   

Purchasing and selling (in both a market-making and a proprietary-trading capacity) securities issued by SPEs/variable interest entities (“VIE”), whether such vehicles are sponsored by the Company or not;

 

   

Entering into derivative transactions with SPEs (whether or not sponsored by the Company);

 

   

Providing warehouse financing to collateralized debt obligations and collateralized loan obligations;

 

   

Entering into derivative agreements with non-SPEs whose value is derived from securities issued by SPEs;

 

   

Servicing assets held by SPEs or holding servicing rights related to assets held by SPEs that are serviced by others under subservicing arrangements;

 

   

Serving as an asset manager to various investment funds that may invest in securities that are backed, in whole or in part, by SPEs; and

 

   

Structuring and/or investing in other structured transactions designed to provide enhanced, tax-efficient yields to the Company or its clients.

The Company engages in securitization activities related to commercial and residential mortgage loans, U.S. agency collateralized mortgage obligations, corporate bonds and loans, municipal bonds and other types of financial instruments. The Company’s involvement with SPEs is discussed further in Note 6 to the condensed consolidated financial statements.

In most cases, these SPEs are deemed for accounting purposes to be VIEs. The Company applies accounting guidance for consolidation of VIEs to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Entities that previously met the criteria as qualifying SPEs that were not subject to consolidation prior to January 1, 2010 became subject to the consolidation requirements for VIEs on that date. Excluding entities subject to the Deferral (as defined in Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K),

 

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effective January 1, 2010, the primary beneficiary of a VIE is the party that both (1) has the power to direct the activities of a VIE that most significantly affect the VIE’s economic performance and (2) has an obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. The Company consolidates entities of which it is the primary beneficiary.

The Company determines whether it is the primary beneficiary of a VIE upon its initial involvement with the VIE and reassesses whether it is the primary beneficiary on an ongoing basis as long as it has any continuing involvement with the VIE. This determination is based upon an analysis of the design of the VIE, including the VIE’s structure and activities, the power to make significant economic decisions held by the Company and by other parties and the variable interests owned by the Company and other parties.

 

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Liquidity and Capital Resources.

The Company’s senior management establishes the liquidity and capital policies of the Company. Through various risk and control committees, the Company’s senior management reviews business performance relative to these policies, monitors the availability of alternative sources of financing, and oversees the liquidity and interest rate and currency sensitivity of the Company’s asset and liability position. The Company’s Treasury Department, Firm Risk Committee (“FRC”), Asset and Liability Management Committee (“ALCO”) and other control groups assist in evaluating, monitoring and controlling the impact that the Company’s business activities have on its condensed consolidated statements of financial condition, liquidity and capital structure. Liquidity and capital matters are reported regularly to the Board’s Risk Committee.

The Balance Sheet.

The Company actively monitors and evaluates the composition and size of its balance sheet. A substantial portion of the Company’s total assets consists of liquid marketable securities and short-term receivables arising principally from sales and trading activities in the Institutional Securities business segment. The liquid nature of these assets provides the Company with flexibility in managing the size of its balance sheet. The Company’s total assets increased to $830,747 million at June 30, 2011 from $807,698 million at December 31, 2010. The increase in total assets was primarily due to securities financing activities.

The Company’s assets and liabilities are primarily related to transactions attributable to sales and trading and securities financing activities. At June 30, 2011, securities financing assets and liabilities were $394 billion and $323 billion, respectively. At December 31, 2010, securities financing assets and liabilities were $358 billion and $321 billion, respectively. Securities financing transactions include repurchase and resale agreements, securities borrowed and loaned transactions, securities received as collateral and obligation to return securities received. Securities borrowed or purchased under agreements to resell and securities loaned or sold under agreements to repurchase are treated as collateralized financings (see Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K). Securities sold under agreements to repurchase and Securities loaned were $169 billion at June 30, 2011 and averaged $195 billion and $197 billion during the quarter and six months ended June 30, 2011, respectively. Securities purchased under agreements to resell and Securities borrowed were $313 billion at June 30, 2011 and averaged $319 billion and $309 billion during the quarter and six months ended June 30, 2011, respectively.

Securities financing assets and liabilities also include matched book transactions with minimal market, credit and/or liquidity risk. Matched book transactions accommodate customers, as well as obtain securities for the settlement and financing of inventory positions. The customer receivable portion of the securities financing transactions includes customer margin loans, collateralized by customer owned securities, and customer cash, which is segregated according to regulatory requirements. The customer payable portion of the securities financing transactions primarily includes customer payables to the Company’s prime brokerage clients. The Company’s risk exposure on these transactions is mitigated by collateral maintenance policies that limit the Company’s credit exposure to customers. Included within securities financing assets were $16 billion and $17 billion at June 30, 2011 and December 31, 2010, respectively, recorded in accordance with accounting guidance for the transfer of financial assets that represented offsetting assets and liabilities for fully collateralized non-cash loan transactions.

 

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The following table sets forth the Company’s tangible common equity and Tier 1 common ratios at June 30, 2011 and December 31, 2010 and average balances during the six months ended June 30, 2011:

 

     Balance at     Average Balance(1)  
   June 30,
2011
    December 31,
2010
    For the Six
Months Ended
June 30, 2011
 
   (dollars in millions, except ratio data)  

Common equity

   $ 58,199      $ 47,614      $ 48,870   

Preferred equity

     1,508        9,597        8,441   
  

 

 

   

 

 

   

 

 

 

Morgan Stanley shareholders’ equity

     59,707        57,211        57,311   

Junior subordinated debentures issued to capital trusts

     4,826        4,817        4,832   

Less: Goodwill and net intangible assets(2)

     (6,860     (6,947     (6,898
  

 

 

   

 

 

   

 

 

 

Tangible Morgan Stanley shareholders’ equity

   $ 57,673      $ 55,081      $ 55,245   
  

 

 

   

 

 

   

 

 

 

Common equity

   $ 58,199      $ 47,614      $ 48,870   

Less: Goodwill and net intangible assets(2)

     (6,860     (6,947     (6,898
  

 

 

   

 

 

   

 

 

 

Tangible common equity(3)

   $ 51,339      $ 40,667      $ 41,972   
  

 

 

   

 

 

   

 

 

 

Tier 1 common ratio(4)

     14.6     10.5     N/M   
  

 

 

   

 

 

   

 

 

 

 

N/M – Not meaningful.
(1) The Company calculates its average balances based upon month-end balances.
(2) Goodwill and net intangible assets exclude mortgage servicing rights (net of disallowable mortgage servicing rights) of $120 million and $141 million at June 30, 2011 and December 31, 2010, respectively, and include only the Company’s share of MSSB’s goodwill and intangible assets.
(3) Tangible common equity, a non-GAAP financial measure, equals common equity less goodwill and net intangible assets as defined above. The Company views tangible common equity as a useful measure to investors because it is a commonly utilized metric and reflects the common equity deployed in the Company’s businesses.
(4) The Tier 1 common ratio, a non-GAAP financial measure, equals Tier 1 common equity divided by Risk Weighted Assets (“RWA”). The Company defines Tier 1 common equity as Tier 1 capital less qualifying perpetual preferred stock, qualifying trust preferred securities and other restricted core capital elements, adjusted for the portion of goodwill and non-servicing intangible assets associated with MSSB’s noncontrolling interests (i.e., Citi’s share of MSSB’s goodwill and intangibles). The Company views its definition of the Tier 1 common equity as a useful measure for investors as it reflects the actual ownership structure and economics of MSSB. This definition of Tier 1 common equity may evolve in the future as regulatory rules may be implemented based on a final proposal regarding noncontrolling interest (also referred to as minority interest) as initially presented in December 2009 in the Basel Committee on Banking Supervision Consultative Document Strengthening the resilience of the banking sector (“BCBS 164”). For a discussion of RWAs and Tier 1 capital, see “Regulatory Requirements” herein.

Balance Sheet and Funding Activity for the Six Months Ended June 30, 2011.

During the six months ended June 30, 2011, the Company issued notes with a principal amount of approximately $23 billion. In connection with the note issuances, the Company generally enters into certain transactions to obtain floating interest rates based primarily on short-term LIBOR trading levels. The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.1 years at June 30, 2011. Subsequent to June 30, 2011 and through July 31, 2011, the Company’s long-term borrowings (net of repayments) increased by approximately $1.5 billion.

At June 30, 2011, the aggregate outstanding principal amount of the Company’s senior indebtedness was approximately $187 billion (including guaranteed obligations of the indebtedness of subsidiaries) compared with $183 billion at December 31, 2010. The increase in the amount of senior indebtedness was primarily due to foreign currency translation adjustments.

 

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MUFG Stock Conversion.

As previously disclosed, on April 21, 2011, MUFG and the Company announced that they had entered into an agreement to convert MUFG’s outstanding Series B Preferred Stock in the Company into the Company’s common stock. On June 30, 2011, the Company and MUFG completed the conversion (see “Executive Summary—Significant Items—MUFG Stock Conversion” herein).

Capital Management.

The Company’s senior management views capital as an important source of financial strength. The Company actively manages its consolidated capital position based upon, among other things, business opportunities, risks, capital availability and rates of return together with internal capital policies, regulatory requirements and rating agency guidelines and, therefore, in the future may expand or contract its capital base to address the changing needs of its businesses. The Company attempts to maintain total capital, on a consolidated basis, at least equal to the sum of its operating subsidiaries’ equity.

At June 30, 2011, the Company had approximately $1.6 billion remaining under its current share repurchase program out of the $6 billion authorized by the Board in December 2006. The share repurchase program is for capital management purposes and considers, among other things, business segment capital needs as well as equity-based compensation and benefit plan requirements. Share repurchases by the Company are subject to regulatory approval. During the quarter and six months ended June 30, 2011, the Company did not repurchase common stock as part of its capital management share repurchase program (see also “Unregistered Sales of Equity Securities and Use of Proceeds” in Part II, Item 2).

The Board determines the declaration and payment of dividends on a quarterly basis. In July 2011, the Company announced that its Board declared a quarterly dividend per common share of $0.05. The Company also announced that the Board declared a quarterly dividend of $252.78 per share of Series A Floating Rate Non-Cumulative Preferred Stock (represented by depositary shares, each representing 1/1,000th interest in a share of preferred stock and each having a dividend of $0.25278) and a quarterly dividend of $25.00 per share of Series C Non-Cumulative Non-Voting Perpetual Preferred Stock. As a result of the recently completed MUFG stock conversion (see “Executive Summary—Significant Items—MUFG Stock Conversion” herein), MUFG did not receive the previously declared dividend that would otherwise have been payable on July 15, 2011 in respect of the Series B Preferred Stock.

Required Capital.

Beginning with the quarter ended June 30, 2010, the Company’s capital estimation is based on the Required Capital Framework, an internal capital adequacy measure. This framework is a risk-based internal use of capital measure, which is compared with the Company’s regulatory Tier 1 capital to help ensure the Company maintains an amount of risk-based going concern capital after absorbing potential losses from extreme stress events at a point in time. The difference between the Company’s Tier 1 capital and aggregate Required Capital is the Company’s Parent capital. Average Tier 1 capital, Required Capital and Parent capital for the quarter ended June 30, 2011 was approximately $50.6 billion, $29.9 billion and $20.7 billion, respectively. The Company generally holds Parent capital for prospective regulatory requirements, including Basel III, organic growth, acquisitions and other capital needs.

Tier 1 capital and common equity attribution to the business segments is based on capital usage calculated by Required Capital. In principle, each business segment is capitalized as if it were an independent operating entity with limited diversification benefit between the business segments. Required Capital is assessed at each business segment and further attributed to product lines. This process is intended to align capital with the risks in each business segment in order to allow senior management to evaluate returns on a risk-adjusted basis. The Required Capital Framework will evolve over time in response to changes in the business and regulatory environment and to incorporate enhancements in modeling techniques. During 2011, the Company will continue to evaluate the framework with respect to the impact of future regulatory requirements, as appropriate.

 

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For a further discussion of the Company’s Tier 1 capital, see “Regulatory Requirements” herein.

The following table presents the Company’s and business segments’ average Tier 1 capital and average common equity for the quarter ended June 30, 2011 and the quarter ended March 31, 2011.

 

     Three Months Ended
June 30, 2011
     Three Months Ended
March 31, 2011
 
     Average
Tier 1
Capital
     Average
Common
Equity
     Average
Tier 1
Capital
     Average
Common
Equity
 
     (dollars in billions)  

Institutional Securities

   $ 25.1       $ 22.1       $ 23.0       $ 20.7   

Global Wealth Management Group

     3.4         7.1         3.1         6.7   

Asset Management

     1.4         2.0         1.4         1.9   

Parent capital

     20.7         18.4         21.8         18.8   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 50.6       $ 49.6       $ 49.3       $ 48.1   
  

 

 

    

 

 

    

 

 

    

 

 

 

On March 31, 2011, the Federal Reserve implemented a limit on the amount of the restricted core capital elements (trust preferred securities and certain noncontrolling interests) to 15% of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. This restriction resulted in approximately $3.9 billion of restricted capital being reclassed from Tier 1 capital to Tier 2 capital for March 31, 2011. To enhance the comparability of the current quarter’s average Tier 1 capital and average common equity by segment to subsequent quarterly averages, the Company applied this limitation to the full quarter average, as if the rule were in place from the beginning of first quarter 2011 (see “Regulatory Requirements” herein for more information).

Capital Covenants.

In October 2006 and April 2007, the Company executed replacement capital covenants in connection with offerings by Morgan Stanley Capital Trust VII and Morgan Stanley Capital Trust VIII (the “Capital Securities”), which become effective after the scheduled redemption date in 2046. Under the terms of the replacement capital covenants, the Company has agreed, for the benefit of certain specified holders of debt, to limitations on its ability to redeem or repurchase any of the Capital Securities for specified periods of time. For a complete description of the Capital Securities and the terms of the replacement capital covenants, see the Company’s Current Reports on Form 8-K dated October 12, 2006 and April 26, 2007.

Liquidity and Funding Management.

The primary goal of the Company’s liquidity management and funding activities is to ensure adequate funding over a wide range of market conditions. Given the mix of the Company’s business activities, funding requirements are fulfilled through a diversified range of secured and unsecured financing.

The Company’s liquidity and funding risk management framework, including policies and governance structure, helps mitigate the potential risk that the Company may not have access to adequate financing. The framework is designed to help ensure that the Company fulfills its financial obligations and to support the execution of the Company’s business strategies. The principal elements of the Company’s liquidity and funding risk management framework are the Contingency Funding Plan and the Global Liquidity Reserve that support the target liquidity profile (see “Liquidity Management—Contingency Funding Plan” and “Liquidity Management—Global Liquidity Reserve” herein).

Liquidity Management.

Contingency Funding Plan.

The Contingency Funding Plan (“CFP”) is the Company’s primary liquidity risk management tool. The CFP outlines the Company’s response to liquidity stress in the markets and incorporates stress testing to identify potential liquidity risk. Liquidity stress tests model multiple scenarios related to idiosyncratic, systemic or a combination of both types of events across various time horizons.

 

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The Company’s CFP incorporates a number of assumptions, including, but not limited to, the following:

 

   

No government support;

 

   

No access to unsecured debt markets;

 

   

Repayment of all unsecured debt maturing within one year;

 

   

Higher haircuts and significantly lower availability of secured funding;

 

   

Additional collateral that would be required by trading counterparties and certain exchanges and clearing organizations related to multi-notch credit rating downgrades;

 

   

Discretionary unsecured debt buybacks;

 

   

Drawdowns on unfunded commitments provided to third parties;

 

   

Client cash withdrawals;

 

   

Limited access to the foreign exchange swap markets;

 

   

Return of securities borrowed on an uncollateralized basis; and

 

   

Maturity roll-off of outstanding letters of credit with no further issuance.

The CFP is produced at the Parent and major operating subsidiary levels, as well as at major currency levels, to capture specific cash requirements and cash availability across the Company. The CFP assumes the subsidiaries will use their own liquidity first to fund their obligations before drawing liquidity from the Parent company. The CFP also assumes that the Parent will support its subsidiaries and will not have access to their liquidity reserves if there are any regulatory, legal or tax constraints.

At June 30, 2011, the Company maintained sufficient liquidity to meet funding and contingent obligations as modeled in its liquidity stress tests.

Global Liquidity Reserve.

The Company maintains sufficient liquidity reserves (“Global Liquidity Reserve”) to cover daily funding needs and meet strategic liquidity targets sized by the CFP. The Global Liquidity Reserve is held within the Parent company and operating subsidiaries. The Company’s Global Liquidity Reserve is comprised of highly liquid and diversified assets including cash and cash equivalents, and unencumbered highly liquid securities such as U.S. government securities, U.S. agency securities, U.S. agency mortgage-backed securities, FDIC-guaranteed corporate debt and non-U.S. government securities.

Global Liquidity Reserve by Type of Investment

The table below summarizes the Company’s Global Liquidity Reserve by type of investment:

 

     At June 30, 2011  
     (dollars in billions)  

Cash deposits with banks

   $ 13   

Cash deposits with central banks

     31   

Unencumbered highly liquid securities:

  

U.S. Government obligations

     69   

U.S. agency and agency MBS

     44   

Non-U.S. sovereign obligations(1)

     16   

Investments in money market funds

     1   

Other investment grade securities

     8   
  

 

 

 

Global Liquidity Reserve

   $ 182   
  

 

 

 

 

(1) At June 30, 2011, approximately 80% of Non-U.S. sovereign obligations were rated AAA.

 

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The ability to monetize assets during the start of a liquidity crisis is critical. The Company believes that the assets held in the Global Liquidity Reserve can be monetized within five business days in a stressed environment given the highly liquid and diversified nature of the reserves.

The currency composition of the Global Liquidity Reserve is consistent with the CFP. The Company’s funding requirements and target liquidity reserves may vary based on changes to the level and composition of its balance sheet, subsidiary-funding needs, timing of specific transactions, client financing activity, market conditions and seasonal factors.

In addition to the Global Liquidity Reserve, the Company has other unencumbered assets that are available for monetization and the Company has not included these balances in the table above.

Global Liquidity Reserve Held by the Parent and Operating Subsidiaries

The table below summarizes the Global Liquidity Reserve held by the Parent and operating subsidiaries:

 

     At
June 30,
2011
     At
March 31,
2011
     Average Balance(1)  
           For the Three
Months Ended
June 30, 2011
     For the Three
Months Ended
March 31, 2011
 
     (dollars in billions)  

Parent

   $ 82       $ 77       $ 76       $ 77   

Non-Bank Subsidiaries:

           

Domestic

     13         8         12         8   

Foreign

     24         24         22         22   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Non-Bank Subsidiaries

     37         32         34         30   
  

 

 

    

 

 

    

 

 

    

 

 

 

Bank Subsidiaries:

           

Domestic

     57         57         56         59   

Foreign

     6         6         6         6   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Bank Subsidiaries

     63         63         62         65   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 182       $ 172       $ 172       $ 172   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) The Company calculates the average global liquidity reserve based upon daily amounts.

As mentioned previously in the Contingency Funding Plan section, the CFP assumes that the Parent will support its subsidiaries and will not have access to their liquidity reserves if there are any regulatory, legal or tax constraints.

Funding Management.

The Company’s funding management policies are designed to provide for financings that are executed in a manner that reduces the risk of disruption to the Company’s operations. The Company pursues a strategy of diversification of secured and unsecured funding sources (by product, by investor and by region) and attempts to ensure that the tenor of the Company’s liabilities equals or exceeds the expected holding period of the assets being financed. Maturities of financings are designed to manage exposure to refinancing risk in any one period.

The Company funds its balance sheet on a global basis through diverse sources. These sources may include the Company’s equity capital, long-term debt, repurchase agreements, securities lending, deposits, commercial paper, letters of credit and lines of credit. The Company has active financing programs for both standard and structured products targeting global investors and currencies.

 

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Secured Financing.    A substantial portion of the Company’s total assets consists of liquid marketable securities and short-term collateralized receivables arising principally from its Institutional Securities sales and trading activities. The liquid nature of these assets provides the Company with flexibility in financing these assets with collateralized borrowings.

The Company’s goal is to achieve an optimal mix of secured and unsecured funding while ensuring continued growth in stable funding sources. The Institutional Securities business segment emphasizes the use of collateralized short-term borrowings to limit the growth of short-term unsecured funding, which is generally more subject to disruption during periods of financial stress. The ability to fund less liquid assets on a secured basis may be impaired in a stress environment. To manage this risk, the Company obtains longer-term secured financing for less liquid assets and has minimal reliance on overnight financing. At June 30, 2011, the weighted average maturity of the Company’s secured financing against less liquid collateral was greater than 120 days. The Company defines less liquid collateral as those that are not consistent with the standards of the Global Liquidity Reserve. In addition, the Company minimizes refinancing risk by diversifying across both counterparties and maturities. The Company holds a portion of its Global Liquidity Reserve against a potential disruption to its secured financing capabilities. This potential disruption may be in the form of additional margin or reduced capacity to refinance maturing trades. The Company continues to extend the tenor of secured financing for less liquid collateral and seeks to build a sufficient buffer to offset the risks discussed above.

Unsecured Financing.    The Company views long-term debt and deposits as stable sources of funding for core inventories and less liquid assets. Securities inventories not financed by secured funding sources and the majority of current assets are financed with a combination of short-term funding, deposits, floating rate long-term debt and fixed rate long-term debt swapped to a floating rate. The Company uses derivative products (primarily interest rate, currency and equity swaps) to assist in asset and liability management and to hedge interest rate risk (see Note 12 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K).

Temporary Liquidity Guarantee Program (“TLGP”).    In October 2008, the Secretary of the U.S. Treasury invoked the systemic risk exception of the FDIC Improvement Act of 1991, and the FDIC announced the TLGP. Based on the Final Rule adopted on November 21, 2008, the TLGP provides a guarantee, through the earlier of maturity or June 30, 2012, of certain senior unsecured debt issued by participating Eligible Entities (including the Company) between October 14, 2008 and June 30, 2009. Of the $23.8 billion issued under the TLGP, $5.5 billion (including $1.7 billion of debt buybacks) were retired through the six months ended June 30, 2011.

Short-Term Borrowings.    The Company’s unsecured short-term borrowings consist of commercial paper, bank loans, bank notes and structured notes with maturities of 12 months or less at issuance.

The table below summarizes the Company’s short-term unsecured borrowings:

 

     At
June 30,
2011
     At
December 31,
2010
 
     (dollars in millions)  

Commercial paper

   $ 865       $ 945   

Other short-term borrowings

     2,701         2,311   
  

 

 

    

 

 

 

Total

   $ 3,566       $ 3,256   
  

 

 

    

 

 

 

Deposits.    The Company’s bank subsidiaries’ funding sources include bank deposits, repurchase agreements, federal funds purchased, certificates of deposit, money market deposit accounts, commercial paper and Federal Home Loan Bank advances.

 

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Deposits were as follows:

 

     At
June 30,
2011(1)
     At
December 31,
2010(1)
 
     (dollars in millions)  

Savings and demand deposits

   $ 62,000       $ 59,856   

Time deposits(2)

     3,525         3,956   
  

 

 

    

 

 

 

Total

   $ 65,525       $ 63,812   
  

 

 

    

 

 

 

 

(1) Total deposits insured by the FDIC at June 30, 2011 and December 31, 2010 were $49 billion and $48 billion, respectively.
(2) Certain time deposit accounts are carried at fair value under the fair value option (see Note 3 to the condensed consolidated financial statements).

With the passage of the Dodd-Frank Act, the statutory standard maximum deposit insurance amount was permanently increased to $250,000 per depositor and is in effect for the Subsidiary Banks.

On November 9, 2010, the FDIC issued a Final Rule implementing Section 343 of the Dodd-Frank Act that provides for unlimited insurance coverage of non-interest bearing transaction accounts. Beginning December 31, 2010 through December 31, 2012, all non-interest bearing transaction accounts are fully insured, regardless of the balance of the account, at all FDIC-insured institutions, including the Company’s FDIC-insured subsidiaries. This unlimited insurance coverage is available to all depositors and is separate from, and in addition to, the insurance coverage provided to a depositor’s other deposit accounts held at an FDIC-insured institution. Money Market Deposit Accounts (“MMDA”) and Negotiable Order of Withdrawal (“NOW”) accounts are not eligible for this unlimited insurance coverage, regardless of the interest rate, even if no interest is paid on the account.

Long-Term Borrowings.    The Company uses a variety of long-term debt funding sources to generate liquidity, taking CFP requirements into consideration. In addition, the issuance of long-term debt allows the Company to reduce reliance on short-term credit sensitive instruments (e.g., commercial paper and other unsecured short-term borrowings). Long-term borrowings are generally structured to ensure staggered maturities, thereby mitigating refinancing risk, and to maximize investor diversification through sales to global institutional and retail clients. Availability and cost of financing to the Company can vary depending on market conditions, the volume of certain trading and lending activities, the Company’s credit ratings and the overall availability of credit. During the six months ended June 30, 2011, the Company issued notes with a principal amount of approximately $23 billion.

The Company may from time to time engage in various transactions in the credit markets (including, for example, debt repurchases) that it believes are in the best interests of the Company and its investors. During the six months ended June 30, 2011, approximately $24 billion in aggregate long-term borrowings were repaid.

Long-term borrowings at June 30, 2011 consisted of the following:

 

     Parent      Subsidiaries      Total  
     (dollars in millions)  

Due in 2011

   $ 9,689       $ 1,460       $ 11,149   

Due in 2012

     35,364         845         36,209   

Due in 2013

     27,653         831         28,484   

Due in 2014

     20,858         1,108         21,966   

Due in 2015

     18,044         3,977         22,021   

Thereafter

     73,880         2,397         76,277   
  

 

 

    

 

 

    

 

 

 

Total

   $ 185,488       $ 10,618       $ 196,106   
  

 

 

    

 

 

    

 

 

 

 

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Credit Ratings.

The Company relies on external sources to finance a significant portion of its day-to-day operations. The cost and availability of financing generally is impacted by the Company’s credit ratings. In addition, the Company’s credit ratings can have a significant impact on certain trading revenues, particularly in those businesses where longer term counterparty performance is critical, such as OTC derivative transactions, including credit derivatives and interest rate swaps. Factors that are important to the determination of the Company’s credit ratings include the level and quality of earnings, capital adequacy, liquidity, risk appetite and management, asset quality, business mix and perceived levels of government support.

The rating agencies have stated that they currently incorporate various degrees of uplift from perceived government support in the credit ratings of systemically important banks, including the credit ratings of the Company. The U.S. financial reform legislation has rating agencies reviewing their methodologies and may be seen as limiting the possibility of extraordinary government support for the financial system in any future financial crises. This may lead to reduced uplift assumptions for U.S. banks and thereby place downward pressure on credit ratings. At the same time, the U.S. financial reform legislation also has credit ratings positive features such as higher standards for capital and liquidity levels. The net result on credit ratings and the timing of any rating agency actions is currently uncertain.

In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business segment, the Company may be required to provide additional collateral or immediately settle any outstanding liability balances with certain counterparties in the event of a credit rating downgrade. At June 30, 2011, the amount of additional collateral or termination payments that could be called by counterparties under the terms of such agreements in the event of a one-notch downgrade of the Company’s long-term credit rating was $1,245 million. A total of $3,258 million in collateral or termination payments could be called in the event of a two-notch downgrade.

Also, the Company is required to pledge additional collateral to certain exchanges and clearing organizations in the event of a credit rating downgrade. At June 30, 2011, the increased collateral requirement at certain exchanges and clearing organizations was $178 million in the event of a one-notch downgrade of the Company’s long-term credit rating. A total of $1,371 million of collateral is required in the event of a two-notch downgrade.

The liquidity impact of additional collateral requirements is accounted for in the Company’s CFP.

At July 31, 2011, the Company’s and Morgan Stanley Bank, N.A.’s senior unsecured ratings were as set forth below:

 

    Company   Morgan Stanley Bank, N.A.
    Short-Term
Debt
  Long-Term
Debt
  Rating
Outlook
  Short-Term
Debt
  Long-Term
Debt
  Rating
Outlook

Dominion Bond Rating Service Limited

  R-1 (middle)   A (high)   Negative      

Fitch Ratings

  F1   A   Stable   F1   A   Stable

Moody’s

  P-1   A2   Negative   P-1   A1   Negative

Rating and Investment Information, Inc.

  a-1   A+   Negative      

Standard & Poor’s

  A-1   A   Negative   A-1   A+   Negative

Off-Balance Sheet Arrangements with Unconsolidated Entities.

The Company enters into various arrangements with unconsolidated entities, including VIEs, primarily in connection with its Institutional Securities business segment. See “Off-Balance Sheet Arrangements with Unconsolidated Entities” included in Part II, Item 7, of the Form 10-K for further information.

See Note 11 to the condensed consolidated financial statements for further information on Guarantees.

 

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Commitments.

The Company’s commitments associated with outstanding letters of credit and other financial guarantees obtained to satisfy collateral requirements, investment activities, corporate lending and financing arrangements, mortgage lending and margin lending at June 30, 2011 are summarized below by period of expiration. Since commitments associated with these instruments may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

 

     Years to Maturity         
     Less
than 1
     1-3      3-5      Over 5      Total at
June 30, 2011
 
     (dollars in millions)  

Letters of credit and other financial guarantees obtained to satisfy collateral requirements

   $ 1,220       $ 2       $ 11       $ —         $ 1,233   

Investment activities

     1,255         359         87         262         1,963   

Primary lending commitments—investment grade(1)

     14,074         20,494         18,138         508         53,214   

Primary lending commitments—non-investment grade

     3,023         4,545         7,824         3,121         18,513   

Secondary lending commitments(2)

     53         250         56         130         489   

Commitments for secured lending transactions

     278         322         231         —           831   

Forward starting reverse repurchase agreements(3)

     69,474         —           —           —           69,474   

Commercial and residential mortgage-related commitments

     583         14         103         588         1,288   

Underwriting commitments

     76         —           —           —           76   

Other commitments

     235         212         2         —           449   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 90,271       $ 26,198       $ 26,452       $ 4,609       $ 147,530   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) This amount includes commitments to asset-backed commercial paper conduits of $275 million at June 30, 2011, of which $138 million have maturities of less than one year and $137 million of which have maturities of one to three years.
(2) These commitments are recorded at fair value within Financial instruments owned and Financial instruments sold, not yet purchased in the condensed consolidated statements of financial condition (see Note 3 to the condensed consolidated financial statements).
(3) The Company enters into forward starting securities purchased under agreements to resell (agreements that have a trade date as of or prior to June 30, 2011 and settle subsequent to period-end) that are primarily secured by collateral from U.S. government agency securities and other sovereign government obligations. These agreements primarily settle within three business days and at June 30, 2011, $67.5 billion settled within three business days.

Regulatory Requirements.

Capital.

The Company is a financial holding company under the BHC Act and is subject to the regulation and oversight of the Federal Reserve. The Federal Reserve establishes capital requirements for the Company, including well-capitalized standards, and evaluates the Company’s compliance with such capital requirements. The Office of the Comptroller of the Currency establishes similar capital requirements and standards for the Company’s national bank subsidiaries (see “Other Matters—Regulatory Outlook” herein).

The Company calculates its capital ratios and RWAs in accordance with the capital adequacy standards for financial holding companies adopted by the Federal Reserve. These standards are based upon a framework described in the “International Convergence of Capital Measurement and Capital Standards,” July 1988, as amended, also referred to as Basel I. In December 2007, the U.S. banking regulators published final regulation incorporating the Basel II Accord, which requires internationally active banking organizations, as well as certain of their U.S. bank subsidiaries, to implement Basel II standards over the next several years. The timeline set out in December 2007 for the implementation of Basel II in the U.S. may be impacted by the developments concerning Basel III described below. Starting July 2010, the Company has been reporting on a parallel basis under the current regulatory capital regime (Basel I) and Basel II. During the parallel run period, the Company

 

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continues to be subject to Basel I but simultaneously calculates its risks under Basel II. The Company reports the capital ratios under both of these standards to the regulators. There will be at least four quarters of parallel reporting before the Company enters the three-year transitional period to implement Basel II standards. In addition, under provisions of the Dodd-Frank Act, the generally applicable capital standards, which are currently based on Basel I standards, but may themselves change over time, will serve as a permanent floor to minimum capital requirements calculated under the Basel II standard the Company is currently required to implement, as well as future capital standards.

Basel III contains new capital standards that raise the quality of capital and strengthen counterparty credit risk capital requirements and introduces a leverage ratio as a supplemental measure to the risk-based ratio. Basel III includes a new capital conservation buffer, which imposes a common equity requirement above the new minimum that can be depleted under stress, subject to restrictions on capital distributions, a new additional loss absorbency capital requirement for global systematically important financials institutions and a new countercyclical buffer which regulators can activate during periods of excessive credit growth in their jurisdiction. The Basel III proposals complement an earlier proposal for revisions to the Market Risk Framework that increases capital requirements for securitizations within the Company’s trading book. In 2011, the U.S. regulators have issued proposed rules that are intended to implement certain aspects of the Market Risk Framework proposals. The U.S. regulators will require implementation of Basel III subject to an extended phase-in period.

Under the Basel Committee’s proposed framework, based on a preliminary analysis of the guidelines published to date, the Company estimates its Tier 1 common ratio will be in a range between 8% and 10% by the end of 2012. This is a preliminary estimate and may change based on guidelines for implementation to be issued by the Federal Reserve.

The new proposed framework includes new standards to raise the quality of capital which may impact the components of Tier 1 capital and Tier 1 common equity. The Company currently defines Tier 1 common equity as Tier 1 capital less qualifying perpetual preferred stock, qualifying restricted core capital elements (including junior subordinated debt issued to trusts (“trust preferred securities”) and noncontrolling interest), adjusted for the portion of goodwill and non-servicing intangible assets associated with MSSB’s noncontrolling interests (i.e., Citi’s share of MSSB’s goodwill and intangibles). This definition of Tier 1 common equity may evolve in the future as regulatory rules may be implemented based on a final proposal regarding noncontrolling interest as initially presented by the Basel Committee. For the discussion of Tier 1 common equity, see “The Balance Sheet” herein.

Pursuant to provisions of the Dodd-Frank Act, over time, trust preferred securities will no longer qualify as Tier 1 capital but will only qualify as Tier 2 capital. This change in regulatory capital treatment will be phased in incrementally during a transition period that will start on January 1, 2013 and end on January 1, 2016. This provision of the Dodd-Frank Act accelerates the phasing in of the disqualification of the trust preferred securities as provided for by Basel III.

At June 30, 2011, the Company was in compliance with Basel I capital requirements with ratios of Tier 1 capital to RWAs of 16.7% and total capital to RWAs of 18.3% (6% and 10% being well-capitalized for regulatory purposes, respectively). In addition, financial holding companies are also subject to a Tier 1 leverage ratio as defined by the Federal Reserve. The Company calculated its Tier 1 leverage ratio as Tier 1 capital divided by adjusted average total assets (which reflects adjustments for disallowed goodwill, certain intangible assets, deferred tax assets and financial and non-financial equity investments). The adjusted average total assets are derived using weekly balances for the year.

 

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The following table reconciles the Company’s total shareholders’ equity to Tier 1 and Total capital as defined by the regulations issued by the Federal Reserve and presents the Company’s consolidated capital ratios at June 30, 2011 and December 31, 2010:

 

     At
June 30,
2011
    At
December 31
2010
 
     (dollars in millions)  

Allowable capital

    

Tier 1 capital:

    

Common shareholders’ equity

   $ 58,199      $ 47,614   

Qualifying preferred stock

     1,508        9,597   

Qualifying restricted core capital elements

     9,400        12,924   

Less: Goodwill

     (6,744     (6,739

Less: Non-servicing intangible assets

     (4,355     (4,526

Less: Net deferred tax assets

     (5,510     (3,984

Less: After-tax debt valuation adjustment

     (54     (20

Other deductions

     (1,437     (1,986
  

 

 

   

 

 

 

Total Tier 1 capital

     51,007        52,880   
  

 

 

   

 

 

 

Tier 2 capital:

    

Other components of allowable capital:

    

Qualifying subordinated debt and restricted core capital elements

     5,356        2,412   

Other qualifying amounts

     32        82   

Other deductions

     (637     (897
  

 

 

   

 

 

 

Total Tier 2 capital

     4,751        1,597   
  

 

 

   

 

 

 

Total allowable capital

   $ 55,758      $ 54,477   
  

 

 

   

 

 

 

Total risk weighted assets

   $ 304,759      $ 329,560   
  

 

 

   

 

 

 

Capital ratios

    

Total capital ratio

     18.3     16.5
  

 

 

   

 

 

 

Tier 1 capital ratio

     16.7     16.1
  

 

 

   

 

 

 

Tier 1 leverage ratio

     6.0     6.6
  

 

 

   

 

 

 

Total allowable capital is composed of Tier 1 and Tier 2 capital. Tier 1 capital consists predominately of common shareholders’ equity as well as qualifying preferred stock and qualifying restricted core capital elements (trust preferred securities and noncontrolling interests) less goodwill, non-servicing intangible assets (excluding allowable mortgage servicing rights), net deferred tax assets (recoverable in excess of one year), an after-tax debt valuation adjustment and certain other deductions, including equity investments. The debt valuation adjustment in the above table represents the cumulative change in fair value of certain long-term and short-term borrowings that was attributable to the Company’s own instrument-specific credit spreads and is included in retained earnings. For a further discussion of fair value, see Note 3 to the condensed consolidated financial statements.

At June 30, 2011, the Company calculated its RWAs in accordance with the regulatory capital requirements of the Federal Reserve, which is consistent with guidelines described under Basel I. RWAs reflect both on and off-balance sheet risk of the Company. The risk capital calculations will evolve over time as the Company enhances its risk management methodology and incorporates improvements in modeling techniques while maintaining compliance with the regulatory requirements and interpretations. RWAs decreased from December 31, 2010 to June 30, 2011 as a result of a combination of business mix, analytics and collateral changes.

 

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Market RWAs reflect capital charges attributable to the risk of loss resulting from adverse changes in market prices and other factors. For a further discussion of the Company’s market risks and Value-at-Risk (“VaR”) model, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A, of the Form 10-K and in Part I, Item 3 herein. Market RWAs incorporate two components: systematic risk and specific risk. Systematic and specific risk charges are computed using either the Company’s VaR model or Standardized Approach in accordance with regulatory requirements.

Credit RWAs reflect capital charges attributable to the risk of loss arising from a borrower or counterparty failing to meet its financial obligations. For a further discussion of the Company’s credit risks, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management—Credit Risk” in Part II, Item 7A, of the Form 10-K and in Part I, Item 3 herein.

Liquidity.

The Basel Committee on Banking Supervision has developed two standards for supervisors to use in liquidity risk supervision. The first standard’s objective is to promote the short-term resilience of the liquidity risk profile of banks and bank holding companies. The Committee developed the Liquidity Coverage Ratio (“LCR”) to ensure banks have sufficient high-quality liquid assets to cover net outflows arising from significant stress lasting 30 calendar days. The standard requires that the value of the ratio be no lower than 100%. The second standard’s objective is to promote resilience over a longer time horizon. The Net Stable Funding Ratio (“NSFR”) has a time horizon of one year and builds on traditional “net liquid asset” and “cash capital” methodologies used widely by internationally active banking organizations to provide a sustainable maturity structure of assets and liabilities. The NSFR is defined as the amount of available stable funding to the amount of required stable funding. This ratio must be greater than 100%. After an observation period beginning in 2011, the LCR, including any revisions, will be introduced on January 1, 2015. The NSFR, including any revisions, will move to a minimum standard by January 1, 2018. The Company will continue to monitor the development and the potential impact of these standards.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Market Risk.

Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, implied volatilities (the price volatility of the underlying instrument imputed from option prices), correlations or other market factors, such as market liquidity, will result in losses for a position or portfolio. Generally, the Company incurs market risk as a result of trading, investing and client facilitation activities, principally within the Institutional Securities business segment where the substantial majority of the Company’s VaR for market risk exposures is generated. In addition, the Company incurs trading related market risk within the Global Wealth Management Group business segment. The Asset Management business segment incurs principally non-trading market risk primarily from capital investments in real estate funds and investments in private equity vehicles. Regarding sales and trading and related activities, the Company is exposed to concentration risk in certain of its OTC derivatives portfolios related to the additional cost of closing out particularly large risk positions. For a further discussion of the Company’s Market Risk, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.

VaR.

The Company uses VaR as one of a range of risk management tools. VaR methodology has various strengths and limitations, which include, but are not limited to: use of historical changes in market risk factors, which may not be accurate predictors of future market conditions, and may not fully incorporate the risk of extreme market events that are outsized relative to observed historical market behavior or reflect the historical distribution of results beyond the 95% confidence interval; and reporting of losses in a single day, which does not reflect the risk of positions that cannot be liquidated or hedged in one day. A small proportion of market risk generated by trading positions is not included in VaR. The modeling of the risk characteristics of some positions relies on approximations that, under certain circumstances, could produce significantly different results from those produced using more precise measures.

The Company’s VaR model evolves over time in response to changes in the composition of trading portfolios and to improvements in modeling techniques and systems capabilities. The Company is committed to continuous review and enhancement of VaR methodologies and assumptions in order to capture evolving risks associated with changes in market structure and dynamics. As part of regular process improvement, additional systematic and name-specific risk factors may be added to improve the VaR model’s ability to more accurately estimate risks to specific asset classes or industry sectors. Additionally, the Company continues to evaluate enhancements to the VaR model to make it more responsive to recent market conditions, while maintaining a longer-term perspective.

The Company also performs routine stress testing to more comprehensively monitor the risks in the portfolio. Morgan Stanley utilizes Stress VaR (“S-VaR”), which is a proprietary methodology that seeks to measure both the Company’s market and credit risks, while adjusting for the different liquidity characteristics of the underlying risks (in contrast to traditional VaR measures which are typically calculated using the same horizon for all risks). It is an important metric used in establishing the Company’s risk tolerance and its capital allocation framework. Further information on S-VaR can be found in “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.

Since the reported VaR statistics are estimates based on historical positions and market data, VaR should not be viewed as predictive of the Company’s future revenues or financial performance or of its ability to monitor and manage risk. There can be no assurance that the Company’s actual losses on a particular day will not exceed the VaR amounts indicated below or that such losses will not occur more than five times in 100 trading days for a 95%/one-day VaR. VaR does not predict the magnitude of losses which, should they occur, may be significantly greater than the VaR amount.

 

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The table below presents VaR for the Company’s Trading portfolio, on a quarter-end, quarterly average and quarterly high and low basis (see Table 1 below). The VaR that would result if the Company were to adopt alternative parameters for its calculations, such as a higher confidence level for the VaR statistic (99% rather than 95%) or a shorter historical time series of market data (one year rather than four years), are also disclosed (see Table 2 below).

The Company’s Trading VaR includes mark-to-market lending exposures and associated hedges. In addition, counterparty credit valuation adjustments and related hedges are also included in Trading VaR.

Trading Risks.

The table below presents the Company’s 95%/one-day Trading VaR:

 

Table 1: 95% Total Trading VaR    95%/One-Day VaR for the
Quarter Ended June 30, 2011
     95%/One-Day VaR for the
Quarter Ended March 31, 2011
 

Primary Market Risk Category

   Period
End
    Average     High      Low      Period
End
    Average     High      Low  
     (dollars in millions)  

Interest rate and credit spread

   $ 116      $ 131      $ 146       $ 116       $ 123      $ 105      $ 131       $ 91   

Equity price

     31        31        37         26         29        28        33         23   

Foreign exchange rate

     23        20        26         12         19        18        27         10   

Commodity price

     32        30        35         27         30        33        44         26   

Less Diversification benefit(1)(2)

     (73     (67     N/A         N/A         (67     (63     N/A         N/A   
  

 

 

   

 

 

         

 

 

   

 

 

      

Total Trading VaR

   $ 129      $ 145      $ 168       $ 128       $ 134      $ 121      $ 145       $ 103   
  

 

 

   

 

 

         

 

 

   

 

 

      

 

(1) Diversification benefit equals the difference between Total VaR and the sum of the VaRs for the four primary risk categories. This benefit arises because the simulated one-day losses for each of the four primary market risk categories occur on different days; similar diversification benefits also are taken into account within each category.
(2) N/A—Not Applicable. The minimum and maximum VaR values for the Total and each of the four risk categories might have occurred on different days during the quarter and therefore the Diversification benefit is not an applicable measure.

The Company’s average Trading VaR for the quarter ended June 30, 2011 was $145 million compared with $121 million for the quarter ended March 31, 2011. The increase was driven by the interest rate and credit spread asset class.

VaR Statistics under Varying Assumptions.

VaR statistics are not readily comparable across firms because of differences in the breadth of products included in each firm’s VaR model, in the statistical assumptions made when simulating changes in market factors, and in the methods used to approximate portfolio revaluations under the simulated market conditions. These differences can result in materially different VaR estimates for similar portfolios. The impact varies depending on the factor history assumptions, the frequency with which the factor history is updated, and the confidence level. As a result, VaR statistics are more reliable and relevant when used as indicators of trends in risk taking rather than as a basis for inferring differences in risk taking across firms.

Table 2 presents the VaR statistics that would result if the Company were to adopt alternative parameters for its calculations, such as the reported confidence level (95% versus 99%) for the VaR statistic or a shorter historical time series (four-year versus one-year) for market data upon which it bases its simulations. The four-year VaR measure continues to reflect the high market volatilities experienced in the latter half of 2007 through 2008, while the one-year VaR is no longer affected by these phenomena.

 

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Table 2: 95% and 99% Average Trading VaR with

Four-Year / One-Year Historical Time Series

   95% Average One-Day VaR
for the Quarter Ended
June 30, 2011
    99% Average One-Day VaR
for the Quarter Ended
June 30, 2011
 

Primary Market Risk Category

   Four-Year
Factor History
    One-Year
Factor History
    Four-Year
Factor History
    One-Year
Factor History
 
     (dollars in millions)  

Interest rate and credit spread

   $ 131      $ 86      $ 240      $ 149   

Equity price

     31        26        44        37   

Foreign exchange rate

     20        17        34        34   

Commodity price

     30        22        50        35   

Less Diversification benefit(1)

     (67     (50     (99     (77
  

 

 

   

 

 

   

 

 

   

 

 

 

Total Trading VaR

   $ 145      $ 101      $ 269      $ 178   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Diversification benefit equals the difference between Total VaR and the sum of the VaRs for the four primary risk categories. This benefit arises because the simulated one-day losses for each of the four primary market risk categories occur on different days; similar diversification benefits also are taken into account within each category.

Distribution of VaR Statistics and Net Revenues for the quarter ended June 30, 2011.

As shown in Table 1, the Company’s average 95%/one-day Trading VaR for the quarter ended June 30, 2011 was $145 million. The histogram below presents the distribution of the Company’s daily 95%/one-day Trading VaR for the quarter ended June 30, 2011. The most frequently occurring value was between $145 million and $150 million, while for approximately 72% of trading days during the quarter, VaR ranged between $135 million and $155 million.

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One method of evaluating the reasonableness of the Company’s VaR model as a measure of the Company’s potential volatility of net revenue is to compare the VaR with actual trading revenue. Assuming no intra-day trading, for a 95%/one-day VaR, the expected number of times that trading losses should exceed VaR during the year is 13, and, in general, if trading losses were to exceed VaR more than 21 times in a year, the accuracy of the VaR model could be questioned. Accordingly, the Company evaluates the reasonableness of its VaR model by comparing the potential declines in portfolio values generated by the model with actual trading results for both the Company as well as individual business units. For days where losses exceed the 95% or 99% VaR statistic, the Company examines the drivers of trading losses to evaluate the VaR model’s accuracy relative to realized trading results.

The histogram below shows the distribution of daily net trading revenue for the quarter ended June 30, 2011 for the Company’s trading businesses (these figures include revenue from the counterparty portfolio and also include net interest and non-agency commissions but exclude certain non-trading revenues such as primary, fee-based and prime brokerage revenue credited to the trading businesses). During the quarter ended June 30, 2011, the Company experienced net trading losses on 8 days, none of which were in excess of the 95%/one-day Trading VaR. The lack of realized trading losses that exceeded the VaR statistic over recent history is largely due to the inclusion of the high market volatilities experienced in the latter half of 2007 through 2008 in the calculation of the VaR statistic, while recent realized market volatilities have been more subdued.

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Non-Trading Risks.

The Company believes that sensitivity analysis is an appropriate representation of the Company’s non-trading risks. Reflected below is this analysis, which covers substantially all of the non-trading risk in the Company’s portfolio.

 

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Counterparty Exposure Related to the Company’s Own Spread.

The credit spread risk relating to the Company’s own mark-to-market derivative counterparty exposure is managed separately from VaR. The credit spread risk sensitivity of this exposure corresponds to an increase in value of approximately $8 million for each 1 basis point widening in the Company’s credit spread level for both June 30, 2011 and March 31, 2011.

Funding Liabilities.

The credit spread risk sensitivity of the Company’s mark-to-market funding liabilities corresponded to an increase in value of approximately $12 million and $13 million for each 1 basis point widening in the Company’s credit spread level at June 30, 2011 and March 31, 2011, respectively.

Interest Rate Risk Sensitivity on Income from Continuing Operations.

The Company measures the interest rate risk of certain assets and liabilities not included in Trading VaR by calculating the hypothetical sensitivity of income from continuing operations (before income taxes) to potential changes in the level of interest rates over the next twelve months. This sensitivity analysis includes positions that are mark-to-market as well as positions that are accounted for on an accrual basis.

Given the currently low interest rate environment, the Company uses the following two interest rate scenarios to quantify the Company’s sensitivity: instantaneous parallel shocks of 100 and 200 basis point increases to all points on all yield curves simultaneously. With respect to MSSB, the Company’s assessment of interest rate risk focuses on its economic investment in MSSB (the Company’s 51% share of MSSB’s income from continuing operations before income taxes).

For non-interest-bearing positions and for interest-sensitive positions that are not mark-to-market, the Company measures the incremental impact of the funding expense or coupon accrual over the next 12 months. For interest rate-sensitive positions that are mark-to-market, the sensitivities include the income impact of the instantaneous yield curve shock on the present value of the positions. For interest rate derivatives that are perfect economic hedges to non-mark-to-market assets or liabilities, the disclosed sensitivities include only the impact of the coupon accrual mismatch. This treatment mitigates the effects caused by the measurement basis differences between the economic hedge and the corresponding hedged instrument.

The hypothetical model does not assume any growth, change in business focus, asset pricing philosophy or asset/liability funding mix and does not capture how the Company would respond to significant changes in market conditions. Furthermore, the model does not reflect the Company’s expectations regarding the movement of interest rates in the near term, nor the actual effect on income from continuing operations before income taxes if such changes were to occur.

 

     June 30, 2011      March 31, 2011  
     +100
basis points
     +200
basis points
     +100
basis points
     +200
basis points
 
     (dollars in millions)  

Impact on income from continuing operations before income taxes

   $ 619       $ 1,215       $ 543       $ 1,090   

Impact on income from continuing operations before income taxes excluding Citi’s shares of MSSB(1)

     424         832         365         730   

 

(1) Reflects the exclusion of the portion of income from continuing operations before taxes associated with MSSB’s noncontrolling interest in the joint venture.

 

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Principal Investments.

The Company makes investments in both public and private companies. These investments are predominantly equity positions with long investment horizons, the majority of which are for business facilitation purposes. The market risk related to these investments is measured by estimating the potential reduction in net revenues associated with a 10% decline in asset values.

 

     10% Sensitivity  

Investments

   June 30, 2011      March 31, 2011  
     (dollars in millions)  

Investments related to Asset Management activities:

     

Hedge fund investments

   $ 158       $ 178   

Private equity and infrastructure funds

     122         114   

Real estate funds

     116         113   

Other investments:

     

Mitsubishi UFJ Financial Group JV

     127         110   

Other Company investments

     300         302   

Credit Risk.

For a further discussion of the Company’s credit risks, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management—Credit Risk” in Part II, Item 7A of the Form 10-K.

Credit Exposure—Corporate Lending.    In connection with certain of its Institutional Securities business segment activities, the Company provides loans or lending commitments (including bridge financing) to selected corporate clients. Such loans and lending commitments can generally be classified as either “relationship-driven” or “event-driven”. These loans and lending commitments have varying terms, may be senior or subordinated, may be secured or unsecured, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated, traded or hedged by the Company.

“Relationship-driven” loans and lending commitments are generally made to expand business relationships with select clients. Commitments associated with “relationship-driven” activities may not be indicative of the Company’s actual funding requirements, as the commitment may expire unused or the borrower may not fully utilize the commitment. The Company may hedge its exposures in connection with “relationship-driven” transactions, and commitments may be subject to conditions including financial covenants. These loans are carried either at fair value with changes in fair value recorded in earnings or amortized cost in the condensed consolidated statements of financial condition.

“Event-driven” loans and lending commitments refer to activities associated with a particular event or transaction, such as to support client merger, acquisition or recapitalization activities. Commitments associated with these “event-driven” activities may not be indicative of the Company’s actual funding requirements since funding is contingent upon a proposed transaction being completed. In addition, the borrower may not fully utilize the commitment or the Company’s portion of the commitment may be reduced through the syndication or sales process. The “event-driven” loans are typically syndicated or sold to third party institutional investors. The Company may have a custodial relationship with these institutional investors, for instance, prime brokerage clients. The borrower’s ability to draw on the commitment is also subject to certain terms and conditions, among other factors. The Company risk manages its exposures in connection with “event-driven” transactions through various means, including syndication, distribution and/or hedging. The Company’s “event-driven” loans and lending commitments consist of term loans, bridge loans and revolving lines of credit. These loans are carried at fair value in the condensed consolidated statements of financial condition with changes in fair value recorded in earnings.

At June 30, 2011, the aggregate amount of investment grade loans was $7.2 billion and the aggregate amount of non-investment grade loans was $7.0 billion. In connection with these corporate lending activities (which include

 

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corporate funded loans and lending commitments), the Company had hedges (which include “single name,” “sector” and “index” hedges) with a notional amount of $34.0 billion related to the total corporate lending exposure of $86.0 billion at June 30, 2011.

The table below also presents the Company’s credit exposure from its corporate lending positions and lending commitments at June 30, 2011. The “total corporate lending exposure” column includes both lending commitments and funded loans. Lending commitments represent legally binding obligations to provide funding to clients at June 30, 2011 for both “relationship-driven” and “event-driven” lending transactions. Since commitments associated with these business activities may expire unused, they do not necessarily reflect the actual future cash funding requirements.

Corporate Lending Commitments and Funded Loans at June 30, 2011

 

Credit Rating(1)

  Years to Maturity     Total
Corporate
Lending

Exposure(2)
    Corporate
Lending
Exposure at

Carrying Value(3)
    Corporate
Lending

Commitments(4)
 
  Less than 1     1-3     3-5     Over 5        
    (dollars in millions)  

AAA

  $ 805      $ 368      $ 89      $ —        $ 1,262      $ —        $ 1,262   

AA

    3,370        3,500        3,240        93        10,203        1,001        9,202   

A

    6,452        7,850        5,831        65        20,198        2,727        17,471   

BBB

    5,198        11,897        11,251        430        28,776        3,497        25,279   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Investment grade

    15,825        23,615        20,411        588        60,439        7,225        53,214   

Non-investment grade

    3,604        6,335        11,261        4,359        25,559        7,046        18,513   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 19,429      $ 29,950      $ 31,672      $ 4,947      $ 85,998      $ 14,271      $ 71,727   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Obligor credit ratings are determined by the Credit Risk Management Department.
(2) Total corporate lending exposure represents the Company’s potential loss assuming the fair value of funded loans and lending commitments was zero.
(3) The Company’s corporate lending exposure carried at fair value includes $14.3 billion of funded loans and $0.8 billion of lending commitments recorded in Financial instruments owned and Financial instruments sold, not yet purchased, respectively, in the condensed consolidated statements of financial condition at June 30, 2011. The Company’s corporate lending exposure carried at amortized cost includes $0.8 billion of funded loans and $0.8 billion of unfunded loans recorded in Loans and Other Liabilities and accrued expenses, respectively in the condensed consolidated statements of financial condition. See Notes 7 and 11 to the condensed consolidated financial statements for information on corporate loans and corporate lending commitments, respectively.
(4) Amounts represent the notional amount of unfunded lending commitments less the amount of commitments reflected in the Company’s condensed consolidated statements of financial condition. For syndications led by the Company, lending commitments accepted by the borrower but not yet closed are net of the amounts agreed to by counterparties that will participate in the syndication. For syndications that the Company participates in and does not lead, lending commitments accepted by the borrower but not yet closed include only the amount that the Company expects it will be allocated from the lead syndicate bank.

“Event-Driven” Loans and Lending Commitments at June 30, 2011.

Included in the total corporate lending exposure amounts in the table above at June 30, 2011 is “event-driven” exposure of $11.1 billion composed of funded loans of $2.0 billion and lending commitments of $9.1 billion. Included in the “event-driven” exposure at June 30, 2011 were $7.2 billion of loans and lending commitments to non-investment grade borrowers. The maturity profile of the “event-driven” loans and lending commitments at June 30, 2011 was as follows: 52% will mature in less than 1 year, 9% will mature within 1 to 3 years, 9% will mature within 3 to 5 years, and 30% will mature in over 5 years.

At June 30, 2011, $224 million of the Company’s “event-driven” loans were on non-accrual basis. These loans primarily are those the Company originated prior to the financial crisis in 2008 and was unable to sell or syndicate due to the financial crisis. For loans carried at fair value that are on non-accrual status, interest income is recognized on a cash basis.

 

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Activity associated with the corporate “event-driven” lending exposure during the six months ended June 30, 2011 was as follows (dollars in millions):

 

“Event-driven” lending exposures at December 31, 2010

   $ 5,409   

Closed commitments

     10,266   

Net reductions, primarily through syndication or sales

     (4,527

Mark-to-market adjustments

     (52
  

 

 

 

“Event-driven” lending exposures at June 30, 2011

   $ 11,096   
  

 

 

 

Credit Exposure—Derivatives.    For credit exposure information on the Company’s OTC derivative products, see Note 10 to the condensed consolidated financial statements.

Credit Derivatives.    A credit derivative is a contract between a seller (guarantor) and buyer (beneficiary) of protection against the risk of a credit event occurring on a set of debt obligations issued by a specified reference entity. The beneficiary pays a periodic premium (typically quarterly) over the life of the contract and is protected for the period. If a credit event occurs, the guarantor is required to make payment to the beneficiary based on the terms of the credit derivative contract. Credit events include bankruptcy, dissolution or insolvency of the referenced entity, failure to pay, obligation acceleration, repudiation and payment moratorium. Debt restructurings are also considered a credit event in some cases. In certain transactions referenced to a portfolio of referenced entities or asset-backed securities, deductibles and caps may limit the guarantor’s obligations.

The Company trades in a variety of derivatives and may either purchase or write protection on a single name or portfolio of referenced entities. The Company is an active market maker in the credit derivatives markets. As a market maker, the Company works to earn a bid-offer spread on client flow business and manage any residual credit or correlation risk on a portfolio basis. Further, the Company uses credit derivatives to manage its exposure to residential and commercial mortgage loans and corporate lending exposures during the periods presented.

The Company actively monitors its counterparty credit risk related to credit derivatives. A majority of the Company’s counterparties are banks, broker-dealers, insurance and other financial institutions, and Monolines. Contracts with these counterparties do not include ratings-based termination events but do include provisions related to counterparty rating downgrades, which may result in additional collateral being required by the Company. For further information on the Company’s exposure to Monolines, see “Executive Summary—Significant Items—Monoline Insurers” in Part I, Item 2 herein. The master agreements with these Monoline counterparties are generally unsecured, and the few ratings-based triggers (if any) generally provide the Company the ability to terminate only upon significant downgrade. As with all derivative contracts, the Company considers counterparty credit risk in the valuation of its positions and recognizes credit valuation adjustments as appropriate within Principal transactions—Trading.

The following table summarizes the key characteristics of the Company’s credit derivative portfolio by counterparty at June 30, 2011. The fair values shown are before the application of any counterparty or cash collateral netting:

 

     At June 30, 2011  
     Fair Values(1)      Notionals  
     Receivable      Payable      Net      Beneficiary      Guarantor  
     (dollars in millions)  

Banks and securities firms

   $ 95,146       $ 89,566       $ 5,580       $ 2,432,370       $ 2,414,276   

Insurance and other financial institutions

     13,517         11,949         1,568         418,536         442,502   

Monolines(2)

     3,343         —           3,343         25,322         —     

Non-financial entities

     280         223         57         5,990         3,848   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 112,286       $ 101,738       $ 10,548       $ 2,882,218       $ 2,860,626   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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(1) The Company’s credit default swaps are classified in both Level 2 and Level 3 of the fair value hierarchy. Approximately 14% of receivable fair values and 8% of payable fair values represent Level 3 amounts.
(2) Credit derivatives used to hedge the Company’s credit exposure to Monolines (including derivative counterparty exposure) are included in the table based on the counterparties writing such hedges. None of these hedges are written by other Monolines.

See Note 10 to the condensed consolidated financial statements for further information on credit derivatives.

Country Exposure—Exposure to European Peripherals.    In connection with certain of its Institutional Securities business segment activities, the Company has exposure to European peripheral countries, which are defined as exposures in Greece, Ireland, Italy, Portugal and Spain. At June 30, 2011, gross funded exposure before the benefit of hedges was approximately $5 billion and net funded exposure after hedges was approximately $2 billion. Gross funded exposure includes obligations from sovereign governments, corporations, and financial institutions. In addition to the gross funded exposure, at June 30, 2011, the Company had European peripheral country exposure for overnight deposits with banks of approximately $2 billion and unfunded loans to corporations of approximately $1.5 billion.

Country Exposure—Corporate Lending and OTC Derivative products.    At June 30, 2011 primarily based on the domicile of the counterparty, approximately 6% of the Company’s credit exposure (for credit exposure arising from corporate loans and lending commitments as discussed above and current exposure arising from the Company’s OTC derivative contracts) was to emerging markets, and no one emerging market country accounted for more than approximately 1% of the Company’s credit exposure.

The Company defines emerging markets to include generally all countries where the economic, legal and political systems are transitional and in the process of developing into more transparent and accountable systems that are consistent with advanced countries.

The following tables show the Company’s percentage of credit exposure from its primary corporate loans and lending commitments and OTC derivative products by country at June 30, 2011:

 

Country

   Corporate Lending
Exposure(1)
 

United States

     62

United Kingdom

     8   

Germany

     6   

France

     3   

Netherlands

     2   

Canada

     2   

Luxembourg

     2   

Spain

     2   

Other

     13   
  

 

 

 

Total

     100
  

 

 

 

 

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Country

   OTC  Derivative
Products(1)(2)
 

United States

     35

United Kingdom

     10   

Cayman Islands

     8   

Italy

     8   

Germany

     3   

France

     3   

Netherlands

     2   

Canada

     2   

Australia

     2   

Japan

     2   

Luxembourg

     2   

Chile

     2   

Austria

     2   

Other

     19   
  

 

 

 

Total

     100
  

 

 

 

 

(1) Credit exposure amounts are based on the domicile of the counterparty.
(2) Credit exposure amounts do not reflect the offsetting benefit of financial instruments that the Company utilizes to hedge credit exposure arising from OTC derivative products.

Industry Exposure—Corporate Lending and OTC Derivative products.    The Company also monitors its credit exposure to individual industries for credit exposure arising from corporate loans and lending commitments as discussed above and current exposure arising from the Company’s OTC derivative contracts.

The following tables show the Company’s percentage of credit exposure from its primary corporate loans and lending commitments and OTC derivative products by industry at June 30, 2011:

 

Industry

   Corporate Lending
Exposure
 

Utilities

     10

Energy

     10   

Financial institutions(1)

     9   

Pharmaceutical and healthcare

     9   

Technology

     7   

Chemicals, metals, mining and other materials

     6   

Telecommunications services

     6   

Media-related entities

     6   

Capital goods

     5   

Insurance

     4   

Food, beverage and tobacco

     4   

Transportation

     3   

Banks

     3   

Real estate

     3   

Other

     15   
  

 

 

 

Total

     100
  

 

 

 

 

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Industry

   OTC Derivative
Products
 

Financial institutions(1)

     28

Sovereign governments

     13   

Insurance

     11   

Banks

     11   

Utilities

     8   

Regional governments

     6   

Energy

     6   

Chemicals, metals, mining and other materials

     3   

Pharmaceutical and healthcare

     3   

Other

     11   
  

 

 

 

Total

     100
  

 

 

 

 

(1) Percentage reflects credit exposures from special purpose entity vehicles, other diversified financial service entities and mutual and pension funds, exchanges and clearinghouses, and private equity and real estate funds.

 

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Item 4. Controls and Procedures.

Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.

No change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) occurred during the period covered by this report that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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FINANCIAL DATA SUPPLEMENT (Unaudited)

Average Balances and Interest Rates and Net Interest Income

 

    Three Months Ended June 30, 2011  
    Average
Weekly
    Balance    
        Interest         Annualized
Average
Rate
 
    (dollars in millions)  

Assets

     

Interest earning assets:

     

Financial instruments owned(1):

     

U.S. 

  $ 124,225      $ 592        1.9

Non-U.S. 

    132,668        334        1.0   

Securities available for sale:

     

U.S. 

    26,899        96        1.4   

Loans:

     

U.S. 

    11,812        77        2.6   

Non-U.S. 

    171        6        14.2   

Interest bearing deposits with banks:

     

U.S. 

    43,834        12        0.1   

Non-U.S. 

    15,001        31        0.8   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed:

     

U.S. 

    222,620        (57     (0.1

Non-U.S. 

    96,348        387        1.6   

Other:

     

U.S. 

    45,473        426        3.8   

Non-U.S. 

    17,660        53        1.2   
 

 

 

   

 

 

   

Total

  $ 736,711      $ 1,957        1.1
   

 

 

   

Non-interest earning assets

    138,191       
 

 

 

     

Total assets

  $ 874,902       
 

 

 

     

Liabilities and Equity

     

Interest bearing liabilities:

     

Deposits:

     

U.S. 

  $ 63,974      $ 60        0.4

Non-U.S. 

    92        —          —     

Commercial paper and other short-term borrowings:

     

U.S. 

    1,307        2        0.6   

Non-U.S. 

    2,067        9        1.8   

Long-term debt:

     

U.S. 

    187,432        1,285        2.8   

Non-U.S. 

    7,365        7        0.4   

Financial instruments sold, not yet purchased(1):

     

U.S. 

    36,686        —          —     

Non-U.S. 

    73,101        —          —     

Securities sold under agreements to repurchase and Securities loaned:

     

U.S. 

    114,917        191        0.7   

Non-U.S. 

    79,965        491        2.5   

Other:

     

U.S. 

    89,654        (159     (0.7

Non-U.S. 

    38,882        143        1.5   
 

 

 

   

 

 

   

Total

  $ 695,442      $ 2,029        1.2   
   

 

 

   

Non-interest bearing liabilities and equity

    179,460       
 

 

 

     

Total liabilities and equity

  $ 874,902       
 

 

 

     

Net interest income and net interest rate spread

    $ (72     (0.1 )% 
   

 

 

   

 

 

 

 

(1) Interest expense on Financial instruments sold, not yet purchased is reported as a reduction of Interest income.

 

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FINANCIAL DATA SUPPLEMENT (Unaudited)—Continued

Average Balances and Interest Rates and Net Interest Income

 

 

     Three Months Ended June 30, 2010  
     Average
Weekly
Balance
     Interest     Annualized
Average
Rate
 
     (dollars in millions)  

Assets

       

Interest earning assets:

       

Financial instruments owned(1):

       

U.S.

   $ 141,597       $ 860        2.5

Non-U.S.

     105,566         199        0.8   

Securities available for sale:

       

U.S.

     18,726         55        1.2   

Loans:

       

U.S.

     7,231         65        3.7   

Non-U.S.

     198         5        10.2   

Interest bearing deposits with banks:

       

U.S.

     34,480         18        0.2   

Non-U.S.

     22,123         24        0.4   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed:

       

U.S.

     204,316         27        0.1   

Non-U.S.

     106,595         148        0.6   

Other:

       

U.S.

     30,103         399        5.4   

Non-U.S.

     19,805         (53     (1.1
  

 

 

    

 

 

   

Total

   $ 690,740       $ 1,747        1.0
     

 

 

   

Non-interest earning assets

     141,711        
  

 

 

      

Total assets

   $ 832,451        
  

 

 

      

Liabilities and Equity

       

Interest bearing liabilities:

       

Deposits:

       

U.S.

   $ 64,928       $ 78        0.5

Non-U.S.

     78         —          —     

Commercial paper and other short-term borrowings:

       

U.S.

     1,736         2        0.5   

Non-U.S.

     1,321         1        0.3   

Long-term debt:

       

U.S.

     182,847         1,151        2.6   

Non-U.S.

     4,807         3        0.3   

Financial instruments sold, not yet purchased(1):

       

U.S.

     15,999         —          —     

Non-U.S.

     69,840         —          —     

Securities sold under agreements to repurchase and Securities loaned:

       

U.S.

     139,046         196        0.6   

Non-U.S.

     77,445         227        1.2   

Other:

       

U.S.

     89,027         (209     (1.0

Non-U.S.

     33,510         157        1.9   
  

 

 

    

 

 

   

Total

   $ 680,584       $ 1,606        1.0   
     

 

 

   

Non-interest bearing liabilities and equity

     151,867        
  

 

 

      

Total liabilities and equity

   $ 832,451        
  

 

 

      

Net interest income and net interest rate spread

      $ 141        —  
     

 

 

   

 

 

 

 

(1) Interest expense on Financial instruments sold, not yet purchased is reported as a reduction of Interest income.

 

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FINANCIAL DATA SUPPLEMENT (Unaudited)—Continued

Average Balances and Interest Rates and Net Interest Income

 

 

     Six Months Ended June 30, 2011  
     Average
Weekly
Balance
     Interest     Annualized
Average
Rate
 
     (dollars in millions)  

Assets

       

Interest earning assets:

       

Financial instruments owned(1):

       

U.S.

   $ 122,604       $ 1,322        2.2

Non-U.S.

     126,796         523        0.8   

Securities available for sale:

       

U.S.

     27,011         191        1.4   

Loans:

       

U.S.

     11,388         148        2.6   

Non-U.S.

     183         11        12.2   

Interest bearing deposits with banks:

       

U.S.

     46,160         24        0.1   

Non-U.S.

     14,812         53        0.7   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed:

       

U.S.

     214,927         (3     —     

Non-U.S.

     93,836         608        1.3   

Other:

       

U.S.

     43,273         694        3.3   

Non-U.S.

     17,400         240        2.8   
  

 

 

    

 

 

   

Total

   $ 718,390       $ 3,811        1.1
     

 

 

   

Non-interest earning assets

     136,894        
  

 

 

      

Total assets

   $ 855,284        
  

 

 

      

Liabilities and Equity

       

Interest bearing liabilities:

       

Deposits:

       

U.S.

   $ 62,809       $ 126        0.4

Non-U.S.

     865         —          —     

Commercial paper and other short-term borrowings:

       

U.S.

     1,040         4        0.8   

Non-U.S.

     2,207         14        1.3   

Long-term debt:

       

U.S.

     186,742         2,589        2.8   

Non-U.S.

     7,049         15        0.4   

Financial instruments sold, not yet purchased(1):

       

U.S.

     29,792         —          —     

Non-U.S.

     67,662         —          —     

Securities sold under agreements to repurchase and Securities loaned:

       

U.S.

     115,917         378        0.7   

Non-U.S.

     80,972         777        1.9   

Other:

       

U.S.

     87,898         (365     (0.8

Non-U.S.

     36,370         344        1.9   
  

 

 

    

 

 

   

Total

   $ 679,323       $ 3,882        1.2   
     

 

 

   

Non-interest bearing liabilities and equity

     175,961        
  

 

 

      

Total liabilities and equity

   $ 855,284        
  

 

 

      

Net interest income and net interest rate spread

      $ (71     (0.1 )% 
     

 

 

   

 

(1) Interest expense on Financial instruments sold, not yet purchased is reported as a reduction of Interest income.

 

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FINANCIAL DATA SUPPLEMENT (Unaudited)—Continued

Average Balances and Interest Rates and Net Interest Income

 

 

     Six Months Ended June 30, 2010  
     Average
Weekly
Balance
     Interest     Annualized
Average
Rate
 
     (dollars in millions)  

Assets

       

Interest earning assets:

       

Financial instruments owned(1):

       

U.S.

   $ 148,208       $ 1,835        2.5

Non-U.S.

     103,253         355        0.7   

Securities available for sale:

       

U.S.

     11,738         65        1.1   

Loans:

       

U.S.

     7,042         129        3.7   

Non-U.S.

     203         11        11.0   

Interest bearing deposits with banks:

       

U.S.

     34,880         41        0.2   

Non-U.S.

     21,088         42        0.4   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed:

       

U.S.

     204,157         60        0.1   

Non-U.S.

     110,044         265        0.5   

Other:

       

U.S.

     29,137         740        5.2   

Non-U.S.

     19,960         (60     (0.6
  

 

 

    

 

 

   

Total

   $ 689,710       $ 3,483        1.0
     

 

 

   

Non-interest earning assets

     142,836        
  

 

 

      

Total assets

   $ 832,546        
  

 

 

      

Liabilities and Equity

       

Interest bearing liabilities:

       

Deposits:

       

U.S.

   $ 64,134       $ 160        0.5

Non-U.S.

     97         —          —     

Commercial paper and other short-term borrowings:

       

U.S.

     1,625         4        0.5   

Non-U.S.

     1,037         2        0.4   

Long-term debt:

       

U.S.

     185,833         2,227        2.4   

Non-U.S.

     4,576         6        0.3   

Financial instruments sold, not yet purchased(1):

       

U.S.

     15,043         —          —     

Non-U.S.

     67,754         —          —     

Securities sold under agreements to repurchase and Securities loaned:

       

U.S.

     142,331         342        0.5   

Non-U.S.

     77,508         366        1.0   

Other:

       

U.S.

     86,533         (260     (0.6

Non-U.S.

     34,672         127        0.7   
  

 

 

    

 

 

   

Total

   $ 681,143       $ 2,974        0.9   
     

 

 

   

Non-interest bearing liabilities and equity

     151,403        
  

 

 

      

Total liabilities and equity

   $ 832,546        
  

 

 

      

Net interest income and net interest rate spread

      $ 509        0.1
     

 

 

   

 

 

 

 

(1) Interest expense on Financial instruments sold, not yet purchased is reported as a reduction of Interest income.

 

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FINANCIAL DATA SUPPLEMENT (Unaudited)—Continued

 

Rate/Volume Analysis

The following tables set forth an analysis of the effect on net interest income of volume and rate changes:

 

     Three Months Ended June 30, 2011 versus
Three Months Ended June 30, 2010
 
     Increase (decrease) due to change in:        
           Volume                 Rate                 Net change        
     (in millions)  

Interest earning assets

      

Financial instruments owned:

      

U.S.

   $ (106   $ (162   $ (268

Non-U.S.

     51        84        135   

Securities available for sale:

      

U.S.

     24        17        41   

Loans:

      

U.S.

     41        (29     12   

Non-U.S.

     (1     2        1   

Interest bearing deposits with banks:

      

U.S.

     5        (11     (6

Non-U.S.

     (8     15        7   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed:

      

U.S.

     2        (86     (84

Non-U.S.

     (14     253        239   

Other:

      

U.S.

     205        (178     27   

Non-U.S.

     6        100        106   
  

 

 

   

 

 

   

 

 

 

Change in interest income

   $ 205      $ 5      $ 210   
  

 

 

   

 

 

   

 

 

 

Interest bearing liabilities

      

Deposits:

      

U.S.

   $ (1   $ (17   $ (18

Non-U.S.

     —          —          —     

Commercial paper and other short-term borrowings:

      

U.S.

     —          —          —     

Non-U.S.

     1        7        8   

Long-term debt:

      

U.S.

     29        105        134   

Non-U.S.

     2        2        4   

Securities sold under agreements to repurchase and Securities loaned:

      

U.S.

     (34     29        (5

Non-U.S.

     7        257        264   

Other:

      

U.S.

     (1     51        50   

Non-U.S.

     24        (38     (14
  

 

 

   

 

 

   

 

 

 

Change in interest expense

   $ 27      $ 396      $ 423   
  

 

 

   

 

 

   

 

 

 

Change in net interest income

   $ 178      $ (391   $ (213
  

 

 

   

 

 

   

 

 

 

 

 

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FINANCIAL DATA SUPPLEMENT (Unaudited)—Continued

 

 

     Six Months Ended June 30, 2011 versus
Six Months Ended June 30, 2010
 
     Increase (decrease) due to change in:        
           Volume                 Rate                 Net change        
     (in millions)  

Interest earning assets

      

Financial instruments owned:

      

U.S.

   $ (317   $ (196   $ (513

Non-U.S.

     81        87        168   

Securities available for sale:

      

U.S.

     85        41        126   

Loans:

      

U.S.

     80        (61     19   

Non-U.S.

     (1     1        —     

Interest bearing deposits with banks:

      

U.S.

     13        (30     (17

Non-U.S.

     (12     23        11   

Federal funds sold and securities purchased under agreements to resell and Securities borrowed:

      

U.S.

     3        (66     (63

Non-U.S.

     (39     382        343   

Other:

      

U.S.

     358        (404     (46

Non-U.S.

     8        292        300   
  

 

 

   

 

 

   

 

 

 

Change in interest income

   $ 259      $ 69      $ 328   
  

 

 

   

 

 

   

 

 

 

Interest bearing liabilities

      

Deposits:

      

U.S.

   $ (3   $ (31   $ (34

Non-U.S.

     —          —          —     

Commercial paper and other short-term borrowings:

      

U.S.

     (1     1        —     

Non-U.S.

     2        10        12   

Long-term debt:

      

U.S.

     11        351        362   

Non-U.S.

     3        6        9   

Securities sold under agreements to repurchase and Securities loaned:

      

U.S.

     (63     99        36   

Non-U.S.

     16        395        411   

Other:

      

U.S.

     (4     (101     (105

Non-U.S.

     6        211        217   
  

 

 

   

 

 

   

 

 

 

Change in interest expense

   $ (33   $ 941      $ 908   
  

 

 

   

 

 

   

 

 

 

Change in net interest income

   $ 292      $ (872   $ (580
  

 

 

   

 

 

   

 

 

 

 

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Part II—Other Information.

 

Item 1. Legal Proceedings.

In addition to the matters described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010 (the “Form 10-K”), the Company’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2011 (the “First Quarter Form 10-Q”) and those described below, in the normal course of business, the Company has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities as a global diversified financial services institution. Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding the Company’s business, including, among other matters, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief.

The Company contests liability and/or the amount of damages as appropriate in each pending matter. Where available information indicates that it is probable a liability had been incurred at the date of the condensed consolidated financial statements and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income.

In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. The Company cannot predict with certainty if, how or when such proceedings will be resolved or what the eventual settlement, fine, penalty or other relief, if any, may be, particularly for proceedings that are in their early stages of development or where plaintiffs seek substantial or indeterminate damages. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, and by addressing novel or unsettled legal questions relevant to the proceedings in question, before a loss or additional loss or range of loss or additional loss can be reasonably estimated for any proceeding. Subject to the foregoing, the Company believes, based on current knowledge and after consultation with counsel, that the outcome of such proceedings will not have a material adverse effect on the consolidated financial condition of the Company, although the outcome of such proceedings could be material to the Company’s operating results and cash flows for a particular period depending on, among other things, the level of the Company’s revenues or income for such period.

Recently, the level of litigation activity focused on residential mortgage and credit crisis related matters has increased materially in the financial services industry. As a result, the Company expects that it may become the subject of increased claims for damages and other relief regarding residential mortgages and related securities in the future and, while the Company has identified below certain proceedings that the Company believes to be material, individually or collectively, there can be no assurance that additional material losses will not be incurred from residential mortgage claims that have not yet been notified to the Company or are not yet determined to be material.

The following developments have occurred with respect to certain matters previously reported in the Form 10-K and the First Quarter Form 10-Q or concern new actions that have been filed since the first quarter Form 10-Q:

Residential Mortgage and Credit Crisis Related Matters.

Class Actions.

On June 9, 2011, plaintiffs in Joel Stratte-McClure, et al. v. Morgan Stanley, et al., filed a Second Amended Complaint in response to the court’s order of April 4, 2011.

 

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On July 21, 2011, the court presiding over In re Washington Mutual, Inc. Securities Litigation issued an order preliminarily approving the settlement of this litigation by the Company and other defendants.

On July 27, 2011, the court presiding over In re: Lehman Brothers Equity/Debt Securities Litigation issued an opinion granting in part and denying in part the underwriter defendants’ motion to dismiss the current amended complaint.

Other Litigation.

On May 25, 2011, the court presiding over Citibank, N.A. v. Morgan Stanley & Co. International, PLC issued an order denying the Company’s motion for summary judgment and granting Citibank, N.A.’s cross motion for summary judgment. On June 27, 2011, the court entered a final judgment against the Company for approximately $269 million plus post-judgment interest. On June 27, 2011, the Company filed a notice of appeal with United States Court of Appeals for the Second Circuit.

By orders dated June 23, 2011 and July 18, 2011, the court presiding over Federal Home Loan Bank of Seattle v. Morgan Stanley & Co. Inc., et al. denied defendants’ omnibus motion to dismiss the Amended Complaint. The Company’s individual motion to dismiss remains pending before the court.

On May 26, 2011, the court presiding over MBIA Insurance Corporation v. Morgan Stanley, et al. partially denied the Company’s motion to dismiss. On June 28, 2011, the Company filed a notice appealing this decision to the Appellate Division of the New York Supreme Court, First Department.

On July 5, 2011, Allstate Insurance Company and certain of its affiliated entities filed a complaint against the Company in New York State Supreme Court styled Allstate Insurance Company v. Morgan Stanley, et al. The complaint alleges that defendants made untrue statements and material omissions in the sale to plaintiff of certain mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The amount of certificates allegedly sold to plaintiffs by the Company was approximately $104 million. The complaint raises common law claims of fraud, fraudulent inducement, aiding and abetting fraud and negligent misrepresentation and seeks, among other things, compensatory and/or rescissionary damages associated with plaintiffs’ purchases of such certificates.

On July 7, 2011, the appellate court in China Development Industrial Bank v. Morgan Stanley & Co. Incorporated et al. affirmed the lower court’s decision denying the Company’s motion to dismiss.

On July 18, 2011, the Western and Southern Life Insurance Company and certain affiliated companies filed a complaint against the Company and other defendants in the Court of Common Pleas in Ohio, styled Western and Southern Life Insurance Company, et al. v. Morgan Stanley Mortgage Capital Inc., et al. The complaint alleges that defendants made untrue statements and material omissions in the sale to plaintiff of certain mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The amount of certificates allegedly sold to plaintiffs by the Company was approximately $130 million. The complaint raises claims under the Ohio Securities Act and federal securities laws and seeks, among other things, to rescind the plaintiffs’ purchases of such certificates.

 

Item 1A. Risk Factors.

Concerns regarding downgrade of the U.S. credit rating and the sovereign debt crisis in Europe could have a material adverse effect on our business, financial condition and liquidity.

On August 5, 2011, Standard & Poor’s lowered its long term sovereign credit rating on the United States of America from AAA to AA+. While U.S. lawmakers reached agreement to raise the federal debt ceiling on August 2, 2011, the downgrade reflected Standard & Poor’s view that the fiscal consolidation plan within that agreement fell short of what would be necessary to stabilize the U.S. government’s medium term debt dynamics. This downgrade could have material adverse impacts on financial markets and economic conditions in the United

 

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States and throughout the world and, in turn, the market’s anticipation of these impacts could have a material adverse effect on our business, financial condition and liquidity. In particular, it could disrupt payment systems, money markets, long-term or short-term fixed income markets, foreign exchange markets, commodities markets and equity markets and adversely affect the cost and availability of funding and certain impacts, such as increased spreads in money market and other short term rates, have been experienced already as the market anticipated the downgrade. In addition, it could adversely affect our credit ratings, as well as those of our clients and/or counterparties and could require us to post additional collateral on loans collateralized by U.S. Treasury securities. Because of the unprecedented nature of negative credit rating actions with respect to U.S. government obligations, the ultimate impacts on global markets and our business, financial condition and liquidity are unpredictable and may not be immediately apparent.

In addition, global markets and economic conditions have been negatively impacted by the ability of certain European Union (“EU”) member states to service their sovereign debt obligations. The continued uncertainty over the outcome of the EU governments’ financial support programs and the possibility that other EU member states may experience similar financial troubles could further disrupt global markets. In particular, it has and could in the future disrupt equity markets and result in volatile bond yields on the sovereign debt of EU members. These factors could have an adverse effect on our business, financial condition and liquidity. In particular, in connection with certain of our Institutional Securities business segment activities, we have exposure to European peripheral countries, which are defined as exposures in Greece, Ireland, Italy, Portugal and Spain. At June 30, 2011, gross funded exposure before the benefit of hedges to European peripheral countries was approximately $5 billion and net funded exposure after hedges was approximately $2 billion. Gross funded exposure includes obligations from sovereign governments, corporations, and financial institutions. In addition to the gross funded exposure, at June 30, 2011, the Company had European peripheral country exposure for overnight deposits with banks of approximately $2 billion and unfunded loans to corporations of approximately $1.5 billion.

The financial services industry is subject to extensive regulation, which is undergoing major changes that will impact our business.

As a major financial services firm, we are subject to extensive regulation by U.S. federal and state regulatory agencies and securities exchanges and by regulators and exchanges in each of the major markets where we operate. We also face the risk of investigations and proceedings by governmental and self-regulatory agencies in all countries in which we conduct our business. Interventions by authorities may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. In addition to the monetary consequences, these measures could, for example, impact our ability to engage in, or impose limitations on, certain of our businesses. The number of these investigations and proceedings, as well as the amount of penalties and fines sought, has increased substantially in recent years with regard to many firms in the financial services industry, including us. Significant regulatory action against us could materially adversely affect our business, financial condition or results of operations or cause us significant reputational harm, which could seriously harm our business. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) also provides a bounty to whistleblowers who present the Securities and Exchange Commission (“SEC”) with information related to securities laws violations that leads to a successful enforcement action. As a result of this bounty, we may face an increased number of investigations by the SEC.

In response to the financial crisis, legislators and regulators, both in the U.S. and worldwide, have adopted, or are currently considering enacting, financial market reforms that have resulted and could result in major changes to the way our global operations are regulated. In particular, as a result of the Dodd-Frank Act, we are subject to significantly revised and expanded regulation and supervision, to new activities limitations, to a systemic risk regime which will impose especially high capital and liquidity requirements, and to comprehensive new derivatives regulation. Additional restrictions on our activities would result if we were to no longer meet certain capital or management requirements at the financial holding company level. Certain portions of the Dodd-Frank Act were effective immediately, while other portions will be effective only following extended transition periods, but many of these changes could in the future materially impact the profitability of our businesses, the value of assets we hold, expose us to additional costs, require changes to business practices or force us to discontinue

 

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businesses, could adversely affect our ability to pay dividends, or could require us to raise capital, including in ways that may adversely impact our shareholders or creditors.

For example, the Volcker Rule provision of the Dodd-Frank Act will have an impact on us, including potentially limiting various aspects of our business. With respect to the “proprietary trading” prohibition of the Volcker Rule, we have previously announced plans to dispose of our in-house proprietary quantitative trading unit, Process-Driven Trading (“PDT”), in 2012. For the year ended December 31, 2010, PDT did not have a material impact on our financial condition, results of operations and liquidity. We have also previously exited other standalone proprietary trading businesses (defined as those businesses that were dedicated solely to investing our capital), and we are continuing to liquidate legacy positions related to those businesses. Beyond the restriction on standalone proprietary trading businesses, any additional limitations will depend on the details of agency rulemaking, which have not been published. Given the lack of clarity, we are unable to identify which other parts of our business will or might be defined to be “proprietary trading” or, even if defined as “proprietary trading,” whether we would benefit from a “permitted activity” exception, such as market-making or hedging. We are closely monitoring regulatory developments related to the Volcker Rule, and when the regulations are final, we will be in a position to complete a review of our relevant activities and make plans to implement compliance with the Volcker Rule, which will likely not require full conformance until July 2014, subject to extensions.

Holding large and concentrated positions may expose us to losses.

Concentration of risk may reduce revenues or result in losses in our market-making, investing, block trading, underwriting and lending businesses in the event of unfavorable market movements. We commit substantial amounts of capital to these businesses, which often results in our taking large positions in the securities of, or making large loans to, a particular issuer or issuers in a particular industry, country or region. For example, our exposure to monoline insurers (“Monolines”) at June 30, 2011 includes $1.7 billion of bonds that are insured by Monolines and $1.6 billion of positive net derivative counterparty exposure (principally MBIA Insurance Corporation). Our hedging program for Monoline counterparty exposure continues to become more costly and difficult to effect because of the basis risk (risk associated with imperfect hedging) between the Monoline counterparty exposure and the related hedges. The quarter and six months ended June 30, 2011 included gains of $471 million and $153 million, respectively, compared with losses of $186 million and $330 million, respectively, in the prior year comparative periods. Although we proactively manage our Monoline exposure, as market conditions continue to evolve, significant additional gains or losses could be incurred. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Executive Summary—Significant Items—Monoline Insurers” in Part I, Item 2, herein.

Our borrowing costs and access to the debt capital markets depend significantly on our credit ratings.

 

The cost and availability of unsecured financing generally are dependent on our short-term and long-term credit ratings. Factors that are important to the determination of our credit ratings include the level and quality of our earnings, capital adequacy, liquidity, risk appetite and management, asset quality, business mix and actual and perceived levels of government support.

Our debt ratings also can have a significant impact on certain trading revenues, particularly in those businesses where longer term counterparty performance is critical, such as over-the-counter (“OTC”) derivative transactions, including credit derivatives and interest rate swaps. In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business segment, we may be required to provide additional collateral to certain counterparties in the event of a credit ratings downgrade. At June 30, 2011, the amount of additional collateral or termination payments that could be called by counterparties under the terms of such agreements in the event of a one-notch downgrade of our long-term credit rating was $1,245 million. A total of $3,258 million in collateral or termination payments could be called in the event of a two-notch downgrade. In addition, we may be required to pledge additional collateral to certain exchanges and

 

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clearing organizations in the event of a credit ratings downgrade. At June 30, 2011, the increased collateral requirement at certain exchanges and clearing organizations was $178 million in the event of a one-notch downgrade of our long-term credit rating. A total of $1,371 million of collateral is required in the event of a two-notch downgrade.

The rating agencies are considering the impact of the Dodd-Frank Act’s resolution authority provisions on large banking institutions and it is possible that they could downgrade our ratings and those of similar institutions.

We have incurred, and may continue to incur, significant losses in the real estate sector.

We finance and acquire principal positions in a number of real estate and real estate-related products for our own account, for investment vehicles managed by affiliates in which we also may have a significant investment, for separate accounts managed by affiliates and for major participants in the commercial and residential real estate markets. At June 30, 2011, the condensed consolidated statements of financial condition included amounts representing real estate investment assets of consolidated subsidiaries of approximately $2.0 billion, net of noncontrolling interests of approximately $1.6 billion. In addition, we had contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to real estate investments of $1.0 billion at June 30, 2011.

We also originate loans secured by commercial and residential properties. Further, we securitize and trade in a wide range of commercial and residential real estate and real estate-related whole loans, mortgages and other real estate and commercial assets and products, including residential and commercial mortgage-backed securities. These businesses have been, and may continue to be, adversely affected by the downturn in the real estate sector. In connection with these activities, we have provided, or otherwise agreed to be responsible for, certain representations and warranties. Under certain circumstances, we may be required to repurchase such assets or make other payments related to such assets if such representations and warranties were breached. Between 2004 and June 30, 2011, we sponsored approximately $147 billion of residential mortgage-backed securities (“RMBS”) primarily containing U.S. residential loans. Of that amount, we made representations and warranties concerning approximately $46 billion of loans and agreed to be responsible for the representations and warranties made by third-party sellers, many of which are now insolvent, on approximately $21 billion of loans. At June 30, 2011, the current unpaid principal balance (“UPB”) for all the residential assets subject to such representations and warranties was approximately $25.1 billion and the cumulative losses associated with U.S. RMBS were approximately $9.6 billion. We did not make, or otherwise agree to be responsible, for the representations and warranties made by third party sellers on approximately $80 billion of residential loans that we securitized during that time period. We have not sponsored any U.S. RMBS transactions since 2007.

We have also made representations and warranties in connection with our role as an originator of certain commercial mortgage loans that we securitized in commercial mortgage-backed securities (“CMBS”). Between 2004 and 2010, we originated approximately $43 billion and $29 billion of U.S. and non-U.S. commercial mortgage loans, respectively, that were placed into CMBS sponsored by us. At June 30, 2011, the current UPB for all U.S. commercial mortgage loans subject to such representations and warranties was $36.6 billion. At June 30, 2011, the current UPB for all non-U.S. commercial mortgage loans, subject to such representations and warranties was approximately $17 billion.

Recently, the level of litigation activity focused on residential mortgage and credit crisis-related matters has increased materially in the financial services industry. As a result, we expect that we may become the subject of increased claims for damages and other relief regarding residential mortgages and related securities in the future. We continue to monitor our real estate-related activities in order to manage our exposures and potential liability from these markets and businesses. See “Legal Proceedings—Residential Mortgage and Credit Crisis Related Matters” in Part II, Item 1 herein. For a discussion of additional risk factors affecting the Company, see also “Risk Factors” in Part I, Item 1A of the Form 10-K.

 

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We may be unable to fully capture the expected value from acquisitions, joint ventures, minority stakes and strategic alliances.

In connection with past or future acquisitions, joint ventures (including Morgan Stanley Smith Barney Holdings LLC) or strategic alliances (including with Mitsubishi UFJ Financial Group, Inc. (“MUFG”)), we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls and to integrate relationships with clients, trading counterparties and business partners. In the case of joint ventures and minority stakes, we are subject to additional risks and uncertainties because we may be dependent upon, and subject to liability, losses or reputational damage relating to, systems, controls and personnel that are not under our control.

For example, the ownership arrangements relating to the Company’s joint venture in Japan with MUFG of their respective investment banking and securities businesses are complex. MUFG and the Company have integrated their respective Japanese securities businesses by forming two joint venture companies, Mitsubishi UFJ Morgan Stanley Securities Co., Ltd. (“MUMSS”) and Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Other Matters—Japanese Securities Joint Venture” in Part I, Item 2 herein. For the quarter ended March 31, 2011, the Company recorded a loss of $655 million arising from its 40% stake in MUMSS related to certain fixed income trading positions at MUMSS, which is a subsidiary of MUFG that is controlled and risk managed by MUFG. As a result of this loss, during the quarter ended March 31, 2011, the Company entered into a transaction with MUMSS, whereby the fixed income trading positions that previously caused the majority of the aforementioned MUMSS losses were transferred to MSMS, a subsidiary of the Company that is controlled and risk managed by the Company. While MUFG contributed $370 million in capital to MUMSS in connection with the trading losses and has or will take certain other actions, including the replacement of certain management personnel and enhancement of risk management processes and controls, additional losses could be incurred by MUMSS in the future.

In addition, conflicts or disagreements between us and any of our joint venture partners may negatively impact the benefits to be achieved by the relevant joint venture.

There is no assurance that any of our acquisitions will be successfully integrated or yield all of the positive benefits anticipated. If we are not able to integrate successfully our past and future acquisitions, there is a risk that our results of operations, financial condition and cash flows may be materially and adversely affected.

Certain of our business initiatives, including expansions of existing businesses, may bring us into contact, directly or indirectly, with individuals and entities that are not within our traditional client and counterparty base and may expose us to new asset classes and new markets. These business activities expose us to new and enhanced risks, greater regulatory scrutiny of these activities, increased credit-related, sovereign and operational risks, and reputational concerns regarding the manner in which these assets are being operated or held.

See also “Risk Factors” in Part I, Item 1A of the Form 10-K and “Supervision and Regulation” in Part I, Item 1 of the 2010 Form 10-K.

 

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

The table below sets forth the information with respect to purchases made by or on behalf of the Company of its common stock during the quarterly period ended June 30, 2011.

Issuer Purchases of Equity Securities

(dollars in millions, except per share amounts)

 

Period

   Total
Number of
Shares
Purchased
     Average Price
Paid Per
Share
     Total Number of
Shares Purchased
As Part of Publicly
Announced Plans
or Programs(C)
     Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs
 

Month #1

           

(April 1, 2011—April 30, 2011)

           

Share Repurchase Program(A)

     —           —           —         $ 1,560   

Employee Transactions(B)

     91,393       $ 27.09         —           —     

Month #2

           

(May 1, 2011—May 31, 2011)

           

Share Repurchase Program(A)

     —           —           —         $ 1,560   

Employee Transactions(B)

     119,198       $ 24.98         —           —     

Month #3

           

(June 1, 2011—June 30, 2011)

           

Share Repurchase Program(A)

     —           —           —         $ 1,560   

Employee Transactions(B)

     216,857       $ 23.34         —           —     

Total

           

Share Repurchase Program(A)

     —           —           —         $ 1,560   

Employee Transactions(B)

     427,449       $ 24.60         —           —     

 

(A) On December 19, 2006, the Company announced that its Board of Directors authorized the repurchase of up to $6 billion of the Company’s outstanding stock under a share repurchase program (the “Share Repurchase Program”). The Share Repurchase Program is a program for capital management purposes that considers, among other things, business segment capital needs, as well as equity-based compensation and benefit plan requirements. The Share Repurchase Program has no set expiration or termination date. Share repurchases by the Company are subject to regulatory approval.
(B) Includes: (1) shares delivered or attested in satisfaction of the exercise price and/or tax withholding obligations by holders of employee and director stock options (granted under employee and director stock compensation plans) who exercised options; (2) shares withheld, delivered or attested (under the terms of grants under employee and director stock compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares; (3) shares withheld, delivered and attested (under the terms of grants under employee and director stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units, and (4) shares withheld, delivered and attested (under the terms of grants under employee and director stock compensation plans) to offset the cash payment for fractional shares. The Company’s employee and director stock compensation plans provide that the value of the shares withheld, delivered or attested shall be valued using the fair market value of the Company’s common stock on the date the relevant transaction occurs, using a valuation methodology established by the Company.
(C) Share purchases under publicly announced programs are made pursuant to open-market purchases, Rule 10b5-1 plans or privately negotiated transactions (including with employee benefit plans) as market conditions warrant and at prices the Company deems appropriate.

 

Item 6. Exhibits.

An exhibit index has been filed as part of this Report on Page E-1.

 

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

MORGAN STANLEY

(Registrant)

By:   /S/ RUTH PORAT
 

Ruth Porat

Executive Vice President and

Chief Financial Officer

By:   /S/ PAUL C. WIRTH
 

Paul C. Wirth

Deputy Chief Financial Officer

Date: August 8, 2011

 

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EXHIBIT INDEX

MORGAN STANLEY

Quarter Ended June 30, 2011

 

Exhibit No.

  

Description

    2.1    Amended and Restated Joint Venture Contribution and Formation Agreement dated as of May 29, 2009 by and among Citigroup Inc. and Morgan Stanley and Morgan Stanley Smith Barney Holdings LLC (Exhibit 10.1 to Morgan Stanley’s Current Report on Form 8-K dated May 29, 2009).
    2.2    Integration and Investment Agreement, dated as of March 30, 2010 by and between Mitsubishi UFJ Financial Group, Inc. and Morgan Stanley.
  10.1    Amendment to Morgan Stanley 401(k) Plan, dated as of June 1, 2011.
  10.2    Amendment to Morgan Stanley 401(k) Savings Plan, dated as of June 1, 2011.
  10.3    Amendment to Morgan Stanley Supplemental Executive Retirement and Excess Plan, dated as of June 1, 2011.
  12    Statement Re: Computation of Ratio of Earnings to Fixed Charges and Computation of Earnings to Fixed Charges and Preferred Stock Dividends.
  15    Letter of awareness from Deloitte & Touche LLP, dated August 8, 2011, concerning unaudited interim financial information.
  31.1    Rule 13a-14(a) Certification of Chief Executive Officer.
  31.2    Rule 13a-14(a) Certification of Chief Financial Officer.
  32.1    Section 1350 Certification of Chief Executive Officer.
  32.2    Section 1350 Certification of Chief Financial Officer.
101    Interactive data files pursuant to Rule 405 of Regulation S-T: (i) the Condensed Consolidated Statements of Financial Condition—June 30, 2011 and December 31, 2010, (ii) the Condensed Consolidated Statements of Income—Three and Six Months Ended June 30, 2011 and 2010, (iii) the Condensed Consolidated Statements of Comprehensive Income—Three and Six Months Ended June 30, 2011 and 2010, (iv) the Condensed Consolidated Statements of Cash Flows—Six Months Ended June 30, 2011 and 2010, (v) the Condensed Consolidated Statements of Changes in Total Equity—Six Months Ended June 30, 2011 and 2010, and (vi) Notes to Condensed Consolidated Financial Statements (unaudited).*

 

* As provided in Rule 406T of Regulation S-T, this information is furnished and not filed for purposes of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934.

 

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