10-K 1 d10k.htm FORM 10-K Form 10-K
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended November 30, 2008

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)

Title of each class

   Name of exchange on

which registered

Securities registered pursuant to Section 12(b) of the Act:

  
Common Stock, $0.01 par value    New York Stock Exchange

Depositary Shares, each representing 1/1,000th interest in a share of Floating Rate Non-Cumulative Preferred Stock, Series A, $0.01 par value

   New York Stock Exchange
6 1/4% Capital Securities of Morgan Stanley Capital Trust III (and Registrant’s guaranty with respect thereto)    New York Stock Exchange
6 1/4% Capital Securities of Morgan Stanley Capital Trust IV (and Registrant’s guaranty with respect thereto)    New York Stock Exchange
5 3/4% Capital Securities of Morgan Stanley Capital Trust V (and Registrant’s guaranty with respect thereto)    New York Stock Exchange
6.60% Capital Securities of Morgan Stanley Capital Trust VI (and Registrant’s guaranty with respect thereto)    New York Stock Exchange
6.60% Capital Securities of Morgan Stanley Capital Trust VII (and Registrant’s guaranty with respect thereto)    New York Stock Exchange
6.45% Capital Securities of Morgan Stanley Capital Trust VIII (and Registrant’s guaranty with respect thereto)    New York Stock Exchange

SPARQS® due February 20, 2009; SPARQS due March 20, 2009; SPARQS due April 20, 2009; SPARQS due May 20, 2009; SPARQS due July 20, 2009 (2 issuances)

   NYSE Arca, Inc.
Exchangeable Notes due December 30, 2010; Exchangeable Notes due June 30, 2011    NYSE Alternext US LLC

BRIDGESSM due February 28, 2009; BRIDGES due March 30, 2009; BRIDGES due June 30, 2009; BRIDGES due July 30, 2009; BRIDGES due August 30, 2009; BRIDGES due October 30, 2009; BRIDGES due December 30, 2009; BRIDGES due June 15, 2010

   NYSE Arca, Inc.

Capital Protected Notes due December 30, 2009; Capital Protected Notes due April 20, 2010; Capital Protected Notes due July 20, 2010 (2 issuances); Capital Protected Notes due August 30, 2010; Capital Protected Notes due October 30, 2010; Capital Protected Notes due January 30, 2011; Capital Protected Notes due February 20, 2011; Capital Protected Notes due March 30, 2011
(2 issuances); Capital Protected Notes due June 30, 2011; Capital Protected Notes due August 20, 2011; Capital Protected Notes due October 30, 2011; Capital Protected Notes due December 30, 2011; Capital Protected Notes due September 30, 2012

   NYSE Arca, Inc.
Capital Protected Notes due September 1, 2010    The NASDAQ Stock Market LLC

MPSSM due December 30, 2009; MPS due February 1, 2010; MPS due June 15, 2010; MPS due December 30, 2010; MPS due March 30, 2012

   NYSE Arca, Inc.
MPS due December 30, 2010    NYSE Alternext US LLC
MPS due March 30, 2009    The NASDAQ Stock Market LLC
Stock Participation Notes due September 15, 2010; Stock Participation Notes due December 30, 2010    NYSE Alternext US LLC

PLUSSM due February 20, 2009; PLUS due April 20, 2009; PLUS due May 20, 2009; PLUS due June 20, 2009; PLUS due June 30, 2009

   NYSE Arca, Inc.
PLUS due September 30, 2009    The NASDAQ Stock Market LLC
Buffered PLUSSM due December 20, 2010    NYSE Arca, Inc.
PROPELSSM due December 30, 2011 (3 issuances)    NYSE Arca, Inc.

Protected Absolute Return Barrier Notes due June 20, 2009; Protected Absolute Return Barrier Notes due July 20, 2009; Protected Absolute Return Barrier Notes due September 20, 2009; Protected Absolute Return Barrier Notes due October 20, 2009; Protected Absolute Return Barrier Notes due December 20, 2009; Protected Absolute Return Barrier Notes due January 20, 2010; Protected Absolute Return Barrier Notes due March 20, 2010; Protected Absolute Return Barrier Notes due July 20, 2010

   NYSE Arca, Inc.
Strategic Total Return Securities due December 17, 2009; Strategic Total Return Securities due July 30, 2011    NYSE Arca, Inc.
BOXESSM due October 30, 2031; BOXES due January 30, 2032    NYSE Arca, Inc.
Market Vectors ETNs due March 31, 2020 (2 issuances); Market Vectors ETNs due April 30, 2020 (2 issuances)    NYSE Arca, Inc.

Targeted Income Strategic Total Return Securities due March 30, 2010; Targeted Income Strategic Total Return Securities due July 30, 2011; Targeted Income Strategic Total Return Securities due January 15, 2012

   NYSE Arca, Inc.
Targeted Income Strategic Total Return Securities due October 30, 2011    The NASDAQ Stock Market LLC

Indicate by check mark if Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES x NO ¨

Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. YES ¨ NO x

Indicate by check mark whether 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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

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 Registrant is a shell company (as defined in Exchange Act Rule 12b-2). YES ¨ NO x

As of May 31, 2008, the aggregate market value of the common stock of Registrant held by non-affiliates of Registrant was approximately $48,765,826,243. This calculation does not reflect a determination that persons are affiliates for any other purposes.

As of December 31, 2008, there were 1,074,497,565 shares of Registrant’s common stock, $0.01 par value, outstanding.

Documents Incorporated By Reference: Portions of Registrant’s definitive proxy statement for its 2009 annual meeting of shareholders are incorporated by reference in Part III of this Form 10-K.


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ANNUAL REPORT ON FORM 10-K

for the fiscal year ended November 30, 2008

 

Table of Contents          Page

Part I

     

Item 1.

   Business    1
  

Overview

   1
  

Available Information

   1
  

Recent Business Developments

   2
  

Business Segments

   2
  

Institutional Securities

   3
  

Global Wealth Management Group

   5
  

Asset Management

   6
  

Research

   7
  

Competition

   7
  

Supervision and Regulation

   8
  

Executive Officers of Morgan Stanley

   16

Item 1A.

   Risk Factors    17

Item 1B.

   Unresolved Staff Comments    26

Item 2.

   Properties    27

Item 3.

   Legal Proceedings    28

Item 4.

   Submission of Matters to a Vote of Security Holders    31
Part II      

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   32

Item 6.

   Selected Financial Data    34

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    36
  

Introduction

   36
  

Executive Summary

   38
  

Certain Factors Affecting Results of Operations

   45
  

Capital-Related Transactions

   47
  

Business Segments

   48
  

Other Matters

   63
  

Critical Accounting Policies

   70
  

Liquidity and Capital Resources

   74

Item 7A.

   Quantitative and Qualitative Disclosures about Market Risk    88

Item 8.

   Financial Statements and Supplementary Data    106
  

Report of Independent Registered Public Accounting Firm

   106
  

Consolidated Statements of Financial Condition

   107
  

Consolidated Statements of Income

   109
  

Consolidated Statements of Comprehensive Income

   110
  

Consolidated Statements of Cash Flows

   111
  

Consolidated Statements of Changes in Shareholders’ Equity

   112
  

Notes to Consolidated Financial Statements

   113
  

Financial Data Supplement (Unaudited)

   189

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    191

Item 9A.

   Controls and Procedures    191

Item 9B.

   Other Information    193

 

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Table of Contents          Page
Part III      

Item 10.

   Directors, Executive Officers and Corporate Governance    194

Item 11.

   Executive Compensation    194

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   

195

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    196

Item 14.

   Principal Accountant Fees and Services    196
Part IV      

Item 15.

   Exhibits and Financial Statement Schedules    197
Signatures    S-1
Index to Financial Statements and Financial Statement Schedules    F-1
Exhibit Index    E-1

 

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Forward-Looking Statements

 

We have included or incorporated by reference into this report, and from time to time may make in our public filings, press releases or other public statements, certain statements, including (without limitation) those under “Legal Proceedings” in Part I, Item 3, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 and “Quantitative and Qualitative Disclosures about Market Risk” in Part II, Item 7A, that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. In addition, our management may make forward-looking statements to analysts, investors, representatives of the media and others. These forward-looking statements are not historical facts and represent only Morgan Stanley’s beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control.

 

The nature of Morgan Stanley’s business makes predicting the future trends of our revenues, expenses and net income difficult. The risks and uncertainties involved in our businesses could affect the matters referred to in such statements and it is possible that our actual results may differ from the anticipated results indicated in these forward-looking statements. Important factors that could cause actual results to differ from those in the forward-looking statements include (without limitation):

 

   

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;

 

   

the level and volatility of equity prices, 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 Morgan Stanley’s unsecured short-term and long-term debt;

 

   

investor sentiment and confidence in the financial markets;

 

   

our reputation;

 

   

the actions and initiatives of current and potential competitors;

 

   

the impact of current, pending and future legislation, regulation, legal actions and technological changes and events in the U.S. and worldwide; and

 

   

other risks and uncertainties detailed under “Competition” and “Regulation” in Part I, Item 1, “Risk Factors” in Part I, Item 1A, and elsewhere throughout this report.

 

Accordingly, you are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which they are made. Morgan Stanley undertakes no obligation to update publicly or revise any forward-looking statements to reflect the impact of circumstances or events that arise after the dates they are made, whether as a result of new information, future events or otherwise except as required by applicable law. You should, however, consult further disclosures Morgan Stanley may make in future filings of its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and any amendments thereto or in future press releases or other public statements.

 

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Part I

 

Item 1.     Business.

 

Overview.

 

Morgan Stanley is a global financial services firm that, through its subsidiaries and affiliates, provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. Morgan Stanley was originally incorporated under the laws of the State of Delaware in 1981, and its predecessor companies date back to 1924. Morgan Stanley conducts its business from its headquarters in and around New York City, its regional offices and branches throughout the U.S. and its principal offices in London, Tokyo, Hong Kong and other world financial centers. At November 30, 2008, Morgan Stanley had 46,964 employees worldwide. Unless the context otherwise requires, the terms “Morgan Stanley,” the “Company,” “we,” “us” and “our” mean Morgan Stanley and its consolidated subsidiaries.

 

On September 21, 2008, Morgan Stanley obtained approval from the Board of Governors of the Federal Reserve System (the “Fed”) to become a bank holding company upon the conversion of its wholly owned indirect subsidiary, Morgan Stanley Bank (Utah), from a Utah industrial bank to a national bank. On September 23, 2008, the Office of the Comptroller of the Currency (the “OCC”) authorized Morgan Stanley Bank (Utah) to commence business as a national bank, operating as Morgan Stanley Bank, N.A. Concurrent with this conversion, Morgan Stanley became a financial holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). For more information about Morgan Stanley’s transition into a financial holding company, see “Supervision and Regulation—Financial Holding Company” herein.

 

Financial information concerning Morgan Stanley, its business segments and geographic regions for each of the fiscal years ended November 30, 2008, November 30, 2007 and November 30, 2006 is included in the consolidated financial statements and the notes thereto in “Financial Statements and Supplementary Data” in Part II, Item 8.

 

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 our 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;

 

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Charters for our Audit Committee; Internal Audit Subcommittee; Compensation, Management Development and Succession Committee; and Nominating and Governance 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.

 

Morgan Stanley’s Code of Ethics and Business Conduct applies to all directors, officers and employees, including its Chief Executive Officer, its Chief Financial Officer and its Controller and Principal Accounting 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.

 

Recent Business Developments.

 

Morgan Stanley Smith Barney Joint Venture.

 

On January 13, 2009, Morgan Stanley and Citigroup Inc. (“Citi”) announced they had reached a definitive agreement to combine Morgan Stanley’s Global Wealth Management Group and Citi’s Smith Barney in the U.S., Quilter in the U.K., and Smith Barney Australia into a new joint venture to be called Morgan Stanley Smith Barney. Morgan Stanley will own 51%, and Citi will own 49% of the joint venture, after the contribution of the respective businesses to the joint venture and Morgan Stanley’s payment of $2.7 billion to Citi. Morgan Stanley will appoint four directors to the joint venture’s board and Citi will appoint two directors. After year three, Morgan Stanley and Citi will have various purchase and sales rights for the joint venture. The transaction is expected to close in the third quarter of 2009 and is subject to regulatory approvals and other customary closing conditions.

 

Business Segments.

 

Morgan Stanley 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. A summary of the activities of each of the business segments follows.

 

Institutional Securities includes 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; benchmark indices and risk management analytics; and investment activities.

 

Global Wealth Management Group provides brokerage and investment advisory services 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.

 

Asset Management provides global asset management products and services in equity, fixed income, alternative investments, which includes hedge funds and funds of funds, and merchant banking, which includes real estate, private equity and infrastructure, to institutional and retail clients through proprietary and third-party distribution channels. Asset Management also engages in investment activities.

 

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Institutional Securities.

 

Morgan Stanley provides financial advisory and capital-raising services to a diverse group of corporate and other institutional clients globally, primarily through wholly owned subsidiaries that include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley & Co. International plc, Morgan Stanley Japan Securities Co., Ltd. and Morgan Stanley Asia Limited. These and other subsidiaries also conduct sales and trading activities worldwide, as principal and agent, and provide related financing services on behalf of institutional investors.

 

Investment Banking and Corporate Lending Activities.

 

Financial Advisory Services.    Morgan Stanley provides corporate and other institutional clients globally with advisory services on key strategic matters, such as mergers and acquisitions, divestitures, corporate defense strategies, joint ventures, privatizations, recapitalizations, spin-offs, corporate restructurings, shareholder relations, tender offers, exchange offers and leveraged buyouts. Morgan Stanley also provides advice concerning rights offerings, dividend policy, valuations, foreign exchange exposure, financial risk management strategies and financial planning. In addition, Morgan Stanley furnishes advice and services regarding project financings and provides advisory services in connection with the purchase, sale, leasing and financing of real estate.

 

Capital Raising.    Morgan Stanley manages and participates in public offerings and private placements of debt, equity and other securities worldwide. Morgan Stanley is a leading underwriter of common stock, preferred stock and other equity-related securities, including convertible securities and American Depositary Receipts (“ADRs”). Morgan Stanley is a leading underwriter of fixed income securities, including investment grade debt, non-investment grade instruments, mortgage-related and other asset-backed securities, tax-exempt securities and commercial paper and other short-term securities.

 

Corporate Lending.    Morgan Stanley provides loans or lending commitments, including bridge financing, to selected corporate clients through subsidiaries (including Morgan Stanley Bank, N.A.). These loans and commitments have varying terms, may be senior or subordinated and/or secured or unsecured, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower and may be syndicated, hedged or traded by Morgan Stanley*. The borrowers may be rated investment grade or non-investment grade.

 

Sales and Trading Activities.

 

Morgan Stanley conducts sales, trading, financing and market-making activities on securities and futures exchanges and in over-the-counter (“OTC”) markets around the world. Morgan Stanley’s Institutional Securities sales and trading activities include Equity Trading; Interest Rates, Credit and Currencies; Commodities; and Clients and Services.

 

Equity Trading.    Morgan Stanley acts as principal (including as a market maker) and agent in executing transactions globally in equity and equity-related products, including common stock, ADRs, global depositary receipts and exchange-traded funds.

 

Morgan Stanley’s equity derivatives sales, trading and market-making activities cover equity-related products globally, including equity swaps, options, warrants and futures overlying individual securities, indices and baskets of securities and other equity-related products. Morgan Stanley also issues and makes a principal market in equity-linked products to institutional and individual investors, including principal-protected securities.

 

Interest Rates, Credit and Currencies.    Morgan Stanley trades, makes markets and takes long and short proprietary positions in fixed income securities and related products globally, including, among other products, investment and non-investment grade corporate debt, distressed debt, bank loans, U.S. and other sovereign securities, emerging market bonds and loans, convertible bonds, collateralized debt obligations, credit, currency and other fixed income linked notes, and securities issued by structured investment vehicles, mortgage-related

 

* Revenues and expenses associated with the trading of syndicated loans are included in “Sales and Trading Activities.”

 

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and other asset-backed securities and real estate loan products, municipal securities, preferred stock and commercial paper, money market and other short-term securities. Morgan Stanley is a primary dealer of U.S. Federal Government securities and a member of the selling groups that distribute various U.S. agency and other debt securities. Morgan Stanley is also a primary dealer or market maker of government securities in numerous European, Asian and emerging market countries.

 

Morgan Stanley trades, makes markets and takes long and short proprietary positions globally in listed futures and 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 indexes, asset-backed security indexes, property indexes, mortgage-related and other asset-backed securities and real estate loan products.

 

Morgan Stanley trades, makes markets and takes long and short proprietary positions in major foreign currencies, such as the Japanese yen, euro, British pound, Swiss franc and Canadian dollar, as well as in emerging markets currencies. Morgan Stanley trades these currencies on a principal basis in the spot, forward, option and futures markets.

 

Through the use of repurchase and reverse repurchase agreements, Morgan Stanley acts as an intermediary between borrowers and lenders of short-term funds and provides funding for various inventory positions. Morgan Stanley also provides financing to customers for commercial and residential real estate loan products and other securitizable asset classes. In addition, Morgan Stanley engages in principal securities lending with clients, institutional lenders and other broker-dealers.

 

Morgan Stanley advises on investment and liability strategies and assists corporations in their debt repurchases and tax planning. Morgan Stanley structures debt securities and derivatives with risk/return factors designed to suit client objectives, including using repackaged asset and other structured vehicles through which clients can restructure asset portfolios to provide liquidity or reconfigure risk profiles.

 

Commodities.    Morgan Stanley trades as principal and maintains long and short proprietary trading positions in the spot, forward and futures markets in several commodities, including metals (base and precious), agricultural products, crude oil, oil products, natural gas, electric power, emission credits, coal, freight, liquefied natural gas and related products and indices. Morgan Stanley is a market-maker in exchange-traded options and futures and OTC options and swaps on commodities, and offers counterparties hedging programs relating to production, consumption, reserve/inventory management and structured transactions, including energy-contract securitizations. Morgan Stanley is an electricity power marketer in the U.S. and owns six electricity generating facilities in the U.S. and Europe.

 

Morgan Stanley owns TransMontaigne Inc. and its subsidiaries, a group of companies operating in the refined petroleum products marketing and distribution business, and owns an interest in the Heidmar Group of companies that provide international marine transportation and U.S. marine logistics services.

 

Clients and Services.    Morgan Stanley provides financing services, including prime brokerage, which offers, among other services, consolidated clearance, settlement, custody, financing and portfolio reporting services to clients trading multiple asset classes. In addition, Morgan Stanley’s institutional distribution and sales activities are overseen and coordinated through Clients and Services.

 

Other Activities.

 

Benchmark Indices and Risk Management Analytics.    As of November 30, 2008, Morgan Stanley’s subsidiary, MSCI Inc. (“MSCI®”), calculates and distributes over 100,000 international and U.S. equity benchmark indices (including the MSCI World and EAFE® Indices) covering 70 countries, and has a historical database spanning over 35 years that includes fundamental and valuation data on thousands of equity securities in developed and emerging market countries. MSCI’s subsidiary, Barra, Inc., is a leading provider of risk analytic

 

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tools and services to investors to help them analyze, measure and manage portfolio and firm-wide investment risk. Morgan Stanley sold a minority interest in MSCI in an initial public offering on November 15, 2007 and sold additional MSCI shares in two secondary offerings in fiscal 2008. As of November 30, 2008, Morgan Stanley owned approximately 28 million shares of MSCI’s class B common stock, representing approximately 66% of the combined voting power of all classes of MSCI’s voting stock.

 

Investments.    Morgan Stanley from time to time makes investments that represent business facilitation or principal investing activities. Business facilitation investments are strategic investments undertaken by Morgan Stanley to facilitate core business activities. Principal investing activities are investments and capital commitments provided to public and private companies, funds and other entities generally for proprietary purposes to maximize total returns to Morgan Stanley. These principal investment activities are conducted within the investment banking and sales and trading areas in Institutional Securities and Asset Management.

 

Morgan Stanley sponsors and manages investment vehicles and separate accounts for clients seeking exposure to private equity, real estate-related and other alternative investments. Morgan Stanley may also invest in and provide capital to such investment vehicles. See also “Asset Management.”

 

Operations and Information Technology.

 

Morgan Stanley’s Operations and Information Technology departments provide the process and technology platform that supports Institutional Securities sales and trading activity, including post-execution trade processing and related internal controls over activity from trade entry through settlement and custody, such as asset servicing. This is done for proprietary and customer transactions in listed and OTC transactions in commodities, equity and fixed income securities, including both primary and secondary trading, as well as listed, OTC and structured derivatives in markets around the world. This activity is undertaken through Morgan Stanley’s own facilities, through membership in various clearing and settlement organizations, and through agreements with unaffiliated third parties.

 

Global Wealth Management Group.

 

Morgan Stanley’s Global Wealth Management Group provides comprehensive financial services to clients through a network of approximately 8,400 global representatives in approximately 500 locations globally, including over 450 U.S. locations at fiscal year end. As of November 30, 2008, Morgan Stanley had $546 billion in client assets.

 

Clients.

 

Global Wealth Management Group professionals serve individual investors and small-to-medium size businesses and institutions with an emphasis on ultra high net worth, high net worth and affluent investors. In the U.S., products and services are delivered through three principal channels. Specialized private wealth management investment representative teams located in dedicated offices provide sophisticated investment solutions and services for ultra high net worth individuals, families and foundations. Financial advisors located in branches across the U.S. provide solutions designed to accommodate individual investment objectives, risk tolerance and liquidity needs for ultra high net worth, high net worth and affluent investors. Call centers are available to meet the needs of emerging affluent clients. Outside the U.S., Morgan Stanley offers financial services to clients in Europe, the Middle East, Asia and Latin America.

 

Products and Services.

 

Morgan Stanley’s Global Wealth Management Group provides clients with a comprehensive array of financial solutions, including Morgan Stanley’s products and services, and products and services from third party providers, such as insurance companies and mutual fund families. Morgan Stanley offers brokerage and investment advisory services covering various investment alternatives, including equities, options, futures, foreign currencies, precious metals, fixed income securities, mutual funds, structured products, alternative investments, unit investment trusts, managed futures, separately managed accounts and mutual fund asset

 

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allocation programs. Morgan Stanley also offers financial and wealth planning services, including education savings programs, as well as annuity and other insurance products.

 

In addition, Morgan Stanley offers several cash management services, including cash sweeps, debit cards, electronic bill payments and check writing, as well as lending products, including securities based lending and a mortgage referral program, which provides residential mortgages originated through Morgan Stanley’s affiliated entities. Morgan Stanley’s BusinesScapeSM program offers cash management and commercial credit solutions to qualified small and medium businesses in the U.S.  Morgan Stanley provides individual and corporate retirement solutions, including IRAs and 401(k) plans and U.S. stock plan services to corporate executives and businesses. Morgan Stanley also offers trust and fiduciary services to individual and corporate clients.

 

Morgan Stanley’s Global Wealth Management Group offers its clients a variety of ways to establish a relationship and conduct business, including brokerage accounts with transaction-based pricing and investment advisory accounts with asset-based fee pricing. The Active Assets Account® offers clients brokerage and cash management services in one account. Clients can also choose a fee-based, separately managed account managed by affiliated or unaffiliated professional asset managers.

 

Operations and Information Technology.

 

Morgan Stanley’s Operations and Information Technology departments provide the process and technology platform that supports the activities of Morgan Stanley’s Global Wealth Management Group from trade capture through clearance, settlement and custody, including asset servicing as well as bank deposit and loan processing through Morgan Stanley’s affiliated banks. These activities are undertaken through Morgan Stanley’s own facilities, through memberships in various clearing and settlement organizations, and through agreements with unaffiliated third parties.

 

Asset Management.

 

Morgan Stanley Investment Management is one of the largest global asset management organizations of any full-service financial services firm and offers individual and institutional clients a diverse array of equity, fixed income and alternative investments and merchant banking strategies. Morgan Stanley Investment Management had $399 billion of assets under management or supervision as of November 30, 2008. Morgan Stanley’s asset management activities are principally conducted under the Morgan Stanley and Van Kampen brands. Portfolio managers located in the U.S., Europe, Japan, Singapore and India manage investment products ranging from money market funds to equity, taxable and tax-exempt fixed income funds and alternative investment and merchant banking products in developed and emerging markets. Morgan Stanley offers clients various investment styles, such as value, growth, core, fixed income and asset allocation; global investments; active and passive management; and diversified and concentrated portfolios.

 

Morgan Stanley offers a range of alternative investment and merchant banking products for institutional investors and high net worth individuals. Morgan Stanley’s alternative investments platform includes hedge funds, funds of hedge funds, funds of private equity funds and portable alpha overlays, including FrontPoint Partners LLC, a leading provider of absolute return strategies with approximately $8.4 billion in assets under management, and minority stakes in Lansdowne Partners and Avenue Capital Group. Morgan Stanley’s Merchant Banking Division, formed in 2007, includes Morgan Stanley’s real estate investing business, private equity funds and infrastructure investing group. Morgan Stanley typically acts as general partner of, and investment adviser to, its alternative investment and merchant banking funds and typically commits to invest a minority of the capital of such funds with subscribing investors contributing the majority.

 

Institutional Investors.

 

Morgan Stanley provides asset management products and services to institutional investors worldwide, including pension plans, corporations, private funds, non-profit organizations, foundations, endowments, governmental agencies, insurance companies and banks. Products and services are available to institutional investors primarily through separate accounts, U.S. mutual funds and other pooled vehicles. Morgan Stanley Investment

 

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Management also sub-advises funds for various unaffiliated financial institutions and intermediaries. A global sales force and a team dedicated to covering the investment consultant industry serve institutional investors.

 

Individual Investors.

 

Morgan Stanley offers open-end and alternative investment funds and separately managed accounts to individual investors through affiliated and unaffiliated broker-dealers, banks, insurance companies and financial planners. Closed-end funds managed by Morgan Stanley or Van Kampen are available to individual investors through affiliated and unaffiliated broker-dealers. A small number of unaffiliated broker-dealers account for a substantial portion of Van Kampen open-end fund sales. Morgan Stanley also sells Van Kampen funds through numerous retirement plan platforms. Internationally, Morgan Stanley distributes traditional investment products to individuals outside the U.S. through non-proprietary distributors, and alternative investment products are distributed through affiliated broker-dealers.

 

Operations and Information Technology.

 

Morgan Stanley’s Operations and Information Technology departments provide or oversee the process and technology platform required to support its asset management business. Support activities include transfer agency, mutual fund accounting and administration, transaction processing and certain fiduciary services, on behalf of institutional, retail and intermediary clients. These activities are undertaken through Morgan Stanley’s own facilities, through membership in various clearing and settlement organizations, and through agreements with unaffiliated third parties.

 

Research.

 

In December 2008, Morgan Stanley announced that its global research department (“Research”), formerly part of its Institutional Securities business segment, would be coordinated globally across all of Morgan Stanley’s businesses. Research consists of economists, strategists and industry analysts who engage in equity and fixed income research activities and produce reports and studies on the U.S. and global economy, financial markets, portfolio strategy, technical market analyses, individual companies and industry developments. Research examines worldwide trends covering numerous industries and individual companies, the majority of which are located outside of the U.S.; provides analysis and forecasts relating to economic and monetary developments that affect matters such as interest rates, foreign currencies, securities, derivatives and economic trends; and provides analytical support and publishes reports on asset-backed securities and the markets in which such securities are traded and data are disseminated to investors through third party distributors, proprietary internet sites such as Client Link and Morgan Stanley’s sales forces.

 

Competition.

 

All aspects of Morgan Stanley’s businesses are highly competitive and Morgan Stanley expects them to remain so. Morgan Stanley competes in the U.S. and globally for clients, market share and human talent in all aspects of its business segments. Morgan Stanley’s competitive position depends on its reputation and the quality of its products, services and advice. Morgan Stanley’s ability to sustain or improve its competitive position also depends substantially on its ability to continue to attract and retain qualified employees while managing compensation and other costs. Morgan Stanley competes with commercial banks, brokerage firms, insurance companies, sponsors of mutual funds, hedge funds, energy companies and other companies offering financial services in the U.S., globally and through the internet. Over time, certain sectors of the financial services industry have become more concentrated, as institutions involved in a broad range of financial services have been acquired by or merged into other firms or have declared bankruptcy. In fiscal 2008, this trend accelerated considerably, as several major U.S. financial institutions consolidated, were forced to merge, received substantial government assistance or were placed into conservatorship by the U.S. Federal Government. These developments could result in Morgan Stanley’s remaining competitors gaining greater capital and other resources, such as the ability to offer a broader range of products and services and geographic diversity.

 

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Institutional Securities and Global Wealth Management Group.

 

Morgan Stanley’s competitive position depends on innovation, execution capability and relative pricing. Morgan Stanley competes directly in the U.S. and globally with other securities and financial services firms and broker-dealers, and with others on a regional or product basis.

 

Morgan Stanley’s ability to access capital at competitive rates (which is generally dependent on Morgan Stanley’s credit ratings) and to commit capital efficiently, particularly in its capital-intensive underwriting and sales, trading, financing and market-making activities, also affects its competitive position. Corporate clients may request that Morgan Stanley provide loans or lending commitments in connection with certain investment banking activities.

 

It is possible that competition may become even more intense as Morgan Stanley continues to compete with financial institutions that may be larger, or better capitalized, or may have a stronger local presence and longer operating history in certain areas. Many of these firms have greater capital than Morgan Stanley and have the ability to offer a wide range of products and services that may enhance their competitive position and could result in pricing pressure in our businesses. The complementary trends in the financial services industry of consolidation and globalization present, among other things, technological, risk management, regulatory and other infrastructure challenges that require effective resource allocation in order for Morgan Stanley to remain competitive.

 

Morgan Stanley has experienced intense price competition in some of its businesses in recent years. In particular, the ability to execute securities trades electronically on exchanges and through other automated trading markets has increased the pressure on trading commissions. The trend toward direct access to automated, electronic markets will likely continue. It is possible that Morgan Stanley will experience competitive pressures in these and other areas in the future as some of its competitors may seek to obtain market share by reducing prices.

 

Asset Management.

 

Competition in the asset management industry is affected by several factors, including Morgan Stanley’s reputation, investment objectives, quality of investment professionals, performance of investment products relative to peers and an appropriate benchmark index, advertising and sales promotion efforts, fee levels, the effectiveness of and access to distribution channels, and the types and quality of products offered. Morgan Stanley’s alternative investment products, such as private equity funds, real estate and hedge funds, compete with similar products offered by both alternative and traditional asset managers.

 

Supervision and Regulation.

 

Most aspects of Morgan Stanley’s business are subject to stringent regulation by U.S. federal and state regulatory agencies and securities exchanges and by non-U.S. government agencies or regulatory bodies and securities exchanges. Aspects of Morgan Stanley’s public disclosure, corporate governance principles, internal control environment and the roles of auditors and counsel are subject to the Sarbanes-Oxley Act of 2002 and related regulations and rules of the SEC and the NYSE.

 

In light of current conditions in the global financial markets and the global economy, regulators have increased their focus on the regulation of the financial services industry. Proposals for legislation that could substantially intensify the regulation of the financial services industry are expected to be introduced in the U.S. Congress, in state legislatures and around the world.

 

The agencies regulating the financial services industry also frequently adopt changes to their regulations. Substantial regulatory and legislative initiatives, including a comprehensive overhaul of the regulatory system in the U.S., are possible in the months or years ahead. Any such action could have a materially adverse effect on our business, financial condition and results of operations. As a global financial institution, to the extent that different regulatory regimes impose inconsistent or iterative requirements on the conduct of its business, Morgan Stanley faces complexity and additional costs in its compliance efforts.

 

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Regulatory Developments.

 

The year 2008 saw an unprecedented number of government initiatives both in the U.S. and abroad designed to respond to the stresses experienced in global financial markets.

 

U.S. regulatory agencies including primarily the U.S. Department of Treasury (the “U.S. Treasury”), the Fed, the Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve Bank of New York have taken a number of steps to enhance the liquidity support available to financial institutions such as Morgan Stanley and certain of its subsidiaries. These steps have included (i) expanding the types and quality of assets that can be used as collateral for borrowings by primary dealers from the Federal Reserve Bank of New York under the primary dealer credit facility, (ii) extending the term for which the Fed will lend the U.S. Treasury securities to primary dealers under its term securities lending facility, (iii) adopting temporary exceptions to the Federal Reserve Act limitations on transactions between insured depository institutions, such as Morgan Stanley Bank, N.A., and their affiliates to permit them to provide liquidity to their affiliates for assets typically funded in the tri-party repo market, and (iv) authorizing the Federal Reserve Bank of New York to extend credit to the U.S.- and London-based broker-dealer subsidiaries of Morgan Stanley and those of two other institutions against all types of collateral that may be pledged at the primary dealer credit facility. Furthermore, the FDIC agreed to temporarily guarantee certain senior unsecured debt of all FDIC-insured institutions, their U.S. holding companies, and of certain other affiliates accepted into the program, and to temporarily guarantee deposits in certain transaction accounts of FDIC-insured institutions or branches. Morgan Stanley and its FDIC-insured depository institutions are participating in both FDIC programs and will incur fees assessed in connection with such programs (see also “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Funding Management Policies—Temporary Liquidity Guarantee Program” in Part II, Item 7 herein). On October 27, 2008, the Fed’s Commercial Paper Funding Facility, a facility designed to provide a liquidity backstop to U.S. issuers of commercial paper, became operational.

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (initially introduced as the Troubled Asset Relief Program or “TARP”) was enacted. On October 14, 2008, the U.S. Treasury announced its intention to inject capital into nine large U.S. financial institutions, including Morgan Stanley, under the TARP Capital Purchase Program (the “CPP”), and since has injected capital into many other financial institutions. Morgan Stanley was part of the initial group of financial institutions participating in the CPP, and on October 26, 2008 entered into a Securities Purchase Agreement–Standard Terms with the U.S. Treasury pursuant to which, among other things, Morgan Stanley sold to the U.S. Treasury for an aggregate purchase price of $10 billion, preferred stock and warrants. Under the terms of the CPP, Morgan Stanley is prohibited from increasing dividends on its common stock, and from making certain repurchases of equity securities, including its common stock, without the U.S. Treasury’s consent. Furthermore, as long as the preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including Morgan Stanley’s common stock, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies” in Part II, Item 7 herein.

 

On October 14, 2008, the SEC published final rules, effective as of October 17, 2008, under the Exchange Act adopting, among other changes, a temporary rule, set to expire on July 31, 2009, which contains a firm delivery requirement for long and short sales, and the “naked” short selling anti-fraud rule.

 

In Europe, governments and regulatory agencies have also implemented several initiatives to respond to the stresses experienced in the global financial markets, including capital injections to certain financial institutions and a range of economic and fiscal stimuli. Most regulators in the European Union introduced temporary or permanent rules to further regulate short selling and enhance disclosure of short sales. In the United Kingdom, as well as pursuing an increased focus on the capital and liquidity strength of regulated firms, the Financial Services

 

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Authority wrote to chief executive officers of financial services firms expressing its intention to focus on management structures and the culture of supervisory responsibility within firms, and setting out its views on best practice in the area of position valuation and risk control following a number of mis-marking incidents across the industry.

 

Financial Holding Company.

 

On September 21, 2008, Morgan Stanley obtained approval from the Fed to become a bank holding company upon the conversion of its wholly owned indirect subsidiary, Morgan Stanley Bank, from a Utah industrial bank to a national bank. On September 23, 2008, the OCC authorized Morgan Stanley Bank to commence business as a national bank, operating as Morgan Stanley Bank, N.A. Concurrently with this conversion, Morgan Stanley became a financial holding company under the BHC Act.

 

Morgan Stanley Bank, N.A.    Morgan Stanley Bank, N.A. is an FDIC-insured national bank and, as such, is subject to the supervision and regulation by the OCC and, in certain matters, by the Fed and FDIC. The activities of Morgan Stanley Bank, N.A., as a consumer lender, are also subject to regulation under various U.S. federal laws, including the Truth–in–Lending, Equal Credit Opportunity, Fair Credit Reporting, Fair Debt Collection Practice and Electronic Funds Transfer acts, as well as various state laws. These statutes impose requirements on the making, enforcement and collection of consumer loans and on the types of disclosures that need to be made in connection with such loans.

 

Other Banking Institutions.    Morgan Stanley Trust is a wholly owned subsidiary that conducts certain transfer agency, sub-accounting and other activities. It is an FDIC-insured federal savings bank whose activities are subject to comprehensive regulation and periodic examination by the Office of Thrift Supervision. Morgan Stanley Trust is also a registered transfer agent subject to regulation and examination by the SEC.

 

Morgan Stanley Trust National Association, a wholly owned subsidiary, is a non-depository national bank whose activities are limited to fiduciary activities, primarily personal trust services. It is subject to comprehensive regulation and periodic examination by the OCC. Morgan Stanley Trust National Association is not FDIC-insured and is not considered a “bank” for purposes of the BHC Act.

 

Scope of Permitted Activities.    As a financial holding company, Morgan Stanley is able to engage in any activity that is financial in nature, incidental to a financial activity or complementary to a financial activity. Unless otherwise required by the Fed, Morgan Stanley is permitted to commence any new financial activity, or acquire a company engaged in any financial activity, as long as it provides after–the–fact notice of such new activity or investment to the Fed. However, Morgan Stanley must obtain the prior approval of the Fed before acquiring more than five percent of any class of voting stock of a U.S. depository institution or bank holding company or commencing any activity that is complementary to a financial activity.

 

Morgan Stanley believes that most of the activities it conducted before becoming a financial holding company remain permissible. In addition, the BHC Act gives Morgan Stanley two years to conform its existing nonfinancial activities and investments to the requirements of the BHC Act with the possibility of three one-year extensions for a total grace period of up to five years. The BHC Act also grandfathers any “activities related to the trading, sale or investment in commodities and underlying physical properties,” provided that Morgan Stanley conducted any of such activities as of September 30, 1997 and provided that certain other conditions that are within Morgan Stanley’s reasonable control are satisfied. In addition, the BHC Act permits the Fed to determine by regulation or order that certain activities are complementary to a financial activity and do not pose a risk to safety and soundness.

 

It is possible that certain of Morgan Stanley’s existing activities will not be deemed to be permissible financial activities, or incidental or complementary to such activities or otherwise grandfathered. If so, Morgan Stanley will

 

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be required to divest them before the end of the grace period discussed above. Morgan Stanley does not believe that any such required divestment will have a material adverse impact on its financial condition or results of operations.

 

Consolidated Supervision.    As a financial holding company, Morgan Stanley is subject to the comprehensive, consolidated supervision and regulation of the Fed. This means that Morgan Stanley is, among other things, subject to the Fed’s risk-based and leverage capital requirements and information reporting requirements for bank holding companies. The Fed has the authority to conduct on-site examinations of Morgan Stanley and any of its affiliates, subject to coordinating with any state or federal functional regulator of any particular affiliate.

 

In addition to the Fed’s consolidated supervision, certain of Morgan Stanley’s subsidiaries are regulated directly by other regulators based upon the activities of those subsidiaries. Except for Morgan Stanley Bank, N.A., which has become subject to the supervision and regulation of the OCC upon becoming a national bank, the functional regulation of Morgan Stanley’s subsidiaries by other state and federal regulators has not changed. Morgan Stanley, by participating in the FDIC’s Temporary Liquidity Guarantee Program, has become subject to additional oversight by the FDIC, limited to compliance with the terms of that program (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Funding Management Policies—Temporary Liquidity Guarantee Program” in Part II, Item 7 herein). Participation in the program does not change the Fed’s role as Morgan Stanley’s consolidated supervisor.

 

In order to maintain Morgan Stanley’s status as a financial holding company, its depository institution subsidiaries must remain well capitalized and well managed. Under regulations implemented by the Fed, if any depository institution controlled by a financial holding company no longer meets certain capital or management standards, the Fed may impose corrective capital and/or managerial requirements on the financial holding company and place limitations on its ability to conduct the broader financial activities permissible for financial holding companies. In addition, as a last resort if the deficiencies persist, the Fed may order a financial holding company to cease the conduct of or to divest those businesses engaged in activities other than those permissible for bank holding companies that are not financial holding companies. The regulations also provide that if any depository institution controlled by a financial holding company fails to maintain a satisfactory rating under the Community Reinvestment Act, the Fed must prohibit the financial holding company and its subsidiaries from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies.

 

Capital Standards.    Federal banking regulators have adopted risk–based capital and leverage guidelines that require Morgan Stanley’s capital–to–assets ratios to meet certain minimum standards.

 

The denominator or asset portion of the risk–based capital ratio is determined by allocating assets and specified off–balance sheet financial instruments into four weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. Under the guidelines, capital is divided into two tiers: Tier 1 capital and Tier 2 capital. The amount of Tier 2 capital may not exceed the amount of Tier 1 capital. Total capital is the sum of Tier 1 capital and Tier 2 capital. Under the guidelines, banking organizations are required to maintain a total capital ratio (total capital to risk–weighted assets) of at least 10% and a Tier 1 capital ratio of at least 6% in order to qualify as well capitalized and for their holding company parent to be able to qualify as a financial holding company.

 

The federal banking regulators also have established minimum leverage ratio guidelines. The Tier 1 leverage ratio is defined as Tier 1 capital divided by adjusted average total book assets (which reflects adjustments for disallowed goodwill, certain intangible assets and deferred tax assets). The adjusted average total assets are derived using month-end balances for each fiscal quarter. The minimum leverage ratio is 3% for bank holding companies that are considered “strong” under Fed guidelines or which have implemented the Fed’s risk–based capital measure for market risk. Other bank holding companies must have a minimum leverage ratio of 4%.

 

The Fed generally requires Morgan Stanley and its peer financial holding companies to maintain risk-based and leverage capital ratios substantially in excess of these minimum levels, depending upon general economic conditions and their particular condition, risk profile and growth plans.

 

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U.S. banking regulators are in the process of incorporating the Basel II Accord (“Basel II”) into the existing risk–based capital requirements. After a transitional period, core financial institutions, including Morgan Stanley, are required to implement advanced measurement techniques by employing internal estimates of certain key risk drivers to derive capital requirements. Prior to becoming a financial holding company, as part of its status until September 2008 as a consolidated supervised entity subject to the group–wide supervision and examination by the SEC, Morgan Stanley calculated its minimum capital requirements in accordance with Basel II as implemented by the SEC. Morgan Stanley’s significant European regulated entities implemented Basel II Capital Standards on January 1, 2008. For March 31, 2009 and future dates, the Company expects to calculate its capital ratios and risk weighted assets in accordance with the capital adequacy standards for bank holding companies adopted by the Fed. These standards are based upon a framework described in the “International Convergence of Capital Measurement,” July 1988, as amended, also referred to as Basel I.

 

Compliance with the capital requirements, including leverage ratios, may limit Morgan Stanley’s operations requiring the intensive use of capital. Such requirements may limit Morgan Stanley’s ability to pay dividends, repay debt or redeem or purchase shares of its own outstanding stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect Morgan Stanley’s ability to pay dividends or to expand or maintain present business levels.

 

Dividends.    In addition to certain dividend restrictions that apply by law to certain of Morgan Stanley’s subsidiaries, as described below, the OCC, the Fed and the FDIC have authority to prohibit or to limit the payment of dividends by the banking organizations they supervise, including Morgan Stanley, Morgan Stanley Bank, N.A. and other depository institution subsidiaries, if, in the banking regulator’s opinion, payment of a dividend would constitute an unsafe or unsound practice in light of the financial condition of the banking organization. It is Fed policy that bank holding companies should generally pay dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. It is also Fed policy that bank holding companies should not maintain dividend levels that undermine the company’s ability to be a source of strength to its banking subsidiaries. Under the terms of the CPP, for so long as any preferred stock issued under the CPP remains outstanding, Morgan Stanley is prohibited from increasing dividends on its common stock, and from making certain repurchases of equity securities, including its common stock, without the U.S. Treasury’s consent until the third anniversary of the U.S. Treasury’s investment or until the U.S. Treasury has transferred all of the preferred stock it purchased under the CPP to third parties. Furthermore, as long as the preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including Morgan Stanley’s common stock, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies” in Part II, Item 7 herein).

 

Prompt Corrective Action.    The Federal Deposit Insurance Corporation Improvement Act of 1991 provides a framework for regulation of depository institutions and their affiliates, including parent holding companies, by their federal banking regulators. Among other things, it requires the relevant federal banking regulator to take “prompt corrective action” with respect to a depository institution if that institution does not meet certain capital adequacy standards. Supervisory actions by the appropriate federal banking regulator under the prompt corrective action rules generally depend upon an institution’s classification within five capital categories. The regulations apply only to insured banks and thrifts such as Morgan Stanley Bank, N.A. or Morgan Stanley Trust, and not to bank holding companies such as Morgan Stanley. However, subject to limitations, the Fed is authorized to take appropriate action at the holding company level, based upon the undercapitalized status of the holding company’s subsidiary banking institutions. In certain instances relating to an undercapitalized banking institution, the bank holding company would be required to guarantee the performance of the undercapitalized subsidiary’s capital restoration plan and might be liable for civil money damages for failure to fulfill its commitments on that guarantee.

 

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Transactions with Affiliates.    Morgan Stanley Bank, N.A. and Morgan Stanley Trust are both subject to Sections 23A and 23B of the Federal Reserve Act, which impose restrictions on any extensions of credit to, purchase of assets from, and on certain other transactions with, any affiliates. These restrictions include limits on the total amount of credit exposure that they may have to any one affiliate and to all affiliates, as well as collateral requirements, and they require all such transactions to be made on market terms.

 

FDIC Regulation.    An FDIC–insured depository institution is generally liable for any loss incurred or expected to be incurred by the FDIC in connection with the failure of a commonly controlled insured depository institution.

 

If the FDIC is appointed the conservator or receiver of an insured depository institution upon its insolvency or in certain other events, the FDIC has the power: to transfer any of the depository institution’s assets and liabilities to a new obligor; to enforce the terms of the depository institution’s contracts pursuant to their terms notwithstanding any clause that purports to accelerate or terminate the contracts; or to repudiate or disaffirm any contract or lease to which the depository institution is a party, subject to certain standards. The above provisions would be applicable to Morgan Stanley Bank, N.A. and Morgan Stanley Trust.

 

As FDIC-insured depository institutions, Morgan Stanley Bank, N.A. and Morgan Stanley Trust are exposed to changes in the cost of such insurance. On January 1, 2009, the FDIC increased the Deposit Insurance Fund assessment rates as part of the FDIC’s Deposit Insurance Fund restoration plan and has proposed to make, beginning in the second quarter of 2009, further risk-based changes to its deposit insurance assessment system. In addition, by participating in the FDIC’s Temporary Liquidity Guarantee Program, Morgan Stanley Bank, N.A. and Morgan Stanley Trust have temporarily become subject to an additional assessment on deposits in excess of $250,000 in certain transaction accounts.

 

Anti-Money Laundering.

 

Morgan Stanley’s Anti-Money Laundering (“AML”) program is coordinated on an enterprise-wide basis. In the U.S., for example, the USA PATRIOT Act of 2001 (the “PATRIOT Act”) imposes significant obligations on financial institutions to detect and deter money laundering and terrorist financing activity, including requiring banks, broker-dealers and mutual funds to identify and verify customers that maintain accounts. The PATRIOT Act also mandates that certain types of financial institutions monitor and report suspicious activity to appropriate law enforcement or regulatory authorities. An institution subject to the PATRIOT Act also must designate an AML compliance officer, provide employees with training on money laundering prevention, and undergo an annual, independent audit to assess the effectiveness of its AML program. Outside the U.S., applicable laws and regulations similarly subject designated types of financial institutions to AML program requirements. Morgan Stanley has implemented policies, procedures and internal controls that are designed to comply with these AML program requirements. Morgan Stanley has also implemented policies, procedures, and internal controls that are designed to comply with the regulations and economic sanctions programs administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control.

 

Protection of Client Information.

 

Many aspects of Morgan Stanley’s business are subject to legal requirements concerning the use and protection of certain customer information, including those adopted pursuant to the Gramm-Leach-Bliley Act and the Fair and Accurate Credit Transactions Act of 2003 in the U.S., the European Union Data Protection Directive in the EU and various laws in Asia, including the Japanese Personal Information (Protection) Law, the Hong Kong Personal Data (Protection) Ordinance and the Australian Privacy Act. Morgan Stanley has adopted measures in response to such requirements. Morgan Stanley has adopted measures designed to comply with these and related applicable requirements in all relevant jurisdictions.

 

Research.

 

Both U.S. and non-U.S. regulators continue to focus on research conflicts of interest. Research-related regulations have been implemented in many jurisdictions and are proposed or under consideration in other jurisdictions. New and revised requirements resulting from these regulations and the global research settlement

 

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with U.S. Federal and state regulators (to which Morgan Stanley is a party) have necessitated the development or enhancement of corresponding policies and procedures.

 

Institutional Securities and Global Wealth Management Group.

 

Broker-Dealer Regulation.    Morgan Stanley’s primary U.S. broker-dealer subsidiary, MS&Co., is registered as a broker-dealer with the SEC and in all 50 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands, and is a member of various self-regulatory organizations, including the Financial Industry Regulatory Authority, Inc. (“FINRA”) and securities exchanges, including the NYSE. Broker-dealers are subject to laws and regulations covering all aspects of the securities business, including sales and trading practices, securities offerings, publication of research reports, use of customers’ funds and securities, capital structure, record-keeping and retention and the conduct of their directors, officers, representatives and other associated persons. Broker-dealers are also regulated by securities administrators in those states where they do business. Violations of the laws and regulations governing a broker-dealer’s actions could result in censures, fines, the issuance of cease-and-desist orders, revocation of licenses or registrations, the suspension or expulsion from the securities industry of such broker-dealer or its officers or employees, or other similar consequences by both federal and state securities administrators.

 

Margin lending by broker-dealers is regulated by the Fed’s restrictions on lending in connection with customer and proprietary purchases and short sales of securities, as well as securities borrowing and lending activities. Broker-dealers are also subject to maintenance and other margin requirements imposed under the FINRA rules. In many cases, Morgan Stanley’s broker-dealer subsidiaries’ margin policies are more stringent than these rules.

 

As registered U.S. broker-dealers, certain subsidiaries of Morgan Stanley, including MS&Co., are subject to the SEC’s net capital rule and the net capital requirements of various securities exchanges. Many non-U.S. securities exchanges and regulatory authorities either have imposed or are proposing rules relating to capital requirements applicable to Morgan Stanley’s non-U.S. broker-dealer subsidiaries. These rules, which specify minimum capital requirements, are generally designed to measure general financial integrity and liquidity and require that at least a minimum amount of net assets be kept in relatively liquid form. See also “Consolidated Supervision” and “Capital Standards” above. Rules of FINRA and other self-regulatory organizations also impose limitations and requirements on the transfer of member organizations’ assets.

 

Compliance with the capital requirements may limit Morgan Stanley’s operations requiring the intensive use of capital. Such requirements restrict Morgan Stanley’s ability to withdraw capital from its broker-dealer subsidiaries, which in turn may limit its ability to pay dividends, repay debt or redeem or purchase shares of its own outstanding stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect Morgan Stanley’s ability to pay dividends or to expand or maintain present business levels. In addition, such rules may require Morgan Stanley to make substantial capital infusions into one or more of its broker-dealer subsidiaries in order for such subsidiaries to comply with such rules, either in the form of cash or subordinated loans made in accordance with the requirements of the SEC’s net capital rule.

 

MS&Co. is a member of the Securities Investor Protection Corporation (“SIPC”), which provides protection for customers of broker-dealers against losses in the event of the liquidation of a broker-dealer. SIPC protects customers’ securities accounts held by a broker-dealer up to $500,000 for each eligible customer, subject to a limitation of $100,000 for claims for cash balances. To supplement this SIPC coverage, MS&Co. has purchased additional protection for the benefit of its customers from Lloyd’s of London, in addition to its existing supplemental coverage from Customer Asset Protection Company (“CAPCO”). The CAPCO coverage will expire on February 16, 2009, after which Lloyd’s of London will be the sole excess SIPC coverage provider.

 

Regulation of Certain Commodities Activities.    The commodities activities in the Institutional Securities business segment are subject to extensive and evolving energy, commodities, environmental, health and safety and other governmental laws and regulations in the U.S. and abroad. Intensified scrutiny of certain energy markets by U.S. federal, state and local authorities in the U.S. and abroad and by the public has resulted in increased regulatory and legal enforcement and remedial proceedings involving energy companies, including those engaged in power generation and liquid hydrocarbons trading.

 

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Terminal facilities and other assets relating to Morgan Stanley’s commodities activities are also subject to environmental laws both in the U.S. and abroad. In addition, pipeline, transport and terminal operations are subject to state laws in connection with the cleanup of hazardous substances that may have been released at properties currently or previously owned or operated by us or locations to which we have sent wastes for disposal.

 

Additional Regulation of U.S. Entities.    As a registered futures commission merchant, MS&Co. is subject to the net capital requirements of, and its activities are regulated by, the Commodity Futures Trading Commission (the “CFTC”) and various commodity exchanges. Certain subsidiaries of Morgan Stanley are registered with the CFTC as commodity trading advisors and/or commodity pool operators. Morgan Stanley’s futures and options-on-futures businesses are also regulated by the National Futures Association (the “NFA”), a registered futures association, of which MS&Co. and certain of its affiliates are members. Violations of the rules of the CFTC, the NFA or the commodity exchanges could result in remedial actions including fines, registration restrictions or terminations, trading prohibitions or revocations of commodity exchange memberships.

 

Non-U.S. Regulation.    Morgan Stanley’s businesses are also regulated extensively by non-U.S. regulators, including governments, securities exchanges, commodity exchanges, self-regulatory organizations, central banks and regulatory bodies, especially in those jurisdictions in which Morgan Stanley maintains an office. Certain Morgan Stanley subsidiaries are regulated as broker-dealers under the laws of the jurisdictions in which they operate. Subsidiaries engaged in banking and trust activities outside the U.S. are regulated by various government agencies in the particular jurisdiction where they are chartered, incorporated and/or conduct their business activity. For instance, the Financial Services Authority and several U.K. securities and futures exchanges, including the London Stock Exchange and Euronext.liffe regulate Morgan Stanley’s activities in the U.K.; the Deutsche Bôrse AG and the Bundesanstalt für Finanzdienstleistungsaufsicht (the Federal Financial Supervisory Authority) regulate its activities in the Federal Republic of Germany; the Swiss Federal Banking Commission regulates its activities in Switzerland; the Financial Services Agency, the Bank of Japan, the Japanese Securities Dealers Association and several Japanese securities and futures exchanges, including the Tokyo Stock Exchange, the Osaka Securities Exchange and the Tokyo International Financial Futures Exchange, regulate its activities in Japan; the Hong Kong Securities and Futures Commission, the Hong Kong Exchanges and Clearing Limited regulate its operations in Hong Kong; and the Monetary Authority of Singapore and the Singapore Exchange Limited regulate its business in Singapore.

 

Asset Management.

 

Many of the subsidiaries engaged in Morgan Stanley’s asset management activities are registered as investment advisers with the SEC, and, in certain states, some employees or representatives of subsidiaries are registered as investment adviser representatives. Many aspects of Morgan Stanley’s asset management activities are subject to federal and state laws and regulations primarily intended to benefit the investor or client. These laws and regulations generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict Morgan Stanley from carrying on its asset management activities in the event that it fails to comply with such laws and regulations. Sanctions that may be imposed for such failure include the suspension of individual employees, limitations on Morgan Stanley engaging in various asset management activities for specified periods of time, the revocation of registrations, other censures and fines.

 

Morgan Stanley’s Asset Management business is also regulated outside the U.S.   For example, the Financial Services Authority regulates Morgan Stanley’s business in the U.K.; the Financial Services Agency regulates Morgan Stanley’s business in Japan; the Securities and Exchange Board of India regulates Morgan Stanley’s business in India; and the Monetary Authority of Singapore regulates Morgan Stanley’s business in Singapore.

 

For a discussion of certain risks relating to Morgan Stanley’s regulatory environment, see “Risk Factors” herein.

 

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Executive Officers of Morgan Stanley.

 

The executive officers of Morgan Stanley and their ages and titles as of January 28, 2009 are set forth below. Business experience for the past five years is provided in accordance with SEC rules.

 

John J. Mack (64).    Chairman of the Board of Directors and Chief Executive Officer (since June 2005). Chairman of Pequot Capital Management (June 2005). Co-Chief Executive Officer of Credit Suisse Group (January 2003 to June 2004). President, Chief Executive Officer and Director of Credit Suisse First Boston (July 2001 to June 2004). President and Chief Operating Officer of Morgan Stanley (May 1997 to March 2001).

 

Walid Chammah (54).    Co-President (since December 2007). Chairman and Chief Executive Officer of Morgan Stanley International (since July 2007). Head of Investment Banking (August 2005 to July 2007) and Head of Global Capital Markets (July 2002 to August 2005).

 

James Gorman (50).    Co-President (since December 2007) and Co-Head of Strategic Planning (since October 2007). President and Chief Operating Officer of the Global Wealth Management Group (February 2006 to April 2008). Head of Corporate Acquisitions Strategy & Research at Merrill Lynch & Co., Inc. (“Merrill Lynch”) (July 2005 to August 2005) and President of the Global Private Client business at Merrill Lynch (December 2002 to July 2005). Director of MSCI Inc. (since November 2007).

 

Colm Kelleher (51).    Executive Vice President and Chief Financial Officer and Co-Head of Strategic Planning (since October 2007). Head of Global Capital Markets (February 2006 to October 2007). Co-Head of Fixed Income Europe (May 2004 to February 2006). Head of Fixed Income Sales Europe (December 2000 to May 2004).

 

Gary G. Lynch (58).    Executive Vice President and Chief Legal Officer (since October 2005). Global General Counsel (October 2001 to October 2005) of Credit Suisse First Boston. Executive Vice Chairman (July 2004 to October 2005) and Vice Chairman (December 2002 to July 2004) of Credit Suisse First Boston and member of the Executive Board (July 2004 to July 2005) of Credit Suisse Group. Partner at the law firm of Davis Polk & Wardwell (September 1989 to October 2001).

 

Thomas R. Nides (47).    Executive Vice President, Chief Administrative Officer and Secretary (since September 2005). Worldwide President and Chief Executive Officer of Burson-Marsteller (November 2004 to August 2005). Chief Administrative Officer of Credit Suisse First Boston (June 2001 to June 2004).

 

Kenneth M. deRegt (53).    Chief Risk Officer (since February 2008). Managing Director of Aetos Capital, LLC, an investment management firm (December 2002 to February 2008). Director of MSCI Inc. (since November 2007).

 

Linda H. Riefler (48).    Global Head of Research (since December 2008). Chief Talent Officer (June 2006 to November 2008). Head of Client Services (October 2005 to June 2006). Managing Director of MS&Co. (since December 1998). Director of MSCI Inc. (since October 2005).

 

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Item 1A.    Risk Factors.

 

Liquidity Risk.

 

Liquidity and funding risk refers to the risk that Morgan Stanley will be unable to finance its operations due to a loss of access to the capital markets or difficulty in liquidating its assets. Liquidity and funding risk also encompasses the ability of Morgan Stanley to meet its financial obligations without experiencing significant business disruption or reputational damage that may threaten its viability as a going concern. For more information on how we monitor and manage liquidity and funding risk, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in Part II, Item 7 herein.

 

Liquidity is essential to our businesses and we rely on external sources to finance a significant portion of our operations.

 

Liquidity is essential to our businesses. Our liquidity could be substantially affected in a negative fashion by an inability to raise funding in the long-term or short-term debt capital markets or the equity capital markets or an inability to access the secured lending markets. Factors that we cannot control, such as disruption of the financial markets or negative views about the financial services industry generally, could impair our ability to raise funding. In addition, our ability to raise funding could be impaired if lenders develop a negative perception of our long-term or short-term financial prospects. Such negative perceptions could be developed if we incur large trading losses, we are downgraded or put on (or remain on) negative watch by the rating agencies, we suffer a decline in the level of our business activity, regulatory authorities take significant action against us, or we discover significant employee misconduct or illegal activity, among other reasons. If we are unable to raise funding using the methods described above, we would likely need to finance or liquidate unencumbered assets, such as our investment and trading portfolios, to meet maturing liabilities. We may be unable to sell some of our assets, or we may have to sell assets at a discount from market value, either of which could adversely affect our results of operations.

 

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 and business mix.

 

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 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.

 

We are a holding company and depend on payments from our subsidiaries.

 

We depend on dividends, distributions and other payments from our subsidiaries to fund dividend payments and to fund all payments on our obligations, including debt obligations. Regulatory and other legal restrictions may limit our ability to transfer funds freely, either to or from our subsidiaries. In particular, many of our subsidiaries, including our broker-dealer subsidiaries, are subject to laws and regulations that authorize regulatory bodies to block or reduce the flow of funds to the parent holding company, or that prohibit such transfers altogether in certain circumstances. These laws and regulations may hinder our ability to access funds that we may need to make payments on our obligations. Furthermore, as a bank holding company, we may become subject to a prohibition or to limitations on our ability to pay dividends. The OCC, the Fed and the FDIC have the authority, and under certain circumstances the duty, to prohibit or to limit the payment of dividends by the banking organizations they supervise, including us and our bank holding company subsidiaries.

 

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Future dividend payments and common stock repurchases are restricted by the terms of the U.S. Treasury’s equity investment in us.

 

Under the terms of the CPP, for so long as any preferred stock issued under the CPP remains outstanding, we are prohibited from increasing dividends on our common stock, and from making certain repurchases of equity securities, including our common stock, without the U.S. Treasury’s consent until the third anniversary of the U.S. Treasury’s investment or until the U.S. Treasury has transferred all of the preferred stock it purchased under the CPP to third parties. Furthermore, as long as the preferred stock issued to the U.S. Treasury is outstanding, dividend payments and repurchases or redemptions relating to certain equity securities, including our common stock, are prohibited until all accrued and unpaid dividends are paid on such preferred stock, subject to certain limited exceptions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies” in Part II, Item 7 herein.

 

Our liquidity and financial condition have been and could continue to be adversely affected by U.S. and international markets and economic conditions.

 

Our ability to raise funding in the long-term or short-term debt capital markets or the equity markets, or to access secured lending markets, has been and could continue to be adversely affected by conditions in the U.S. and international markets and economy. Global market and economic conditions have been, and continue to be, disrupted and volatile, and in the past six months the volatility has reached unprecedented levels. In particular, our cost and availability of funding have been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. As a result of concern about the stability of the markets generally and the strength of counterparties specifically, many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers. Continued turbulence in the U.S. and international markets and economy may adversely affect our liquidity and financial condition and the willingness of certain counterparties and customers to do business with us.

 

Market Risk.

 

Market risk refers to the risk that a change in the level of one or more market prices of commodities or securities, rates, indices, implied volatilities (the price volatility of the underlying instrument imputed from option prices), correlations or other market factors, such as liquidity, will result in losses for a position or portfolio. For more information on how we monitor and manage market risk, see “Risk Management—Market Risk” in Part II, Item 7A herein.

 

Our results of operations may be materially affected by market fluctuations and by economic and other factors.

 

The amount, duration and range of our market risk exposures have been increasing over the past several years, and may continue to do so. Our results of operations may be materially affected by market fluctuations due to economic and other factors. Results of operations in the past have been, and in the future may continue to be, materially affected by many factors of a global nature, including political, economic and market conditions; the availability and cost of capital; the liquidity of global markets; the level and volatility of equity prices, commodity prices and interest rates; currency values and other market indices; technological changes and events; the availability and cost of credit; inflation; natural disasters; acts of war or terrorism; investor sentiment and confidence in the financial markets; or a combination of these or other factors. In addition, legislative, legal and regulatory developments related to our businesses potentially could increase costs, thereby affecting results of operations. These factors also may have an impact on our ability to achieve our strategic objectives.

 

The results of our Institutional Securities business segment, particularly results relating to our involvement in primary and secondary markets for all types of financial products, are subject to substantial fluctuations due to a variety of factors, such as those enumerated above that we cannot control or predict with great certainty. These fluctuations impact results by causing variations in new business flows and in the fair value of securities and other financial products. Fluctuations also occur due to the level of global market activity, which, among other things, affects the size, number and timing of investment banking client assignments and transactions and the

 

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realization of returns from our principal investments. During periods of unfavorable market or economic conditions, the level of individual investor participation in the global markets, as well as the level of client assets, may also decrease, which would negatively impact the results of our Global Wealth Management Group business segment. In addition, fluctuations in global market activity could impact the flow of investment capital into or from assets under management or supervision and the way customers allocate capital among money market, equity, fixed income or other investment alternatives, which could negatively impact our Asset Management business segment.

 

We may experience further writedowns of our financial instruments and other losses related to volatile and illiquid market conditions.

 

Market volatility, illiquid market conditions and disruptions in the credit markets have made it extremely difficult to value certain of our securities. Subsequent valuations, in light of factors then prevailing, may result in significant changes in the values of these securities in future periods. In addition, at the time of any sales and settlements of these securities, the price we ultimately realize will depend on the demand and liquidity in the market at that time and may be materially lower than their current fair value. Any of these factors could require us to take further writedowns in the value of our securities portfolio, which may have an adverse effect on our results of operations in future periods.

 

Holding large and concentrated positions may expose us to losses.

 

Concentration of risk may reduce revenues or result in losses in our market-making, proprietary trading, 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 make large loans to, a particular issuer or issuers in a particular industry, country or region.

 

Markets have experienced, and may continue to experience, periods of high volatility accompanied by reduced liquidity.

 

Financial markets are susceptible to severe events evidenced by rapid depreciation in asset values accompanied by a reduction in asset liquidity. Under these extreme conditions, hedging and other risk management strategies may not be as effective at mitigating trading losses as they would be under more normal market conditions. Moreover, under these conditions market participants are particularly exposed to trading strategies employed by many market participants simultaneously and on a large scale, such as crowded trades. Morgan Stanley’s risk management and monitoring processes seek to quantify and mitigate risk to more extreme market moves. Severe market events have historically been difficult to predict, however, and Morgan Stanley could realize significant losses if unprecedented extreme market events were to occur, such as the recent conditions in the global financial markets and global economy.

 

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, and originate loans secured by commercial and residential properties. We also 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.

 

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Credit Risk.

 

Credit risk refers to the risk of loss arising from borrower or counterparty default when a borrower, counterparty or obligor does not meet its obligations. For more information on how we monitor and manage credit risk, see “Credit Risk” in Part II, Item 7A herein.

 

We are exposed to the risk that third parties that are indebted to us will not perform their obligations.

 

We incur significant “single-name” credit risk exposure through the Institutional Securities business segment. This risk may arise, for example, from entering into swap or other derivative contracts under which counterparties have long-term obligations to make payments to us and by extending credit to our clients through various credit arrangements. Corporate clients seek loans or lending commitments from us in connection with investment banking and other assignments. We incur “individual consumer” credit risk in the Global Wealth Management Group business segment through margin and non-purpose loans to individual investors, which are collateralized by securities.

 

Recent market conditions, including decreased liquidity and pricing transparency along with increased market volatility, will negatively impact our “single-name” credit risk exposure. In addition, as a clearing member firm, we finance our customer positions and we could be held responsible for the defaults or misconduct of our customers. Although we regularly review our credit exposures, default risk may arise from events or circumstances that are difficult to detect or foresee.

 

Defaults by another larger financial institution could adversely affect financial markets generally.

 

The commercial soundness of many financial institutions may be closely interrelated as a result of credit, trading, clearing or other relationships between the institutions. As a result, concerns about, or a default or threatened default by, one institution could lead to significant market-wide liquidity and credit problems, losses or defaults by other institutions. This is sometimes referred to as “systemic risk” and may adversely affect financial intermediaries, such as clearing agencies, clearing houses, banks, securities firms and exchanges, with which we interact on a daily basis, and therefore could adversely affect Morgan Stanley.

 

Operational Risk.

 

Operational risk refers to the risk of financial or other loss, or potential damage to a firm’s reputation, resulting from inadequate or failed internal processes, people, resources, systems or from external events (e.g., external or internal fraud, legal and compliance risks, damage to physical assets, etc.). Morgan Stanley may incur operational risk across its full scope of business activities, including revenue-generating activities (e.g., sales and trading) and support functions (e.g., information technology and trade processing). Legal and compliance risk is included in the scope of operational risk and is discussed below under “Legal Risk.” For more information on how we monitor and manage operational risk, see “Operational Risk” in Part II, Item 7A herein.

 

We are subject to operational risk that could adversely affect our businesses.

 

Our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies. In general, the transactions we process are increasingly complex. We perform the functions required to operate our different businesses either by ourselves or through agreements with third parties. We rely on the ability of our employees, our internal systems and systems at technology centers operated by third parties to process a high volume of transactions.

 

We also face the risk of operational failure or termination of any of the clearing agents, exchanges, clearing houses or other financial intermediaries we use to facilitate our securities transactions. In the event of a breakdown or improper operation of our or third party’s systems or improper action by third parties or employees, we could suffer financial loss, an impairment to our liquidity, a disruption of our businesses, regulatory sanctions or damage to our reputation.

 

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Despite the business contingency plans we have in place, our ability to conduct business may be adversely affected by a disruption in the infrastructure that supports our business and the communities where we are located. This may include a disruption involving physical site access, terrorist activities, disease pandemics, electrical, communications or other services used by Morgan Stanley, its employees or third parties with whom we conduct business.

 

Legal Risk.

 

Legal risk refers to the risk of non-compliance with applicable legal and regulatory requirements and standards. Legal risk also includes contractual and commercial risk such as the risk that a counterparty’s performance obligations will be unenforceable. For more information on how we monitor and manage legal risk, see “Risk Management—Legal Risk” in Part II, Item 7A herein.

 

Our business, financial condition and results of operations could be adversely affected by regulations to which we are and will become subject as a result of becoming a financial holding company.

 

On September 21, 2008, we obtained approval from the Fed to become a bank holding company. On September 23, 2008, we became a financial holding company concurrent with the conversion of Morgan Stanley Bank into a national bank. We have a statutory grace period of two years, with the possibility of three one-year extensions for a total grace period of five years, to conform existing activities and investments to the restrictions on nonbanking activities that apply to financial holding companies. The BHC Act also grandfathers commodities activities provided that certain conditions are satisfied. In addition, the BHC Act permits the Fed to determine by regulation or order that certain activities are complementary to a financial activity and do not pose a risk to safety and soundness. The Fed has previously determined that a wide range of commodities activities are either financial in nature or complementary to a financial activity. Although we expect to be able to continue to engage in most of the activities in which we currently engage after such time, it is possible that certain of our existing activities will not be deemed to be permissible under applicable regulations. If so, we will be required to divest them before the end of the grace period discussed above. We do not believe that any such required divestment will have a material adverse impact on our financial condition or results of operations.

 

As a result of becoming a financial holding company, we will be restricted in engaging in new activities that are not financial in nature. This may limit our ability to pursue business opportunities we might otherwise consider engaging in. In addition, in order to maintain our status as a financial holding company, our depository institution subsidiaries, such as Morgan Stanley Bank, N.A., must remain well capitalized and well managed. Under regulations implemented by the Fed, if any depository institution controlled by us no longer meets certain capital or management standards, the Fed may impose corrective capital and/or managerial requirements on us and place limitations on our ability to conduct the broader financial activities permissible for financial holding companies. If any depository institution controlled by us were to fail to maintain a satisfactory rating under the Community Reinvestment Act, the Fed would be required to restrict our and our subsidiaries’ ability to engage in additional activities to the range of activities permissible for bank holding companies that are not financial holding companies, which would severely restrict our ability to conduct our business.

 

As a financial holding company, we are subject to the comprehensive, consolidated supervision and regulation of the Fed, including risk-based and leverage capital requirements. The Fed generally requires us and our peer financial holding companies to maintain risk-based and leverage capital ratios substantially in excess of the minimum levels required by certain guidelines published by the federal banking regulators, depending upon general economic conditions and each financial holding company’s particular condition, risk profile and growth plans. Compliance with the capital requirements, including leverage ratios, may limit our operations requiring the intensive use of capital. Such requirements may limit our ability to pay dividends, repay debt or redeem or purchase shares of our outstanding stock. Any change in such rules or the imposition of new rules affecting the scope, coverage, calculation or amount of capital requirements, or a significant operating loss or any unusually large charge against capital, could adversely affect our ability to pay dividends or to expand or maintain present

 

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business levels. Further requirements, including certain dividend restrictions, have been imposed on us and other financial institutions participating in the CPP (see “Supervision and Regulation—Financial Holding Company—Dividends” in Part I, Item 1 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies” in Part II, Item 7 herein).

 

Our business, financial condition and results of operations are heavily regulated and could be adversely affected by new regulations or by changes in regulations or the application thereof in any of the jurisdictions in which we operate.

 

The financial services industry is heavily regulated. We are subject to extensive regulation globally and face the risk of significant intervention by regulatory authorities in the jurisdictions in which we conduct our businesses. Among other things, we could be fined, prohibited from engaging in some of our business activities or subject to limitations or conditions on our business activities.

 

In light of current conditions in the global financial markets and the global economy, regulators have increased their focus on the regulation of the financial services industry. Most recently, governments in the U.S. and abroad have intervened on an unprecedented scale, responding to the stresses experienced in the global financial markets. Steps undertaken in the U.S. include enhancing the liquidity support available to financial institutions, including by establishing a commercial paper funding facility, temporarily guaranteeing money market funds and certain types of debt issuances, insuring deposits in certain transaction deposit accounts, and injecting capital into financial institutions. Some of the measures subject us and other institutions for which they were designed to additional restrictions, oversight or costs that may have an impact on our business, results of operations or the price of our common stock.

 

Proposals for legislation that could substantially intensify the regulation of the financial services industry are expected to be introduced in the U.S. Congress, in state legislatures and around the world. The agencies regulating the financial services industry also frequently adopt changes to their regulations. Substantial regulatory and legislative initiatives, including a comprehensive overhaul of the regulatory system in the U.S. and rules to more closely regulate credit default swaps and other derivative transactions, are possible in the years ahead. We are unable to predict whether any of these initiatives will succeed, which form they will take, or whether any additional changes to statutes or regulations, including the interpretation or implementation thereof, will occur in the future. Any such action could affect us in substantial and unpredictable ways and could have an adverse effect on our business, financial condition and results of operations. For more information regarding the regulatory environment in which we operate, see “Supervision and Regulation” in Part I, Item 1 herein.

 

The financial services industry faces substantial litigation and regulatory risks, and we may face damage to our reputation and legal liability.

 

We have been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions, and other litigation, arising in connection with our 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 issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

 

We are also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding our business, including, among other things, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these investigations and proceedings has increased in recent years with regard to many firms in the financial services industry, including us. Like any large corporation, we are also subject to risk from potential employee misconduct, including non-compliance with policies and improper use or disclosure of confidential information. Substantial legal liability or significant regulatory action

 

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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. For more information regarding legal proceedings in which we are involved see “Legal Proceedings” in Part I, Item 3 herein.

 

Our business, financial condition and results of operations could be adversely affected by governmental fiscal and monetary policies.

 

We are affected by fiscal and monetary policies adopted by regulatory authorities and bodies of the U.S. and other governments. For example, the actions of the Fed and international central banking authorities directly impact our cost of funds for lending, capital raising and investment activities and may impact the value of financial instruments we hold. In addition, such changes in monetary policy may affect the credit quality of our customers. Changes in domestic and international monetary policy are beyond our control and difficult to predict.

 

Our commodities activities subject us to extensive regulation, potential catastrophic events and environmental risks and regulation that may expose us to significant costs and liabilities.

 

In connection with the commodities activities in our Institutional Securities business segment, we engage in the production, storage, transportation, marketing and trading of several commodities, including metals (base and precious), agricultural products, crude oil, oil products, natural gas, electric power, emission credits, coal, freight, liquefied natural gas and related products and indices. In addition, we own six electricity generating facilities in the U.S. and Europe; TransMontaigne Inc. and its subsidiaries, a group of companies operating in the refined petroleum products marketing and distribution business; and have an interest in the Heidmar Group of companies, which provide international marine transportation and U.S. marine logistics services. As a result of these activities, we are subject to extensive and evolving energy, commodities, environmental, health and safety and other governmental laws and regulations. For example, liability may be incurred without regard to fault under certain environmental laws and regulations for the remediation of contaminated areas. Our commodities business also exposes us to the risk of unforeseen and catastrophic events, including natural disasters, leaks, spills, explosions, release of toxic substances, fires, accidents on land and at sea, wars, and terrorist attacks that could result in personal injuries, loss of life, property damage, and suspension of operations.

 

Although we have attempted to mitigate our pollution and other environmental risks by, among other measures, adopting appropriate policies and procedures for power plant operations, monitoring the quality of petroleum storage facilities and transport vessels and implementing emergency response programs, these actions may not prove adequate to address every contingency. In addition, insurance covering some of these risks may not be available, and the proceeds, if any, from insurance recovery may not be adequate to cover liabilities with respect to particular incidents. As a result, our financial condition and results of operations may be adversely affected by these events.

 

We also expect the other laws and regulations affecting our commodities business to increase in both scope and complexity. During the past several years, intensified scrutiny of certain energy markets by federal, state and local authorities in the U.S. and abroad and the public has resulted in increased regulatory and legal enforcement, litigation and remedial proceedings involving companies engaged in the activities in which we are engaged. For example, the EU has increased its focus on the energy markets which has resulted in increased regulation of companies participating in the energy markets, including those engaged in power generation and liquid hydrocarbons trading. We may incur substantial costs in complying with current or future laws and regulations and our overall businesses and reputation may be adversely affected by the current legal environment. In addition, failure to comply with these laws and regulations may result in substantial civil and criminal fines and penalties.

 

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A failure to deal with conflicts of interest appropriately could adversely affect our businesses.

 

As a global financial services firm that provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals, we face potential conflicts of interests in the normal course of business. For example, potential conflicts can occur when there is a divergence of interests between Morgan Stanley and a client, among clients, or between an employee on the one hand and the Firm or a client on the other. We have policies, procedures and controls that are designed to address potential conflicts of interest. However, identifying and managing potential conflicts of interest can be complex and challenging, and can become the focus of media and regulatory scrutiny. Indeed, actions that merely appear to create a conflict can put our reputation at risk. It is possible that potential or perceived conflicts could give rise to litigation or enforcement actions, which may lead to our clients being less willing to enter into transactions in which a conflict may occur and could adversely affect our businesses.

 

Competitive Environment.

 

We face strong competition from other financial services firms, which could lead to pricing pressures that could materially adversely affect our revenue and profitability.

 

The financial services industry and all of our businesses are intensely competitive, and we expect them to remain so. We compete with commercial banks, insurance companies, sponsors of mutual funds, hedge funds, energy companies and other companies offering financial services in the U.S., globally and through the internet. We compete on the basis of several factors, including transaction execution, capital or access to capital, products and services, innovation, reputation and price. Over time, certain sectors of the financial services industry have become more concentrated, as institutions involved in a broad range of financial services have been acquired by or merged into other firms or have declared bankruptcy. In fiscal 2008, this trend accelerated considerably, as several major U.S. financial institutions consolidated, were forced to merge, received substantial government assistance or were placed into conservatorship by the U.S. Federal Government. These developments could result in our competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. We may experience pricing pressures as a result of these factors and as some of our competitors seek to increase market share by reducing prices. For more information regarding the competitive environment in which we operate, see “Competition” in Part I, Item 1 herein.

 

Our ability to retain and attract qualified employees is critical to the success of our business and the failure to do so may materially adversely affect our performance.

 

Our people are our most important resource and competition for qualified employees is intense. In order to attract and retain qualified employees, we must compensate such employees at market levels. Typically, those levels have caused employee compensation to be our greatest expense as compensation is highly variable and changes with performance. If we are unable to continue to attract and retain qualified employees, or do so at rates necessary to maintain our competitive position, or if compensation costs required to attract and retain employees become more expensive, our performance, including our competitive position, could be materially adversely affected.

 

Pursuant to the standardized terms of the CPP described above, among other things, we have agreed to institute certain restrictions on the compensation of certain senior management positions, which could have an adverse effect on our ability to hire or retain the most qualified senior management. It is possible that the U.S. Treasury may, as it is permitted to do, impose further requirements on us.

 

Automated trading markets may adversely affect our business and may increase competition.

 

We have experienced intense price competition in some of our businesses in recent years. In particular, the ability to execute securities trades electronically on exchanges and through other automated trading markets has increased the pressure on trading commissions. The trend toward direct access to automated, electronic markets will likely continue. It is possible that we will experience competitive pressures in these and other areas in the future as some of our competitors may seek to obtain market share by reducing prices.

 

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International Risk.

 

We are subject to numerous political, economic, legal, operational, franchise and other risks as a result of our international operations which could adversely impact our businesses in many ways.

 

We are subject to political, economic, legal, operational, franchise and other risks that are inherent in operating in many countries, including risks of possible nationalization, expropriation, price controls, capital controls, exchange controls and other restrictive governmental actions, as well as the outbreak of hostilities or political and governmental instability. In many countries, the laws and regulations applicable to the securities and financial services industries are uncertain and evolving, and it may be difficult for us to determine the exact requirements of local laws in every market. Our inability to remain in compliance with local laws in a particular market could have a significant and negative effect not only on our business in that market but also on our reputation generally. We are also subject to the enhanced risk that transactions we structure might not be legally enforceable in all cases.

 

Various emerging market countries have experienced severe political, economic and financial disruptions, including significant devaluations of their currencies, capital and currency exchange controls, high rates of inflation and low or negative growth rates in their economies. Crime and corruption, as well as issues of security and personal safety, also exist in certain of these countries. These conditions could adversely impact our businesses and increase volatility in financial markets generally.

 

The emergence of a pandemic or other widespread health emergency, or concerns over the possibility of such an emergency, could create economic and financial disruptions in emerging markets and other areas throughout the world, and could lead to operational difficulties (including travel limitations) that could impair our ability to manage our businesses around the world.

 

Acquisition Risk.

 

We may be unable to fully capture the expected value from acquisitions, joint ventures, minority stakes and strategic alliances.

 

We expect to grow in part through acquisitions, joint ventures and minority stakes. To the extent we make acquisitions or enter into combinations, joint ventures or strategic alliances, 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 and business partners. In the case of joint ventures and minority stakes, we are subject to additional risks and uncertainties in that 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. In addition, conflicts or disagreements between us and our joint venture partners may negatively impact the benefits to be achieved by the joint venture. There is no assurance that our acquisitions or any business we acquire will be successfully integrated and result in 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 may be materially and adversely affected.

 

In October 2008, Morgan Stanley and Mitsubishi UFJ Financial Group, Inc. announced a global strategic alliance and have identified areas of potential collaboration for such alliance, including corporate and investment banking, certain areas of retail banking and asset management, and lending activities such as corporate and project related loans. In January 2009, Morgan Stanley and Citi announced they had reached a definitive agreement to combine Morgan Stanley’s Global Wealth Management Group and Citi’s Smith Barney in the U.S., Quilter in the U.K., and Smith Barney Australia into a new joint venture to be called Morgan Stanley Smith Barney (see also “Recent Business Developments” in Part I, Item 1 herein).

 

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Risk Management.

 

Our hedging strategies and other risk management techniques may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk.

 

We have devoted significant resources to develop our risk management policies and procedures and expect to continue to do so in the future. Nonetheless, our hedging strategies and other risk management techniques may not be fully effective in mitigating our risk exposure in all market environments or against all types of risk, including risks that are unidentified or unanticipated. Some of our methods of managing risk are based upon our use of observed historical market behavior. As a result, these methods may not predict future risk exposures, which could be significantly greater than the historical measures indicate. Management of market, credit, liquidity, operational, legal and regulatory risks requires, among other things, policies and procedures to record properly and verify a large number of transactions and events, and these policies and procedures may not be fully effective. For more information on how we monitor and manage market and certain other risks, see “Risk Management—Market Risk” in Part II, Item 7A herein.

 

Item 1B.    Unresolved Staff Comments.

 

Morgan Stanley, like other well-known seasoned issuers, from time to time receives written comments from the staff of the SEC regarding its periodic or current reports under the Exchange Act. There are no comments that remain unresolved that Morgan Stanley received not less than 180 days before the end of its fiscal year to which this report relates that Morgan Stanley believes are material.

 

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Item 2.    Properties.

 

Morgan Stanley and its subsidiaries have offices, operations and data centers located around the world. Morgan Stanley’s properties that are not owned are leased on terms and for durations that are reflective of commercial standards in the communities where these properties are located. Morgan Stanley believes the facilities it owns or occupies are adequate for the purposes for which they are currently used and are well maintained. Our principal offices consist of the following properties:

 

Location   

Owned/

Leased

   Lease Expiration    Approximate Square Footage
as of November 30, 2008(A)
 

U.S. Locations

       

1585 Broadway

New York, New York

(Global Headquarters and Institutional Securities Headquarters)

   Owned    N/A    894,597 square feet
     

2000 Westchester Avenue

Purchase, New York

(Global Wealth Management Group Headquarters)

   Owned    N/A    606,158 square feet
     

522 Fifth Avenue

New York, New York

(Asset Management Headquarters)

   Owned    N/A    581,245 square feet
     

New York, New York

(Several locations)

   Leased    2009 – 2018    2,239,668 square feet
     

One Pierrepont Plaza

Brooklyn, New York

   Leased    2013    456,686 square feet
     

Jersey City, New Jersey

(Several locations)

   Leased    2009 – 2014    493,695 square feet
 

International Locations

     

25 Cabot Square, Canary Wharf

(London Headquarters)

   Owned(B)    N/A    448,088 square feet
     

Canary Wharf

(Several locations)

   Leased    2013 – 2038    1,001,605 square feet
     

1 Austin Road West

Kowloon

(Hong Kong Headquarters)

   Leased    2019    598,318 square feet
     

Sapporo’s Yebisu Garden Place,

Ebisu, Shibuya-ku

(Tokyo Headquarters)

   Leased    2010(C)    432,380 square feet

 

 

(A) The indicated total aggregate square footage leased does not include space occupied by Morgan Stanley securities branch offices.
(B) Morgan Stanley holds the freehold interest in the land and building.
(C) Option to return half of the space from April 2010 and any amount of space up to the full space after April 2011; 6 months notice required.

 

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Item 3.    Legal Proceedings.

 

In addition to the matters described below, in the normal course of business, Morgan Stanley 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 issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

 

Morgan Stanley is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies regarding Morgan Stanley’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.

 

Morgan Stanley contests liability and/or the amount of damages as appropriate in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Morgan Stanley cannot predict with certainty the loss or range of loss, if any, related to such matters, how or if such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, fine, penalty or other relief, if any, might be. Subject to the foregoing, Morgan Stanley believes, based on current knowledge and after consultation with counsel, that the outcome of such pending matters will not have a material adverse effect on the consolidated financial condition of Morgan Stanley, although the outcome of such matters could be material to Morgan Stanley’s operating results and cash flows for a particular future period, depending on, among other things, the level of Morgan Stanley’s revenues or income for such period.

 

IPO Allocation Matters.

 

Beginning in March 2001, numerous purported class actions, now captioned In re Initial Public Offering Securities Litigation, were filed in the U.S. District Court for the Southern District of New York (the “SDNY”) against certain issuers of initial public offering (“IPO”) securities, certain individual officers of those issuers, Morgan Stanley and other underwriters of those IPOs, purportedly on behalf of purchasers of stock in the IPOs or the aftermarket. These complaints allege that defendants required customers who wanted allocations of “hot” IPO securities to pay undisclosed and excessive underwriters’ compensation in the form of increased brokerage commissions and to buy shares of securities offered in the IPOs after the IPOs were completed at escalating price levels higher than the IPO price (a practice plaintiffs refer to as “laddering”), and claim violations of the federal securities laws, including Sections 11 and 12(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”), and Section 10(b) of the Exchange Act. Some of the complaints also allege that continuous “buy” recommendations by the defendants’ research analysts improperly increased or sustained the prices at which the securities traded after the IPOs. In February 2003, the underwriter defendants’ joint motion to dismiss was denied, except as to certain specified offerings. In December 2006, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) reversed the SDNY’s grant of class certification, and ruled that these cases could not be certified for class treatment. In August 2007, plaintiffs filed second consolidated amended class action complaints, which purport to amend the allegations in light of the Second Circuit’s reversal of the SDNY’s decision approving the cases to proceed as class actions. On March 26, 2008, the underwriter defendants’ joint motion to dismiss the second consolidated amended complaint was denied, except as to claims brought under Section 11 of the Securities Act by those plaintiffs who sold securities for a price in excess of the initial offering price and by those plaintiffs who purchased outside the previously certified class period. On September 12, 2008, Morgan Stanley and other defendants reached an agreement in principle with plaintiffs to settle this matter, subject to final agreement on documentation and court approval.

 

In October 2007, numerous derivative actions, purportedly brought on behalf of certain issuers of IPO securities, were filed in the U.S. District Court for the Western District of Washington (the “Western District of

 

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Washington”) against Morgan Stanley and other underwriters of those IPOs. The actions seek to recover “short swing” profits allegedly generated in violation of Section 16(b) of the Exchange Act. Defendants have filed a motion to dismiss these actions, which motion is pending before the Western District of Washington.

 

Residential Mortgage-related Matters.

 

Regulatory and Governmental Matters.    Morgan Stanley is responding to subpoenas and requests for information from certain regulatory and governmental entities concerning the origination, purchase, securitization and servicing of subprime and non-subprime residential mortgages and related issues.

 

Class Actions.    Beginning in March 2007, Morgan Stanley was named as a defendant in several putative class action lawsuits brought under Sections 11 and 12 of the Securities Act related to its role as a member of the syndicates that underwrote offerings of securities and mortgage pass through certificates for certain entities that have been exposed to subprime and other mortgage-related losses. These putative class actions include lawsuits related to: (i) New Century Financial Corp. (“New Century”), pending in the United States District Court for the Central District of California (the “Central District of California”); (ii) Countrywide Financial Corp. and its affiliates, one consolidated lawsuit is pending in the Central District of California and two other lawsuits are pending in the Superior Court of the State of California in Los Angeles; (iii) Merrill Lynch & Co., Inc., pending in the SDNY; (iv) Wachovia Corporation, pending in the United States District Court for the Superior Court of the State of California in Alameda County; (v) Washington Mutual, Inc. (“Washington Mutual”), pending in the Western District of Washington; (vi) Fifth Third Bancorp, pending in the United States District Court for the Southern District of Ohio; (vii) Fannie Mae, pending in the SDNY and the District of New Jersey; (viii) Lehman Brothers Holdings Inc. (“Lehman Brothers”), pending in the SDNY, the Eastern District of New York and the United States District Courts for the Eastern and Western Districts of Arkansas; (ix) Citigroup, Inc., pending in the SDNY; (x) American International Group, Inc., pending in the SDNY; (xi) Royal Bank of Scotland Group plc pending in the SDNY; and (xii) IndyMac Bank, F.S.B. (“IndyMac”), pending in the Superior Court of the State of California in Los Angeles. Morgan Stanley is contractually entitled to be indemnified in connection with these putative class actions by the entities that offered the securities at issue, but four of these entities, New Century, Lehman Brothers, Washington Mutual and IndyMac, have filed for bankruptcy and this may decrease or eliminate the value of the indemnities that Morgan Stanley received from these four entities. On December 3, 2008, the court in the case related to New Century, which is styled In Re New Century, denied the underwriter defendants’ motion to dismiss the second amended consolidated class action complaint. On December 8, 2008, the underwriter defendants filed a motion to dismiss the consolidated class action complaint in the case related to Washington Mutual, which is styled In Re Washington Mutual, Inc. Securities Litigation.

 

Beginning in December 2007, several purported class action complaints were filed in the SDNY asserting claims on behalf of participants in Morgan Stanley’s 401(k) plan and employee stock ownership plan against Morgan Stanley and other parties, including certain present and former directors and officers, under the Employee Retirement Income Security Act of 1974 (“ERISA”). The complaints relate in large part to subprime-related losses, and allege, among other things, that Morgan Stanley’s stock was not a prudent investment and that risks associated with its stock and its financial condition were not adequately disclosed. On February 11, 2008, all of the pending actions asserting claims under ERISA related to Morgan Stanley’s 401(k) and employee stock ownership plan were consolidated in a single proceeding in the SDNY, which is styled In re Morgan Stanley ERISA Litigation. On July 25, 2008, the plaintiffs filed a consolidated complaint, which defendants have moved to dismiss. The consolidated complaint in this action relates in large part to Morgan Stanley’s subprime and other mortgage related losses, but also includes allegations regarding Morgan Stanley’s disclosures, internal controls, accounting and other matters.

 

On February 12, 2008, a plaintiff filed a purported class action, which was amended on November 24, 2008, naming Morgan Stanley and certain present and former senior executives as defendants and alleging claims for, among other things, violations of the securities laws related in large part to Morgan Stanley’s subprime related losses. The amended complaint, which is styled Joel Stratte-McClure, et al. v. Morgan Stanley, et al., is pending in the Central District of California. Subject to certain exclusions, the amended complaint purports to assert claims under the federal securities laws on behalf of a purported class of persons and entities who purchased

 

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shares of Morgan Stanley common stock during the period June 20, 2007 to December 19, 2007 and who suffered damages as a result of such purchases. The allegations in the amended complaint relate in large part to Morgan Stanley’s subprime and other mortgage related losses, but also include allegations regarding Morgan Stanley’s disclosures, internal controls, accounting and other matters.

 

On December 2, 2008, a plaintiff filed a purported class action against Morgan Stanley, certain present and former officers and other defendants asserting claims under Sections 11, 12 and 15 of the Securities Act related to alleged false and misleading statements in the registration statements and other offering documents associated with fourteen trusts that issued mortgage pass through certificates backed by residential mortgage loans in 2006. The lawsuit, which is styled Public Employees’ Retirement System of Mississippi v. Morgan Stanley, et al., was filed in the Superior Court of the State of California for Orange County. On December 31, 2008, the defendants removed the case to federal court in the Central District of California.

 

Shareholder Derivative Matter.    A shareholder derivative lawsuit was filed in the SDNY during November 2007 asserting claims related in large part to losses caused by certain subprime-related trading positions and related matters. The complaint in that lawsuit, which is styled Steve Staehr, Derivatively on Behalf of Morgan Stanley v. John J. Mack, et al., was served on Morgan Stanley on February 15, 2008. On July 18, 2008, the plaintiff filed an amended complaint, which defendants have moved to dismiss.

 

Other Matters.    Morgan Stanley, along with a number of other financial institutions, has been named as a defendant in a lawsuit brought by the City of Cleveland, Ohio, alleging that defendants’ activities in connection with securitizations of subprime loans created a “public nuisance” in Cleveland. The lawsuit has been removed to United States District Court for the Northern District of Ohio and the defendants have moved to dismiss the complaint.

 

Auction Rate Securities Matters.

 

On March 25, 2008, a putative class action complaint, which is styled Miller v. Morgan Stanley & Co. Incorporated, was filed in the SDNY purportedly on behalf of persons who acquired auction rate securities (“ARS”) from Morgan Stanley from March 25, 2003 through February 13, 2008 and who were allegedly damaged thereby. The complaint alleges, among other things, that Morgan Stanley failed to disclose material facts with respect to ARS and thereby violated Section 10(b) of the Exchange Act and SEC Rule 10b-5. The complaint seeks damages, attorneys’ fees, and rescission. On March 31, 2008, a similar action, which is styled Jamail v. Morgan Stanley, et al., was filed in the same court seeking damages, attorneys’ fees and equitable and/or injunctive relief. On May 28, 2008, a third putative class action, which is styled Bartholomew v. Morgan Stanley et al., was filed in the SDNY purportedly on behalf of individuals who allegedly had their ARS “frozen” by Morgan Stanley and who have been damaged thereby. The complaint alleges, among other things, that Morgan Stanley made misrepresentations and omissions with respect to ARS and breached a fiduciary duty to the putative class by failing to participate in auctions and asserts claims under the Investment Advisers Act of 1940 and state law. The complaint seeks damages, disgorgement, attorneys’ fees, and a declaration that Morgan Stanley’s ARS transactions with the putative class members are void.

 

Morgan Stanley also received requests for documents and information from various government agencies regarding ARS and is cooperating with the investigations. On August 13, 2008, Morgan Stanley reached an agreement in principle with the Office of the New York State Attorney General and the Office of the Illinois Secretary of State, Securities Department (on behalf of a task force of other states under the auspices of the North American Securities Administrators Association) in connection with the proposed settlement of their investigations relating to the sale of ARS. Morgan Stanley agreed, among other things to: (1) repurchase at par illiquid ARS that were purchased by certain retail clients prior to February 13, 2008; (2) pay certain retail clients that sold ARS below par the difference between par and the price at which the clients sold the securities; (3) arbitrate, under special procedures, claims for consequential damages by certain retail clients; (4) refund refinancing fees to certain municipal issuers of ARS; and (5) pay a total penalty of $35 million. A separate investigation of these matters by the SEC remains ongoing.

 

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On August 27, 2008, a shareholder derivative complaint, which is styled Louisiana Municipal Police Employees Retirement System v. Mack, et al., was filed in the SDNY. On September 12, 2008, a second complaint, which is styled Thomas v. Mack, et al., was filed in the SDNY. The complaints are substantially similar and name as defendants the members of Morgan Stanley’s Board of Directors as well as certain current and former officers. Morgan Stanley, on whose behalf the suits are purportedly brought, is named as a nominal defendant in each action. The complaints raise claims of breach of fiduciary duty, abuse of control, gross mismanagement, and violation of Section 10(b) and Rule 10b-5 of the Exchange Act related to Morgan Stanley’s sale of ARS over the period from June 20, 2007 to the present. Among other things, the complaints allege that, over the relevant period, Morgan Stanley’s public filings and statements were materially false and misleading in that they failed to disclose the illiquid nature of its ARS inventories and that Morgan Stanley’s practices in the sale of ARS exposed it to significant liability for settlements and judgments. The complaints also allege that during the relevant period certain defendants sold Morgan Stanley’s stock while in possession of material non-public information. The complaints seek, among other things, unspecified compensatory damages, restitution from the defendants with respect to compensation, benefits and profits obtained, and the institution of certain reforms to Morgan Stanley’s internal control functions. On November 24, 2008, the SDNY ordered the consolidation of the two actions.

 

Environmental Matters.

 

On October 29, 2008, the U.S. Environmental Protection Agency (“EPA”) sent Morgan Stanley a proposed administrative settlement agreement to resolve certain violations of the U.S. environmental laws allegedly committed by Morgan Stanley during 2005. These alleged violations include: distribution of approximately 2.7 million gallons of reformulated gasoline that failed to comply with maximum benzene content limitations; failure to report volume and property information for each batch of gasoline blendstock imported and reformulated gasoline produced; failure to conduct an annual attest engagement; and failure to provide product transfer documents for each transfer of reformulated gasoline and each batch of previously certified gasoline. The EPA has proposed a civil penalty of $599,000 to resolve these matters. Morgan Stanley believes that the proposed penalty fails to adequately take into consideration certain mitigating factors and other information, and is continuing to communicate with the EPA regarding the resolution of this matter.

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

There were no matters submitted to a vote of security holders during the fourth quarter of our fiscal year ended November 30, 2008.

 

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Part II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Morgan Stanley’s common stock trades on the NYSE under the symbol “MS.” As of January 23, 2009, Morgan Stanley had approximately 94,565 holders of record; however, Morgan Stanley believes the number of beneficial owners of common stock exceeds this number.

 

The table below sets forth, for each of the last eight fiscal quarters, the low and high sales prices per share of Morgan Stanley’s common stock as reported by Bloomberg Financial Markets and the amount of any cash dividends declared per share of Morgan Stanley’s common stock.

 

     Low
Sale Price
   High
Sale Price
   Dividends(A)

Fiscal 2008:

        

Fourth Quarter

   $ 6.71    $ 44.50    $ 0.27

Third Quarter

   $ 29.60    $ 46.58    $ 0.27

Second Quarter

   $ 33.56    $ 51.80    $ 0.27

First Quarter

   $ 40.76    $ 55.39    $ 0.27

Fiscal 2007:

        

Fourth Quarter

   $ 47.56    $ 69.87    $ 0.27

Third Quarter(B)

   $ 54.90    $ 90.95    $ 0.27

Second Quarter

   $ 70.30    $ 87.44    $ 0.27

First Quarter

   $ 73.04    $ 84.66    $ 0.27

 

(A) As a result of its participation in the CPP, Morgan Stanley is subject to restrictions limiting its ability to pay dividends on its common stock. For a description of these restrictions, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies” herein.
(B) On June 30, 2007, Morgan Stanley completed the spin-off of Discover Financial Services (the “Discover Spin-off”). Prior to the Discover Spin-off, the Low Sale Price and the High Sale Price for the Third Quarter were $82.73 and $90.95, respectively.

 

The table below sets forth the information with respect to purchases made by or on behalf of Morgan Stanley of its common stock during the fourth quarter of our fiscal year ended November 30, 2008.

 

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 (September 1, 2008—September 30, 2008)

       

Share Repurchase Program(A)

  24,325,126   $ 20.01   24,325,126   $ 1,785

Employee Transactions(B)

  23,814,798   $ 43.03   N/A     N/A

Month #2 (October 1, 2008—October 31, 2008)

       

Share Repurchase Program(A)(D)

  14,873,030   $ 15.09   14,873,030   $ 1,560

Employee Transactions(B)

  107,807   $ 36.13   N/A     N/A

Month #3 (November 1, 2008—November 30, 2008)

       

Share Repurchase Program(A)

  —     $ —     —     $ 1,560

Employee Transactions(B)

  103,935   $ 14.44   N/A     N/A

Total

       

Share Repurchase Program(A)

  39,198,156   $ 18.14   39,198,156   $ 1,560

Employee Transactions(B)

  24,026,540   $ 42.88   N/A     N/A

 

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(A) On December 19, 2006, the Company announced that its Board of Directors authorized the repurchase of up to $6 billion of its outstanding stock under a new 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.
(B) Includes: (1) shares delivered or attested to in satisfaction of the exercise price and/or tax withholding obligations by holders of employee and director stock options (granted under employee stock compensation plans) who exercised options; (2) restricted shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon vesting and release of restricted shares; and (3) shares withheld (under the terms of grants under employee stock compensation plans) to offset tax withholding obligations that occur upon the delivery of outstanding shares underlying restricted stock units. Morgan Stanley’s employee stock compensation plans provide that the value of the shares delivered or attested, or withheld, shall be valued using the fair market value of Morgan Stanley common stock on the date the relevant transaction occurs, using a valuation methodology established by Morgan Stanley.
(C) Share purchases under publicly announced programs are made pursuant to capital management 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. In addition, share purchases under such programs are in compliance with CPP restrictions. For more information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies” in Part II, Item 7 herein.
(D) Share purchases made during the month of October were made prior to the equity investment by the U.S. Treasury under its CPP (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Equity Capital Management Policies”) in Part II, Item 7 herein.

 

***

 

Stock performance graph.    The following graph compares the cumulative total shareholder return (rounded to the nearest whole dollar) of our common stock, the S&P 500 Stock Index (“S&P 500”) and the S&P 500 Diversified Financials Index (“S5DIVF”) for our last five fiscal years. The graph assumes a $100 investment at the closing price on November 28, 2003 and reinvestment of dividends on the respective dividend payment dates without commissions. Historical prices are adjusted to reflect the Discover Spin-off. This graph does not forecast future performance of our common stock.

 

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     MS    S&P 500    S5DIVF

11/28/03

   $ 100.00    $ 100.00    $ 100.00

11/30/04

   $ 93.57    $ 112.84    $ 106.68

11/30/05

   $ 105.39    $ 122.36    $ 122.57

11/30/06

   $ 145.59    $ 139.76    $ 146.20

11/30/07

   $ 123.20    $ 150.54    $ 133.10

11/28/08

   $ 35.63    $ 93.22    $ 54.21

 

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Item 6. Selected Financial Data.

 

MORGAN STANLEY

 

SELECTED FINANCIAL DATA

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

 

     Fiscal Year(1)
     2008     2007    2006    2005     2004

Income Statement Data:

            

Revenues:

            

Investment banking

   $ 4,092     $ 6,368    $ 4,755    $ 3,843     $ 3,341

Principal transactions:

            

Trading

     5,452       3,206      11,805      7,377       5,512

Investments

     (4,192 )     3,262      1,807      1,128       721

Commissions

     4,463       4,682      3,770      3,331       3,235

Asset management, distribution and administration fees

     5,660       6,519      5,238      4,915       4,436

Other

     6,062       1,161      545      185       4
                                    

Total non-interest revenues

     21,537       25,198      27,920      20,779       17,249
                                    

Interest and dividends

     40,725       60,083      42,776      25,987       16,719

Interest expense

     37,523       57,302      40,897      23,552       13,977
                                    

Net interest

     3,202       2,781      1,879      2,435       2,742
                                    

Net revenues

     24,739       27,979      29,799      23,214       19,991
                                    

Non-interest expenses:

            

Compensation and benefits

     12,306       16,552      13,986      10,749       9,320

Other

     10,146       8,033      6,749      6,711       5,482

September 11th related insurance recoveries, net

     —         —        —        (251 )     —  
                                    

Total non-interest expenses

     22,452       24,585      20,735      17,209       14,802
                                    

Income from continuing operations before income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change, net

     2,287       3,394      9,064      6,005       5,189

Provision for income taxes

     480       831      2,729      1,473       1,384

Dividends on preferred securities subject to mandatory redemption

     —         —        —        —         45
                                    

Income from continuing operations before cumulative effect of accounting change, net

     1,807       2,563      6,335      4,532       3,760
                                    

Discontinued operations:

            

Net (loss) gain from discontinued operations

     (100 )     1,024      1,666      559       1,129

Provision for income taxes

     —         378      529      201       403
                                    

Net (loss) gain on discontinued operations

     (100 )     646      1,137      358       726

Cumulative effect of accounting change, net

     —         —        —        49       —  
                                    

Net income

   $ 1,707     $ 3,209    $ 7,472    $ 4,939     $ 4,486
                                    

Earnings applicable to common shareholders(2)

   $ 1,588     $ 3,141    $ 7,453    $ 4,939     $ 4,486
                                    

 

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     Fiscal Year(1)  
     2008     2007     2006     2005     2004  

Per Share Data:

          

Earnings per basic common share:

          

Income from continuing operations

   $ 1.64     $ 2.49     $ 6.25     $ 4.32     $ 3.48  

(Loss) gain on discontinued operations

     (0.10 )     0.64       1.13       0.33       0.67  

Cumulative effect of accounting change, net

     —         —         —         0.05       —    
                                        

Earnings per basic common share

   $ 1.54     $ 3.13     $ 7.38     $ 4.70     $ 4.15  
                                        

Earnings per diluted common share:

          

Income from continuing operations

   $ 1.54     $ 2.37     $ 5.99     $ 4.19     $ 3.40  

(Loss) gain on discontinued operations

     (0.09 )     0.61       1.08       0.33       0.66  

Cumulative effect of accounting change, net

     —         —         —         0.05       —    
                                        

Earnings per diluted common share

   $ 1.45     $ 2.98     $ 7.07     $ 4.57     $ 4.06  
                                        

Book value per common share

   $ 30.24     $ 28.56     $ 32.67     $ 27.59     $ 25.95  

Dividends per common share

   $ 1.08     $ 1.08     $ 1.08     $ 1.08     $ 1.00  

Balance Sheet and Other Operating Data:

          

Total assets

   $ 658,812     $ 1,045,409     $ 1,121,192     $ 898,835     $ 747,578  

Consumer loans, net

     —         —         22,915       21,966       19,166  

Total capital(3)

     192,297       191,085       162,134       125,891       110,793  

Long-term borrowings(3)

     141,466       159,816       126,770       96,709       82,587  

Shareholders’ equity

     50,831       31,269       35,364       29,182       28,206  

Return on average common shareholders’ equity

     4.9 %     8.9 %     23.5 %     17.3 %     16.8 %

Average common and equivalent shares(2)

     1,028,180,275       1,001,878,651       1,010,254,255       1,049,896,047       1,080,121,708  

 

(1) Certain prior-period information has been reclassified to conform to the current year’s presentation.
(2) Amounts shown are used to calculate earnings per basic common share.
(3) These amounts exclude the current portion of long-term borrowings and include junior subordinated debt issued to capital trusts and include capital units as of November 30, 2006, November 30, 2005 and November 30, 2004.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Introduction.

 

Morgan Stanley (the “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. A summary of the activities of each of the business segments is as follows.

 

Institutional Securities includes 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; benchmark indices and risk management analytics; and investment activities.

 

Global Wealth Management Group provides brokerage and investment advisory services 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.

 

Asset Management provides global asset management products and services in equity, fixed income, alternative investments, which includes hedge funds and funds of funds, and merchant banking, which includes real estate, private equity and infrastructure, to institutional and retail clients through proprietary and third-party distribution channels. Asset Management also engages in investment activities.

 

The Company’s results of operations for the 12 months ended November 30, 2008 (“fiscal 2008”), November 30, 2007 (“fiscal 2007”) and November 30, 2006 (“fiscal 2006”) are discussed below.

 

Financial Holding Company.

 

On September 21, 2008, the Company obtained approval from the Board of Governors of the Federal Reserve System (the “Fed”) to become a bank holding company upon the conversion of its wholly owned indirect subsidiary, Morgan Stanley Bank (Utah), from a Utah industrial bank to a national bank. On September 23, 2008, the Office of the Comptroller of the Currency (the “OCC”) authorized Morgan Stanley Bank to commence business as a national bank, operating as Morgan Stanley Bank, N.A. Concurrent with this conversion, the Company became a financial holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). For more information about the Company’s transition into a financial holding company, see “Supervision and Regulation—Financial Holding Company” in Part I, Item 1 herein.

 

Change in Fiscal Year End.

 

On December 16, 2008, the Board of Directors of the Company approved a change in the Company’s fiscal year end from November 30 to December 31 of each year. This change to the calendar year reporting cycle began January 1, 2009. As a result of the change, the Company will have a December 2008 fiscal month transition period, the results of which will be separately reported in the Company’s Quarterly Report on Form 10-Q for the calendar quarter ending March 31, 2009 and in the Company’s Annual Report on Form 10-K for the calendar year ending December 31, 2009.

 

Recent Business Developments.

 

Morgan Stanley Smith Barney Joint Venture.    On January 13, 2009, the Company and Citigroup Inc. (“Citi”) announced they had reached a definitive agreement to combine the Company’s Global Wealth Management Group and Citi’s Smith Barney in the U.S., Quilter in the U.K., and Smith Barney Australia into a new joint venture to be called Morgan Stanley Smith Barney. The Company will own 51%, and Citi will own 49% of the joint venture, after the contribution of the respective businesses to the joint venture and the Company’s payment

 

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of $2.7 billion to Citi. The Company will appoint four directors to the joint venture’s board and Citi will appoint two directors. After year three, the Company and Citi will have various purchase and sales rights for the joint venture. The transaction is expected to close in the third quarter of 2009 and is subject to regulatory approvals and other customary closing conditions.

 

Discontinued Operations.

 

On June 30, 2007, the Company completed the spin-off (the “Discover Spin-off”) of its business segment Discover Financial Services (“DFS”) to its shareholders. The results of DFS are reported as discontinued operations for all periods presented through the date of the Discover Spin-off. Fiscal 2008 included costs related to a legal settlement between DFS, VISA and MasterCard. The results of Quilter Holdings Ltd., Global Wealth Management Group’s former mass affluent business in the U.K., are also reported as discontinued operations for all periods presented through its sale on February 28, 2007. The results of the Company’s former aircraft leasing business are also reported as discontinued operations through March 24, 2006, the date of sale. See Note 19 to the consolidated financial statements.

 

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Executive Summary.

 

Financial Information.

 

     Fiscal Year  
     2008     2007     2006  

Net revenues (dollars in millions):

      

Institutional Securities

   $ 16,622     $ 16,102     $ 21,070  

Global Wealth Management Group

     7,019       6,625       5,512  

Asset Management

     1,292       5,493       3,453  

Intersegment Eliminations

     (194 )     (241 )     (236 )
                        

Consolidated net revenues

   $ 24,739     $ 27,979     $ 29,799  
                        

Income (loss) before income taxes (dollars in millions)(1):

      

Institutional Securities

   $ 2,925     $ 770     $ 7,682  

Global Wealth Management Group

     1,154       1,155       508  

Asset Management

     (1,807 )     1,467       851  

Intersegment Eliminations

     15       2       23  
                        

Consolidated income (loss) before income taxes

   $ 2,287     $ 3,394     $ 9,064  
                        

Consolidated net income (dollars in millions)

   $ 1,707     $ 3,209     $ 7,472  
                        

Earnings applicable to common shareholders (dollars in millions)(2)

   $ 1,588     $ 3,141     $ 7,453  
                        

Earnings per basic common share:

      

Income from continuing operations

   $ 1.64     $ 2.49     $ 6.25  

(Loss) gain on discontinued operations

     (0.10 )     0.64       1.13  
                        

Earnings per basic common share

   $ 1.54     $ 3.13     $ 7.38  
                        

Earnings per diluted common share:

      

Income from continuing operations

   $ 1.54     $ 2.37     $ 5.99  

(Loss) gain on discontinued operations

     (0.09 )     0.61       1.08  
                        

Earnings per diluted common share

   $ 1.45     $ 2.98     $ 7.07  
                        

Regional net revenues (dollars in millions)(3):

      

Americas

   $ 13,317     $ 12,026     $ 18,577  

Europe, Middle East and Africa

     8,971       10,085       7,948  

Asia

     2,451       5,868       3,274  
                        

Consolidated net revenues

   $ 24,739     $ 27,979     $ 29,799  
                        

Statistical Data.

      

Book value per common share(4)

   $ 30.24     $ 28.56     $ 32.67  

Average common equity (dollars in billions)(5):

      

Institutional Securities

   $ 23.3     $ 23.9     $ 18.0  

Global Wealth Management Group

     1.5       1.7       3.0  

Asset Management

     3.9       3.5       2.4  

Unallocated capital

     4.9       2.9       3.1  
                        

Total from continuing operations

     33.6       32.0       26.5  

Discontinued operations

     —         3.2       5.2  
                        

Consolidated average common equity

   $ 33.6     $ 35.2     $ 31.7  
                        

 

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     Fiscal Year  
Statistical Data (Continued).    2008     2007     2006  

Return on average common equity(5):

      

Consolidated

     5 %     9 %     23 %

Institutional Securities

     9 %     4 %     30 %

Global Wealth Management Group

     48 %     41 %     11 %

Asset Management

     N/M       26 %     21 %

Effective income tax rate from continuing operations

     21.0 %     24.5 %     30.1 %

Worldwide employees (excluding 13,186 DFS employees in 2006)

     46,964       48,746       43,124  

Average liquidity (dollars in billions)(6):

      

Parent company liquidity

   $ 69     $ 49     $ 36  

Bank and other subsidiary liquidity

     69       36       8  
                        

Total liquidity

   $ 138     $ 85     $ 44  
                        

Capital ratios at November 30, 2008(7):

      

Total capital ratio

     26.8 %    

Tier 1 capital ratio

     17.9 %    

Tier 1 leverage ratio

     6.6 %    

Consolidated assets under management or supervision by asset class (dollars in billions):

      

Equity(8)

   $ 186     $ 355     $ 307  

Fixed income(8)

     197       235       200  

Alternatives(9)

     48       67       41  

Private equity

     4       4       2  

Infrastructure

     4       2       —    

Real estate

     34       36       18  
                        

Subtotal

     473       699       568  

Unit trusts

     9       15       14  

Other(8)

     39       61       63  
                        

Total assets under management or supervision(10)

     521       775       645  

Share of minority interest assets(11)

     6       7       4  
                        

Total

   $ 527     $ 782     $ 649  
                        

Institutional Securities:

      

Mergers and acquisitions completed transactions (dollars in billions)(12):

      

Global market volume

   $ 597.2     $ 1,330.1     $ 733.5  

Market share

     23.5 %     34.9 %     25.5 %

Rank

     5       1       4  

Mergers and acquisitions announced transactions (dollars in billions)(12):

      

Global market volume

   $ 558.3     $ 1,141.3     $ 984.7  

Market share

     20.5 %     29.4 %     29.3 %

Rank

     5       2       2  

Global equity and equity-related issues (dollars in billions)(12):

      

Global market volume

   $ 51.0     $ 64.7     $ 57.2  

Market share

     9.4 %     7.4 %     8.0 %

Rank

     3       5       4  

Global debt issues (dollars in billions)(12):

      

Global market volume

   $ 182.9     $ 381.2     $ 410.1  

Market share

     4.3 %     5.6 %     5.8 %

Rank

     9       7       7  

Global initial public offerings (dollars in billions)(12):

      

Global market volume

   $ 5.0     $ 24.0     $ 22.6  

Market share

     5.9 %     7.8 %     8.4 %

Rank

     6       3       2  

Pre-tax profit margin(13)

     18 %     5 %     37 %

 

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     Fiscal Year  
Statistical Data (Continued).    2008     2007     2006  

Global Wealth Management Group:

      

Global representatives

     8,426       8,429       7,944  

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

   $ 746     $ 811     $ 651  

Client assets by segment (dollars in billions):

      

$10 million or more

   $ 152     $ 247     $ 199  

$1 million to $10 million

     197       275       243  
                        

Subtotal $1 million or more

     349       522       442  

$100,000 to $1 million

     151       179       177  

Less than $100,000

     22       23       27  
                        

Client assets excluding corporate and other accounts

     522       724       646  

Corporate and other accounts

     24       34       30  
                        

Total client assets

   $ 546     $ 758     $ 676  
                        

Fee-based assets as a percentage of total client assets(15)

     25 %     27 %     29 %

Client assets per global representative (dollars in millions)(16)

   $ 65     $ 90     $ 85  

Bank deposits (dollars in billions)(17)

   $ 36.4     $ 26.2     $ 13.3  

Pre-tax profit margin(13)

     16 %     17 %     9 %

Asset Management:

      

Assets under management or supervision (dollars in billions)(18)

   $ 399     $ 597     $ 496  

Percent of fund assets in top half of Lipper rankings(19)

     39 %     49 %     40 %

Pre-tax profit margin(13)

     N/M       27 %     25 %

 

N/M—Not Meaningful

(1) Amounts represent income (loss) from continuing operations before income taxes and cumulative effect of accounting change, net.
(2) Earnings applicable to common shareholders are used to calculate earnings per share information. Fiscal 2008 includes a preferred stock dividend of $97 million as well as $15 million for the amortization of discount on the issuance of Series D Preferred Stock and an allocation of $7 million of earnings to the Equity Units. See Notes 11 and 12 to the consolidated financial statements for more information. Fiscal 2007 and fiscal 2006 include a preferred stock dividend of $68 million and $19 million, respectively.
(3) Regional net revenues 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 location. Asset Management: client location, except for the merchant banking business, which is based on asset location.
(4) Book value per common share equals common shareholders’ equity of $31,676 million at November 30, 2008, $30,169 million at November 30, 2007 and $34,264 million at November 30, 2006, divided by common shares outstanding of 1,048 million at November 30, 2008, 1,056 million at November 30, 2007 and 1,049 million at November 30, 2006.
(5) The computation of average common equity for each business segment is based upon an economic capital framework that estimates the amount of equity capital required to support the businesses over a wide range of market environments while simultaneously satisfying regulatory, rating agency and investor requirements. The economic capital framework will evolve over time in response to changes in the business and regulatory environment and to incorporate enhancements in modeling techniques. The effective tax rates used in the computation of segment return on average common equity were determined on a separate entity basis.
(6) For a discussion of average liquidity, see “Liquidity and Capital Resources—Liquidity and Funding Management Policies—Liquidity Reserves” herein.
(7) For a discussion of capital ratios, see “Liquidity and Capital Resources—Regulatory Requirements” herein.
(8) Equity and fixed income amounts include assets under management or supervision associated with the Asset Management and Global Wealth Management Group business segments. Other amounts include assets under management or supervision associated with the Global Wealth Management Group business segment.
(9) Amounts reported for Alternatives reflect the Company’s invested equity in those funds and include a range of alternative investment products such as hedge funds, funds of hedge funds and funds of private equity funds.
(10) Revenues and expenses associated with these assets are included in the Company’s Asset Management and Global Wealth Management Group business segments.
(11) Amounts represent Asset Management’s proportional share of assets managed by entities in which it owns a minority interest.
(12) Source: Thomson Reuters, data as of January 5, 2009—The data for fiscal 2008, fiscal 2007 and fiscal 2006 are for the periods from January 1 to December 31, 2008, January 1 to December 31, 2007 and January 1 to December 31, 2006, respectively, as the industry standard is to view these data on a calendar-year basis.
(13) Percentages represent income from continuing operations before income taxes as a percentage of net revenues.
(14) Annualized net revenue per global representative amounts equal Global Wealth Management Group’s net revenues (excluding the sale of MSWM S.V., S.A.U.) divided by the quarterly average global representative headcount for the periods presented.
(15) The decline in fee-based assets as a percentage of total client assets largely reflected the termination on October 1, 2007 of the Company’s fee-based (fee in lieu of commission) brokerage program pursuant to a court decision vacating a Securities and Exchange Commission (“SEC”) rule that permitted fee-based brokerage. Client assets that were in the fee-based program primarily moved to commission-based brokerage accounts, or at the election of some clients, into other fee-based advisory programs, including Morgan Stanley Advisory, a nondiscretionary account launched in August 2007.
(16) Client assets per global representative equal total period-end client assets divided by period-end global representative headcount.
(17) Bank deposits are held at certain of the Company’s Federal Deposit Insurance Corporation (the “FDIC”) insured depository institutions for the benefit of retail clients through their accounts.
(18) Amounts include Asset Management’s proportional share of assets managed by entities in which it owns a minority interest.
(19) Source: Lipper, one-year performance excluding money market funds as of November 30, 2008, November 30, 2007 and November 30, 2006, respectively.

 

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Global Market and Economic Conditions in Fiscal 2008.

 

During fiscal 2008, a severe downturn in the economy led to price declines and a period of unprecedented volatility across various asset classes. Losses that had previously been limited largely to the subprime mortgage sector during fiscal 2007 spread to residential and commercial mortgages during fiscal 2008 as property prices declined rapidly. The effect of the economic and market downturn also spread to other areas of the credit market, including investment grade and non-investment grade corporate debt, convertible securities, emerging market debt and equity, and leveraged loans. The magnitude of these declines led to a crisis of confidence in the financial sector as a result of concerns about the capital base and viability of certain financial institutions. During this period, interbank lending and commercial paper borrowing fell sharply, precipitating a credit freeze for both institutional and individual borrowers.

 

In the U.S., credit conditions worsened considerably over the course of the year, and the U.S. entered into a recession (as announced by the National Bureau of Economic Research) and the credit crisis assumed global proportions. The landscape of the U.S. financial services industry changed dramatically, especially during the fourth quarter of fiscal 2008. Lehman Brothers Holdings Inc. (“Lehman Brothers”) declared bankruptcy, and many major U.S. financial institutions consolidated, were forced to merge or were put into conservatorship by the U.S. Federal Government, including The Bear Stearns Companies, Inc., Wachovia Corporation, WashingtonMutual, Inc., Federal Home Loan Mortgage Corporation (“Freddie Mac”) and Federal National Mortgage Association (“Fannie Mae”). In addition, the U.S. Federal Government provided a loan to American International Group Inc. (“AIG”) in exchange for an equity interest in AIG. In September 2008, following Lehman Brothers’ bankruptcy, the Company and Goldman Sachs Group, Inc. each experienced significantly wider credit spreads on their outstanding debt and sharp declines in stock market capitalization and subsequently received approval from the Fed to become bank holding companies. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (initially introduced as the Troubled Asset Relief Program or “TARP”) was enacted. On October 14, 2008, the U.S. Department of Treasury (the “U.S. Treasury”) announced its intention to inject capital into nine large U.S. financial institutions, including the Company, under the TARP Capital Purchase Program (the “CPP”) and since has injected capital into many other financial institutions. In November 2008, the U.S. Treasury, the Federal Deposit Insurance Corporation (“FDIC”) and the Fed provided additional assistance to Citi, including an additional capital injection and a government guarantee on certain troubled assets, in exchange for preferred stock as well as other corporate governance measures.

 

The U.S. unemployment rate at the end of fiscal 2008 increased to 6.7% from 4.7% at the end of fiscal 2007, reaching the highest level in the last fifteen years. In the U.S., equity market indices ended the fiscal year period significantly lower. Concerns about future economic growth, the adverse developments in the credit markets, mixed views about the U.S. Federal Government’s response to the economic crisis, including the CPP, lower levels of consumer spending, a high rate of unemployment and lower corporate earnings continued to challenge the U.S. economy and the equity markets. Adverse developments in the credit markets, including failed auctions for auction rate securities (“ARS”), rising default rates on residential mortgages, extremely high implied default rates on commercial mortgages and liquidity issues underlying short-term investment products, such as structured investment vehicles and money market funds, weighed heavily as well on equity markets. Oil prices also reached record levels during fiscal 2008 before declining sharply, partly due to lower demand and weaker economic conditions.

 

During fiscal 2008, the Fed announced a number of initiatives aimed to provide additional liquidity and stability to the financial markets, and the Fed continues to focus its efforts on mitigating the negative economic impact related to the credit markets. The Fed announced enhancements to its programs to provide additional liquidity to the asset-backed commercial paper and money markets, and the Fed has indicated that it plans to purchase from primary dealers short-term debt obligations issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. The Fed has established a commercial paper funding facility in order to provide additional liquidity to the short-term debt markets. The Fed continues to consult frequently with its global central bank counterparts and

 

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during fiscal 2008, a number of coordinated benchmark interest rate reductions were announced by central banks globally. The Fed lowered both the federal funds benchmark rate and the discount rate by 3.50% during fiscal 2008, and at fiscal year end the federal funds target rate was 1.00% and the discount rate was 1.25%. Also, during fiscal 2008, the Fed lowered the primary credit rate by 0.25%. In an additional effort to unlock credit markets, the Fed, the U.S. Treasury and the FDIC announced that the FDIC will temporarily guarantee certain senior unsecured debt issued by FDIC-insured institutions and their U.S. bank holding companies, subject to certain conditions. In December 2008, the Fed lowered both the federal funds benchmark rate and the discount rate by 0.75% to 0.25% and 0.50%, respectively, and rates remained at historically low levels.

 

In Europe, the unemployment rate rose and economic growth continued to slow during fiscal 2008 as export demand decreased, housing prices declined, consumer spending and business investment slowed, and the disruption in the global financial markets continued. In Europe, equity market indices were lower at the end of the fiscal year. Concerns about the economic outlook and difficult conditions in the credit markets continued to challenge the European economy and the equity markets. In the first three quarters of fiscal 2008, the European Central Bank (“ECB”) indicated that it remained concerned about global inflation and raised the benchmark interest rate by 0.25% to 4.25%, while the Bank of England (“BOE”) decreased the benchmark interest rate by an aggregate of 0.75% to 5.00%. In September 2008, the Lehman Brothers’ bankruptcy triggered additional credit disruptions, European governments intervened to support large financial institutions and financial services companies within Europe began to consolidate as lending conditions among European banks worsened. After September 2008, global central banks worked collaboratively to reduce interest rates. In the fourth quarter of fiscal 2008, the ECB lowered its benchmark interest rates by 1.00% to 3.25% and the BOE lowered its benchmark interest rate by 2.00% to 3.00%. In December 2008, the ECB lowered its benchmark interest rate by 0.75% to 2.50% and the BOE lowered its benchmark interest rate by 1.00% to 2.00%. In January 2009, the ECB lowered its benchmark interest rate by an additional 0.50% to 2.00%, and the BOE lowered its benchmark interest rate by an additional 0.50% to a historically low 1.50%.

 

In Asia, the global credit and financial crisis that began in the U.S. and spread throughout Europe adversely impacted the demand for Asian exports, in Japan as well as in emerging markets across Asia. The level of unemployment in Japan, which began the fiscal year at relatively low levels began to rise. Major Asian equity market indices ended fiscal 2008 lower. The Bank of Japan (“BOJ”) lowered the benchmark interest rate by 0.2% to 0.3% during fiscal 2008, and in December 2008, the BOJ reduced its benchmark interest rate by 0.2% to 0.1%. Economies elsewhere in Asia had slower growth, particularly in China and India, due to a lower level of exports, which more than offset domestic demand for capital projects and domestic consumption. Central banks across Asia that previously had relatively high benchmark interest rates, such as Australia, China and India, have all significantly lowered their benchmark interest rates, along with global central bank coordinated interest rate reductions.

 

Overview of Fiscal 2008 Financial Results.

 

The Company recorded net income of $1,707 million in fiscal 2008, a 47% decrease from $3,209 million in the prior year. Net revenues (total revenues less interest expense) decreased 12% to $24,739 million in fiscal 2008. Non-interest expenses decreased 9% to $22,452 million from the prior year, primarily due to lower compensation costs, partly offset by goodwill and intangible asset impairment charges. Compensation and benefits expense decreased 26%, primarily reflecting lower incentive-based compensation accruals due to lower net revenues in certain of the Company’s businesses. Diluted earnings per share were $1.45 compared with $2.98 a year ago. Diluted earnings per share from continuing operations were $1.54 compared with $2.37 last year. The return on average common equity in fiscal 2008 was 4.9% compared with 8.9% in the prior year. The return on average common equity from continuing operations for fiscal 2008 was 5.2% compared with 7.8% in fiscal 2007.

 

The Company’s effective income tax rate from continuing operations was 21.0% in fiscal 2008 compared with 24.5% in fiscal 2007. The decrease primarily reflected lower earnings and a change in the geographic mix of earnings, partly offset by an increase in the rate due to the goodwill impairment charges (see Note 6 to the consolidated financial statements).

 

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Institutional Securities.    Institutional Securities recorded income from continuing operations before income taxes of $2,925 million, a 280% increase from a year ago. Net revenues increased 3% to $16,622 million. The increase in net revenues reflected record equity sales and trading results, higher fixed income sales and trading results, primarily due to lower net mortgage-related losses, gains related to the repurchase of the Company’s debt, pre-tax gains related to two secondary offerings of MSCI Inc. and the widening of credit spreads on the Company’s borrowings for which the fair value option was elected, partially offset by net losses from investments in passive limited partnership interests and lower results in investment banking. Non-interest expenses decreased 11% to $13,697 million, primarily due to lower compensation costs, partially offset by higher non-compensation expenses. Non-compensation expenses increased 24%, primarily due to a charge of approximately $694 million for the impairment of goodwill and intangible assets related to certain fixed income businesses.

 

Investment banking revenues decreased 34% to $3,630 million from last year due to lower revenues from advisory fees from merger, acquisition and restructuring transactions and lower revenues from underwriting transactions. Advisory fees from merger, acquisition and restructuring transactions were $1,740 million, a decrease of 32% from fiscal 2007. Underwriting revenues decreased 37% from last year to $1,890 million. The decrease in investment banking revenues reflected the unprecedented market turmoil in fiscal 2008 that significantly reduced levels of market activity.

 

Equity sales and trading revenues increased 10% to a record $9,968 million and reflected higher net revenues from derivative products and slightly higher results in prime brokerage. Equity sales and trading also benefited by approximately $1.6 billion from the widening of the Company’s credit spreads on certain long-term and short-term borrowings accounted for at fair value. Fiscal 2008 reflected lower revenues from principal trading strategies. Fixed income sales and trading revenues were $3,862 million in fiscal 2008 from $268 million in fiscal 2007. Fiscal 2008 results reflected lower losses in mortgage loan products, record revenues from commodities and record results in foreign exchange products, partially offset by lower net revenues from the interest rate and credit businesses, reflecting the continued dislocation in the credit markets and unfavorable positioning. In addition, fixed income sales and trading benefited by approximately $3.5 billion from the widening of the Company’s credit spreads on certain long-term and short-term borrowings that are accounted for at fair value.

 

In fiscal 2008, other sales and trading losses of approximately $3,133 million reflected mark-to-market losses on loans and commitments that were partly offset by gains on related hedges. Fiscal 2008 also included losses related to mortgage-related securities portfolios in the Company’s domestic subsidiary banks. In addition, other sales and trading losses included mark-to-market gains on certain swaps previously designated as hedges of a portion of the Company’s long-term debt. These swaps were no longer considered hedges once the related debt was repurchased by the Company (i.e., the swaps were “de-designated” as hedges). During the period the swaps were hedging the debt, changes in fair value of these instruments were generally offset by adjustments to the basis of the debt being hedged.

 

Principal transaction net investment losses aggregating $2,477 million were recognized in fiscal 2008 compared with net investment gains of $1,459 million in fiscal 2007. The losses were primarily related to net realized and unrealized losses from the Company’s investments in passive limited partnership interests associated with the Company’s real estate funds and investments that benefit certain employee deferred compensation and co-investment plans, and other principal investments.

 

Global Wealth Management Group.    Global Wealth Management Group recorded income from continuing operations before income taxes of $1,154 million compared with $1,155 million in fiscal 2007. Fiscal 2008 included a pre-tax gain of $687 million related to the sale of Morgan Stanley Wealth Management S.V., S.A.U. (“MSWM S.V.”), the Spanish onshore mass affluent wealth management business (see Note 20 to the consolidated financial statements). Fiscal 2008 also included a charge of $532 million associated with the ARS repurchase program and $108 million associated with subsequent writedowns of some of these securities that have been repurchased (see Note 9 to the consolidated financial statements). Net revenues were $7,019 million, a 6% increase over a year ago, primarily related to the previously mentioned sale of MSWM S.V. and higher net interest revenues from growth in the bank deposit program. The increase in net revenues was partly offset by

 

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lower revenues from asset management, distribution and administration fees and lower investment banking revenues. The decline in asset management revenues reflected a change in the classification of sub-advisory fees due to modifications of certain customer agreements, the discontinuance of the Company’s fee-based (fee in lieu of commission) brokerage program in the fourth quarter of fiscal 2007 pursuant to a court decision vacating an SEC rule that permitted fee-based brokerage and asset depreciation. Client assets in fee-based accounts decreased 32% from a year ago to $136 billion and decreased as a percentage of total client assets to 25% from last year’s 27%. In addition, total client assets decreased to $546 billion, down 28% from the prior fiscal year-end, primarily due to asset depreciation.

 

Total non-interest expenses were $5,865 million, a 7% increase from a year ago. Compensation and benefits expense remained flat in fiscal 2008, as severance-related expenses of $41 million and investment in the business were offset by lower incentive-based compensation accruals. Non-compensation costs increased 25%, primarily due to the charge of $532 million for the ARS. In addition, fiscal 2007 included an insurance reimbursement related to a litigation matter. The increase in non-compensation costs was partly offset by a change in the classification of sub-advisory fees due to modifications of certain customer agreements. As of November 30, 2008, the number of global representatives was 8,426.

 

Asset Management.    Asset Management recorded losses before income taxes of $1,807 million in fiscal 2008 compared with income before income taxes of $1,467 million in fiscal 2007. Net revenues of $1,292 million decreased 76% from the prior year. The decrease in fiscal 2008 primarily reflected principal transaction net investment losses of $1,661 million compared with gains of $1,774 million a year ago. The losses in fiscal 2008 were primarily related to net investment losses associated with the Company’s merchant banking business, which includes the real estate, private equity and infrastructure businesses, and losses associated with certain investments for the benefit of the Company’s employee deferred compensation and co-investment plans. The decrease in fiscal 2008 was also due to lower asset management, distribution and administration fees, primarily due to lower performance fees from alternative investment products, lower distribution fees, and lower fund management and administration fees reflecting a decrease in average assets under management. Assets under management or supervision within Asset Management of $399 billion were down $198 billion, or 33%, from last year, primarily reflecting decreases in equity and fixed income products resulting from market depreciation and net outflows. Non-interest expenses decreased 23% from the prior year to $3,099 million. Compensation and benefits expense decreased primarily due to lower net revenues and losses associated with principal investments for the benefit of the Company’s employee deferred compensation and co-investment plans. The decrease in compensation expense in fiscal 2008 was partially offset by severance-related expenses of $97 million. The decrease in non-interest expenses was partly offset by an impairment charge of $243 million related to Crescent Real Estate Equities Limited Partnership (“Crescent”).

 

Strategic Initiatives.

 

The Company has launched several strategic initiatives to further improve its position in the rapidly changing market environment, including:

 

   

Targeting capital to businesses where the Company believes it will have better risk-adjusted returns, including flow trading, equity derivatives, foreign exchange, interest rates and commodities;

 

   

Engaging in a reduction of balance sheet intensive businesses within the Institutional Securities business segment, including a resizing of prime brokerage and the exit from select proprietary trading strategies;

 

   

Targeting an additional $2 billion in cost savings, including the annualized effect of the previously announced headcount reductions and additional non-compensation expense savings in 2009;

 

   

Developing a global alliance with Mitsubishi UFJ Financial Group, Inc. (“MUFG”), Japan’s largest banking group, and pursuing initiatives in corporate and investment banking, retail banking and lending activities;

 

   

Launching a Retail Banking business to build bank deposits leveraging the Company’s existing retail banking capabilities and financial holding company structure; and

 

   

Forming the largest wealth management business firm with Citi, as measured by financial advisors, through a joint venture (see “Recent Business Developments” herein).

 

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Certain Factors Affecting Results of Operations.

 

The Company’s results of operations may be materially affected by market fluctuations and by economic factors. In addition, results of operations in the past have been, and in the future may continue to be, materially affected by many factors of a global nature, including 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; the level and volatility of equity prices, 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 Company’s reputation; the actions and initiatives of current and potential competitors; and the impact of current, pending and future legislation, regulation, and technological changes in the U.S. and worldwide. Such factors also may have an impact on the Company’s ability to achieve its strategic objectives on a global basis. 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.

 

The following items significantly affected the Company’s results in fiscal 2008 and fiscal 2007.

 

Corporate Lending.    The results for fiscal 2008 included net losses of approximately $3.3 billion (consisting of negative mark-to-market valuations and losses of approximately $6.3 billion net of gains on related hedges of approximately $3.0 billion) associated with loans and lending commitments largely related to “event-driven” lending to non-investment grade companies. These losses were primarily related to the illiquid market conditions that existed during the year.

 

The results for fiscal 2007 included losses of approximately $700 million, primarily recorded in the third quarter of fiscal 2007 that reflected mark-to-market valuations associated with loans and lending commitments largely related to “event-driven” lending to non-investment grade companies. The losses included markdowns of leveraged lending commitments associated with “event-driven” lending transactions that were accepted by the borrower but not yet closed. These losses were primarily related to the illiquid market conditions that existed during the second half of fiscal 2007.

 

Mortgage-Related Trading Losses.    In fiscal 2008, the Company recorded mortgage-related losses of approximately $1.7 billion. The $1.7 billion included losses on non-subprime residential mortgages of approximately $2.6 billion, partially offset by gains on commercial mortgage-backed securities and commercial whole loan positions of approximately $800 million and gains of approximately $100 million on U.S. subprime mortgage proprietary trading exposures. See “Other Matters—Real Estate-Related Positions” herein for information relating to the Company’s mortgage-related trading exposures.

 

In the fourth quarter of fiscal 2007, the Company recorded $9.0 billion of mortgage-related writedowns resulting from an unfavorable subprime mortgage-related trading strategy and the deterioration and lack of market liquidity for subprime and other mortgage-related instruments. The writedowns included $7.8 billion related to U.S. subprime trading positions, principally super senior derivative positions in collateralized debt obligations (“CDOs”). These derivative positions were entered into primarily by the Company’s mortgage proprietary trading group. As the credit markets in general, and the mortgage markets in particular, declined dramatically in the fourth quarter, increases in the implied cumulative losses in the subprime mortgage market, coupled with the illiquid nature of the Company’s trading positions, led to a significant deterioration in value in its subprime-related trading positions. The writedowns in fiscal 2007 also included $1.2 billion related to commercial mortgage-backed securities (“CMBS”), Alt-A mortgages (a categorization that falls between prime and subprime due to certain loan characteristics) and other loans, conduit and non-performing loans and European non-conforming loans.

 

Subsidiary Banks.    The Company recorded losses of approximately $900 million in fiscal 2008 related to mortgage-related securities portfolios of Morgan Stanley Bank, N.A. and Morgan Stanley Trust (collectively, the

 

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“Subsidiary Banks”). See “Other Matters—Real Estate-Related Positions—Subsidiary Banks” herein for further information on these securities portfolios.

 

Prior to the fourth quarter of fiscal 2007, the securities in the Subsidiary Banks’ portfolios were classified as securities available for sale in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”). In the fourth quarter of fiscal 2007, the Company determined that it no longer intended to hold these securities until the fair value of the securities recovered to a level that exceeded their initial cost. Accordingly, the Company recorded an other-than-temporary impairment charge of $437 million in Principal transactions-trading revenues in the consolidated statement of income on its portfolio of securities available for sale in the fourth quarter of fiscal 2007 and reclassified the portfolios to Financial instruments owned in the consolidated statement of financial condition effective November 30, 2007.

 

Auction Rate Securities.    Under the terms of various agreements entered into with government agencies and the terms of the Company’s announced offer to repurchase, the Company agreed to repurchase at par certain ARS held by retail clients that were purchased through the Company. In addition, the Company agreed to reimburse retail clients who have sold certain ARS purchased through the Company at a loss. Fiscal 2008 reflected charges of $532 million for the ARS repurchase program and writedowns of $108 million associated with ARS held in inventory (see Note 9 to the consolidated financial statements).

 

Monoline Insurers.    Monoline insurers (“Monolines”) provide credit enhancement to capital markets transactions. Fiscal 2008 included losses of $1.7 billion related to monoline exposures. The current credit environment severely affected the capacity of such financial guarantors. 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 November 30, 2008 consisted primarily of asset-backed securities (“ABS”) bonds of approximately $700 million in the Subsidiary Banks’ portfolio that are collateralized primarily by first and second lien subprime mortgages enhanced by financial guarantees, $3.1 billion in insured municipal bond securities and approximately $500 million in net counterparty exposure (gross exposure of approximately $8.0 billion net of cumulative credit valuation adjustments of approximately $3.8 billion and net of hedges). The Company’s exposure to Monolines at November 30, 2007 consisted primarily of ABS bonds of $1.5 billion in the Subsidiary Banks’ portfolio, $1.3 billion in insured municipal bond securities and $800 million in net counterparty exposure. The Company’s hedging program for Monoline risk includes the use of both CDSs and transactions that effectively mitigate certain market risk components of existing underlying transactions with the Monolines. The increase in the Company’s exposure to Monolines from November 30, 2007 was primarily due to the ARS repurchase program as previously mentioned, as many ARS are insured by Monolines.

 

Structured Investment Vehicles.    The Company recognized losses of $470 million in fiscal 2008 compared with $129 million in fiscal 2007 related to securities issued by structured investment vehicles (“SIVs”) included in the Company’s consolidated statements of financial condition (see “Asset Management” herein).

 

Real Estate Holdings and Real Estate Investor Funds.    Principal transaction net investment revenues in fiscal 2008 included losses related to real estate holdings and investor funds. Approximately $1.2 billion and $0.9 billion of these losses were recognized in the Institutional Securities and Asset Management business segments, respectively. Losses in the Institutional Securities business segment were related to net realized and unrealized losses from the Company’s investments in passive limited partnership interests associated with the Company’s real estate funds. Losses in the Asset Management business segment included writedowns on its investment in Crescent of approximately $250 million prior to the Company consolidating its assets and liabilities in fiscal 2008. These writedowns are reflected in Principal transactions—investments in the consolidated statement of income.

 

Also, in the fourth quarter of fiscal 2008, the Company recorded an impairment charge of $243 million related to Crescent, which is reflected in Other expenses in the consolidated statement of income. See “Other Matters—Real Estate-Related Positions” herein for further information.

 

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Goodwill and Intangibles.    Fiscal 2008 included impairment charges related to goodwill and intangible assets of $725 million (see Note 6 to the consolidated financial statements). Given the future uncertainty in the performance of financial market and economic conditions, the Company will perform an interim impairment test as necessary in 2009, which could result in additional impairment charges.

 

Morgan Stanley Debt.    Net revenues benefited by approximately $5.6 billion and $840 million in fiscal 2008 and fiscal 2007, respectively, from the widening of the Company’s credit spreads on certain long-term and short-term borrowings, including structured notes and junior subordinated debentures, that are accounted for at fair value.

 

In addition, in the fourth quarter of fiscal 2008, the Company recorded gains of approximately $2.3 billion from repurchasing its debt in the open market and mark-to-market gains of approximately $1.4 billion on certain swaps previously designated as hedges of a portion of the Company’s long-term debt. These swaps were no longer considered hedges once the related debt was repurchased by the Company (i.e., the swaps were “de-designated” as hedges). During the period the swaps were hedging the debt, changes in fair value of these instruments were generally offset by adjustments to the basis of the debt being hedged.

 

Sales of Subsidiaries and Other Items.    Results for fiscal 2008 included a pre-tax gain of $1.5 billion related to the secondary offerings of MSCI Inc. and a pre-tax gain of $687 million related to the sale of MSWM S.V. (see Note 20 to the consolidated financial statements).

 

Results for fiscal 2007 included a gain of $168 million ($109 million after-tax) in discontinued operations related to the sale of Quilter Holdings Ltd. on February 28, 2007 (see Note 19 to the consolidated financial statements) and the $360 million reversal of the Coleman (Parent) Holdings Inc. (“Coleman”) litigation reserve.

 

Capital-Related Transactions.

 

During fiscal 2008, the Company entered into several capital-related transactions that increased shareholders’ equity and long-term borrowings by approximately $24.6 billion. Such transactions included the sale of equity units (the “Equity Units”) to a wholly owned subsidiary of the China Investment Corporation Ltd. (“CIC”) for approximately $5.6 billion and the issuance to MUFG of shares of Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock and shares of Series C Non-Cumulative Non-Voting Perpetual Preferred Stock for a total of $9 billion. In addition, the Company, as part of the CPP, issued to the U.S. Treasury 10,000,000 shares of Series D Fixed Rate Cumulative Perpetual Preferred Stock and Warrants to purchase 65,245,759 shares of common stock for a purchase price of $10 billion.

 

See Note 11 to the consolidated financial statements for further discussion of these capital-related transactions.

 

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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 segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations represents the effect of timing differences associated with the revenue and expense recognition of commissions paid by the Asset Management business segment to the Global Wealth Management Group business segment associated with sales of certain products and the related compensation costs paid to the Global Wealth Management Group business segment’s global representatives. Income from continuing operations before income taxes recorded in Intersegment Eliminations was $15 million, $2 million and $23 million in fiscal 2008, fiscal 2007 and fiscal 2006, respectively. Included in the results of Intersegment Eliminations for fiscal 2007 is a $25 million advisory fee related to the Discover Spin-off that was eliminated in consolidation. In addition, the results in the Institutional Securities business segment for fiscal 2006 included a $30 million advisory fee related to the Company’s sale of its former aircraft leasing business that was eliminated in consolidation.

 

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INSTITUTIONAL SECURITIES

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2008
    Fiscal
2007
    Fiscal
2006
     (dollars in millions)

Revenues:

      

Investment banking

   $ 3,630     $ 5,538     $ 4,228

Principal transactions:

      

Trading

     5,194       2,740       11,326

Investments

     (2,477 )     1,459       1,081

Commissions

     3,100       3,262       2,606

Asset management, distribution and administration fees

     142       103       73

Other

     4,630       936       404
                      

Total non-interest revenues

     14,219       14,038       19,718
                      

Interest and dividends

     39,359       59,131       42,106

Interest expense

     36,956       57,067       40,754
                      

Net interest

     2,403       2,064       1,352
                      

Net revenues

     16,622       16,102       21,070
                      

Total non-interest expenses

     13,697       15,332       13,388
                      

Income before income taxes

     2,925       770       7,682

Provision for (benefit from) income taxes

     724       (170 )     2,213
                      

Net income

   $ 2,201     $ 940     $ 5,469
                      

 

Investment Banking.    Investment banking revenues are comprised of fees from advisory services and revenues from the underwriting of securities offerings and syndication of loans. Investment banking revenues were as follows:

 

     Fiscal
2008
   Fiscal
2007
   Fiscal
2006
     (dollars in millions)

Advisory fees from merger, acquisition and restructuring transactions

   $ 1,740    $ 2,541    $ 1,753

Equity underwriting revenues

     1,045      1,570      1,059

Fixed income underwriting revenues

     845      1,427      1,416
                    

Total investment banking revenues

   $ 3,630    $ 5,538    $ 4,228
                    

 

Investment banking revenues decreased 34% in fiscal 2008, reflecting the unprecedented market turmoil in fiscal 2008 that significantly reduced levels of market activity. This contrasts to fiscal 2007, when investment banking revenues increased 31% from fiscal 2006 and reached record levels, reflecting a more favorable market environment with higher levels of advisory and capital raising activity.

 

In fiscal 2008, advisory fees from merger, acquisition and restructuring transactions were $1,740 million, a decrease of 32% from fiscal 2007. Advisory fees in fiscal 2008 reflected lower levels of activity due to the challenging market environment. In fiscal 2007, advisory fees from merger, acquisition and restructuring transactions increased 45% to a record $2,541 million, primarily reflecting a strong volume of transaction activity.

 

Equity underwriting revenues decreased 33% to $1,045 million in fiscal 2008, reflecting significantly lower levels of market activity, particularly for initial public offerings. Equity underwriting revenues increased 48% to a record $1,570 million in fiscal 2007, reflecting higher global industry-wide equity and equity-related activity.

 

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Fixed income underwriting revenues decreased 41% to $845 million in fiscal 2008 and increased 1% to $1,427 million in fiscal 2007. Fiscal 2008 revenues were impacted by significantly lower levels of market activity across most products, particularly loan syndications and securitized products. The 1% increase in fiscal 2007 was primarily due to strong revenues from underwriting investment grade corporate products, which was partially offset by declines in other debt products, primarily non-investment grade.

 

At the end of fiscal 2008, the backlog for investment banking transactions was lower across most products as compared with the end of fiscal 2007, reflecting difficult market conditions. The backlog of merger, acquisition and restructuring transactions and equity and fixed income underwriting transactions is subject to the risk that transactions may not be completed due to challenging or unforeseen economic and market conditions, adverse developments regarding one of the parties to the transaction, a failure to obtain required regulatory approval or a decision on the part of the parties involved not to pursue a transaction.

 

Sales and Trading Revenues.    Sales and trading revenues are composed of principal transaction trading revenues, commissions and net interest revenues (expenses). In assessing the profitability of its sales and trading activities, the Company views principal trading, commissions and net interest revenues (expenses) 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, 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.

 

The components of the Company’s sales and trading revenues are described below:

 

Principal Transactions–Trading.    Principal transaction 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.

 

Commissions.    Commission revenues primarily arise from agency transactions in listed and over-the-counter (“OTC”) equity securities and options.

 

Net Interest.    Interest and dividend revenues 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, reverse repurchase and repurchase agreements, trading strategies, customer activity in the Company’s prime brokerage business, and the prevailing level, term structure and volatility of interest rates. Certain reverse repurchase and 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.

 

Total sales and trading revenues increased 33% and decreased 47% in fiscal 2008 and fiscal 2007, respectively. The increase in fiscal 2008 reflected higher equity and fixed income sales and trading revenues, partially offset by higher losses in other sales and trading revenue.

 

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Sales and trading revenues can also be analyzed as follows:

 

     Fiscal
2008(1)
    Fiscal
2007(1)
    Fiscal
2006(1)
 
     (dollars in millions)  

Equity

   $ 9,968     $ 9,040     $ 6,549  

Fixed income

     3,862       268       9,023  

Other

     (3,133 )     (1,242 )     (288 )
                        

Total sales and trading revenues

   $ 10,697     $ 8,066     $ 15,284  
                        

 

(1) Amounts include Principal transactions—trading, Commissions and Net interest revenues (expenses). Other sales and trading net revenues primarily include net losses from loans and lending commitments and related hedges associated with the Company’s investment banking, corporate lending and other corporate activities. All prior-year amounts have been reclassified to conform to the current year’s presentation.

 

Equity Sales and Trading Revenues.    Equity sales and trading revenues increased 10% to a record $9,968 million in fiscal 2008 and reflected record net revenues from derivative products and slightly higher results in prime brokerage. Equity sales and trading revenues also benefited from the widening of the Company’s credit spreads on financial instruments that are accounted for at fair value, including, but not limited to, those for which the fair value option was elected pursuant to SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”) on December 1, 2006 (see Note 3 to the consolidated financial statements). Equity sales and trading revenues reflected approximately $1.6 billion due to the widening of the Company’s credit spreads during fiscal 2008 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. Revenues from derivative products reflected higher customer flows and high levels of volatility. Principal trading strategies reflected significantly lower revenues in fiscal 2008 as the Company exited select proprietary trading strategies. Although prime brokerage revenues increased in fiscal 2008, in the fourth quarter, the Company’s prime brokerage business experienced significant outflows as clients withdrew their cash balances and reallocated positions. These outflows have had a negative impact on prime brokerage’s operating results in fiscal 2008.

 

Fiscal 2008 equity sales and trading revenues also reflected unrealized losses of approximately $300 million related to changes in the fair value of net derivative contracts attributable to the widening of the counterparties’ credit default spreads. The Company also recorded unrealized gains of approximately $125 million in fiscal 2008 related to changes in the fair value of net derivative contracts attributable to the widening of the Company’s credit default swap spreads. The unrealized losses and gains do not reflect any gains or losses on related non-derivative hedging instruments.

 

Equity sales and trading revenues increased 38% to a then record $9,040 million in fiscal 2007, benefiting from international revenues. The increase was driven by higher revenues from derivative products, prime brokerage and equity cash and financing products, partially offset by trading losses in quantitative strategies resulting from unfavorable positioning. Revenues from derivative products benefited from strong customer flows. Prime brokerage generated increased revenues, reflecting continued growth in global client asset balances. Higher revenues from financing products were primarily due to higher commission revenues driven by strong market volumes. Equity sales and trading revenues also reflected approximately $390 million due to the widening of the Company’s credit spreads 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.

 

Fixed Income Sales and Trading Revenues.    Fixed income sales and trading revenues increased to $3,862 million in fiscal 2008 from $268 million in fiscal 2007. Fiscal 2008 results reflected lower losses in mortgage loan products, record revenues from commodities and record results in foreign exchange products, partially offset by lower net revenues from the interest rate and credit businesses. Interest rate, currency and credit products revenues decreased 55% in fiscal 2008. Continued dislocation in the credit markets resulted in lower net revenues from credit products including losses of $1.7 billion related to exposure to monoline insurers (see

 

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“Certain Factors Affecting Results of Operations—Monoline Insurers” herein) and unfavorable positioning, partially offset by higher revenues from foreign exchange products and strong results in interest rate products. Record results in foreign exchange products were primarily due to higher levels of customer flows and market volatility. Mortgage-related losses of approximately $1.7 billion were primarily due to a broadening decline in the residential and commercial mortgage sector. The decline in the Company’s mortgage loan product activities reflected the difficult credit market conditions in fiscal 2008. See “Other Matters—Real Estate-Related Positions” herein for further information. Commodity revenues increased 62%, primarily due to higher revenues from oil liquids and electricity and natural gas products, reflecting higher market volatility and strong customer flow. Fixed income sales and trading revenues also benefited in fiscal 2008 by approximately $3.5 billion from the widening of the Company’s credit spreads 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.

 

Fiscal 2008 fixed income sales and trading revenues reflected unrealized losses of approximately $6.6 billion related to changes in the fair value of net derivative contracts attributable to the widening of the counterparties’ credit default spreads. The Company also recorded unrealized gains of approximately $2.0 billion in fiscal 2008, related to changes in the fair value of net derivative contracts attributable to the widening of the Company’s credit default swap spreads. The unrealized losses and gains do not reflect any gains or losses on related non-derivative hedging instruments.

 

Fixed income sales and trading revenues decreased 97% to $268 million in fiscal 2007. Fiscal 2007 results reflected significant losses in credit products and lower results in commodities, partially offset by record results in interest rate and currency products. Credit product revenues decreased $9.4 billion, primarily reflecting mortgage-related writedowns of $7.8 billion, reflecting the deterioration in value of U.S. subprime trading positions, principally super senior derivative positions in CDOs entered into primarily by the Company’s mortgage proprietary trading group. Spread widening, lower liquidity and higher volatility resulted in lower origination, securitization and trading results across most credit product groups and also adversely affected the performance of the Company’s hedging strategies. The Company’s residential and commercial mortgage loan activities contributed to the significant decline in credit product revenues, reflecting the difficult market conditions, as well as continued concerns in the subprime mortgage loan sector. Interest rate, credit and currency products revenues increased 16% in fiscal 2007, reflecting higher revenues from interest rate, emerging markets and foreign exchange products. Commodity revenues decreased 33%, primarily due to lower trading results from oil liquids, electricity and natural gas products and lower revenues recognized on structured transactions. Fixed income sales and trading revenues also benefited from gains on interest rate derivatives. Fixed income sales and trading revenues also benefited in fiscal 2007 by approximately $450 million from the widening of the Company’s credit spreads 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.

 

In addition to the equity and fixed income sales and trading revenues discussed above, sales and trading revenues included other trading revenues, consisting primarily of certain activities associated with the Company’s corporate lending activities. In connection with its corporate lending activities, the Company provides to select clients loans or lending commitments (including bridge financing) that are generally classified as either “event-driven” or “relationship-driven.” “Event-driven” loans and commitments refer to activities associated with a particular event or transaction, such as to support client merger, acquisition or recapitalization transactions. “Relationship-driven” loans and lending commitments are generally made to expand business relationships with select clients. For further information about the Company’s corporate lending activities, see Item 7A, “Quantitative and Qualitative Disclosures about Market Risk—Credit Risk.” The Company’s corporate lending business intends to distribute its current positions; however, this is taking substantially longer than in the past due to market conditions. Widening credit spreads for non-investment grade loans have resulted in significant writedowns in fiscal 2008 and fiscal 2007, and further deterioration could result in additional writedowns for these loans and lending commitments in excess of hedges. The fair value measurement of loans and lending commitments takes into account certain fee income that is attributable to the contingent commitment contract.

 

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In fiscal 2008, other sales and trading losses were approximately $3.1 billion. Included in the $3.1 billion were net losses of $3.3 billion (negative mark-to-market valuations and losses of $6.3 billion, net of gains on related hedges of $3.0 billion) associated with loans and lending commitments largely related to certain “event-driven” lending to non-investment grade companies. 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. The $3.1 billion also included writedowns of securities of approximately $1.2 billion in the Company’s Subsidiary Banks. For further information, see “Other Matters—Real Estate-Related Positions—Subsidiary Banks” herein. In addition, other sales and trading losses included mark-to-market gains of approximately $1.4 billion on certain swaps previously designated as hedges of a portion of the Company’s long-term debt. These swaps were no longer considered hedges once the related debt was repurchased by the Company (i.e., the swaps were “de-designated” as hedges). During the period the swaps were hedging the debt, changes in fair value of these instruments were generally offset by adjustments to the basis of the debt being hedged.

 

In fiscal 2007, other sales and trading losses of approximately $1.2 billion primarily reflected approximately $700 million of mark-to-market valuations associated with loans and commitments largely related to “event-driven” lending to non-investment grade companies and the impairment charge related to securities in the Company’s Subsidiary Banks. The losses included markdowns of leveraged lending commitments associated with “event-driven” lending transactions that were accepted by the borrower but not yet closed. These losses were primarily related to the illiquid market conditions that existed during the second half of fiscal 2007.

 

Principal Transactions—Investments.    The Company’s investments generally are held for long-term appreciation. It is not possible to determine when the Company will realize the value of such investments since, among other factors, such investments generally are subject to significant sales restrictions. Moreover, 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.

 

Principal transaction net investment losses aggregating $2,477 million were recognized in fiscal 2008 as compared with net investment gains aggregating $1,459 million and $1,081 million in fiscal 2007 and fiscal 2006, respectively. The losses in fiscal 2008 were primarily related to net realized and unrealized losses from the Company’s investments in passive limited partnership interests associated with the Company’s real estate funds and investments that benefit certain employee deferred compensation and co-investment plans and other principal investments. The increase in fiscal 2007 was primarily related to realized and unrealized net gains associated with certain of the Company’s investments, including Grifols S.A. and Bovespa Holdings S.A., and higher revenues from the Company’s investments in passive limited partnership interests associated with the Company’s real estate funds. The increase in fiscal 2007 also reflected higher revenues primarily due to the appreciation of investments that benefit certain employee deferred compensation and co-investment plans. Fiscal 2006’s results primarily reflected net gains associated with the Company’s investments.

 

Other.    Other revenues increased 395% in fiscal 2008 and 132% in fiscal 2007. The increase in fiscal 2008 reflected revenues related to Institutional Securities’ share (approximately $2.1 billion) of the Company’s repurchase of debt (see “Certain Factors Affecting Results of Operations—Morgan Stanley Debt” herein for further discussion) and two secondary offerings of MSCI Inc. totaling approximately $1.5 billion (see Note 20 to the consolidated financial statements). Fiscal 2008 also included a gain associated with the sale of a controlling interest in a previously consolidated commodities subsidiary. The increase in fiscal 2007 was primarily attributable to revenues related to the operation of pipelines, terminals and barges and higher sales of benchmark indices and portfolio risk performance analytic products.

 

Non-Interest Expenses.    Non-interest expenses decreased 11% in fiscal 2008, primarily due to lower compensation expense. Compensation and benefits expense decreased 28%, primarily reflecting lower incentive-based compensation accruals due to a challenging market environment, partially offset by severance-related expenses of $653 million in fiscal 2008. Excluding compensation and benefits expense, non-interest expenses increased 24%. Fiscal 2008 results included a charge of approximately $694 million for the impairment of goodwill and intangible assets related to certain fixed income businesses (see Note 6 to the consolidated financial

 

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statements), and fiscal 2007’s results included a reversal of the $360 million legal accrual related to the Company’s favorable outcome from the Coleman litigation. Occupancy and equipment expense increased 27%, primarily due to higher depreciation expense on property and equipment and higher costs associated with exiting certain property lease agreements. Information processing and communications expense increased 5% in fiscal 2008, primarily due to higher data processing costs and market data. Marketing and business development expense decreased 7%, primarily due to lower levels of business activity. Other expenses increased 141%, reflecting the previously mentioned charge of approximately $694 million for the impairment of goodwill and intangible assets and the legal reversal of $360 million in fiscal 2007 as previously mentioned, partially offset by lower minority interest.

 

Non-interest expenses increased 15% in fiscal 2007. Compensation and benefits expense increased 10%, primarily reflecting higher incentive-based compensation accruals for certain businesses. The increase also reflected higher costs associated with certain employee deferred compensation plans, partially offset by Institutional Securities’ share ($190 million) of the incremental compensation expense related to equity awards to retirement-eligible employees in the first quarter of fiscal 2006 (see Note 2 to the consolidated financial statements). Excluding compensation and benefits expense, non-interest expenses increased 24%, reflecting increased levels of business activity and expenses associated with acquired businesses. Occupancy and equipment expense increased 33%, primarily due to higher rent and occupancy costs in Europe, Asia and the U.S. Brokerage, clearing and exchange fees increased 30%, primarily reflecting substantially increased equity and fixed income trading activity. Marketing and business development expense increased 27%, primarily due to a higher level of business activity. Professional services expense increased 6%, primarily due to higher legal and consulting costs related to increased business activity. Other expenses increased 51%, reflecting costs associated with the subsidiaries acquired in September and December 2006, partially offset by lower net litigation accruals. Fiscal 2007 results included a reversal of the $360 million legal accrual related to the Company’s favorable outcome from the Coleman litigation. Fiscal 2006 included legal accruals related to the pending settlement of General American litigation, which was partially offset by a favorable outcome related to the LVMH litigation.

 

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GLOBAL WEALTH MANAGEMENT GROUP

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2008
    Fiscal
2007
   Fiscal
2006
     (dollars in millions)

Revenues:

       

Investment banking

   $ 427     $ 625    $ 428

Principal transactions:

       

Trading

     613       598      487

Investments

     (54 )     29      57

Commissions

     1,408       1,433      1,168

Asset management, distribution and administration fees

     2,726       3,067      2,757

Other

     965       163      130
                     

Total non-interest revenues

     6,085       5,915      5,027
                     

Interest and dividends

     1,239       1,221      1,004

Interest expense

     305       511      519
                     

Net interest

     934       710      485
                     

Net revenues

     7,019       6,625      5,512
                     

Total non-interest expenses

     5,865       5,470      5,004
                     

Income from continuing operations before income taxes

     1,154       1,155      508

Provision for income taxes

     440       459      167
                     

Income from continuing operations

   $ 714     $ 696    $ 341
                     

 

Investment Banking.    Global Wealth Management Group investment banking includes revenues from the distribution of equity and fixed income securities, including initial public offerings, secondary offerings, closed-end funds and unit trusts, which are generally earned from offerings underwritten by the Institutional Securities business segment. Investment banking revenues decreased 32% in fiscal 2008, primarily due to lower underwriting activity across equity and unit trust products, partially offset by an increase in fixed income underwriting activity. Investment banking revenues increased 46% in fiscal 2007, primarily due to strong underwriting activity across equity, fixed income and unit trust products.

 

Principal Transactions—Trading.    Principal transactions 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 inventory positions held, primarily to facilitate customer transactions. Principal transaction trading revenues increased 3% in fiscal 2008, primarily due to higher revenues from municipal, corporate and government fixed income securities, partially offset by $108 million in writedowns on $3.8 billion of ARS repurchased from clients and held on the Company’s consolidated statement of financial condition and losses associated with investments that benefit certain employee deferred compensation plans. In fiscal 2007, principal transaction trading revenues increased 23%, primarily due to higher revenues from derivative products, municipal and corporate fixed income securities, and foreign exchange products and higher revenues associated with investments that benefit certain employee deferred compensation plans.

 

Principal Transactions—Investments.    Principal transaction net investment losses were $54 million in fiscal 2008 compared with net investment gains of $29 million and $57 million in fiscal 2007 and fiscal 2006, respectively. The results in fiscal 2008 reflected net losses associated with investments that benefit certain employee deferred compensation plans. The results in fiscal 2007 reflected lower net gains from certain of the Company’s investments in exchanges and memberships compared with fiscal 2006.

 

Commissions.    Commission revenues primarily arise from agency transactions in listed and OTC equity securities and sales of mutual funds, futures, insurance products and options. Commission revenues decreased 2% in fiscal 2008, reflecting lower client activity. Commission revenues increased 23% in fiscal 2007, reflecting higher client activity.

 

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Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees include revenues from individual investors electing a fee-based pricing arrangement and fees for investment management, account services and administration. The Company also receives shareholder servicing fees and fees for services it provides in distributing certain open-ended mutual funds and other products. Mutual fund distribution fees are based on either the average daily fund net asset balances or average daily aggregate net fund sales and are affected by changes in the overall level and mix of assets under management or supervision.

 

Asset management, distribution and administration fees decreased 11% in fiscal 2008 compared with an 11% increase in fiscal 2007. In fiscal 2008, the decrease was driven by a change in the classification of sub-advisory fees due to modifications of certain customer agreements, the discontinuance of the Company’s fee-based brokerage program in the fourth quarter of fiscal 2007 and asset depreciation. In fiscal 2007, the increase was primarily due to higher client asset balances in fee-based accounts. Client assets in fee-based accounts decreased 32% to $136 billion as of November 30, 2008 and represented 25% of total client assets versus 27% at November 30, 2007. Client assets in fee-based accounts rose 3% to $201 billion at November 30, 2007 and represented 27% of total client assets versus 29% at November 30, 2006.

 

Total client asset balances decreased to $546 billion as of November 30, 2008 from $758 billion as of November 30, 2007, primarily due to asset depreciation. Client asset balances in households greater than $1 million decreased to $349 billion as of November 30, 2008 from $522 billion at November 30, 2007 and $442 billion at November 30, 2006.

 

Net Interest.    Interest and dividend revenues and interest expense are a function of the level and mix of total assets and liabilities, including customer bank deposits and margin loans and securities borrowed and securities loaned transactions. Net interest revenues increased 32% and 46% in fiscal 2008 and fiscal 2007, respectively. The increase in both periods was primarily due to increased customer account balances in the bank deposit program. Balances in the bank deposit program rose to $36.4 billion as of November 30, 2008 from $26.2 billion at November 30, 2007.

 

Other.    Other revenues primarily include customer account service fees and other miscellaneous revenues. Other revenues were $965 million and $163 million in fiscal 2008 and fiscal 2007, respectively. Fiscal 2008 included $743 million related to the sale of MSWM S.V., the Spanish onshore mass affluent wealth management business, during the second quarter of fiscal 2008 (see Note 20 to the consolidated financial statements) and Global Wealth Management Group’s share ($43 million) of the Company’s repurchase of debt (see “Certain Factors Affecting Results of Operations—Morgan Stanley Debt” herein for further discussion). Fiscal 2007 reflected higher service fees and higher other miscellaneous revenues.

 

Non-Interest Expenses.    Non-interest expenses increased 7% in fiscal 2008, primarily reflecting the charge of $532 million for the ARS repurchase program (see Note 9 to the consolidated financial statements). Compensation and benefits expense remained flat in fiscal 2008, as severance-related expenses of $41 million and investment in the business were offset by lower incentive-based compensation accruals. Excluding compensation and benefits expense, non-interest expenses increased 25%. Occupancy and equipment expense increased 8%, primarily due to an increase in space costs and branch renovations. Professional services expense decreased 40%, primarily due to the change in the classification of sub-advisory fees due to modifications of certain customer agreements and lower legal costs. Other expenses increased 206%, primarily resulting from the charge of $532 million related to ARS as previously mentioned and higher litigation costs.

 

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Non-interest expenses increased 9% in fiscal 2007, primarily reflecting an increase in compensation and benefits expense, partially offset by lower non-compensation expenses, primarily due to lower charges for legal and regulatory matters and continued cost discipline across the business. Compensation and benefits expense increased 15%, primarily reflecting higher incentive-based compensation accruals due to higher net revenues and investments in the business, partially offset by Global Wealth Management Group’s share ($50 million) of the incremental compensation expense related to equity awards to retirement-eligible employees in the first quarter of fiscal 2006 (see Note 2 to the consolidated financial statements). Excluding compensation and benefits expense, non-interest expenses decreased 2%. Occupancy and equipment expense increased 6%, primarily due to leasehold improvements and higher rental costs. Information processing and communications expense decreased 8%, primarily due to lower computing costs. Marketing and business development expense increased 39%, primarily due to costs associated with the Company’s advertising campaign. Other expenses decreased 20%, primarily resulting from a reduction in costs associated with legal and regulatory matters, which included an insurance reimbursement related to a litigation matter.

 

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ASSET MANAGEMENT

 

INCOME STATEMENT INFORMATION

 

     Fiscal
2008
    Fiscal
2007
    Fiscal
2006
     (dollars in millions)

Revenues:

      

Investment banking

   $ 61     $ 264     $ 138

Principal transactions:

      

Trading

     (346 )     (129 )     —  

Investments

     (1,661 )     1,774       669

Commissions

     14       23       25

Asset management, distribution and administration fees

     2,960       3,524       2,574

Other

     463       75       26
                      

Total non-interest revenues

     1,491       5,531       3,432
                      

Interest and dividends

     170       74       48

Interest expense

     369       112       27
                      

Net interest

     (199 )     (38 )     21
                      

Net revenues

     1,292       5,493       3,453
                      

Total non-interest expenses

     3,099       4,026       2,602
                      

(Loss) income before income taxes

     (1,807 )     1,467       851

(Benefit from) provision for income taxes

     (690 )     541       340
                      

Net income (loss)

   $ (1,117 )   $ 926     $ 511
                      

 

Investment Banking.    Asset Management generates investment banking revenues primarily from the placement of investments in real estate funds and the underwriting of unit trust products. Investment banking revenues decreased 77% in fiscal 2008 and increased 91% in fiscal 2007. The decrease in fiscal 2008 primarily reflected lower revenues from real estate products. The increase in fiscal 2007 primarily reflected higher revenues from certain real estate products.

 

Principal Transactions—Trading.    In fiscal 2008, the Company recognized losses of $346 million, which included $470 million related to securities issued by SIVs included in the Company’s consolidated statements of financial condition. These losses were partially offset by net gains from hedges on certain investments. In fiscal 2007, the Company recognized losses of $129 million related to SIVs.

 

SIVs are unconsolidated entities that issue various capital notes and debt instruments to fund the purchase of assets. While the Company does not sponsor or serve as asset manager to any unconsolidated SIVs, the Company does serve as investment advisor to certain unconsolidated money market funds (“Funds”) that have investments in securities issued by SIVs. In the second half of fiscal 2007, widespread illiquidity in the commercial paper market led to market value declines and rating agency downgrades of many securities issued by SIVs, some of which were held by the Funds. As a result, the Company purchased at amortized cost approximately $900 million of such securities from the Funds during fiscal 2007 and $217 million of such securities during fiscal 2008. The carrying value of the purchased securities still held by the Company as of November 30, 2008 was $209 million. Such positions are reflected at fair value and are presented in Financial instruments owned—Corporate and other debt in the consolidated statements of financial condition. The Funds had investments in securities issued by SIVs of an aggregate face value of approximately $100 million as of November 30, 2008 compared with $8.2 billion as of November 30, 2007. Subsequent to November 30, 2008, the Company has not purchased additional SIV securities from the Funds and the Funds no longer have investments in such securities. The Company has no obligation to purchase any additional securities from the Funds in the future.

 

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During fiscal 2008, money market and liquidity funds advised by the Company’s asset management affiliates that invest primarily in corporate obligations experienced net outflows of $18 billion. Credit and liquidity conditions deteriorated in the fourth quarter of fiscal 2008, resulting in material redemptions from corporate money market and liquidity funds. The Company purchased approximately $25 billion of securities from the funds during fiscal 2008. Most of the securities have matured or were sold by the Company. At November 30, 2008, $600 million were included in the Company’s consolidated statement of financial condition. The securities were purchased by the Company to fund investor redemptions amid illiquid trading markets for a wide range of money market instruments. Securities purchased included commercial paper, municipals, certificates of deposit and notes. All of the securities were short term in nature and were rated A1/P1 or better. These purchases were funded primarily through various available stabilization facilities.

 

The Company does not consolidate these money market and liquidity funds because the Company does not have a controlling financial interest in the funds nor is it the primary beneficiary of such funds. The Company also does not have a significant variable interest in such funds.

 

Principal Transactions—Investments.    Asset Management principal transaction investment revenues consist primarily of gains and losses on the Company’s investments.

 

Principal transaction net investment losses aggregating $1,661 million were recognized in fiscal 2008 as compared with gains of $1,774 million in fiscal 2007. The results in fiscal 2008 were primarily related to net investment losses associated with the Company’s merchant banking business, including real estate and private equity investments, and losses associated with certain investments for the benefit of the Company’s employee deferred compensation and co-investment plans. Included in the net investment losses in fiscal 2008 were writedowns of approximately $250 million on Crescent prior to its consolidation. See “Other Matters—Real Estate-Related Positions—Real Estate Investor Funds” herein for further discussion. The results in fiscal 2007 were primarily driven by investments associated with the Company’s real estate products and private equity portfolio, including employee deferred compensation plans and co-investment plans.

 

Real estate and private equity investments generally are held for long-term appreciation. It is not possible to determine when the Company will realize the value of such investments since, among other factors, such investments generally are subject to significant sales restrictions. Moreover, estimates of the fair value of the investments 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.

 

Asset Management, Distribution and Administration Fees.    Asset Management, distribution and administration fees include revenues generated from the management and supervision of assets, performance-based fees relating to certain funds, and separately managed accounts and fees relating to the distribution of certain open-ended mutual funds. Asset Management fees arise from investment management services the Company provides to investment vehicles pursuant to various contractual arrangements. The Company receives fees primarily based upon mutual fund daily average net assets or based on monthly or quarterly invested equity for other vehicles. Performance-based fees are earned on certain funds as a percentage of appreciation earned by those funds and, in certain cases, are based upon the achievement of performance criteria. These fees are normally earned annually and are recognized on a monthly or quarterly basis.

 

Asset management, distribution and administration fees decreased 16% in fiscal 2008 compared with an increase of 37% in fiscal 2007. The decrease in fiscal 2008 was primarily due to lower performance fees from alternative investment products, lower distribution fees, and lower fund management and administration fees, reflecting a decrease in average assets under management. Fiscal 2008 also reflected lower shareholder servicing fees related to the modification of certain sub-transfer agent agreements, which resulted in an offsetting reduction to professional services expense. The increase in fiscal 2007 was due to higher fund management and administration fees resulting from an increase in assets under management and a more favorable asset mix. The increase was also due to higher performance fees from the alternatives business.

 

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Asset Management’s year-end and average assets under management or supervision were as follows:

 

     At November 30,    Average for
     2008    2007(1)    2006(1)    Fiscal
2008
   Fiscal
2007(1)
   Fiscal
2006(1)
     (dollars in billions)

Assets under management or supervision by distribution channel:

                 

Morgan Stanley Retail and Intermediary

   $ 46    $ 81    $ 74    $ 70    $ 79    $ 71

Van Kampen Retail and Intermediary

     84      150      142      127      149      133

Retail money markets

     30      31      35      33      33      39
                                         

Total Americas Retail

     160      262      251      230      261      243

U.S. Institutional

     90      128      100      118      116      98

Institutional money markets

     52      68      49      74      57      38

Non-U.S.  

     91      132      92      120      111      81
                                         

Total assets under management or supervision

     393      590      492      542      545      460

Share of minority interest assets(2)

     6      7      4      7      6      1
                                         

Total

   $ 399    $ 597    $ 496    $ 549    $ 551    $ 461
                                         

Assets under management or supervision by asset class:

                 

Equity

   $ 135    $ 265    $ 240    $ 215    $ 256    $ 230

Fixed income

     159      201      177      204      187      167

Alternatives(3)

     48      67      41      67      58      34

Unit trust

     9      15      14      13      15      13
                                         

Total core asset management

     351      548      472      499      516      444
                                         

Private equity

     4      4      2      3      2      2

Infrastructure

     4      2      —        3      1      —  

Real estate

     34      36      18      37      26      14
                                         

Total merchant banking

     42      42      20      43      29      16
                                         

Total assets under management or supervision

     393      590      492      542      545      460

Share of minority interest assets(2)

     6      7      4      7      6      1
                                         

Total

   $ 399    $ 597    $ 496    $ 549    $ 551    $ 461
                                         

 

(1) Prior period information has been reclassified to conform to the current period’s presentation.
(2) Amounts represent Asset Management’s proportional share of assets managed by entities in which it owns a minority interest.
(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.

 

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Activity in Asset Management’s assets under management or supervision during fiscal 2008 and fiscal 2007 were as follows:

 

     Fiscal
2008
    Fiscal
2007(1)
 
     (dollars in billions)  

Balance at beginning of period

   $ 597     $ 496  

Net flows by distribution channel:

    

Morgan Stanley Retail and Intermediary

     (12 )     (1 )

Van Kampen Retail and Intermediary

     (14 )     1  

Retail money markets

     (3 )     (5 )
                

Total Americas Retail

     (29 )     (5 )

U.S. Institutional

     (7 )     3  

Institutional money markets

     (15 )     15  

Non-U.S.  

     (2 )     22  
                

Total net flows

     (53 )     35  

Net market (depreciation)/appreciation

     (145 )     56  
                

Total net increase (decrease)/increase

     (198 )     91  

Acquisitions

     1       7  

Net (decrease) increase in share of minority interest assets(2)

     (1 )     3  
                

Balance at end of period

   $ 399     $ 597  
                

 

(1) Prior period information has been reclassified to conform to the current period’s presentation.
(2) Amount represents Asset Management’s proportional share of assets managed by entities in which it owns a minority interest.

 

Net flows in fiscal 2008 were primarily associated with negative outflows from Van Kampen and Morgan Stanley Retail and Intermediary products and institutional money markets.

 

Other.    Other revenues increased 517% in fiscal 2008, primarily due to the revenues associated with Crescent. See “Real Estate-Related Positions—Real Estate Investor Funds—Crescent” herein for further discussion. The increase in fiscal 2008 also included Asset Management’s share ($74 million) of the Company’s repurchase of debt (see “Certain Factors Affecting Results of Operations—Morgan Stanley Debt” herein for further discussion) and higher revenues associated with Lansdowne Partners (“Lansdowne”), a London-based investment manager in which the Company has a minority interest. Other revenues increased 188% in fiscal 2007, primarily due to revenues associated with Lansdowne and Avenue Capital Group, a New York-based investment manager, which the Company acquired minority stakes in the fourth quarter of fiscal 2006.

 

Non-Interest Expenses.    Non-interest expenses decreased 23% in fiscal 2008, primarily reflecting a decrease in compensation and benefits expense, partially offset by higher operating costs and an impairment charge of $243 million associated with Crescent. Compensation and benefits expense decreased 53% in fiscal 2008, primarily due to a decrease in compensation costs reflecting lower net revenues and losses associated with principal investments for the benefit of the Company’s employee deferred compensation and co-investment plans. The decrease in fiscal 2008 was partially offset by severance-related expenses of $97 million. Excluding compensation and benefits expense, non-interest expenses increased 27%. Occupancy and equipment expense increased 16%, primarily due to higher costs related to increased occupancy usage compared with fiscal 2007. Brokerage, clearing and exchange fees decreased 9%, primarily due to lower commission expenses. Professional services expense decreased 20%, primarily due to lower sub-advisory fees and sub-transfer agent fees, partially offset by an increase in consulting and legal fees. Other expenses increased 412%, primarily due to Crescent operating costs and impairment charges of $268 million, including the $243 million noted above.

 

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Non-interest expenses increased 55% in fiscal 2007, primarily reflecting an increase in compensation and benefits expense. Compensation and benefits expense increased 81% in fiscal 2007, primarily reflecting higher incentive-based compensation accruals due to higher net revenues. The increase in fiscal 2007 was also due to expenses associated with certain employee deferred compensation plans, partially offset by Asset Management’s share ($20 million) of the incremental compensation expense related to equity awards to retirement-eligible employees that was recorded in the first quarter of fiscal 2006 (see Note 2 to the consolidated financial statements). Excluding compensation and benefits expense, non-interest expenses increased 24%. Occupancy and equipment expense increased 29%, primarily due to higher rental costs associated with business growth. Brokerage, clearing and exchange fees increased 10%, primarily due to increased fee sharing, increased assets under management and higher commission expenses associated with the launching of new products. These increases were offset by a decrease in the deferred commission amortization. Information processing and communications expense increased 21%, primarily due to higher licensing fees associated with the acquisition of FrontPoint Partners (“FrontPoint”). Professional services expense increased 47%, primarily due to higher sub-advisory fees related to the acquisition of FrontPoint. Other expenses increased 47%, primarily due to an insurance reimbursement received in fiscal 2006 related to certain legal matters and an increase in other miscellaneous expenses.

 

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Other Matters.

 

The following matters are discussed in the Company’s notes to the consolidated financial statements. For further information on these matters, please see the applicable note:

 

     Note

Accounting Developments:

  

Accounting for Uncertainty in Income Taxes

   2

Employee Benefit Plans

   2

Offsetting of Amounts Related to Certain Contracts

   2

Dividends on Share-Based Payment Awards

   2

Business Combinations

   2

Noncontrolling Interests

   2

Transfers of Financial Assets and Repurchase Financing Transactions

   2

Disclosures about Derivative Instruments and Hedging Activities

   2

Determination of the Useful Life of Intangible Assets

   2

Earnings Per Share

   2

Instruments Indexed to an Entity’s Own Stock

   2

Fair Value Measurements

   2

Transfers of Financial Assets and Extinguishment of Liabilities and Consolidation of Variable Interest Entities

   2

Disclosures about Postretirement Benefit Plan Assets

   2

Disclosures about Transfers of Financial Assets and Interests in Variable Interest Entities

   2

Income Taxes

   17

Discontinued Operations

   19

Business Acquisitions and Dispositions and Sale of Minority Interest

   20

 

Real Estate-Related Positions.

 

Overview.    The Company has real estate exposure(1) to:

 

   

non-subprime residential mortgages, a category which includes prime, Alt-A, European and Asian residential mortgage loans, residential mortgage-backed securities bonds (“RMBS”) and derivatives referencing such mortgages or mortgage-backed securities;

 

   

commercial whole loans, commercial mortgage-backed securities (“CMBS”) and related derivatives;

 

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U.S. subprime mortgage-related trading positions consisting of U.S. asset-backed securities (“ABS”), collateralized debt obligation (“CDO”) securities, investments in subprime loans and derivatives referencing subprime mortgages or subprime mortgage-backed securities; and

 

   

real estate properties and real estate investor funds.

 

(1) Subprime mortgages are loans secured by real property made to a borrower (or borrowers) with a diminished or impaired credit rating or with a limited credit history. A borrower’s credit history is reflected in his credit report and routinely converted into a numerical credit score often referred to as a Fair Isaac Corporation (or “FICO”) score. Generally, a loan made to a borrower with a low FICO score or other credit score has historically been considered subprime. Loans to borrowers with higher FICO scores are typically considered prime or A1t-A, but may be subprime if the loan exhibits other high-risk factors.

 

     The Company exposures include interests in and derivatives with CDOs. CDOs provide credit risk exposure to a portfolio of securities (“cash CDOs”) or a reference portfolio of securities (“synthetic CDOs”). The underlying or reference portfolios may consist of ABS, RMBS, CMBS or other securities. The CDOs to which the Company has exposure were primarily structured and underwritten by third parties, although the Company also structured and underwrote CDOs for which it received structuring and/or distribution fees, and from time to time retained interests in such CDOs.

 

The Company’s interests in mortgage-related positions are carried at fair value with changes recognized in earnings. The valuation methodology used for these instruments incorporates a variety of inputs, including prices observed from the execution of a limited number of trades in the marketplace; ABX, CMBX and similar indices that track the performance of a series of credit default swaps based on subprime residential or commercial mortgages; and other market information, including data on remittances received and updated cumulative loss data on the underlying mortgages. The fair value of such positions experienced significant declines in the second half of fiscal 2007 and throughout fiscal 2008 as a result of a deterioration of value in the benchmark instruments as well as market developments. The value of these positions remains subject to mark-to-market volatility. See Note 2 to the consolidated financial statements for a description regarding valuation of these instruments.

 

The Company’s non-subprime residential, commercial and U.S. subprime mortgage-related exposures have each been reduced in fiscal 2008 through writedowns, sales, paydowns, and hedging and trading activities, whereby the Company purchased protection including credit default, index and total rate-of-return swap positions.

 

The Company continues to monitor its real estate-related and lending-related positions in order to manage its exposures to these markets and businesses. As market conditions continue to evolve, the fair value of these positions could further deteriorate.

 

The following tables provide a summary of the Company’s non-subprime residential, commercial and U.S. subprime mortgage-related exposures (excluding amounts related to mortgage-related securities portfolios in the Company’s Subsidiary Banks) as of and for the fiscal years ended November 30, 2008 and 2007, as well as the Company’s Net Exposure. The Company utilizes various methods of evaluating risk in its trading and other portfolios, including monitoring its Net Exposure. Net Exposure is defined as potential loss to the Company over a period of time in an event of 100% default of the referenced loan, assuming zero recovery. Positive net exposure amounts indicate potential loss (long position) in a default scenario. Negative net exposure amounts indicate potential gain (short position) in a default scenario. Net Exposure does not take into consideration the risk of counterparty default such that actual losses could exceed the amount of Net Exposure. See “Quantitative and Qualitative Disclosures about Market Risk—Credit Risk” in Part II, Item 7A herein for a further description of how credit risk is monitored. For a further discussion of the Company’s risk management policies and procedures see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A herein.

 

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Non-subprime Residential Mortgage-Related Exposures.

 

    Statement of
Financial
Condition
November 30,
2008(1)
  Statement of
Financial
Condition
November 30,
2007(1)
  Profit and
(Loss)

Fiscal Year
Ended
November 30,
2008
    Profit and
(Loss)
Fiscal Year
Ended
November 30,
2007
    Net
Exposure
November 30,
2008
    Net
Exposure
November 30,
2007
 
    (dollars in billions)  

Residential loans(2)

  $ 3.3   $ 4.0   $ (0.2 )   $ (0.8 )   $ 3.3     $ 4.0  

RMBS bonds(2)

    2.0     8.7     (2.2 )     (0.4 )     2.0       8.7  

RMBS-backed warehouse lines

    0.1     0.1     —         —         0.1       0.1  

RMBS swaps(3)

    —       0.1     (0.2 )     —         (0.3 )     (1.9 )

Other secured financings(4)

    2.6     3.6     —         —         —         —    
                                           

Total residential non-subprime(5)

  $ 8.0   $ 16.5   $ (2.6 )   $ (1.2 )   $ 5.1     $ 10.9  
                                           

 

(1) Statement of financial condition amounts are presented on a net asset/liability basis and do not take into account any netting of cash collateral against these positions. As of November 30, 2008, the $8.0 billion is reflected in the Company’s consolidated statement of financial condition as follows: Financial instruments owned of $8.3 billion and Financial instruments sold, not yet purchased of $0.3 billion. As of November 30, 2007, the $16.5 billion is reflected in the Company’s consolidated statement of financial condition as Financial instruments owned of $16.5 billion.
(2) At November 30, 2008, gross and net exposure on non-subprime residential loans and bonds was split 53% Alt-A/near prime and 47% prime underlying collateral. Gross and net exposure of U.S. Alt-A residential loans and bonds was $1.6 billion at November 30, 2008.
(3) Amounts represent both hedges and directional positioning. At November 30, 2008, these positions included credit default and super senior CDO swaps.
(4) Amounts represent assets recorded under certain provisions of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS No. 140”), and Financial Accounting Standards Board (“FASB”) Interpretation No. 46, as revised (“FIN 46R”), “Consolidation of Variable Interest Entities,” that function as collateral for an offsetting amount of non-recourse debt to third parties. Any retained interests in these transactions are reflected in RMBS bonds.
(5) Regional distribution of Net Exposure was 49% U.S., 39% Europe and 12% Asia at November 30, 2008.

 

Commercial Mortgage-Related Exposures.

 

    Statement of
Financial
Condition
November 30,
2008(1)
  Statement of
Financial
Condition
November 30,
2007(1)
  Profit and
(Loss)
Fiscal Year
Ended
November 30,
2008
    Profit and
(Loss)
Fiscal Year
Ended
November 30,
2007
    Net
Exposure
November 30,
2008
    Net
Exposure
November 30,
2007
 
    (dollars in billions)  

CMBS bonds

  $ 3.5   $ 10.0   $ (1.7 )   $ (0.5 )   $ 3.5     $ 10.0  

CMBS-backed warehouse lines(2)

    1.2     1.1     —               1.2       1.8  

Commercial loans(2)(3)

    4.0     12.4     (0.5 )     0.2       4.3       13.9  

CMBS swaps(4)

    5.1     1.0     3.0       0.9       (6.1 )     (8.2 )

Other secured financings(5)

    3.2     7.0     —               —         —    
                                           

Total CMBS/Commercial whole loan exposure(6)

  $ 17.0   $ 31.5   $ 0.8     $ 0.6     $ 2.9     $ 17.5  
                                           

 

(1) Statement of financial condition amounts are presented on a net asset/liability basis and do not take into account any netting of cash collateral against these positions. As of November 30, 2008, the $17.0 billion is reflected in the Company’s consolidated statement of financial condition as follows: Financial instruments owned of $24.1 billion and Financial instruments sold, not yet purchased of $7.1 billion. As of November 30, 2007, the $31.5 billion is reflected in the Company’s consolidated statement of financial condition as follows: Financial instruments owned of $33.2 billion and Financial instruments sold, not yet purchased of $1.7 billion.
(2) Amounts include unfunded lending commitments.
(3) Composition of commercial loans was 68% senior and 32% mezzanine at November 30, 2008.
(4) Amounts represent both hedges and directional positioning. At November 30, 2008, amounts include credit default, super senior CDOs, index and total rate-of-return swaps.
(5) Amounts represent assets recorded under certain provisions of SFAS No. 140 and FIN 46R that function as collateral for an offsetting amount of non-recourse debt to third parties. Any retained interests in these transactions are reflected in CMBS bonds.
(6) Regional distribution of Net Exposure of the long positions (i.e., CMBS bonds, commercial loans and warehouse lines) was 62% U.S., 17% Europe and 21% Asia at November 30, 2008.

 

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U.S. Subprime Mortgage-Related Exposures.

 

    Statement of
Financial
Condition
November 30,
2008(1)
    Statement of
Financial
Condition
November 30,
2007(1)
    Profit and
(Loss)
Fiscal Year
Ended
November 30,
2008
    Profit and
(Loss)
Fiscal Year
Ended
November 30,
2007
    Net
Exposure
November 30,
2008
    Net
Exposure
November 30,
2007
 
    (dollars in billions)  

Super Senior Derivative Exposure:

           

Mezzanine

  $ (3.3 )   $ (8.7 )   $ (1.6 )   $ (9.3 )   $ —       $ 3.9  

CDO squared(2)

    —         (0.1 )     —         (0.1 )     —         0.1  
                                               

Total ABS CDO super senior derivative exposure

  $ (3.3 )   $ (8.8 )   $ (1.6 )   $ (9.4 )   $ —       $ 4.0  
                                               

Other CDO Exposure:

           

ABS CDO CDS

  $ 1.3     $ 2.7     $ 0.8     $ 2.3     $ (0.2 )   $ (1.5 )

ABS CDO bonds

    0.1       1.1       (0.3 )     (0.8 )     0.1       1.1  
                                               

Total other CDO exposure

  $ 1.4     $ 3.8     $ 0.5     $ 1.5     $ (0.1 )   $ (0.4 )
                                               

Subtotal ABS CDO-related exposure(3)

  $ (1.9 )   $ (5.0 )   $ (1.1 )   $ (7.9 )   $ (0.1 )   $ 3.6  
                                               

U.S. Subprime Mortgage-Related Exposure:

           

Loans

  $ 0.2     $ 0.6     $ (0.2 )   $ (0.2 )   $ 0.2     $ 0.6  

Total rate-of-return swaps

    —         —         —         0.1       —         —    

ABS bonds

    0.9       2.7       (1.3 )     (3.8 )     0.9       2.7  

ABS CDS

    10.1       7.8       2.7       5.0       (1.1 )     (5.1 )
                                               

Subtotal U.S. subprime mortgage-related exposure

  $ 11.2     $ 11.1     $ 1.2     $ 1.1     $ —       $ (1.8 )
                                               

Total U.S. subprime trading exposure

  $ 9.3     $ 6.1     $ 0.1     $ (6.8 )   $ (0.1 )   $ 1.8  
                                               

 

(1) Statement of financial condition amounts are presented on a net asset/liability basis and do not take into account any netting of cash collateral against these positions. In addition, these amounts reflect counterparty netting to the extent that there are positions with the same counterparty that are subprime-related; they do not reflect any counterparty netting to the extent that there are positions with the same counterparty that are not subprime related. As of November 30, 2008, the $9.3 billion is reflected in the Company’s consolidated statement of financial condition as follows: Financial instruments owned of $13.9 billion and Financial instruments sold, not yet purchased of $4.6 billion. As of November 30, 2007, the $6.1 billion is reflected in the Company’s consolidated statement of financial condition as follows: Financial instruments owned of $15.3 billion and Financial instruments sold, not yet purchased of $9.2 billion.
(2) CDO squared refers to CDOs where the collateral is comprised entirely of other CDO securities.
(3) In determining the fair value of the Company’s ABS super senior CDO-related exposures the Company took into consideration prices observed from the execution of a limited number of transactions and data for relevant benchmark instruments in synthetic subprime markets. Deterioration of value in the benchmark instruments as well as market developments have led to significant declines in the estimates of fair value. These declines reflected increased implied losses across this portfolio. At November 30, 2008, these implied loss levels are consistent with losses in the range between 22% – 48% implied by the ABX indices. These cumulative loss levels, at a severity rate of 62%, imply defaults in the range of 79% – 95% for 2005 and 2006 outstanding mortgages.

 

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Subsidiary Banks.

 

The securities portfolios of the Subsidiary Banks include certain subprime-related securities. The portfolios contain no subprime whole loans, subprime residuals or CDOs.

 

At November 30, 2008 and November 30, 2007, the securities portfolios totaled $7.2 billion and $9.9 billion, respectively, consisting primarily of investment grade-rated ABS bonds and residential mortgage-backed securities. Of these total amounts, $2.7 billion and $5.5 billion were subprime mortgage-related securities as of November 30, 2008 and November 30, 2007, respectively.

 

Real Estate Investments.

 

Real Estate Investor Funds.    The Company acts as the general partner for various real estate funds and also invests in certain of these funds as a limited partner.

 

Crescent.    An affiliated entity of the Company acquired an investment in Crescent in August 2007. The assets of Crescent primarily include office buildings, investments in resorts and residential developments in select markets across the U.S. (the “Crescent properties”). The Company had originally intended to include the Crescent properties in an investor fund but at the end of the second quarter of fiscal 2008, the Company modified its investment strategy based on various factors, including current market conditions, valuation, size of the investment and timing of the fund, and determined to operate Crescent and risk manage the Crescent properties.

 

As a result, the Company consolidated Crescent’s assets and liabilities of approximately $4.7 billion and $3.9 billion, respectively, as of May 31, 2008. The Company will continue to evaluate the Crescent properties and position them for sale as opportunities arise.

 

Prior to consolidating the assets and liabilities of Crescent, the Company recorded writedowns on its investment of approximately $250 million. These writedowns are included in the Asset Management business segment and are reflected in Principal transactions—investments in the consolidated statement of income for fiscal 2008. In the fourth quarter of fiscal 2008, the Company recorded an impairment charge of $243 million, which is reflected in Other expenses in the consolidated statement of income.

 

Beginning in the third quarter of fiscal 2008, the consolidated operating results of Crescent are included in the Asset Management business segment. Fiscal 2008 included net revenues of $37 million, non-interest expenses of $568 million and a loss before income taxes of $531 million related to Crescent.

 

Real Estate Investments.    The Company’s real estate investments are shown below by business group, property type and geographic region. Such amounts exclude investments that benefit certain employee deferred compensation and co-investment plans.

 

      At November 30,

Business Group

   2008    2007
     (dollars in millions)

Crescent(1)

   $ 3,062    $ —  

Real estate funds

     1,104      2,237

Real estate bridge financing(2)

     208      1,385

Private equity

     828      468

Infrastructure

     108      9
             

Total

   $ 5,310    $ 4,099
             

 

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     At November 30,

Property Type

   2008    2007
     (dollars in millions)

Office

   $ 2,247    $ 408

Mixed-use

     288      496

Hospitality

     475      392

Residential

     977      478

Real estate bridge financing(2)

     208      1,385

Private equity

     828      468

Infrastructure

     108      9

Other real estate

     179      463
             

Total

   $ 5,310    $ 4,099
             

 

Geographic Region

   At November 30, 
     2008    2007
     (dollars in millions)

Americas

   $ 4,000    $ 2,039

Europe

     397      698

Asia

     913      1,362
             

Total

   $ 5,310    $ 4,099
             

 

(1) Amounts are shown gross of any non-recourse debt provided by external lenders which reduces the Company’s exposures.
(2) Real estate bridge financing in fiscal 2007 primarily included amounts related to Crescent.

 

Stock-Based Compensation.

 

The Company accounts for stock-based compensation in accordance with SFAS No. 123R, “Share-Based Payment” (“SFAS No. 123R”). For further information on SFAS No. 123R, see Note 2 to the consolidated financial statements.

 

Additionally, based on interpretive guidance related to SFAS No. 123R in the first quarter of fiscal 2006, the Company changed its accounting policy for expensing the cost of anticipated year-end equity awards that are granted to retirement eligible employees in the first quarter of the following year. Effective December 1, 2005, the Company accrues the estimated cost of these awards over the course of the current fiscal year. As such, the Company accrued the estimated cost of fiscal 2008 year-end awards granted to retirement-eligible employees over the 2008 fiscal year rather than expensing the awards on the date of grant (which occurred in December 2008).

 

As a result, fiscal 2006 stock-based compensation expense primarily included the following costs:

 

   

amortization of fiscal 2003 year-end awards;

 

   

amortization of fiscal 2004 year-end awards;

 

   

amortization of fiscal 2005 year-end awards to non-retirement eligible employees;

 

   

the full cost of fiscal 2005 year-end awards to retirement eligible employees (made in December 2005); and

 

   

the full cost of fiscal 2006 year-end awards to retirement eligible employees (made in December 2006).

 

Fiscal 2007 stock-based compensation expense primarily included the following costs:

 

   

amortization of fiscal 2004 year-end awards;

 

   

amortization of fiscal 2005 year-end awards to non-retirement eligible employees;

 

   

amortization of fiscal 2006 year-end awards to non-retirement eligible employees; and

 

   

the full cost of fiscal 2007 year-end awards to retirement eligible employees (made in December 2007).

 

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Fiscal 2008 stock-based compensation expense primarily included the following costs:

 

   

amortization of fiscal 2005 year-end awards to non-retirement eligible employees;

 

   

amortization of fiscal 2006 year-end awards to non-retirement eligible employees;

 

   

amortization of fiscal 2007 year-end awards to non-retirement eligible employees; and

 

   

the full cost of fiscal 2008 year-end awards to retirement eligible employees (made in December 2008).

 

Fiscal 2003 and fiscal 2004 year-end awards are generally amortized over three and four years, while subsequent year-end awards are generally amortized over two and three years.

 

Coleman Litigation.

 

Effective November 30, 2007, the Company reversed a $360 million reserve previously established under SFAS No. 5, “Accounting for Contingencies” (“SFAS No. 5”) for a claim filed against the Company by Coleman.

 

Defined Benefit Pension and Other Postretirement Plans.

 

Contributions.    The Company made contributions of $326 million and $131 million to its U.S. and non-U.S. defined benefit pension plans in fiscal 2008 and fiscal 2007, respectively. These contributions were funded with cash from operations.

 

The Company determines the amount of its pension contributions to its funded plans by considering several factors, including the level of plan assets relative to plan liabilities, expected plan liquidity needs and expected future contribution requirements. The Company’s policy is to fund at least the amounts sufficient to meet minimum funding requirements under applicable employee benefit and tax regulations (for example, in the U.S., the minimum required contribution under the Employee Retirement Income Security Act of 1974, or “ERISA”). As of November 30, 2008, there were no minimum required ERISA contributions for the Company’s U.S. pension plan that is qualified under Section 401(a) of the Internal Revenue Code. Liabilities for benefits payable under certain postretirement and unfunded supplementary plans are accrued by the Company and are funded when paid to the beneficiaries.

 

Expense.    The Company recognizes the compensation cost of an employee’s pension benefits (including prior-service cost) over the employee’s estimated service period. This process involves making certain estimates and assumptions, including the discount rate and the expected long-term rate of return on plan assets. In accordance with the adoption of SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”), the measurement date to determine plan assets, liabilities and expense was changed from September 30 to November 30. Net periodic pension expense was $134 million, $145 million and $160 million, while net periodic postretirement expense was $17 million, $14 million and $18 million for fiscal 2008, fiscal 2007 and fiscal 2006, respectively.

 

See Notes 2 and 16 to the consolidated financial statements for more information on the Company’s defined benefit pension and postretirement plans including the adoption of SFAS No. 158.

 

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Critical Accounting Policies.

 

The Company’s consolidated financial statements are prepared in accordance with U.S. GAAP, which requires the Company to make estimates and assumptions (see Note 1 to the consolidated financial statements). The Company believes that of its significant accounting policies (see Note 2 to the 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 with changes in fair value recognized in earnings each period. The Company makes estimates regarding valuation of assets and liabilities measured at fair value in preparing the consolidated financial statements. These assets and liabilities include but are not limited to:

 

   

Financial instruments owned and Financial instruments sold, not yet purchased;

 

   

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;

 

   

Other secured financings; and

 

   

Certain Long-term borrowings, primarily structured notes and certain junior subordinated debentures.

 

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 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 dislocation, such as those experienced in fiscal 2008, 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 continued downturn in market conditions could lead to further declines in the valuation of many instruments. For further information on the fair value definition, Level 1, Level 2 and Level 3 hierarchy, and related valuation techniques, see Notes 2 and 3 to the consolidated financial statements.

 

The Company’s Level 3 assets before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $86.2 billion and $73.7 billion as of November 30, 2008 and November 30, 2007, respectively, and represented approximately 27% as of November 30, 2008 and 15% as of November 30, 2007 of the assets measured at fair value (13% and 7% of total assets as of November 30, 2008 and November 30, 2007, respectively). Level 3 liabilities before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $28.4 billion and $19.5 billion as of November 30, 2008 and November 30, 2007, respectively, and represented approximately 16% and 7%, respectively, of the Company’s liabilities measured at fair value.

 

During fiscal 2008, the Company reclassified approximately $17.3 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to residential and commercial mortgage-backed securities, commercial whole loans and corporate loans. The reclassifications were due to a reduction in the volume of recently executed transactions and market price quotations for these instruments, or a lack of available broker quotes, such that unobservable inputs had to be utilized for the fair value measurement of these instruments. These unobservable inputs include, depending upon the position, assumptions to establish

 

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comparability to bonds, loans or swaps with observable price/spread levels, default recovery rates, forecasted credit losses and prepayment rates. The Company reclassified approximately $7.5 billion of certain Corporate and other debt from Level 3 to Level 2. These reclassifications primarily related to ABS and corporate loans as some liquidity re-entered the market for these specific positions, and external prices and spread inputs for these instruments became observable.

 

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. These assets include certain goodwill, certain intangible assets, certain premises and equipment, certain equity method investments, certain loans and certain real estate investments that were impaired during fiscal 2008, primarily in the fourth quarter, and written down to their fair value. In addition, a continued downturn in market conditions could result in additional 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 recurring and non-recurring basis, see Note 2 and Note 3 to the 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 the Financial Control, Market Risk and Credit Risk Departments 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 both parties 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 herein.

 

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 issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

 

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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.

 

Reserves for litigation and regulatory proceedings are generally determined on a case-by-case basis and represent an estimate of probable losses after considering, among other factors, the progress of each case, prior experience and the experience of others in similar cases, and the opinions and views of internal and external legal counsel. Given the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, the Company cannot predict with certainty the loss or range of loss, if any, related to such matters, how such matters will be resolved, when they will ultimately be resolved or what the eventual settlement, fine, penalty or other relief, if any, might be.

 

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 regularly assesses the likelihood of assessments in each of the taxing jurisdictions resulting from current and subsequent years’ examinations, and tax reserves are established as appropriate.

 

The Company establishes reserves for potential losses that may arise out of litigation and regulatory proceedings to the extent that such losses are probable and can be estimated in accordance with SFAS No. 5. The Company establishes reserves for potential losses that may arise out of tax audits in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”. Once established, reserves 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 9 and 17 to the 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 (“SPEs”) 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/VIEs, 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 CDOs and CLOs;

 

   

Entering into derivative agreements with non-SPEs whose value is derived from securities issued by SPEs;

 

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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 5 to the consolidated financial statements.

 

In most cases, these SPEs are deemed for accounting purposes to be variable interest entities (“VIEs”). Unless a VIE is determined to be a QSPE (see Note 1 to the consolidated financial statements), the Company is required to perform an analysis of each VIE at the date upon which the Company becomes involved with it to determine whether the Company is the primary beneficiary of the VIE, in which case the Company must consolidate the VIE. QSPEs are not consolidated. In addition, the Company serves as an investment advisor to numerous unconsolidated money market and other funds.

 

The Company reassesses whether it is the primary beneficiary of a VIE upon the occurrence of certain reconsideration events. If the Company’s initial assessment results in a determination that it is not the primary beneficiary of a VIE, then the Company reassesses this determination upon the occurrence of:

 

   

Changes to the VIE’s governing documents or contractual arrangements in a manner that reallocates the obligation to absorb the expected losses or the right to receive the expected residual returns of the VIE between the current primary beneficiary and the other variable interest holders, including the Company.

 

   

Acquisition by the Company of additional variable interests in the VIE.

 

If the Company’s initial assessment results in a determination that it is the primary beneficiary, then the Company reassesses this determination upon the occurrence of:

 

   

Changes to the VIE’s governing documents or contractual arrangements in a manner that reallocates the obligation to absorb the expected losses or the right to receive the expected residual returns of the VIE between the current primary beneficiary and the other variable interest holders, including the Company.

 

   

A sale or disposition by the Company of all or part of its variable interests in the VIE to parties unrelated to the Company.

 

   

The issuance of new variable interests by the VIE to parties unrelated to the Company.

 

The determination of whether an SPE meets the accounting requirements of a QSPE requires significant judgment, particularly in evaluating whether the permitted activities of the SPE are significantly limited and in determining whether derivatives held by the SPE are passive and nonexcessive. In addition, the analysis involved in determining whether an entity is a VIE, and in determining the primary beneficiary of a VIE, requires significant judgment (see Notes 2 and 5 to the consolidated financial statements).

 

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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 and other control groups, assist in evaluating, monitoring and controlling the impact that the Company’s business activities have on its consolidated statements of financial condition, liquidity and capital structure.

 

Global market and economic conditions have been disrupted and volatile, and in the fourth quarter of fiscal 2008, volatility reached unprecedented levels. In particular, the Company’s cost and availability of funding have been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. During the fourth quarter of fiscal 2008 the Company became a financial holding company under the BHC Act and gained additional access to various government lending programs and facilities including the Commercial Paper Funding Facility (“CPFF”), the Temporary Liquidity Guarantee Program (“TLGP”), the Term Securities Lending Facility (“TSLF”) and the Primary Dealer Credit Facility (“PDCF”) (for a further discussion about these lending programs and facilities, see “Funding Management Policies-Secured Financing” herein). During the fourth quarter of fiscal 2008, the Company further diversified its funding profile and increased its liquidity position by accessing these programs and engaging in a reduction of balance sheet intensive businesses within the Institutional Securities business segment.

 

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 Institutional Securities sales and trading activities. The liquid nature of these assets provides the Company with flexibility in managing the size of its balance sheet.

 

The Company’s total assets decreased to $658,812 million at November 30, 2008, from $1,045,409 million at November 30, 2007. The decrease was primarily due to decreases in securities borrowed, financial instruments owned—corporate and other debt and corporate equities, securities received as collateral, federal funds sold and securities purchased under agreements to resell and receivables from customers, partially offset by increases in interest bearing deposits with banks. In the fourth quarter of fiscal 2008, the Company increased its focus on rescaling the size of its balance sheet intensive businesses including prime brokerage and select proprietary trading strategies.

 

Within the sales and trading related assets and liabilities are transactions attributable to securities financing activities. As of November 30, 2008, securities financing assets and liabilities were $251 billion and $238 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, customer receivables/payables and related segregated customer cash.

 

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 was $5 billion recorded under certain provisions of SFAS No. 140 which represented equal and offsetting assets and liabilities for fully collateralized non-cash loan transactions.

 

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The Company uses the balance sheet leverage ratio, the Tier 1 leverage ratio and risk based capital ratios (see “Regulatory Requirements” herein) as indicators of capital adequacy when viewed in the context of the Company’s overall liquidity and capital policies. The Company utilizes the leverage ratio when evaluating leverage trends. The balance sheet leverage ratio reflects the deduction from shareholders’ equity of the amount of equity used to support goodwill and intangible assets (as the Company does not view this amount of equity as available to support its risk capital needs). In addition, the Company views junior subordinated debt issued to capital trusts as a component of its capital base given the inherent characteristics of the securities including their long-dated nature, the Company’s ability to defer coupon interest, and the subordinated nature of the obligations in the capital structure. The Company also receives rating agency equity credit for these securities.

 

The following table sets forth the Company’s total assets and leverage ratios as of November 30, 2008 and November 30, 2007 and for the average month-end balances during fiscal 2008 and fiscal 2007:

 

     Balance at     Average Month-End Balance  
     November 30,
2008
    November 30,
2007
    Fiscal 2008     Fiscal 2007  
     (dollars in millions, except ratio data)  

Total assets

   $ 658,812     $ 1,045,409     $ 1,006,608     $ 1,202,065  
                                

Common equity

   $ 31,676     $ 30,169     $ 33,590     $ 35,235  

Preferred equity

     19,155       1,100       3,878       1,100  
                                

Shareholders’ equity

     50,831       31,269       37,468       36,335  

Junior subordinated debentures issued to capital trusts

     10,266       4,876       9,963       4,878  
                                

Subtotal

     61,097       36,145       47,431       41,213  

Less: Goodwill and net intangible assets

     (3,138 )     (4,071 )     (3,914 )     (3,924 )
                                

Tangible shareholders’ equity

   $ 57,959     $ 32,074     $ 43,517     $ 37,289  
                                

Leverage ratio(1)

     11.4x       32.6x       23.1x       32.2x  
                                

 

(1) Leverage ratio equals total assets divided by tangible shareholders’ equity.

 

Balance Sheet and Funding Activity in Fiscal 2008.

 

The Company’s total non-current portion of long-term borrowings, shareholders’ equity and deposits form a stable source of long-term funding for the Company.

 

     At
November 30,

2008
   At
November 30,

2007
     (dollars in millions)

Common shareholders’ equity

   $ 31,676    $ 30,169

Preferred stock

     19,155      1,100

Junior subordinated debentures

     10,266      4,876

Non-current portion of long-term borrowings

     141,466      159,816
             

Subtotal

     202,563      195,961
Deposits      42,755      31,179
             
Total long-term funding    $ 245,318    $ 227,140
             

 

During fiscal 2008, the Company issued notes with a carrying value at year-end aggregating approximately $45 billion, including non-U.S. dollar currency notes aggregating approximately $13 billion. In connection with the note issuances, the Company generally enters into certain transactions to obtain floating interest rates based primarily on short-term London Interbank Offered Rates trading levels. The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 6.4 years at November 30, 2008 and 5.5 years at November 30, 2007.

 

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As of November 30, 2008, the aggregate outstanding principal amount of the Company’s senior indebtedness was approximately $156 billion (including guaranteed obligations of the indebtedness of subsidiaries) compared with $207 billion as of November 30, 2007. The decrease in the amount of senior indebtedness was primarily due to maturities and repurchases of senior debt as well as currency revaluations.

 

China Investment Corporation Investment.

 

In December 2007, the Company sold Equity Units that included contracts to purchase Company common stock to a wholly owned subsidiary of CIC for approximately $5,579 million. CIC’s ownership in the Company’s common stock, including the number of shares of common stock to be received by CIC upon settlement of the stock purchase contracts, will be 9.9% or less of the Company’s total shares outstanding based on the total shares that were outstanding on November 30, 2007. CIC is a passive financial investor and has no special rights of ownership nor a role in the management of the Company. A substantial portion of the investment proceeds was treated as Tier 1 capital for regulatory capital purposes.

 

For a more detailed summary of the Equity Units, including the junior subordinated debentures issued to support trust common and trust preferred securities and the stock purchase contracts, see Note 11 to the consolidated financial statements.

 

Mitsubishi UFJ Financial Group, Inc.

 

On October 13, 2008, the Company issued to MUFG 7,839,209 shares of Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock (“Series B Preferred Stock”) and 1,160,791 shares of Series C Non-Cumulative Non-Voting Perpetual Preferred Stock (“Series C Preferred Stock”) for an aggregate purchase price of $9 billion that gave MUFG a 21% ownership interest on a fully-diluted basis at the date of issuance (see Note 11 to the consolidated financial statements). The Series B Preferred Stock and Series C Preferred Stock qualify as Tier 1 capital for regulatory capital purposes.

 

Capital Purchase Program.

 

The Company was part of the initial group of financial institutions participating in the CPP, and on October 26, 2008 entered into a Securities Purchase Agreement—Standard Terms with the U.S. Treasury pursuant to which, among other things, the Company sold to the U.S. Treasury for an aggregate purchase price of $10 billion, 10 million shares of Series D Fixed Rate Cumulative Perpetual Preferred Stock of the Company (the “Series D Preferred Stock”) and warrants to purchase up to 65,245,759 shares of common stock of the Company at an exercise price of $22.99 per share (see Note 11 to the consolidated financial statements).

 

The Series D Preferred Stock qualifies as Tier 1 capital and ranks senior to the Company’s common shares and pari passu, which is at an equal level in the capital structure, with existing preferred shares, other than preferred shares which by their terms rank junior to any other existing preferred shares. The Series D Preferred Stock pays a compounding cumulative dividend rate of 5% per annum for the first five years and will reset to a rate of 9% per annum after year five. The Series D Preferred Stock is non-voting, other than class voting rights on matters that could adversely affect the Series D Preferred Stock. The Series D Preferred Stock is callable at par after three years. Prior to the end of three years, the Series D Preferred Stock may be redeemed with the proceeds from one or more qualified equity offerings of any Tier 1 perpetual preferred or common stock of at least $250 million. The U.S. Treasury may also transfer the Series D Preferred Stock to a third party at any time. The number of shares to be delivered upon settlement of the warrant will be reduced by 50% if the Company receives aggregate gross proceeds of at least 100% of the aggregate Liquidation Preference of the Series D Preferred Stock ($10 billion) from one or more qualified equity offerings prior to December 31, 2009.

 

Equity Capital Management Policies.

 

The Company’s senior management views equity capital as an important source of financial strength. The Company actively manages its consolidated equity capital position based upon, among other things, business opportunities, capital availability and rates of return together with internal capital policies, regulatory

 

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requirements and rating agency guidelines and, therefore, in the future may expand or contract its equity capital base to address the changing needs of its businesses. The Company attempts to maintain total equity, on a consolidated basis, at least equal to the sum of its operating subsidiaries’ equity.

 

As of November 30, 2008, the Company’s equity capital (which includes shareholders’ equity and junior subordinated debentures issued to capital trusts) was $61,097 million, an increase of $24,952 million from November 30, 2007, primarily due to the CIC, MUFG and CPP investments and growth in retained earnings.

 

In December 2006, the Company announced that its Board of Directors had authorized the repurchase of up to $6 billion of the Company’s outstanding common stock. This share repurchase authorization replaced the Company’s previous repurchase authorizations with one repurchase program for capital management purposes that will consider, among other things, business segment capital needs as well as equity-based compensation and benefit plan requirements. As of November 30, 2008, the Company had approximately $1.6 billion remaining under its current share repurchase authorization. During fiscal 2008, the Company repurchased $711 million of its common stock as part of its capital management share repurchase program (see also “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities,” in Part II, Item 5). As a condition under the CPP, the Company’s share repurchases are currently limited to purchases in connection with the administration of any employee benefit plan, consistent with past practices, including purchases to offset share dilution in connection with any such plans. This restriction is effective until October 2011 or until the U.S. Treasury no longer owns any of the Company’s preferred shares issued under the CPP.

 

The Board of Directors determines the declaration and payment of dividends on a quarterly basis. In December 2008, the Company announced that its Board of Directors declared a quarterly dividend per common share of $0.27. The Company also announced that its Board of Directors declared a quarterly dividend of $348.35 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 $0.34835); a quarterly dividend of $25.56 per share of perpetual Fixed Rate Non-Cumulative Convertible Preferred Stock, Series B; a quarterly dividend of $25.56 per share of perpetual Fixed Rate Non-Cumulative Preferred Stock, Series C; and a quarterly dividend of $10.69 per share of perpetual Fixed Rate Cumulative Preferred Stock, Series D. As part of its participation in the CPP, the Company agreed that it would not, without the U.S. Treasury’s consent, increase the current dividend on its common stock as long as any preferred stock issued under the CPP remains outstanding until the third anniversary of the investment or until the U.S. Treasury has transferred all of the preferred stock it purchased under the CPP to third parties.

 

In addition, pursuant to the terms of the CPP investment, the Company is prohibited from paying any dividend with respect to shares of common stock, other junior securities or preferred stock ranking pari passu with the Series D Preferred Stock or repurchasing or redeeming any shares of the Company’s common shares, other junior securities or preferred stock ranking pari passu with the Series D Preferred Stock in any quarter unless all accrued and unpaid dividends are paid on the Series D Preferred Stock for all past dividend periods (including the latest completed dividend period), subject to certain limited exceptions.

 

Economic Capital.

 

The Company’s economic capital framework estimates the amount of equity capital required to support the businesses over a wide range of market environments while simultaneously satisfying regulatory, rating agency and investor requirements. The framework will evolve over time in response to changes in the business and regulatory environment and to incorporate enhancements in modeling techniques.

 

Economic capital is assigned to each business segment and sub-allocated to product lines. Each business segment is capitalized as if it were an independent operating entity. This process is intended to align equity capital with the risks in each business in order to allow senior management to evaluate returns on a risk-adjusted basis (such as return on equity and shareholder value added).

 

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Economic capital is based on regulatory capital usage plus additional capital for stress losses. The Company assesses stress loss capital across various dimensions of market, credit, business and operational risks. Economic capital requirements are met by regulatory Tier 1 capital. For a further discussion of the Company’s Tier 1 capital see “Regulatory Requirements” herein. The difference between the Company’s Tier 1 capital and aggregate economic capital requirements denotes the Company’s unallocated capital position.

 

The following table presents the Company’s allocated average Tier 1 capital (“economic capital”) and average common equity for fiscal 2008 and fiscal 2007:

 

     Fiscal 2008    Fiscal 2007
     Average
Tier 1
capital
   Average
common
equity
   Average
Tier 1
capital
   Average
common
equity
     (dollars in billions)

Institutional Securities

   $ 25.9    $ 23.3    $ 24.6    $ 23.9

Global Wealth Management Group

     1.7      1.5      1.5      1.7

Asset Management

     3.7      3.9      2.7      3.5

Unallocated capital

     6.6      4.9      2.9      2.9
                           

Total from continuing operations

     37.9      33.6      31.7      32.0

Discontinued operations

     —        —        2.7      3.2
                           

Total

   $ 37.9    $ 33.6    $ 34.4    $ 35.2
                           

 

Tier 1 capital allocated to the Institutional Securities business segment increased compared with fiscal 2007 driven by growth in credit risk exposure partially offset by the incorporation of market risk capital model enhancements. Tier 1 capital and common equity allocated to Asset Management increased primarily due to consolidation of Crescent on the Company’s consolidated statement of financial condition. See “Other Matters—Real Estate-Related Positions—Real Estate Investments—Crescent” herein for further discussion. Additionally, the proportion of common equity allocated to the operating segments decreased due to the issuance of hybrid capital. See “China Investment Corporation Investment,” “Mitsubishi UFJ Financial Group Inc.” and “Capital Purchase Program” herein.

 

The Company generally uses available unallocated capital for organic growth, additional acquisitions and other capital needs, including repurchases of common stock where permitted under the terms of the CPP while maintaining adequate capital ratios. For a discussion of risk-based capital ratios, see “Regulatory Requirements” herein.

 

Liquidity and Funding Management Policies.

 

The primary goal of the Company’s liquidity management and funding activities is to ensure adequate funding over a wide range of market environments. 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 policies are designed to mitigate the potential risk that the Company may be unable to access adequate financing to service its financial obligations without material franchise or business impact. The key objectives of the liquidity and funding risk management framework are to support the successful execution of the Company’s business strategies while ensuring sufficient liquidity through the business cycle and during periods of stressed market conditions.

 

Liquidity Management Policies.

 

The principal elements of the Company’s liquidity management framework are the Contingency Funding Plan (“CFP”) and Liquidity Reserves. Comprehensive financing guidelines (secured funding, long-term funding strategy, surplus capacity, diversification and staggered maturities) support the Company’s target liquidity profile.

 

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Contingency Funding Plan.    The Contingency Funding Plan is the Company’s primary liquidity risk management tool. The CFP models a potential, prolonged liquidity contraction over a one-year time period and sets forth a course of action to effectively manage a liquidity event. The CFP and liquidity risk exposures are evaluated on an on-going basis and reported to the Firm Risk Committee and other appropriate risk committees.

 

The Company’s CFP model is designed to be dynamic and scenarios incorporate a wide range of potential cash outflows during a liquidity stress event, including, but not limited to, the following: (i) repayment of all unsecured debt maturing within one year and no incremental unsecured debt issuance; (ii) maturity roll-off of outstanding letters of credit with no further issuance and replacement with cash collateral; (iii) return of unsecured securities borrowed and any cash raised against these securities; (iv) additional collateral that would be required by counterparties in the event of a two-notch long-term credit ratings downgrade; (v) higher haircuts on or lower availability of secured funding, similar to a stressed cash capital approach; (vi) client cash withdrawals; (vii) drawdowns on unfunded commitments provided to third parties; and (viii) discretionary unsecured debt buybacks.

 

The CFP is produced on a parent and major subsidiary