UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended November 30, 20032004

Commission File Number 1-11758

Morgan Stanley

(Exact name of Registrant as specified in its charter)

1585 Broadway

New York, NY 10036

(Address of principal executive offices, including zip code)

(212) 761-4000

(Registrant’s telephone number, including area code: (212) 761-4000code)

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

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. YESx 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.x

Indicate by check mark whether Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YESx NO¨

TheAs of May 31, 2004, the aggregate market value of the common stock of Registrant held by non-affiliates of Registrant as of May 31, 2003 was approximately $49,077,140,217.$58,156,889,114. This calculation does not reflect a determination that persons are affiliates for any other purposes.

NumberAs of December 31, 2004, there were 1,087,465,976 shares outstanding of Registrant’s common stock, $.01 par value, as of December 31, 2003: 1,085,170,940.outstanding.

Documents Incorporated By Reference: Portions of Registrant’s definitive proxy statement for its annual stockholders’ meeting to be held on April 20, 2004March 15, 2005 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.

Annual Report on Form 10-K

for the fiscal year ended November 30, 20032004

Table of Contents

Forward-Looking Statements

CertainWe 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, in this report,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 (“MD&A”), and “Quantitative and Qualitative Disclosures about Market Risk” in Part II, Item 7A, that may constitute forward-looking statements. 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 ourMorgan 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 includingand it is possible that our actual results may differ, possibly materially, 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):

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. We undertakeMorgan 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. You should, however, consult further disclosures Morgan Stanley may make in future filings of its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments thereto.

Part I

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, 2004, Morgan Stanley had 53,284 employees worldwide. Unless the context otherwise requires, the terms “Morgan Stanley,” the “Company,” “we” and “our” mean Morgan Stanley and its consolidated subsidiaries.

Morgan Stanley maintains leading market positions in each of its business segments—Institutional Securities, Individual Investor Group, Investment Management and Credit Services.

Morgan Stanley’s institutional securities business segment (“Institutional Securities”) includes:

Morgan Stanley’s individual investor group business segment (“Individual Investor Group”) includes:

Morgan Stanley’s investment management business segment (“Investment Management”) includes:

Morgan Stanley’s credit services business segment (“Credit Services”) includes:

Morgan Stanley is a holding company that provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals, through its subsidiaries and affiliates. Morgan Stanley conducts its business from its headquarters in 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. Morgan Stanley was originally incorporated under the laws of the State of Delaware in 1981, and its predecessor companies date back to 1924. At November 30, 2003, Morgan Stanley had 51,196 employees worldwide.

Financial information concerning Morgan Stanley, our business segments and geographic regions for each of the fiscal years ended November 30, 2003,2004, November 30, 20022003 and November 30, 20012002 is included in the consolidated financial statements and the notes thereto in “Financial Statements and Supplementary Data” in Part II, Item 8.

Unless the context otherwise requires, the terms “Morgan Stanley”, the “Company”, “we” and “our” mean See also “Results of Operations-Executive Summary” in Part II, Item 7 for an overview of Morgan Stanley and its consolidated subsidiaries.Stanley’s fiscal 2004 performance.

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 450 Fifth Street, NW, 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. The SEC’s internet site iswww.sec.gov.

Morgan Stanley’s internet site iswww.morganstanley.com. You can access Morgan Stanley’s Investor Relations webpage through our internet site,www.morganstanley.com, by clicking on the “About Morgan Stanley” link to the heading “Investor Relations.” You can also access our Investor Relations webpage directly atwww.morganstanley.com/about/ir. Morgan Stanley makes available free of charge, on or through our Investor Relations webpage, its internet site, via a link to the SEC’s internet site atwww.sec.gov, itsproxy statements, annual report on Form 10-K;10-K, quarterly reports on Form 10-Q;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 internet site,our 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 makes available onalso has a Corporate Governance webpage. You can access Morgan Stanley’s Corporate Governance webpage through our internet site,www.morganstanley.com, its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q for the current fiscal year, its most recent proxy statement and its most recent summary annual report to shareholders, although in some cases these documents are not available on our site as soon as they are availableby clicking on the SEC’s site. You will need to have on your computer the Adobe Acrobat Reader^® software to view these documents, which are in PDF format. If you do not have Adobe Acrobat Reader, a“About Morgan Stanley” link to Adobe’s internet site, from which youthe heading “Inside the Company.” You can download the software, is provided. In addition,also access our Corporate Governance webpage directly atwww.morganstanley.com/about/inside/governance. Morgan Stanley posts the following onwww.morganstanley.com its compositeCorporate Governance webpage:

Morgan Stanley’s Code of Ethics and Business Conduct for itsapplies to all directors, officers and employees. You can request a copyemployees, including our chief executive officer, our chief financial officer, our controller and our principal accounting officer. We will post any amendments to the Code of these documents, excluding exhibits, at no cost,Ethics and Business Conduct, and any waivers that are required to be disclosed by writingthe rules of either the SEC or telephoning us at 1585 Broadway,the New York NY 10036, Attention: Investor Relations (212-761-4000).Stock Exchange, Inc. (“NYSE”), on our internet site. The information on Morgan Stanley’s internet site is not incorporated by reference into this report.

You can request a copy of these documents, excluding exhibits, at no cost, by contacting Investor Relations at 1585 Broadway, New York, NY 10036 (212-761-4000).

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Institutional Securities.

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

Investment Banking.

Underwriting.    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.

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, spin-offs, restructurings, proxy and consent solicitations, tender offers, exchange offers and leveraged buyouts. Morgan Stanley provides advice concerning recapitalizations, rights offerings, dividend policy, valuations, foreign exchange exposure, financial risk management strategies and

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financial planning. 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.

Corporate Lending.Morgan Stanley provides to selected corporate clients on a selective basis, through subsidiaries (including Morgan Stanley Bank) loans or lending commitments, including bridge financing. The borrowers may be rated investment grade or non-investment grade (as determined by Morgan Stanley’s Institutional Credit Department using methodologies generally consistent with those employed by external rating agencies). These loans and commitments have varying terms, may be senior or subordinated, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated or traded by Morgan Stanley.*

Sales, Trading, Financing and Market-Making Activities.**

Morgan Stanley conducts its sales, trading, financing and market-making activities on securities and futures exchanges and in over-the-counter (“OTC”) markets around the world.

Equity Securities and Related Products.    Morgan Stanley’s equity sales, trading and market-making activities cover equity and equity-related products globally, including common stock, ADRs, restricted/control stock, convertible securities, preferred securities and exchange-traded funds and warrants, equity index products, equity swaps, futures and options overlying individual securities, indices and baskets of securities and other structuredequity-related products.

Morgan Stanley issues equity-linked products to institutional and individual investors, including BRIDGES^SM,principal-protected securities, Stock Participation Accreting Redemption Quarterly-pay Securities^® (“SPARQS(SPARQS^®”) and Market Participation, Performance Leveraged Upside Securities^SM (“MPS(PLUS^SM”SM). and Strategic Total Return Securities. Morgan Stanley advises clients and executes transactions globally in connection with, among other things, block trades and program trading, equity repurchase strategies, hedging and monetization strategies and other trading strategies. Morgan Stanley engages in proprietary trading and arbitrage activities in equity securities and equity-related products.

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Morgan Stanley provides equity financing services, including prime brokerage, which offers, among other services, consolidated clearance and settlement of securities trades, custody, financing and portfolio reporting services. Morgan Stanley also acts as principal and agent in stock borrowing and stock lending transactions in support of its global trading and brokerage, investment management and clearing activities and as an intermediary between broker-dealers.

Fixed Income Securities and Related Products.    Morgan Stanley trades and makes markets in fixed income securities and related products globally, including investment grade corporate debt, non-investment grade instruments, bank loans, U.S. and non-U.S. government securities, municipal securities, emerging market securities, preferred stock and commercial paper, money market and other short-term securities. Morgan Stanley trades and makes markets in, and acts as principal with respect to, mortgage-related and other asset-backed securities and real estate loan products. Morgan Stanley is a primary dealer of U.S. government securities and a member of the selling groups that distribute various U.S. agency and other debt securities. Morgan Stanley is a primary dealer or market-maker of government securities in severalnumerous European, countriesAsian and is a member of the syndicates that underwrite German and Japanese government bonds.Emerging Market countries. Morgan Stanley is a dealer in interest rate and currency swaps and other relatedfixed income and credit derivative products credit derivatives (including credit default swaps), OTC options on U.S. and non-U.S. government bonds and mortgage-backed forward agreements, options and swaps. Morgan Stanley also trades fixed income futures. Through its triple-A rated subsidiary, Morgan Stanley Derivative Products Inc., Morgan Stanley enters into swaps and related derivative transactions with counterparties seeking a triple-A rated counterparty. Morgan Stanley engages in proprietary trading in various fixed income securities and fixed income-related products.

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Morgan Stanley advises clients globally 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 vehicles through which clients can restructure asset portfolios to provide liquidity or recharacterize risk profiles. 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.

Morgan Stanley is a market-maker in foreign currencies. Most of Morgan Stanley’s foreign exchange business relates to major foreign currencies such as yen, euro, sterling,Yen, Euro, Sterling, Swiss francs and Canadian dollars. Morgan Stanley trades on a principal basis in the spot, forward, option and currency optionfutures markets and takes proprietary positions in such currencies. Morgan Stanley trades currency futures at the International Monetary Market division of the Chicago Mercantile Exchange.

Morgan Stanley trades as principal and maintains proprietary trading positions in the spot, forward and futures markets in several commodities, including precious metals, base metals, crude oil, oil products, natural gas, electric power, emissionsemission credits and related energy products. Morgan Stanley is a market-maker in exchange-traded and OTC options and swaps on commodities, such as metals, crude oil, oil products, natural gas and electricity, and offers clients hedging programs relating to production, consumption, reserve/inventory management and energy-contract securitizations. Morgan Stanley trades many of these products through the IntercontinentalExchange, Inc., an electronic trading system in which Morgan Stanley maintains an ownership interest. Morgan Stanley is an electricity power marketer in the U.S. and owns equity interests inis the sole or majority shareholder of three exempt wholesale generators (as defined in the Public Utility Holding Company Act of 1935) from which Morgan Stanley (solely or acting with a joint venture partner) is the exclusive purchaser of electric power.

From time to time,Other Activities.

Principal Investing and Real Estate Investment Management.    Morgan Stanley has organized, advised and managed certain funds that invest and trade in particular debt securities, foreign currencies, real estate or commodities and may continue to do so in the future. In connection with such activities, Morgan Stanley has made and may continue to make investmentsinvests for its own account and for the account of clients seeking exposure to private equity, real estate-related and other alternative investments. These investments may be made in oneconnection with the investments made by private equity funds, real estate funds and separate accounts for which Morgan Stanley acts as general partner or more of such funds.investment advisor or in connection with Morgan Stanley’s investment banking and sales and trading activities (including foreign

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Other

currencies and commodities), and in other contexts. Such investments may include purchases of equity or debt securities of companies that may have strategic value for Morgan Stanley, such as alternative trading systems, information technology and other strategic businesses and technologies.See also “Investment Management—Private Equity Activities.”

Aircraft Financing.    Morgan Stanley engages in aircraft financing activities. Morgan Stanley also ownsleasing through AWAS Aviation Holdings LLC (also referred to as Ansett Worldwide Aviation Services,Services), one of the world’s leading aircraft leasing groups, leasing commercial jet aircraft to airlines around the world.

MSCI.Benchmark Indices and Risk Management Analytics.    Morgan Stanley’s majority-owned subsidiary, Morgan Stanley Capital International Inc. (“MSCI^®”), calculates and distributes over 25,000 international and U.S. equity benchmark indices (including the MSCI World and EAFE^® Indices) covering 50 countries, and has a 35-year historical database that includes fundamental and valuation data on thousands of equity securities in developed and emerging market countries. MSCI also calculates and distributes over 7,500 fixed income and 190 hedge fund indices. Investment professionals around the world use MSCI data for many purposes, including performance measurement.MSCI’s subsidiary, Barra, Inc., is a global leader in providing risk analytic tools and services to managers of portfolio and firm-wide investment risk.

Principal Investing and Real Estate Investment Management.    Morgan Stanley invests for its own account and for the account of clients seeking exposure to private equity, real estate-related and other alternative investments. These investments may, among other things, be in connection with the investments made by the private equity funds, real estate funds and separate accounts for which Morgan Stanley generally acts as general partner or investment advisor or in connection with Morgan Stanley’s investment banking and sales and trading activities. Such investments may include purchases of equity or debt securities of companies that may have strategic value for Morgan Stanley, such as alternative trading systems, electronic trading systems and other strategic businesses and technologies. See also “Investment Management—Private Equity Activities.”

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Research.    Morgan Stanley’s global research departments (“Research”), comprised of economists, strategists, and industry analysts, 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 approximately 2,200 individual companies, approximately half of which are located outside of the U.S. Research provides analysis and forecasts relating to economic and monetary developments that affect matters such as interest rates, foreign currencies, securities, derivatives and economic trends. Research provides analytical support and publishes reports on asset-backed securities and the markets in which such securities are traded. Research reports and data are disseminated to investors through third-party distributors, proprietary internet sites such as Client Link, and Morgan Stanley’s sales forces.

Operations.

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

Individual Investor Group.

TheMorgan Stanley, through its Individual Investor Group, provides comprehensive brokerage, investment and financial services worldwide to individual investors, globally.families and the companies they control. Through its financial advisors,representatives, Morgan Stanley is committed to delivering adviceprofessional brokerage, investment and financial services to its clients with a focus on affluent, and high net worth investors.and ultra high net worth clients. Morgan Stanley offers securitieshad $602 billion in client assets at November 30, 2004.

Client Coverage.    Morgan Stanley’s global network of 10,962 representatives provides clients with comprehensive brokerage, investment and investment products supported by its investment banking, research, investment management, executionfinancial services through a flexible platform designed to accommodate individual financial needs, objectives and operational resources. Morgan Stanley has one ofrisk profiles.

In the largest financial advisor networksU.S., representatives in the U.S. with approximately 11,000 financial advisors located in nearly 450 branches and conducts this business in the U.S.525 retail locations cover multiple client segments from affluent to ultra high net worth, primarily through itsMorgan Stanley’s wholly-owned subsidiary Morgan Stanley DW Inc. (“MSDWI”). Morgan Stanley had $565 billionCertain representatives specialize in client assets at November 30, 2003.

Client Coverage.    Inserving the U.S., Morgan Stanley provides services to multiple client segments spanning the wealth spectrum through a single sales organization. Morgan Stanley’s network of financial advisors, wealth advisors and investment representatives provide clients with financial planning and investment advisory services through a flexible platform designed to accommodate individual investment goals and risk profiles. Morgan Stanley works with clients to understand their financial needs and objectives through comprehensive financial planning, including education, retirement and estate planning. Morgan Stanley offers tailored financial solutions to ultra high net worth investors, including individuals, families and foundations controlling significant pools of wealth. Dedicated teams of investment representatives draw upon Morgan Stanley’s resources and those of leading third-party providers to establish investment portfolios and global asset allocation strategies to address these clients’ objectives.segment with sophisticated customized financial solutions, primarily through MS&Co.

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Morgan Stanley also offers financial advisory services outside the U.S. to serve the needs ofhigh net worth and ultra high net worth clients in Europe, Asia and Latin America. Morgan Stanley’s international operations also include Morgan Stanleytwo regional businesses: Quilter & Co. Limited, a U.K.-based private client investment management business, thatwhich provides segregated accountasset management and advisory services to individuals,affluent private clients, charities, trusts and pension funds and trusts in the U.K., and Morgan Stanley S.V., S.A. (Spain), which provides asset managementinvestment advice and brokerage servicesexecution to individual investors in Spain.

ClientsClient Solutions.    Morgan StanleyStanley’s network of representatives provides variousclients with comprehensive brokerage, investment and financial services that are tailored to their individual investment objectives, risk tolerance and liquidity needs. These products and services to execute financial plans and position clients to attain their financial goals, includinginclude mutual funds, stocks, bondsequities, fixed income products, alternative investments and professional money management.separately managed accounts. Morgan Stanley also offers mortgage products, such as residential mortgage home loans originated through DFS, and acts as a national general agencyan agent for leading insurance carriers to meet the insurance and annuity needsrequirements of individual clients. In addition, Morgan Stanley offersprovides trust and fiduciary services to individual and corporate clients, including trustee services for personal trusts and tax-qualified retirement plans.clients. Morgan Stanley also offers financial solutions to small businesses in the U.S. through BusinesScape^SM, a program that offers qualified business clients enhanced check writing privileges, cash management and a commercial line of credit. Morgan Stanley also provides definedcredit solutions to qualified business clients. Defined contribution plan services for businesses of all sizes, includingplans, 401(k) plans and stock plan administration.administration complement the services Morgan Stanley offers to businesses of all sizes.

Morgan Stanley offersprovides various account options for individual clients. The Active Assets Account^® offers clients brokerage and banking services in one account. With this account, clients’ uninvested cash is consolidated into various money market options or an FDIC-insured account.account insured by the Federal Deposit Insurance Corporation (“FDIC”). For clients who prefer fee-based pricing, it offersthere is the Morgan Stanley Choice^SM account, which charges a percentage of assets rather than a per-transaction fee. Clients can also choose to have a fee-based separately managed account.account managed by professional asset managers.

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Client Support.Services.    Morgan Stanley’s infrastructure and technology platform supports Client Coverage and Client Solutions. Morgan Stanley executes and clears its transactions (delivery of securities sold, receipt of securities purchased and transfer of related funds) through its own facilities and memberships in various clearing corporations. Systems at computer centers operated by an unaffiliated services provider also support the Individual Investor Group’s operations. Client coverage and solutions are supported by Morgan Stanley’s infrastructure and technology platform.

Investment Management.

Morgan Stanley, hasthrough Morgan Stanley Investment Management, is one of the largest global asset management organizations of any full-service securities firm, with $462$424 billion of assets under management or supervision atas of November 30, 2003*.2004. Morgan Stanley’s investment 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 investmentsinvestment products in developed and emerging markets. Through service companies, distribution subsidiaries and investment advisors, 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.

Individual Investors.    Morgan Stanley provides investment products and services includingoffers proprietary open- and closed-end mutual funds and separately managed accounts to individual investors. Morgan Stanley also provides investment products through intermediary platforms, such as 401(k) plans and variable annuities. Morgan Stanley serves individual investors through its proprietary network of financial advisors who offer, among other things, Morgan Stanley- and Van Kampen-branded products. Morgan Stanley offers Van Kampen-branded products through affiliated and unaffiliated broker-dealers, commercial banks, and thrifts, insurance companies and financial planners. A small number of these distributorsunaffiliated broker-dealers account for a substantial portion of Van Kampen sales in those intermediary channels.fund sales. Morgan Stanley also sells Van Kampen funds directly and through numerous retirement plan platforms. Internationally, Morgan Stanley distributes investment products to individuals outside the U.S. through international non-proprietary distributors.

Institutional Investors.    Morgan Stanley provides investment 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. and non-U.S. mutual funds and other

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pooled vehicles. Morgan Stanley Investment Management sub-advises funds for various unaffiliated financial institutions and intermediaries. A global proprietary sales force and a team dedicated to covering the investment consultant industry serve institutional investors. Morgan Stanley offers clients alternative investment opportunitiesproducts primarily through Alternative Investment Partners, a joint venture that utilizes a fund-of-funds strategy to invest in hedge funds and private equity funds.

Private Equity Activities.    Morgan Stanley’s private equity funds generally invest in companies in a range of industries worldwide. Morgan Stanley generallytypically acts as general partner and advisor of its private equity funds and typically commits to invest a minority of the capital of such funds, with subscribing limited partners contributing the remainder. An independent private equity firm manages the Morgan Stanley Capital Partners funds in a sub-advisory capacity.

Operations.    Morgan Stanley Investment Management performs a variety of functions required to support its business either through its operations group or through agreements with unaffiliated third parties. These functions include transfer agency, mutual fund accounting and administration, transaction processing, custodial, trustee and other fiduciary services, on behalf of institutional, retail and intermediary clients.

Credit Services.**

Based on its approximately 46.146.2 million general purpose credit card accounts at November 30, 2003,2004, Morgan Stanley, through its Credit Services business, is one of the largest single issuers of general purpose credit cards in the U.S. Morgan Stanley’s Credit Services business includes DFS, which operates Credit Services’ general purposeoffers Discover-branded credit card business;cards issued by Discover Business Services,Bank and other consumer products and services; Discover Network, which operates Morgan Stanley’s merchant and cash access network; PULSE, an ATM/debit network; and its Consumer Banking Group International in the UK; and other consumer finance products and services.U.K.

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Credit Cards and Services.    DFS offers several general purpose credit cards that are designed to appeal to different market segments of consumers for use throughand that are used on the Discover Business Services,Network, including the Discover Classic Card, the Discover Platinum Card, the Discover Gold Card, the Discover Titanium Card, the Miles Card from Discover as well as affinity cards and Discover gift cards. DFS offers other consumer finance products and services, including home loans that are offered to Individual Investor Group and DFS customers, and credit protection products. DFS offers cardmembers certificates of deposit and money market accounts and the ability to transfer balances from other accounts or credit sources. In the U.K., Consumer Banking Group International offers the Morgan StanleyCard^SMStanley Card, the Leeds and Holbeck Card and the Morgan Stanley buy and fly! MasterCard on the MasterCard^® network, and personal loan products.

DFS offers cardmembers numerousother customer services. Pursuant to the Cashback Bonus^® award program, DFS provides certain cardmembers awards based upon their level and type of purchases. Cardmembers may register their accountsaccount online with the Discover Card Account Center,at discovercard.com, which offers a menu of free e-mail notifications thatto inform cardmembers about the status of their accounts, including reminders that a cardmember’scardmembers are approaching their credit limit is approaching or that a minimum payment is due. Cardmembers may view detailed account information and receive exclusive discounts and special Cashback Bonus^® awards by shopping at the onlineinternet ShopCenter^SM. In addition, the Discover Deskshop^® virtual credit card enables cardmembers to use a single-use credit card number (a unique credit card number used for purchases at a single web site) for online purchases so that the cardmembers never have to reveal their actual card number. AtAs of November 30, 2003,2004, DFS had over 1213 million Discover cardmembers registered on the Discover Card Account Center.at discovercard.com.

Merchants.Network.    Only merchants that are members ofparticipants in the Discover Business Services networkNetwork accept DFS’s general purpose credit cards. Since its establishmentEstablished in 1986, the Discover Business Services network has becomeNetwork is the largest proprietary credit card network in the U.S. In January 2005, DFS announced that GE Consumer Finance will issue a new card, Wal-Mart Discover, on the Discover Network.

DFS

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Discover Network operates the issuing, network and acquiring businesses primarily in the U.S., provides customized programs to its merchants in such areas as processing, and otherwise tailors program terms to meet merchant needs. DFSDiscover Network utilizes its own national sales and support force, independent sales agents and telemarketing force to maintain and increase its merchant base.

Marketing.    DFS promotesWith its general purposeacquisition in January 2005 of PULSE, an ATM/debit network that links an estimated 90 million cardholders with more than 250,000 ATMS and 3.3 million POS terminals at retail locations nationwide, Credit Services offers financial institutions of various sizes a full-service debit platform and a complete product set, including credit, cards using distinctive features that are designed to appeal to different consumer bases. For instance, pursuant to the Cashback Bonus award program, DFS provides certain cardmembers awards based upon their levelsignature debit, PIN debit, gift card, stored value card and types of purchases.ATM services.

Operations.    DFSCredit Services performs the functions required to service and operate its card accounts either by itself or through agreements with unaffiliated third parties. These functions include new account solicitation, application processing, new account fulfillment, transaction authorization and processing, cardmember billing, payment processing, fraud prevention and investigation, cardmember services and collection of delinquent accounts. DFSCredit Services maintains several operations centers throughout the U.S. and the Consumer Banking Group International maintains one in Scotland. Systems at computer centers operated by an unaffiliated services provider also support DFS’s operations.the operations of Credit Services.

Competition.

All aspects of Morgan Stanley’s businesses are highly competitive and we expectMorgan 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.

Institutional Securities and Individual Investor Group.    Morgan Stanley competes directly in the U.S. and globally with other securities and financial services firms. firms, brokers and dealers. Morgan Stanley competes 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. Morgan Stanley competes with some of its competitors globally and with others on a regional or product basis.

Morgan Stanley’s competitive position depends on its reputation, the quality of its professionals and other personnel, its products, services and advice, ability to make capital commitments, execution capability, relative pricing and innovation. 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 costs.

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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 investment bankingunderwriting and sales, trading, financing and market-making activities, also affects its competitive position. Corporate clients continue to request that Morgan Stanley provide loans or lending commitments in connection with certain investment banking activities and Morgan Stanley expects this activity willto continue in the future.

Besides competition from firms traditionally engaged inCertain sectors of the financial services business, Morgan Stanley competes with commercial banks, insurance companies, sponsors of mutual funds, energy companies and other companies offering financial services in the U.S., globally and through the internet. The financial services industry has experienced consolidation and convergence,have become considerably more concentrated, as financial institutions involved in a broad range of financial services industries have merged.been acquired by or merged into other firms. Such convergence has continued and could result in the Company’sMorgan Stanley’s competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. 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 in certain areas. 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 trades electronically through the internet and other alternative trading systems has increased

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the pressure on trading commissions. The trend toward the use of alternative trading systems will likely continue. In addition, decimalization has led to a reduction in revenues and the implementation of a fee-based pricing structure in our Nasdaq trading business. 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.

Investment Management.    Competition in the asset management industry is affected by several factors, including relative performance of investment products investment objectives,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 servicesproducts offered. Besides fundMorgan Stanley’s products offered by other broker-dealers, the funds Morgan Stanley offers compete with the funds and separately managed account products of other asset management firms and other investment alternatives.alternatives, including hedge funds.

Credit Services.    DFS competes directly with other bank-issued credit cards (the vast majority of which bear the MasterCard or Visa servicemark), charge cards, credit cards that travel and financial advisory companies issue and to a certain extent, debit cards. Credit cards that may be issued on the Discover Network by other financial institutions may also compete with credit cards offered by DFS through Discover Bank. Competition centers on merchant acceptance of credit cards, account acquisition and customer utilization. Merchant acceptance is based on competitive transaction pricing and the volume and usage of cards in circulation. Account acquisition and customer utilization are driven by competitive and appealing credit card features, such as no annual fees, low introductory interest rates and other customized features targeting specific consumer groups. Credit card industry participants have increasingly used advertising, targeted marketing, account acquisitions and pricing competition in interest rates, annual fees, reward programs and low-priced balance transfer programs to compete and grow.

On October 4, 2004, the U.S. Supreme Court rejected an appeal by Visa and MasterCard inU.S. v. Visa/MasterCard. The trial and appellate courts found that Visa and MasterCard rules and policies that prevented virtually all U.S. financial institutions from doing business with competing networks violated the antitrust laws. Following this decision, Credit Services filed a lawsuit in federal court in New York seeking damages for harm caused by the anti-competitive rules. Now that these rules have been struck down as illegal, financial institutions (in addition to Discover Bank) will be able to issue credit and debit cards on the Discover Network. For example, GE Consumer Finance will issue a new card, Wal-Mart Discover, on the Discover Network and DFS’s acquisition of PULSE will enable Credit Services to offer financial institutions a full service debit platform and associated products.

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, and 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 New York Stock Exchange, Inc. (the “NYSE”). NYSE.

New laws or regulations or changes to existing laws and regulations (including changes in the interpretation or enforcement)enforcement thereof) could materially adversely affect the financial condition or results of operations of Morgan Stanley. 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. Regulatory

Consolidated Supervision and Revised Capital Standards.    In April 2004, the SEC approved the Consolidated Supervised Entities rule (the “CSE Rule”) that establishes a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies by the SEC. The framework is designed to minimize the duplicative regulatory requirements scheduledon U.S. securities firms resulting from the European Union (“EU”) Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. The CSE Rule also would allow MS&Co., one of Morgan Stanley’s U.S. broker-dealers, to become effective in 2005use an alternative method, based on mathematical models, to calculate net capital charges

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for market and derivatives-related credit risk. Under the CSE Rule, the SEC will also impose additional regulatory capital requirements atregulate the holding company level and enhanced risk managementany unregulated affiliate of a registered broker-dealer, including subjecting the holding company to capital requirements generally consistent with the standards of the Basel Committee on Banking Supervision (“Basel II”). In December 2004, Morgan Stanley applied to the SEC for permission to operate under the CSE Rule and expects to be approved in fiscal 2005.

Morgan Stanley continues to work with its regulators to understand and assess the impact of the CSE Rule and Basel II capital standards. Morgan Stanley cannot fully predict the impact that these changes will have on its businesses; however, compliance with consolidated supervision and the imposition of revised capital standards are likely to impose additional costs and may affect capital raising and allocation decisions.

Anti-Money Laundering.    Morgan Stanley’s Anti-Money Laundering (“AML”) Program is coordinated and implemented on an enterprise-wide basis. In the U.S., for example, the USA PATRIOT Act of 2001 (the “PATRIOT Act”) imposes significant new obligations 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 report suspicious activity to appropriate law enforcement or regulatory authorities. An institution subject to the PATRIOT Act also must provide employees with AML training, designate an AML compliance officer and undergo an annual, independent audit to assess the effectiveness of its AML Program. Outside the U.S., applicable laws and regulations subject designated types of financial institutions to similar AML requirements. Morgan Stanley has established appropriate policies, procedures across alland internal controls that are designed to comply with these AML requirements

Protection of Client Information.    Many aspects of Morgan Stanley’s businesses.business are subject to increasingly comprehensive legal requirements concerning the use and protection of certain client information including those adopted pursuant to the Gramm-Leach-Bliley Act of 1999 and the Fair and Accurate Credit Transactions Act of 2003 in the U.S. and the European Union Data Protection Directive in the EU. Morgan Stanley has adopted policies and procedures in response to such requirements.

Institutional Securities and Individual Investor Group.

Broker-Dealer Regulation.    MS&Co. and MSDWI are registered as broker-dealers with the SEC and in all 50 states, the District of Columbia and Puerto Rico, and are members of self-regulatory organizations, including the National Association of Securities Dealers, Inc. (the “NASD”) 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, public offerings, publication of research reports, use of customers’ funds and securities, capital structure, record-keeping and retention, and the conduct of their directors, officers, employees and

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employees. 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 censure, fine,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.consequences by both federal and state securities administrators.

Margin lending by certain broker-dealer subsidiaries is regulated by the Federal Reserve Board’s restrictions on lending in connection with customer and proprietary purchases and short sales of securities, as well as securities borrowing and suchlending activities. Such subsidiaries are also required by NASD and NYSE rules to impose maintenance requirements on the value of securities contained in margin accounts. In many cases, Morgan Stanley’s margin policies are more stringent than these rules.

As futures commission merchants, MS&Co. and MSDWI’s activities in the futures and options-on-futures markets are regulated by the Commodity Futures Trading Commission (the “CFTC”) and other 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 business is also regulated by the National Futures Association (the “NFA”), a registered futures association, of which MS&Co. and MSDWI and certain of their affiliates are members. Violations of the rules of the CFTC, the NFA or the commodity exchanges could result in remedial actions including fines, registration terminations or revocations of commodity exchange memberships.

Morgan Stanley conducts some of its government securities activities through Morgan Stanley Market Products Inc., a NASD member registered as a government securities broker-dealer with the SEC and in certain states. The Department of Treasury has promulgated regulations concerning, among other things, capital adequacy, custody

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and use of government securities and transfers and control of government securities subject to repurchase transactions. The rules of the Municipal Securities Rulemaking Board, which are enforced by the NASD, govern the municipal securities activities of Morgan Stanley.

As registered broker-dealers, certain subsidiaries of Morgan Stanley, including MS&Co. and MSDWI, are subject to the SEC’s net capital rule and as futures commission merchants, MS&Co. and MSDWI are subject to the net capital requirements of the CFTC and various commoditysecurities exchanges. Many non-U.S. securities exchanges and regulatory authorities also either have imposed or are proposing rules relating to capital requirements applicable to Morgan Stanley’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 Note 13 in “Notes to Financial Statements” in Part II, Item 8. NASD rules also impose limitations on the transfer of a broker-dealer’s 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.

The USA PATRIOT ActAdditional Regulation of 2001 (the “PATRIOT Act”) contains anti-money launderingU.S. Entities.    As registered futures commission merchants, MS&Co. and financial transparency laws and mandates the implementation of various new regulations applicable to broker-dealers and other financial services companies, including standards for verifying client identification at account opening and obligations to monitor client transactions and detect and report suspicious activities to the government. InstitutionsMSDWI are subject to the PATRIOT Act must implement specialized employee training programs, designate an anti-money laundering compliance officernet capital requirements of, and submit to independent auditstheir 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 MSDWI and certain of their affiliates are members. Violations of the effectivenessrules of the compliance program. Anti-money launderingCFTC, 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.

Morgan Stanley Capital Group Inc., through which Morgan Stanley conducts certain power generation and trading activities, is subject to extensive and evolving energy, environmental and other governmental laws outsideand regulations. In the past several years, intensified scrutiny of the U.S. contain similar provisions. Morgan Stanleyenergy markets by federal, state and local authorities and the public has established policies, proceduresresulted in increased regulatory and systems designed to comply with these regulations.legal enforcement and remedial proceedings involving energy companies, including those engaged in power generation and trading.

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Both U.S. and non-U.S. regulators are increasingly focused on research conflicts of interest. Research-related regulations have been implemented in certain jurisdictions and are proposed or under consideration in other jurisdictions. In addition, Morgan Stanley Bank, through which Morgan Stanley conducts certain financing and lending activities, is party to a research settlement reached with U.S. Federal and state regulators (see “Legal Proceedings” in Part I, Item 3 for a descriptionan industrial bank chartered under the laws of the settlement). NewState of Utah. It has deposits insured by the FDIC and revised requirements resulting from these regulationsis subject to comprehensive regulation and periodic examination by the Utah Department of Financial Institutions and the settlement have necessitatedFDIC. Morgan Stanley Bank is not considered a “bank” under the developmentBank Holding Company Act of corresponding policies and procedures.1956, as amended (the “BHCA”). See also “Credit Services” below.

Morgan Stanley Trust National Association, a wholly-owned subsidiary, is a federally chartered national bank whose activities are limited to fiduciary activities, primarily personal trust services. It is subject to comprehensive regulation and periodic examination by the Office of the Comptroller of the Currency. Morgan Stanley Trust, National Association is not FDIC-insured and is not considered a “bank” for purposes of the BHCA.

Non-U.S. Regulation.Morgan Stanley’s securities and futures businesses are also regulated extensively by non-U.S. governments, securities exchanges, commodity exchanges, self-regulatory organizations, central banks and regulatory bodies, especially in those jurisdictions in which Morgan Stanley maintains an office. For

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instance, the Financial Services Authority, the London Stock Exchange and Euronext.liffe regulate its activities in the U.K.; the Deutsche Borse 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 Comisión Nacional del Mercado del Valores (C.N.M.V.) regulates its activities in Spain; 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 Stock Exchange of Hong Kong Limited and the Hong Kong Futures Exchange Limited regulate its operations in Hong Kong; and the Monetary Authority of Singapore and the Singapore Exchange Securities Trading Limited regulate its business in Singapore.

Morgan Stanley Bank, throughResearch.    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 with U.S. Federal and state regulators (to which Morgan Stanley conducts certain financingis a party) have necessitated the development of corresponding policies and lending activities, is an industrial loan company chartered under the laws of the State of Utah. It has deposits insured by the Federal Deposit Insurance Corporation (“FDIC”), pays FDIC assessments and is subject to comprehensive regulation and periodic examination by the Utah Department of Financial Institutions and the FDIC. Morgan Stanley Bank is not considered a “bank” under the Bank Holding Company Act of 1956, as amended (the “BHCA”). See also “Credit Services” below.procedures.

Investment Management.    CertainThe majority of subsidiaries including MS&Co., MSDWI and those related to Morgan Stanley’s investment management activities and others, including MS&Co. and MSDWI, 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 investment management activities are subject to federal and state laws and regulations primarily intended to benefit the investment product holder.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 investment 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 thevarious investment management activities for specified periods of time, the revocation of registrations, other censures and fines. Subsequent to fiscal 2003, theThe SEC proposedhas also adopted numerous rules and new requirements relating to compliance programsthe operation of the investment companies and investment advisers and rule amendments to enhance the independence and effectiveness of fund boards.management business.

Morgan Stanley Trust National Association, a wholly-owned subsidiary,Stanley’s Investment Management business is a federally chartered national bank whose activities are limited to fiduciary activities, primarily personal trust services. It is subject to comprehensive regulationalso 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 periodic examination byExchange Board of India regulates Morgan Stanley’s business in India; and the OfficeMonetary Authority of the Comptroller of the Currency.Singapore regulates Morgan Stanley’s business in Singapore.

Morgan Stanley Trust, a wholly-owned subsidiary, is a federally chartered savings bank subject to comprehensive regulation and periodic examination by the federal Office of Thrift Supervision (“OTS”) and by the FDIC.. As a result of its ownership of Morgan Stanley Trust, Morgan Stanley is registered with the OTS as a unitary savings and loan holding company (“SLHC”) and subject to regulation and examination by the OTS as a SLHC. Subsidiaries of Morgan Stanley, including Morgan Stanley Trust, are registered transfer agents subject to regulation and examination by the SEC.

Morgan Stanley’s Investment 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

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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.

Credit Services.    Morgan Stanley conducts substantial portions of its Credit Services business in the U.S. through its wholly-owned indirect subsidiary, Discover Bank, a state bank chartered under the laws of the State of Delaware. Discover Bank has itsBank’s deposits are insured by the FDIC pays FDIC assessments and it is subject to comprehensive regulation and periodic examination by the Office of the Delaware bank commissionerBank Commissioner and by the FDIC.

Generally, a company that controls a “bank,” as defined in the BHCA, is required to register as a bank holding company and is regulated as a bank holding company by the Board of Governors of the Federal Reserve System. Discover Bank is considered a “bank” under the BHCA; however, under the BHCA, Morgan Stanley’s control of Discover Bank is grandfathered and Morgan Stanley is generally not treated as a bank holding company for purposes of the BHCA as long as Discover Bank either refrains from engaging in commercial lending or refrains from taking demand deposits.

Certain acquisitions of Morgan Stanley’s common stock may be subject to regulatory approval and notice under federal and state banking law. In addition, if direct or indirect control of Discover Bank were transferred to an unaffiliated third party, the third party’s control of Discover Bank would not be grandfathered under the BHCA and the third party may have to operate in a manner permissible for a bank holding company under the BHCA.

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Federal and state consumer protection laws and regulations regulate extensively the relationships among cardholders and credit card issuers. Under federal law, Discover Bank may charge interest at the rate allowed by Delaware law, the state in which it is located, and export such interest rate to all other states. Delaware law does not limit the amount of interest that may be charged on loans of the typestype offered by Discover Bank. Federal and state bankruptcy and debtor relief laws affect Morgan Stanleymay have a financial impact on Credit Services to the extent such laws result in any loans being charged off as uncollectible.

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), the federal bank regulatory agencies are required to take “prompt corrective action” in respect of banks that do not meet minimum capital requirements, and certain restrictions are imposed upon banks that meet certain capital requirements but are not “well capitalized” for purposes of FDICIA. A bank that is not well capitalized, as defined for purposes of FDICIA, is, among other consequences, generally prohibited from accepting brokered deposits and offering interest rates on any deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited). Discover Bank currently uses brokered deposits as a funding source and, if it were not able to do so, its funding costs could be impacted.

Morgan Stanley conducts its U.K. credit card and personal loan business through Morgan Stanley Dean Witter Bank International Limited, Morgan Stanley’s chartered bank in the U.K., which is subject to regulation related to capital adequacy, consumer protection and deposit protection. The bank is governed primarily by the U.K.’s Financial Services and Markets Act 2000 and its activities are supervised by the Financial Services Authority and by the Office of Fair Trading in relation to its consumer credit activities.

Executive Officers of Morgan Stanley.

The executive officers of Morgan Stanley (all of whom are members of Morgan Stanley’s Management Committee) and their ages and titles as of February 25, 200410, 2005 are set forth below. Business experience for the past five years is provided in accordance with SEC rules.

Philip J. Purcell (60)(61).    Chairman of the Board of Directors and Chief Executive Officer (since May 1997). Director or trustee of approximately 100 registered investment companies for which Morgan Stanley Investment Advisors Inc. serves as investment manager or investment adviser. Director of AMR Corporation.

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Stephan F. Newhouse (56)(57).    President (since December 2003). Co-President and Chief Operating Officer of Institutional Securities (September 2000 to December 2003). Deputy head of Institutional Securities (December 1997 to September 2000) and Chairman of Morgan Stanley & Co. International Limited (December 2000 to November 2003).

Tarek F. Abdel-Meguid (48).    Head of Investment Banking Division (since September 2000). Deputy Head of Investment Banking Division (May 1997 to September 2000).

Stephen S. Crawford (39)*(40).    Executive Vice President and Chief Administrative and Risk Officer (since March 2004). Executive Vice President and Chief Financial Officer (since(March 2001 to March 2001)2004). Executive Vice President and Chief Strategic and Administrative Officer (June 2000 to March 2001). Managing Director of MS&Co. (since 1998).

Zoe Cruz (49)(50).    Head of Fixed Income Division (since September 2000). Co-Head of Foreign Exchange Department (August 1993 to September 2000).

John P. Havens (47)(48).    Head of Institutional Equity Division (since September 2000). Managing Director of MS&Co. (since 1990). Director of Nasdaq Stock Market, Inc.

Roger C. Hochschild (39)(40).    President and Chief Operating Officer of DFS (since January 2004). Executive Vice President and Chief Strategic and Administrative Officer (March 2001 to January 2004). Executive Vice President of DFS (November 1998 to February 2001).

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Donald G. Kempf, Jr. (66)(67).    Executive Vice President, Chief Legal Officer and Secretary (since December 1999). Partner at the law firm of Kirkland & Ellis (1971 to January 2000) and a member of its management committee (1981 to 1998).

Mitchell M. Merin (50)(51).    President and Chief Operating Officer of Investment Management (since December 1998). Director or trustee (since December 1999) of approximately 2055 registered investment companies for which Van Kampen AssetMorgan Stanley Investment Management (or a subsidiary thereof) serves as investment manager or investment adviser.advisor.

David W. Nelms (43).    Chairman and Chief Executive Officer of DFS (since January 2004). President and Chief Operating Officer of DFS (September 1998 to January 2004).

Vikram S. Pandit (47)(48).    President and Chief Operating Officer of Institutional Securities (since December 2003, Co-President September 2000 to December 2003). Head of Institutional Equity Division (May 1997 to September 2000).

Joseph R. Perella (62)(63).    Chairman of Institutional Securities (since September 2000). Head of Investment Banking Division (May(January 1997 to September 2000).

John H. Schaefer (52).    President and Chief Operating Officer of Individual Investor Group (since June 2000). Executive Vice President and Chief Strategic and Administrative Officer (June 1998 to June 2000).

12David H. Sidwell (51).    Executive Vice President and Chief Financial Officer (since March 2004). Chief Financial Officer of the investment bank of J.P. Morgan Chase & Co. (December 2000 to March 2004). Controller of J.P. Morgan & Co. Incorporated (April 1994 to January 2001).

Item 2.    Properties.*

 

Morgan Stanley owns its executive offices, located at 1585 Broadway, New York, New York, where it occupies approximately 925,000 square feet as its New York headquarters. Morgan Stanley owns a 748,000 square foot office building on 107 acres in Westchester County, New York. Morgan Stanley also owns 83 acres in Riverwoods, Illinois where DFS’s executive offices occupy 1,200,000 square feet.

 

Morgan Stanley occupies approximately 1,800,000 square feet at various locations in Manhattan under leases expiring between 20042005 and 2013. Morgan Stanley also leases approximately 420,000 square feet in Brooklyn, New York under a lease expiring in 2013 and approximately 440,000 square feet in Jersey City, New Jersey under leases expiring between 2005 and 2013. In December 2004, and 2012.Morgan Stanley reached an agreement to lease, beginning in January 2005, approximately 445,000 square feet at One New York Plaza in New York, New York under a lease expiring in 2014.

 

Morgan Stanley’s London headquarters are located at 25 Cabot Square, Canary Wharf where it occupies approximately 455,000 square450,000 square feet and owns the freehold interest in the land and the building. Morgan Stanley also leases approximately 1,150,0001,170,000 square feet at locations in Canary Wharf and London Docklands, under lease arrangements expiring or with break options occurring between 20042005 and 2028.

 

Morgan Stanley’s Tokyo headquarters are located in Sapporo’s Yebisu Garden Place, Ebisu, Shibuya-ku, where it occupies approximately 280,000 square feet under a lease with an option to cancel in 2006, or at any time thereafter.

 

Morgan Stanley has offices, operations and processing centers and warehouse facilities located throughout the U.S., and certain subsidiaries maintain offices and other facilities in international locations. Morgan Stanley’s properties that are not owned are leased on terms and for durations that are reflective of commercial standards in

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*	The indicated total aggregate square footage leased is at November 30, 2004 and does not include space occupied by Morgan Stanley securities branch offices.

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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.

 

Item 3.

Legal Proceedings.

 

(a) Morgan Stanley is involved in the following legal proceedings:

 

IPO Fee Litigation.

 

In November and December 1998, purported class actions, later consolidated intoIn re Public Offering Fee Antitrust Litigation, were initiated in the U.S. District Court for the Southern District of New York (the “SDNY”) against Morgan Stanley and 24 other underwriters. The consolidated amended complaint, filed on behalf of purchasers of certain shares in initial public offerings (“IPOs”), alleges that defendants conspired to fix the underwriters’ spread in IPOs of U.S. companies at 7%, particularly in issuances of $20 to $80 million, in violation of Section 1 of the Sherman Act. The consolidated amended complaint seeks treble damages and injunctive relief. During 2001, the courtCourt dismissed this action with prejudice and denied plaintiffs’ motion to amend the complaint to include an issuer plaintiff, but stated that any class actions brought on behalf of issuer plaintiffs were not affected by this decision. On December 13, 2002, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) reversed the district court’s dismissal and remanded the purchaser case to the trial court. On June 24, 2003, defendants filed a supplemental brief in support of their motion to dismiss on the ground of standing. On February 24, 2004, the Court dismissed plaintiffs’ claims for damages on standing grounds, but did not dismiss the claim for injunctive relief.

 

Other purported class actions were filed in the SDNY by issuer plaintiffs making similar antitrust allegations with respect to the 7% underwriters’ spread, and on May 23, 2001, the courtCourt consolidated these actions under the captionIn re Issuer Plaintiff Initial Public Offering Fee Antitrust Litigation. During 2002, the courtCourt denied defendants’ motion to dismiss the issuer plaintiffs’ complaint. On June 26, 2003, the courtCourt denied defendants’ motion to dismiss both the purchaser and issuer class actions on grounds of implied immunity. On March 9, 2004, the Court supplemented its 2002 order denying defendants’ motion to dismiss the issuer plaintiffs’ claims after considering all of defendants’ arguments on statute of limitations grounds.

 

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*	The indicated total aggregate square footage leased is at January 31, 2004 and does not include space occupied by Morgan Stanley securities branch offices.

On September 16, 2004, plaintiffs filed motions for class certification in both the purchaser and issuer class actions.

 

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IPO Allocation Matters.

 

In March 2001, a purported class action, now captionedIn re Initial Public Offering Antitrust Litigation, was initiated in the SDNY against Morgan Stanley and numerous other underwriters of various IPOs. The consolidated amended complaint alleged 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 (“tie-in purchases”) at escalating price levels higher than the IPO price (a practice plaintiffs refer to as “laddering”). The complaint alleged violations of federal and/or state antitrust laws, including Section 1 of the Sherman Act. On November 3, 2003, the courtCourt dismissed all of the federal and state antitrust claims. Plaintiffs have filed aOn April 14, 2004, the Court denied plaintiffs’ motion for reconsideration and a notice of appeal.the dismissal. On June 23, 2004, plaintiffs submitted their appeal to the Second Circuit.

 

Also beginning in March 2001, numerous purported class actions, now captionedIn re Initial Public Offering Securities Litigation, were filed in the SDNY against certain issuers of 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 make factual allegations similar to the complaint in the antitrust action described above, but claim violations of the federal securities laws, including Sections 11 and 12(a)(2) of the Securities Act of 1933 (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

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increased or sustained the prices at which the securities traded after the IPOs. On February 19, 2003, the underwriter defendants’ joint motion to dismiss was denied, except as to certain specified offerings. On June 26, 2003, the10, 2004, plaintiffs announced a proposed settlement with theand issuer defendants and their directors and officersentered into a definitive settlement agreement under which insurers of the issuers would guarantee recovery of at least $1 billion by class members. As part of the settlement, the settling issuer defendants would assign to the class members certain claims they may have against the underwriters. On June 14, 2004, those parties jointly moved for approval of the proposed settlement. On October 13, 2004, the Court granted in large part plaintiffs’ motions for class certification in six focus cases selected for class certification briefing. In November and December 2004, purported assignees of certain issuers filed suit against several members of the underwriting syndicate, including Morgan Stanley, on the ground that underwriters breached the underwriting agreement and related duties by allocating shares in each company’s IPO to customers who allegedly paid the underwriters “excess compensation.” The assignment was conferred in the issuers’ settlement, and plaintiffs have moved to stay this action pending approval of the issuers’ settlement.

 

On or about April 2, 2002, a purported class action complaint, captionedBreakaway Solutions, Inc. v. Morgan Stanley & Co. Incorporated, et al.,was filed in the Delaware Court of Chancery against Morgan Stanley and two other underwriters. The complaint was brought on behalf of a class of issuers that issued IPO securities from January 1, 1998 to October 31, 2000 pursuant to underwriting agreements with defendants and whose securities increased in value by 15 percent or more within 30 days following the IPO. The complaint alleges that defendants allocated underpriced stock to certain of defendants’ favored clients and, directly or indirectly, shared in portions of the profits of such favored clients pursuant to side agreements or understandings, with the alleged effect of depriving issuers of millions of dollars in IPO proceeds. The complaint seeks unspecified damages for allegedly underpricing the IPOs, as well as indemnification and contribution for the costs of defending securities class action lawsuits brought by shareholders relating to issuers’ IPOs. On March 3, 2003, defendants filed aAugust 27, 2004, the Court granted in part and denied in part defendants’ motion to dismiss.dismiss, dismissing a breach of contract claim and the claims for indemnification and/or contribution.

 

In 2001On or about May 18, 2004, Morgan Stanley entered into a settlement with the NASD to resolve a matter relating to IPO allocation practices and 2002,the receipt of higher than usual commission rates. Morgan Stanley submitted a Letter of Acceptance, Waiver and Consent for the purpose of settling alleged violations of NASD Rule 2110 requiring member firms to observe high standards of commercial honor and adhere to just and equitable principles of trade. Morgan Stanley consented, without admitting or denying the allegations, to the imposition of a censure, a fine of $490,000 and a payment of $4.9 million in disgorgement for receiving high commissions from approximately 25 customers without inquiry and within one day of allocating shares of “hot” IPOs to those customers.

On January 25, 2005, the SEC announced a settlement with MS&Co. and NASD issued subpoenasGoldman Sachs & Co. resolving the SEC’s investigation relating to Morgan Stanley (and certain other underwriters of IPOs) in connection with their investigations of IPO allocation practices. During 2003,The SEC filed a settled civil injunction action in the United States District Court for the District of Columbia against MS&Co. relating to the allocation of stock to institutional customers in IPOs underwritten during 1999 and 2000. Under the terms of the settlement, Morgan Stanley was informed thatagreed, without admitting or denying the staffallegations, to the entry of the SEC was considering recommending an enforcement action against Morgan Stanley and that the staffa judgment enjoining it from violating Rule 101 of the NASD was considering recommending a disciplinary action against Morgan Stanley in connection with their investigations of IPO allocation practices. Also in 2002, the SEC initiated an inquiry (with the NYSERegulation M and the NASD) into past IPOpayment of a $40 million civil penalty. The court approved the settlement on February 4, 2005. The complaint alleges that MS&Co. violated Rule 101 of Regulation M by attempting to induce certain customers who received allocations of IPOs to executivesplace purchase orders for additional shares in the aftermarket. No allegation of companies for which Morgan Stanley provided investment banking services.fraud or impact on the market was made.

 

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Research Matters.

 

On April 28, 2003, Morgan Stanley, along with nine other financial services firms operating in the U.S., reached a final settlement with the SEC, the New York State Attorney General’s Office, the NYSE, the NASD, and the North American Securities Administrators Association (on behalf of state securities regulators) to resolve their investigations relating to alleged research conflicts of interest. Without admitting or denying allegations with respect to violations of certain rules of the NYSE and NASD relating to investment research activities (there were no allegations of fraud or federal securities law violations made against Morgan Stanley), Morgan Stanley

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entered into consents and other documentation pursuant to which Morgan Stanley agreed, among other things, to (1) pay $25 million as a penalty, (2) pay $25 million as disgorgement of commissions and other monies, (3) provide $75 million over five years to make available independent third-party research to clients, (4) adopt internal practices and procedures that will further enhance steps it has taken to ensure research analyst integrity and promote investor confidence and (5) be permanently restrained and enjoined from violating certain rules of the NYSE and NASD relating to investment research activities. In connection with the final settlement, Morgan Stanley also voluntarily agreed to adopt restrictions on the allocation of shares in initial public offerings to certain corporate executives and directors. The settlement has been approved by the SEC, the NYSE, the NASD, the SDNY and almost all states, and was entered as a court-ordered injunction in the SDNY on October 31, 2003.

 

On May 30, 2003, the SEC issued a subpoena to Morgan Stanley requesting documents and information in connection with its continuing investigation of research analysts’ conflicts of interests, focusing on supervision by the heads of equity research and investment banking, as well as the chief executive officer.banking. The SEC issued similar subpoenas to all of the firms that settled the investigations regarding research investigations.independence matters. Morgan Stanley continues to receive, and respond to, subpoenas and requests for documents, information and witness testimony.

 

Starting in 2001 and continuing through 2003,2004, Morgan Stanley has been named as a defendant in a number of civil actions, including class, shareholder and derivative actions, alleging various claims relating to research analysts’ conflicts of interest.

On May 21, 2004, inFogarazzo v. Lehman Bros., et al., a case filed in the SDNY against Morgan Stanley continuesand two other underwriters alleging that underwriters failed to defenddisclose that they were issuing positive research on RSL Communications, Inc. to obtain investment banking business, the Court denied defendants’ motion to dismiss.

On June 30, 2004, the Supreme Court of the State of New York dismissedStriffler v. Purcell, et al., a shareholder derivative action against these actions.certain current or former members of the Board of Directors and certain other officers alleging breach of fiduciary duty in connection with research practices. On July 30, 2004, plaintiff filed a notice of appeal.

On July 23, 2004, inState of West Virginia ex rel. Darrell v. Bear Stearns & Co., Inc., et al., a case filed in the Circuit Court of Marshall County, West Virginia against Morgan Stanley and nine other firms that settled regulatory actions in connection with research independence matters seeking to impose civil fines for alleged violations of the West Virginia Consumer Credit and Protection Act based on alleged conflicts of interest between defendants’ investment bankers and research analysts, the Court denied defendants’ motion to dismiss and certified a question for the Supreme Court of Appeals of West Virginia. On September 21, 2004, defendants filed a Petition for Review of Certified Question with the Supreme Court of Appeals of West Virginia. On January 24, 2005, the Supreme Court of Appeals accepted review of the certified question.

On September 29, 2004, the SDNY dismissedShah v. Morgan Stanley & Co. Inc., et al., a shareholder class action alleging that Morgan Stanley’s stock price declined upon disclosure of the 2003 global research settlement and alleged banking-research conflicts. On November 10, 2004, plaintiffs filed a notice of appeal.

 

Mutual Fund Matters.

 

Sales Practices.    On July 14, 2003, the Massachusetts Securities Division (the “Division”) filed an administrative complaint alleging that Morgan Stanley filed false information in response to an inquiry from the Division pertaining to mutual fund sales practices. On August 11, 2003, the Division filed an administrative complaint, alleging that Morgan Stanley failed to make disclosures of incentive compensation for proprietary and partnered mutual fund transactions. On November 25, 2003, the Division filed an administrative complaint, alleging that a former branch manager engaged in securities fraud and dishonest conduct in promoting the sales of proprietary mutual funds. On May 24, 2004, the presiding hearing officer granted Morgan Stanley answered the first two complaints on August 4Stanley’s motion to dismiss all claims relating to Morgan Stanley’s differential compensation practices and September 16, 2003, respectively. Hearings on allits receipt of these matters are scheduled to commence on May 17, 2004.

 

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remuneration from third-party fund families, holding that these practices did not violate any state law or regulation. Regarding the Division’s complaint filed on July 14, 2003, Morgan Stanley and one ofwaived its officers entered into a settlement with the NASD pursuantright to a Letterhearing and agreed to pay an administrative fine of Acceptance, Waiver$25,000 on September 27, 2004. Regarding the Division’s complaints filed on August 11, 2003 and Consent (“AWC”). The AWC alleges violations of applicable NASD rules in connection with various sales contests conducted from October 1999 toNovember 25, 2003, hearings were concluded on December 2002. Under the terms of the settlement, Morgan Stanley and its officer neither admitted nor denied the allegations of the AWC and accepted a censure20, 2004, and the imposition of monetary fines inparties are awaiting a decision from the amounts of $2 million and $250,000, respectively.independent hearing officer.

 

From October 2003 to December 2003, nine purported class actions now captionedIn re Morgan Stanley and Van Kampen Mutual Funds Securities Litigation, were initiated in the SDNY against Morgan Stanley, including certain subsidiaries and various Morgan Stanley and Van Kampen mutual funds, and certain officers of Morgan Stanley and its affiliates and certain trustees of the named Morgan Stanley funds. The consolidated amended complaint was filed on behalf of a purported class ofall persons or entities, other than defendants, who purchased or otherwise acquiredheld shares of certain Morgan Stanley or Van Kampen mutual funds from October 1, 1999 to November 17, 2003 against Morgan Stanley, including certain subsidiaries and various Morgan Stanley and Van Kampen mutual funds. The complaintsPlaintiffs allege that defendants’defendants gave their sales force was given economic incentives to promote the sale of proprietary mutual funds for excessive commissions and further allege that defendantsthey improperly failed to disclose suchthese economic incentives. All nine complaints allegeThe complaint also alleges that defendants improperly used Rule 12b-1 fees and that the named funds paid excessive commissions to MSDWI in connection with the sale of proprietary funds. The complaint alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act, Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 20(a) of the Exchange Act. Some complaints also allege violations ofAct, Section 206 of the Investment

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Advisers Advisors Act of 1940, Sections 36(a)34(b), 36(b) and 36(b)48(a) of the Investment Company Act of 1940, and of common law fiduciary duties. The complaints seek,consolidated amended complaint seeks, among other things, compensatory damages, rescissionary damages, fees and costs. On July 2, 2004, defendants filed a motion to dismiss the consolidated amended complaint.

 

On November 17, 2003, MSDWI consented, without admitting or denying the findings, to the entry of an order (the “Order”) by the SEC that resolved the SEC’s and NASD’s investigations into certain practices relating to MSDWI’s offer and sale of certain mutual funds from January 1, 2000 to the date of the Order. Pursuant to the Order, MSDWI will: (a) distribute for the benefit of certain customers who purchased shares of mutual funds through MSDWI pursuant to the marketing arrangements between MSDWI and certain mutual fund complexes the amount of $50 million; (b) place on its website disclosures relating to certain marketing programs pursuant to which it offered and sold certain mutual funds; (c) prepare a Mutual Fund Bill of Rights that discloses, among other things, the differences in fees and expenses associated with the purchase of different classes of proprietary mutual fund shares; (d) prepare a plan by which certain customers’ proprietary Class B shares can be converted to Class A shares; (e) retain an independent consultant to review, among other things, the adequacy of MSDWI’s disclosures with respect to such marketing programs and other matters in connection with MSDWI’s offer and sale of shares of mutual funds and compliance with the Order; and (f) adopt the recommendations of the independent consultant.

On June 17, 2004, the New Hampshire Bureau of Securities Regulation filed a petition for relief against MSDWI alleging, among other things, that a former representative solicited certain customers to purchase certain unregistered, non-exempt securities, that certain managers promoted the sale of proprietary mutual funds and other products by the use of certain “sales contests” and that MSDWI failed to disclose the allegedly material fact of such contests. The numberpetition for relief seeks, among other things, an administrative fine of purchase transactions of Class B shares that will$500,000 and an order to show cause why MSDWI’s broker-dealer license should not be eligible to convert shares is approximately 8,000. The ultimate financial impact on MSDWI of these conversions will depend on many variables, including the number of eligible purchasers who elect to convert to Class A shares (which carry different fees) and the terms of the conversion (which must be acceptable to the independent consultant).suspended or revoked.

 

Late Trading and Market Timing.    InStarting in July 2003, Morgan Stanley received a subpoenasubpoenas and requests for information from various regulatory and governmental agencies, including the Attorney General of the State of New York, requesting information relating to possible late trading and market timing of mutual funds. In September 2003, the SEC, and NASD, commenced industry-wide examinations of broker-dealers and mutual fund complexes, including Morgan Stanley, relating to possible late trading and market timing of mutual funds. In late 2003, Morgan Stanley received subpoenas from the Massachusetts Securities Division, and the U.S. Attorney’s office inOffice of Massachusetts requesting information about market timing in mutual funds. In addition, Morgan Stanley has also received inquiries from various international regulators. In early February 2004, Morgan Stanley also received subpoenas fromand the Office of the State Auditor and the Attorney General of West Virginia.Virginia in connection with industry-wide investigations of broker-dealers and mutual fund complexes relating to possible late trading and market timing of mutual funds. Morgan Stanley is cooperating with these and other regulatory investigations.investigations and continues to receive, and respond to, subpoenas and requests for documents and information from the SEC, NASD and other regulators.

 

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On December 18, 2003, a purported class action, captionedJackson v. Van Kampen Series Fund, Inc. and Van Kampen Investment Advisory Corp., was filed in the Circuit Court of Madison County, Illinois, alleging that defendants failed to make daily adjustments for fluctuations between the U.S. and foreign markets in calculating net asset values in the Van Kampen International Magnum Fund, thereby exposing long-term shareholders to market timingthe effects of market-timing trades. On January 22, 2004, defendantDefendants removed the case to federal court, but, on April 1, 2004, the case was remanded to state court. The complaint seeks, among other things, compensatory and punitive damages. On April 30, 2004, defendants appealed to the U.S. Court of Appeals for the Seventh Circuit seeking review of the decision to remand the case from federal to state court. On August 10, 2004, the state court denied defendants’ motion to dismiss.

On February 20, 2004, a derivative action, tocaptionedStarr v. Van Kampen Investments Inc., et al.,was filed in the U.S. District Court for the SouthernNorthern District of Illinois.Illinois on behalf of various Van Kampen mutual funds against Van Kampen Investments Inc., Van Kampen Asset Management Inc., Morgan Stanley, MSDWI, Morgan Stanley Investment Advisors Inc. and individual trustees of the funds. The original complaint alleges violations of the Investment Company Act of 1940, the Investment Advisers Act of 1940, and common law breach of fiduciary duty with respect to Van Kampen’s participation in certain mutual fund marketing programs operated by MSDWI. Plaintiff seeks, among other things, to remove current trustees, to rescind the management contracts for the Van Kampen Funds and to replace the manager, disgorgement, monetary damages, including punitive damages and interest, and fees and expenses. On April 26, 2004, the Court ordered the action transferred to the SDNY for coordination withIn re Morgan Stanley and Van Kampen Mutual Funds Securities Litigation. On December 8, 2004, defendants filed a motion to dismiss the First Amended Derivative Complaint. On December 23, 2004, plaintiff filed a Motion for Leave to File a Second Amended Derivative Complaint adding a new allegation that defendants permitted or recklessly disregarded market timing or late trading in Van Kampen funds. On December 23, 2004, plaintiff also filed a Notice of Tag-Along Action with the Judicial Panel on Multidistrict Litigation, requesting that the case be transferred to the United States District Court for the District of Maryland (the “Maryland District Court”). On January 28, 2005, the Judicial Panel on Multidistrict Litigation issued a Conditional Transfer Order. On February 3, 2005, the parties agreed that plaintiff’s proposed Second Amended Derivative Complaint would be withdrawn and that the allegations regarding market-timing and late trading asserted therein would be filed in a separate complaint in the Maryland District Court in coordination withIn re Mutual Funds Investment Litigation. The parties also stipulated that theStarr case in the SDNY would be stayed and placed on the Court’s suspense calendar until the later of a decision on the pending motions to dismiss inIn re Morgan Stanley and Van Kampen Mutual Fund Securities Litigation or a decision by the Maryland District Court of any motion to dismiss the Maryland litigation.

On September 29, 2004, MSDWI was added as a defendant in two of the actions that are part of the multi-district market-timing litigation captionedIn re Mutual Funds Investment Litigation in the United States District Court for the District of Maryland. The complaints,Lepera v. Invesco Funds Group, Inc., et al., andRiggs v. Massachusetts Financial Services Company, et al., assert claims against MSDWI for unjust enrichment, aiding and abetting, breach of fiduciary duty, and violation of Section 10(b) of the Exchange Act and seek, among other things, compensatory and punitive damages. These claims are based on allegations that MSDWI was among a group of broker-dealers that facilitated market-timing transactions in various mutual funds controlled by third parties.

 

Other.On September 28, 2001, a purported class action,Abrams v. Van Kampen Funds Inc., et al., was commenced in the U.S. District Court for the Northern District of Illinois against Van Kampen Funds Inc., Van Kampen Investment Advisory Corp., Van Kampen Prime Rate Income Trust and certain of the Trust’s officers and trustees. The complaint alleges that, from September 30, 1998 to March 26, 2001, defendants violated certain

provisions of the Securities Act and common law fiduciary duties by misstating the Trust’s net asset value in its prospectus, registration statement and financial reports. The complaint seeks rescissionary damages, unspecified damages, interest, fees and costs. In 2002, the courtCourt granted in part and denied in part defendants’ motion to dismiss and granted the lead plaintiff’s motion for class certification. On June 24, 2004, the Court denied plaintiff’s motion for summary judgment and granted in part and denied in part defendants’ motion for summary

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judgment. On December 8, 2003, plaintiffs2004, the Court dismissed with prejudice plaintiffs’ claims under Section 12(a)(2) of the Securities Act and defendants filed cross-motions for summary judgment.plaintiffs’ common law fiduciary duty claims.

 

On November 14, 2001, a purported class action,Hicks v. Morgan Stanley & Co., et al., was filed in the SDNY against Morgan Stanley & Co., Morgan Stanley Dean Witter Services Company Inc., Morgan Stanley Investment Advisors Inc., Morgan Stanley Dean Witter Prime Income Trust, and certain of the Trust’s officers and trustees. The complaint alleges that, between November 1, 1998 and April 26, 2001, defendants violated certain provisions of the Securities Act and common law fiduciary duties by misstating the Trust’s net asset value in its

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prospectus, registration statement and financial reports. The complaint seeks rescissionary damages, unspecified damages, interest, fees and costs. In 2002, the courtCourt dismissed the state law claims. On July 16, 2003, the courtCourt granted plaintiffs’ motion for class certification. The parties reached an agreement-in-principle to settle the matter. On December 9, 2004, the Court entered an Order Preliminarily Approving the Proposed Settlement, Directing Issuance of Notice to the Class, and Setting a Fairness Hearing.

 

In 2002, several purported class action complaints were filed in the SDNY against Morgan Stanley, the Morgan Stanley Technology Fund, the Morgan Stanley Information Fund, Morgan Stanley Investment Management, Inc., and certain other subsidiaries of Morgan Stanley, alleging securities fraud violations in connection with the underwriting and management of the Technology Fund and the Information Fund and seeking unspecified damages for losses on investments in these funds. Plaintiffs allege that Morgan Stanley analysts issued overly optimistic stock recommendations to obtain investment banking business and that investment banking considerations influenced investment decisions made by the fund managers. On August 29, 2003, the SDNY entered an Order approving the parties’ stipulation to stay the actions pending the decision of the U.S. Court of Appeals for the Second Circuit in an appeal from the dismissal of a similar case brought against another party by the same plaintiffs’ law firm.

 

On February 24, 2003, a putative class action captionedEdward Benzon, et al., v. Morgan Stanley Distributors Inc., et al.,was commenced in the U.S. District Court for the Middle District of Tennessee against Morgan Stanley Distributors Inc., Morgan Stanley Investment Advisors Inc., Morgan Stanley Investment Management Inc., Morgan Stanley Investments L.P., Morgan Stanley DW Inc.,MSDWI, and Morgan Stanley. The complaint alleges that defendants failed to disclose certain benefits of Class A and Class C shares relative to Class B shares in the prospectuses of certain Morgan Stanley mutual funds and the alleged financial conflicts of Morgan Stanley financial advisorsrepresentatives in selling Class B shares. In addition to individual claims asserted on behalf of the named plaintiffs, the complaint alleges, on behalf of a purported class of investors who purchased Class B shares from February 25, 1998 to the present, violations of Sections 11 and 12 of the Securities Act and Section 10(b) of the Exchange Act. The complaint seeks unspecified rescissionary damages, unspecified damages, interest, fees and costs. On January 8, 2004, the courtCourt granted defendants’ motions to dismiss. On February 5, 2004, plaintiffs’ motion to alter or amend judgment and for leave to file an amended complaint was denied. On February 17, 2004, plaintiffs filed a notice of appeal.appeal, which appeal is now pending before the U.S. Court of Appeals for the Sixth Circuit.

On May 21, 2004, a putative class action captionedThe Robert N. Clemens Trust, et al., v. Morgan Stanley DW Inc.was filed in the U.S. District Court for the Western District of Tennessee. The complaint alleges that the defendant’s representatives inappropriately recommended Class B shares of Morgan Stanley mutual funds. In addition to individual claims asserted on behalf of the named plaintiffs, the complaint alleges on behalf of a purported class of certain purchasers of Morgan Stanley mutual funds’ Class B shares from February 25, 1998 to the present, violations of Section 10(b) of the Exchange Act and Rules 10b-5(a), (b) and (c). The complaint seeks, among other things, disgorgement and restitution of unspecified fees and charges, and unspecified compensatory and punitive damages, interest, fees and costs.

 

Mutual fund industry practices continue to be the subject of intense regulatory, governmental and public scrutiny. Morgan Stanley has received various regulatory inquiries, relating to, among other things, fees and revenue sharing, and is cooperating with all inquiries.inquiries, including an SEC investigation regarding the amount of fees charged by certain Morgan Stanley index funds, as well as the process by which those fees were determined.

 

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Electricity Trading Matters.

 

Morgan Stanley is involved in severalcertain ongoing proceedings arising out of its activities as a wholesale power marketer in the Western energy markets during and after the summer of 2000.

These proceedings include a number of purported class actions in California state court on behalf of electricity consumers in California and Washington against several power marketers and generators, including Morgan Stanley. The majorityThese complaints assert violations of the complaints allegestate unfair competition statutes based on allegations that, during the summer of 2000, defendants fixed the prices for electricity in violation of California’s unfair competition statutes, andelectricity. In those actions, plaintiffs seek reimbursement of alleged overcharges and punitive damages. An additional class action,Millar v. Allegheny Energy, seeks to rescind various long-term power contracts entered into between the StateCalifornia and defendants, including Morgan Stanley. All of thesethe California actions exceptMillarhave been remanded to California Superior Court. AnCourt, and an appeal of the remand decision remanding all actions other thanMillar is pending before the U.S. Court of Appeals for the Ninth Circuit.Millarwas removed to the U.S. District Court for the Southern District of California. The Washington class action,City of Tacoma v. American Electric Power Service Corp., is pending in the U.S. District Court for the Western District of Washington.

 

Numerous power marketers, including Morgan Stanley also werewas named in various actionsfour proceedings filed with the Federal Energy Regulatory Commission (the “FERC”(“FERC”), by counterparties seeking to rescind or modify long-term power contracts entered into during and after the summer of 2000 as allegedly unjust and unreasonable. On June 26, 2003, the FERC issued a ruling denyingdenied the relief sought in all of these cases. On November 10, 2003,cases, and appeals from FERC’s rulings are pending in the FERC denied requestsU.S. Court of Appeals for rehearing.the Ninth Circuit. Morgan Stanley has settled the long-term contract cases brought by the State of California on July 10, 2003. Appeals from the rulings in the remaining cases against Morgan Stanley have been filed in the U.S. Courts of Appeals for the Ninth Circuit and the District of Columbia.

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In 2002, the FERC announced an investigation of possible trading abuses in the wholesale power markets in California and the Western United States during 2000. On June 25, 2003, the FERC ordered over 50 market participants, including Morgan Stanley, to show cause why certain of their trading in California markets did not violate market tariffs. On August 29, 2003, Morgan Stanley, without admitting any wrongdoing, agreed with the FERC staff to settle the matter and the settlement agreement was referred to the FERC for approval. Several parties have intervened to oppose the settlement.

In re Turkcell Iletisim Hizmetleri, A.S. Securities Litigation.

In November 2000, a class action was filed in the SDNY against Turkcell Iletisim Hizmetleri, A.S., a Turkish telecommunications company (“Turkcell”), certain officers of Turkcell, and six underwriters of Turkcell’s July 11, 2000 IPO, including Morgan Stanley. Plaintiffs filed a consolidated and amended complaint in 2001, which purports to cover a class of purchasers of Turkcell American Depositary Shares during the IPO and thereafter through September 21, 2000. The complaint alleges that the registration statement and prospectus contained materially false and misleading information concerning Turkcell’s business operations. The complaint asserts a claim under Section 11 of the Securities Act against all defendants and seeks unspecified compensatory damages, costs and attorneys’ fees. In 2001, the court granted in part and denied in part defendants’ motion to dismiss. In 2002, the court granted plaintiffs’ motion for class certification. On February 13, 2004, the court preliminarily approved a proposed settlement of this matter as to all defendants.

EEOC Matter.

On September 10, 2001, the U.S. Equal Employment Opportunity Commission (“EEOC”) filed suit against Morgan Stanley in the SDNY alleging that, since 1995, Morgan Stanley has engaged in a pattern or practice of discrimination against Allison Schieffelin, a former employee, and other females who have held the positions of associate, vice president, executive director or managing director in Morgan Stanley’s Institutional Equity Division (“IED”) in pay, promotion and other terms, conditions and privileges of employment. The complaint seeks compensatory and punitive damages. The EEOC also alleges that Morgan Stanley retaliated against Schieffelin. Also in 2001, Schieffelin intervened in the EEOC action, filing an individual complaint alleging that she had been discriminated and retaliated against and seeking similar damages. In 2002, the court permitted the EEOC to amend its complaint to expand the class to include all IED female exempt non-officers eligible to be promoted to vice president, including associates and professionals. On December 2, 2002, the court denied without prejudice Morgan Stanley’s motion for partial summary judgment.PacificCorp.

 

AOL Time Warner Litigation.

 

Beginning on April 11, 2003, Morgan Stanley washas been named as a defendant in one purported class action in the SDNY and a number of individual state court actions involving AOL Time Warner, including cases in New Jersey, Ohio, West Virginia, Pennsylvania, Alaska, and four cases in California whichthat have been coordinated in the Superior Court of the State of California, County of Los Angeles. All these cases also name as defendants AOL Time Warner, numerous individual defendants, AOL Time Warner’s auditors, and other underwriter defendants. The complaints allege that AOL Time Warner issued false and misleading financial statements by inflating advertising revenues, among other things. These complaints also name Morgan Stanley in its capacity as financial advisor to Time Warner in the merger of America Online and Time Warner, and/or as underwriter of bond offerings completed in 2001 and 2002. The complaints allege violations of Section 11 of the Securities Act and Section 14(a) of the Exchange Act (and Rule 14a-9 thereunder) in connection with the merger registration statement, as well as various state laws, and violations of Section 11 and 12(a)(2) of the Securities Act in connection with the bond registration statements.

In 2003, defendants filed motions to dismiss the actions in the SDNY and in the New Jersey and Ohio state courts. In January 2004, the parties agreed to stay the New Jersey action pendingaction. On May 5, 2004, the outcome of theCourt granted Morgan Stanley’s motion to dismiss in the SDNY action. On May 19, and August 13, 2004, respectively, defendants filed motions to dismiss the West Virginia and Alaska actions. On July 20, 2004, plaintiffs and bank defendants entered into a tolling agreement and stipulation of discontinuance and dismissal in the Pennsylvania action. On September 10, 2004, defendants filed demurrers seeking dismissal of the California coordinated actions. On October 8, 2004, in the Ohio state individual action, the Ohio Court of Common Pleas denied Morgan Stanley’s motion to dismiss the state securities law claims, but dismissed the common law claims.

 

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Coleman Litigation.

 

On May 8, 2003, a complaint captionedColeman (Parent) Holdings Inc. v. Morgan Stanley & Co., Inc., was filed in the Circuit Court of the Fifteenth Judicial Circuit in and for Palm Beach County, Florida (the “Fifteenth Circuit”) relating to Coleman (Parent) Holdings Inc.’s (“CPH”) receipt of 14.1 million shares of Sunbeam Corporation common stock when it sold its 82% interest in The Coleman Company (“Coleman”) to Sunbeam on March 30, 1998. The complaint alleges that Morgan Stanley misrepresented Sunbeam’s financial condition,

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inducing CPH to enter into the transaction, and makes claims for fraudulent misrepresentation, aiding and abetting fraud, conspiracy and negligent misrepresentation. On May 12, 2003, Morgan Stanley Senior Funding, Inc. (“MSSF”) filed an action against MacAndrews & Forbes Holdings Inc. (the parent of CPH) and CPH in the same court, alleging fraud and negligent misrepresentation for losses MSSF incurred in connection with a loan it made to Sunbeam to finance Sunbeam’s acquisition of Coleman. On December 15, 2003, the courtCourt denied Morgan Stanley’s motion to dismiss the CPH complaint. In November 2004, the court allowed CPH to amend its complaint to add a claim for punitive damages. On February 1, 2005, Morgan Stanley’s motion for summary judgment was denied. Trial is scheduled to begin in February 2005.

On March 1, 2004, Morgan Stanley, MS&Co. and Morgan Stanley Senior Funding, Inc. filed an action in the Fifteenth Circuit against Arthur Andersen LLP and certain of its affiliates and former partners. The complaint asserts fraudulent misrepresentation, fraudulent inducement, and aiding and abetting fraud, and seeks to recover damages incurred by Morgan Stanley and its affiliates as a result of their reliance on Arthur Andersen’s certification of Sunbeam’s financial statements. Morgan Stanley filed a First Amended Complaint in August 2004. Between August and September 2004, all defendants filed various motions to dismiss the complaint.

 

LVMH Litigation.

 

On October 30, 2002, the French company LVMH Moet Hennessey Louis Vuitton (“LVMH”) initiated proceedings in the Paris Commercial Court against Morgan Stanley & Co. International Limited and Morgan Stanley alleging that, between 1999 and 2002, in research reports and newspaper interviews concerning the luxury goods sector, Morgan Stanley failed in its duties of independence and impartiality and denigrated LVMH to the benefit of Gucci, a Morgan Stanley client.

 

In a judgment dated January 12, 2004, the Paris Commercial Court upheld LVMH’s complaint. The Court awarded LVMH €30 million for damage to its image and appointed an expert to assist it in assessing whether LVMH is entitled to additional damages, and, if so, in what amount. On October 18, 2004, LVMH filed submissions before the expert claiming €182.9 million in additional damages.

On February 12, 2004, Morgan Stanley filed a notice of appeal against the judgment. The parties are in the process of filing appeal submissions.

 

Carlos Soto Matter.

 

In fiscal 2004, Morgan Stanley discovered irregularities in the accounts of certain clients of Carlos Soto, a former financial advisorregistered representative in its San Juan, Puerto Rico branch. Mr. Soto stated that, with respect to certain clients, he had raised some funds by making misrepresentations, had issuedissuing false account statements and had diverteddiverting some funds to accounts he controlled. Morgan Stanley promptly notified regulators and law enforcement. On February 11 and 13, 2004, respectively, the U.S. District Court for District of Puerto Rico granted the SEC’s and Morgan Stanley’s requests for temporary restraining orders freezing Mr. Soto’s assets. On February 19, 2004, Mr. Soto was arrested by federal authorities. On February 20, 2004, in the SEC matter, the Court granted a preliminary injunction freezing Mr. Soto’s assets, and on November 8, 2004, the SEC barred Mr. Soto from any association with any broker or dealer. On December 3, 2004, Morgan Stanley reached a final settlement with the NYSE to resolve this matter (see also “New York Stock Exchange Matter” below). Morgan Stanley is continuing to assist other regulators in their investigations of Mr. Soto’s activities and to resolve customer claims concerning those activities. On November 29, 2004, the U.S. District Court for the District of Puerto Rico presiding in Mr. Soto’s criminal proceeding issued a preliminary order of forfeiture with respect to Mr. Soto’s assets. Morgan Stanley continuesand others have filed petitions in that proceeding with respect to assist authorities insuch assets. On January 25, 2005, the investigation of Mr. Soto.United States Attorney’s Office moved to dismiss the third-party petitions.

 

Parmalat Matter.

Morgan Stanley and several other financial institutions have been requested to provide documents and other information to Italian and UK authorities conducting criminal and regulatory investigations relating to Parmalat, an Italian publicly-listed company, which was declared insolvent on December 27, 2003. Morgan Stanley is cooperating with these investigations. Allegations of fraud have been raised with respect to former Parmalat management and other individuals who had dealings with Parmalat. The administrator of Parmalat is also reviewing past Parmalat transactions and may seek restitution of monies paid by Parmalat to counterparties.

 

From 2001 through 2003, Morgan Stanley entered into interest rate and currency derivative transactions with Parmalat.Parmalat, an Italian publicly-listed company. In 2002 and 2003, Morgan Stanley also was involved in two public and one private bond offerings for Parmalat outside the U.S.

 

19In fiscal 2004, Morgan Stanley and several other financial institutions were requested to provide documents and other information to Italian and U.K. authorities conducting criminal and regulatory investigations relating to

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Parmalat, which was declared insolvent on December 27, 2003. Morgan Stanley and several other financial institutions, together with employees of those institutions involved in Parmalat-related matters, are under investigation in Italy. Morgan Stanley is cooperating with these various investigations.

On April 8, 2004, Morgan Stanley voluntarily provided the SEC information concerning its dealings with Parmalat.

On December 17, 2004, the Parma, Italy bankruptcy court ruled to admit the full amount of Morgan Stanley’s €35 million claim in the administration of Parmalat. This claim resulted from amounts due to Morgan Stanley on the closing out of various derivative transactions with Parmalat at the time of its declaration of insolvency.

The administrator of Parmalat is also reviewing past Parmalat transactions and has filed various suits seeking restitution of monies paid by Parmalat to various banks and auditors. On January 27, 2005, the administrator of Parmalat filed an insolvency clawback claim against Morgan Stanley & Co. International Ltd. and Morgan Stanley Bank International Ltd. in the civil court of Parma, Italy seeking repayment of approximately €136 million. The basis of this claim is that Morgan Stanley allegedly knew that Parmalat was insolvent at the time the monies were paid by Parmalat.

Indonesian Litigation.

In November 2003, two proceedings were initiated in the Indonesian District Courts by two members of the Asia Pulp & Paper Group (PT Indah Kiat Pulp & Paper Tbk and PT Lontar Papyrus Pulp & Paper Industry, respectively) against Morgan Stanley and thirteen other defendants, with respect to two bond issues in 1994 and 1995, guaranteed by plaintiffs, in which Morgan Stanley acted as underwriter. The claims allege that the bond issues were invalid and contrary to Indonesian law, and allege damages in the amount of all principal and interest paid under the bonds as well as other amounts. In September 2004, the Courts issued their judgments, declaring the bond issues to be illegal and void, holding that defendants (including Morgan Stanley) had committed unspecified tortious acts, but awarding no damages. Morgan Stanley has appealed both judgments.

In April 2004, another proceeding was filed in the Indonesian District Courts by PT Lontar Papyrus against Morgan Stanley and 28 other defendants, alleging that the defendants violated injunctions issued by the Indonesian District Court in the first claim brought by PT Lontar Papyrus and conspired to cause the failure of plaintiff’s restructuring negotiations. Plaintiff seeks damages in respect of losses allegedly suffered. On January 3, 2005, Morgan Stanley entered an appearance before the Indonesian District Court.

In October 2004, an additional proceeding was filed in the Indonesian District Courts by APP International Finance Company BV, a member of the Asia Pulp & Paper Group and the issuer of the 1995 bond issue, against Morgan Stanley and eighteen other defendants, making allegations similar to those in the November 2003 claim brought by PT Lontar Papyrus. Plaintiff seeks damages in respect of losses allegedly suffered.

NASD Matter.

On November 18, 2004, the NASD enforcement staff informed Morgan Stanley that it had made a preliminary determination to recommend that a disciplinary action be brought against MSDWI in connection with the staff’s investigation of fee-based brokerage accounts. The potential disciplinary action, which would allege NASD Rule violations, concerns Morgan Stanley’s opening and maintenance of certain Choice accounts, the fees charged for certain such accounts and the content of certain Choice marketing materials.

Variable Annuity Matters.

On January 20, 2005, a putative class action complaint was filed in the United States District Court for the Southern District of California against Morgan Stanley and MSDWI alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and of Section 206 of the Investment Advisers Act of 1940. The complaint alleges that MSDWI had undisclosed contingent fee sharing agreements with insurance companies issuing variable annuities, and that MSDWI breached its fiduciary duties to plaintiffs and made misstatements and omissions of material fact in connection with the allegedly undisclosed fee agreements. The complaint seeks,

		23

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among other things, unspecified compensatory damages and injunctive or equitable relief including restitution and disgorgement, attorneys’ fees and costs. MSDWI has also received a request for information and documents from the NASD, and a subpoena from the Commonwealth of Massachusetts, regarding issues relating to variable annuity sales and marketing practices.

(b) The following matters were terminated during the quarter ended November 30, 2004:

SEC Matter.

On November 4, 2004, Morgan Stanley reached a final settlement with the SEC to resolve an informal accounting investigation by executing an offer of settlement and agreeing to entry of a cease-and-desist order. The SEC found that Morgan Stanley valued certain impaired aircraft in its aircraft leasing business in late 2001, late 2002 and early 2003, and certain bonds in its high-yield bond portfolio in late 2000, in a manner that did not comply with generally accepted accounting principles, and thus violated financial reporting, recordkeeping and internal controls provisions of the federal securities laws. The resolution does not involve any restatement of past financial statements, any monetary penalty or any allegation of fraud.

New York Stock Exchange Matter.

On December 3, 2004, Morgan Stanley executed two stipulations of facts and consent to penalty (one with respect to Morgan Stanley’s failure to comply with certain prospectus delivery requirements, operational deficiencies and other matters, and the other with respect to employee defalcations, including the Carlos Soto matter). The first stipulation included a fine of $13 million and the second a fine of $6 million. On December 9, 2004, a hearing panel of the NYSE accepted both settlements.

* * *

Other.

 

In addition to the matters described above, 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 legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. Morgan Stanley is also involved, from time to time, in investigations and proceedings by governmental and self-regulatory agencies, certain of which may result in adverse judgments, fines or penalties. The number of these investigations and proceedings has increased in recent years with regard to many financial services institutions, including Morgan Stanley. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or otherwise in financial distress.

 

Morgan Stanley is also involved, from time to time, in other reviews, investigations and proceedings by governmental and self-regulatory agencies (both formal and informal) 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. The number of these investigations and proceedings has increased in recent years with regard to many firms in the financial services industry, including Morgan Stanley.

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

 

Item 4.

Submission of Matters to a Vote of Security Holders.

 

None.

None.
		24

20

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Part II

 

Item 5.

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

 

Morgan Stanley’s common stock trades on the NYSE and The Pacific Exchange. At November 30, 2004, Morgan Stanley had approximately 133,000125,000 holders of record at November 30, 2003;record; however, Morgan Stanley believes the number of beneficial owners of common stock exceeds this number.

 

Set forth below, for each of the last eight fiscal quarters, is 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			Low Sale Price			High Sale Price			Dividends
Fiscal 2004:
Fourth Quarter											$	47.30		$	53.78		$	0.25
Third Quarter											$	46.80		$	54.64		$	0.25
Second Quarter											$	50.61		$	62.22		$	0.25
First Quarter											$	55.02		$	61.60		$	0.25
Fiscal 2003:
Fourth Quarter		$	47.81		$	58.07		$	0.23		$	47.81		$	58.07		$	0.23
Third Quarter		$	42.42		$	50.49		$	0.23		$	42.42		$	50.49		$	0.23
Second Quarter		$	32.46		$	48.03		$	0.23		$	32.46		$	48.03		$	0.23
First Quarter		$	34.32		$	46.70		$	0.23		$	34.32		$	46.70		$	0.23
Fiscal 2002:
Fourth Quarter		$	28.80		$	46.83		$	0.23
Third Quarter		$	33.50		$	46.50		$	0.23
Second Quarter		$	43.92		$	58.27		$	0.23
First Quarter		$	45.90		$	60.02		$	0.23

		25

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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, 2004.

 

21Issuer 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 (Sept. 1, 2004—Sept. 30, 2004)
Equity Anti-dilution Program (A)		869,470		$	49.5403		869,470			(A	)
Capital Management Program (B)		—			N/A		—		$	600
Employee Transactions (D)		3,613,911		$	52.4356		N/A			N/A
Month #2 (Oct. 1, 2004—Oct. 31, 2004)
Equity Anti-dilution Program (A)		9,334,850		$	48.8998		9,334,850			(A	)
Capital Management Program (B)		—			N/A		—		$	600
Employee Transactions (D)		187,522		$	50.2587		N/A			N/A
Month #3 (Nov. 1, 2004—Nov. 30, 2004)
Equity Anti-dilution Program (A)		3,636,176		$	51.8660		3,636,176			(A	)
Capital Management Program (B)		—			N/A		—		$	600
Employee Transactions (D)		87,386		$	50.9655		N/A			N/A
Total
Equity Anti-dilution Program (A)		13,840,496		$	49.7193		13,840,496			(A	)
Capital Management Program (B)		—			N/A		—		$	600
Employee Transactions (D)		3,888,819		$	52.2976		N/A			N/A

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Item 6.(A)

Selected Financial Data.Morgan Stanley’s board of directors authorized this program to purchase common stock to help offset the dilutive impact of grants and exercises of awards under Morgan Stanley’s equity-based compensation and benefit plans. The program was publicly announced on January 7, 1999 and has no set expiration or termination date. There is no maximum amount of shares that may be purchased under the program.

(B)

Morgan Stanley’s board of directors authorized this program to purchase common stock for capital management purposes. The program was publicly announced on February 12, 1998 at which time up to $3 billion of stock was authorized to be purchased. The program was subsequently increased by $1 billion on December 18, 1998, $1 billion on December 20, 1999 and $1.5 billion on June 20, 2000. This program has a remaining capacity of $600 million at November 30, 2004 and has no set expiration or termination date.

(C)	Share purchases under publicly announced programs are made pursuant to open-market purchases, Rule 10b5-1 plans or privately negotiated transactions (including with employee benefit plans) as market conditions warrant and at prices Morgan Stanley deems appropriate.

(D)

Includes: (1) shares delivered or attested to in satisfaction of the exercise price and/or tax withholding obligations by holders of employee 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 the average of the high and low price of Morgan Stanley’s common stock on the date the relevant transaction occurs.

		26

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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)																	Fiscal Year(1)
		2003			2002				2001				2000			1999			2004				2003				2002				2001				2000
Income Statement Data:
Revenues:
Investment banking		$	2,440		$	2,478			$	3,413			$	5,008		$	4,523		$	3,341			$	2,440			$	2,478			$	3,413			$	5,008
Principal transactions:
Trading			6,138			2,730				5,503				7,361			5,796			5,525				6,192				3,479				5,503				7,361
Investments			86			(31	)			(316	)			193			725			512				86				(31	)			(316	)			193
Commissions			2,970			3,278				3,159				3,664			2,783			3,264				2,887				3,191				3,066				3,566
Fees:
Asset management, distribution and administration			3,706			3,932				4,205				4,381			3,448			4,412				3,731				3,953				4,238				4,420
Merchant and cardmember			1,379			1,420				1,349				1,256			1,030			1,318				1,379				1,420				1,349				1,256
Servicing			2,015			2,080				1,888				1,489			1,232			1,993				2,015				2,080				1,888				1,489
Interest and dividends			15,744			15,879				24,132				21,233			14,879			18,590				15,744				15,879				24,132				21,233
Other			455			660				553				539			278			594				506				724				586				592
Total revenues			34,933			32,426				43,886				45,124			34,694			39,549				34,980				33,173				43,859				45,118
Interest expense			12,809			11,970				20,729				18,148			12,487			14,859				12,856				12,710				20,720				18,145
Provision for consumer loan losses			1,267			1,336				1,052				810			526			925				1,267				1,336				1,052				810
Net revenues			20,857			19,120				22,105				26,166			21,681			23,765				20,857				19,127				22,087				26,163
Non-interest expenses:
Compensation and benefits			8,545			7,940				9,376				10,899			8,365			9,880				8,545				7,940				9,376				10,899
Other			6,545			6,225				7,045				6,748			5,560			7,200				6,507				6,214				7,033				6,748
Restructuring and other charges			—			235				—				—			—			—				—				235				—				—
Total non-interest expenses			15,090			14,400				16,421				17,647			13,925			17,080				15,052				14,389				16,409				17,647
Gain on sale of business			—			—				—				35			—			—				—				—				—				35
Income before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change			5,767			4,720				5,684				8,554			7,756
Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change																				6,685				5,805				4,738				5,678				8,551
Losses from unconsolidated investees			279			77				30				33			21			328				279				77				30				33
Provision for income taxes			1,547			1,568				2,024				3,037			2,916			1,803				1,562				1,575				2,022				3,036
Dividends on preferred securities subject to mandatory redemption			154			87				50				28			28			45				154				87				50				28
Income from continuing operations before cumulative effect of accounting change																				4,509				3,810				2,999				3,576				5,454
Discontinued operations:
(Loss)/gain from discontinued operations																				(38	)			(38	)			(18	)			6				3
Income tax benefit/(provision)																				15				15				7				(2	)			(1	)
(Loss)/gain on discontinued operations																				(23	)			(23	)			(11	)			4				2
Income before cumulative effect of accounting change			3,787			2,988				3,580				5,456			4,791			4,486				3,787				2,988				3,580				5,456
Cumulative effect of accounting change			—			—				(59	)			—			—			—				—				—				(59	)			—
Net income		$	3,787		$	2,988			$	3,521			$	5,456		$	4,791		$	4,486			$	3,787			$	2,988			$	3,521			$	5,456
Earnings applicable to common shares(2)		$	3,787		$	2,988			$	3,489			$	5,420		$	4,747		$	4,486			$	3,787			$	2,988			$	3,489			$	5,420
Per Share Data:
Earnings per common share:
Basic before cumulative effect of accounting change		$	3.52		$	2.76			$	3.26			$	4.95		$	4.33
Cumulative effect of accounting change			—			—				(0.05	)			—			—
Basic		$	3.52		$	2.76			$	3.21			$	4.95		$	4.33
Diluted before cumulative effect of accounting change		$	3.45		$	2.69			$	3.16			$	4.73		$	4.10
Cumulative effect of accounting change			—			—				(0.05	)			—			—
Diluted		$	3.45		$	2.69			$	3.11			$	4.73		$	4.10

 

22

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		Fiscal Year(1)																				Fiscal Year(1)
																						2004				2003				2002				2001				2000
Per Share Data:
Basic earnings per common share:
Income from continuing operations before cumulative effect of accounting change																						$	4.17			$	3.54			$	2.77			$	3.26			$	4.95
Loss from discontinued operations																							(0.02	)			(0.02	)			(0.01	)			—				—
Cumulative effect of accounting change																							—				—				—				(0.05	)			—
Basic earnings per common share																						$	4.15			$	3.52			$	2.76			$	3.21			$	4.95
Diluted earnings per common share:
Income from continuing operations before cumulative effect of accounting change																						$	4.08			$	3.47			$	2.70			$	3.16			$	4.73
Loss from discontinued operations																							(0.02	)			(0.02	)			(0.01	)			—				—
Cumulative effect of accounting change																							—				—				—				(0.05	)			—
Diluted earnings per common share																						$	4.06			$	3.45			$	2.69			$	3.11			$	4.73
		2003				2002				2001				2000				1999
Book value per common share		$	22.93			$	20.24			$	18.64			$	16.91			$	14.85			$	25.95				22.93				20.24				18.64			$	16.91
Dividends per common share		$	0.92			$	0.92			$	0.92			$	0.80			$	0.48			$	1.00				0.92				0.92				0.92			$	0.80
Balance Sheet and Other Operating Data:
Total assets		$	602,843			$	529,499			$	482,628			$	421,279			$	366,967			$	775,410				602,843				529,499				482,628			$	421,279
Consumer loans, net			19,382				23,014				19,677				21,743				20,963				20,226				19,382				23,014				19,677				21,743
Total capital(3)			82,769				65,936				61,633				49,637				39,699				110,793				82,769				65,936				61,633				49,637
Long-term borrowings(3)			57,902				44,051				40,917				30,366				22,685				82,587				57,902				44,051				40,917				30,366
Shareholders’ equity			24,867				21,885				20,716				19,271				17,014				28,206				24,867				21,885				20,716				19,271
Return on average common shareholders’ equity			16.5	%			14.1	%			18.0	%			30.9	%			32.6	%			16.8	%			16.5	%			14.1	%			18.0	%			30.9	%
Average common and equivalent shares(2)			1,076,754,740				1,083,270,783				1,086,121,508				1,095,858,438				1,096,789,720				1,080,121,708				1,076,754,740				1,083,270,783				1,086,121,508				1,095,858,438

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(1)	Certain prior-period information has been reclassified to conform to the current year’s presentation.

(2)	Amounts shown are used to calculate basic earnings per common share.

(3)	These amounts exclude the current portion of long-term borrowings and include Capital Units and Preferred securities subjectjunior subordinated debt issued to mandatory redemption.capital trusts.

 

23

		28

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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 leading market positions in each of its business segments—Institutional Securities, Individual Investor Group, Investment Management and Credit Services. The Company’s Institutional Securities business includes securities underwriting and distribution; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; sales, trading, financing and market-making activities in equity securities and related products and fixed income securities and related products, including foreign exchange and commodities; principal investing and real estate investment management; aircraft financing activities.activities; providing benchmark indices and risk management analytics; and research. The Company’s Individual Investor Group business provides comprehensive financial planningbrokerage, investment and investment advisoryfinancial services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s financial advisors and investment representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s private equity activities also are included within the Investment Management business segment. The Company’s Credit Services business offers Discover^®-branded cards and other consumer finance products and services, including residential mortgage loans, and includes the operation of Discover Business Services,Network, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services business segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

 

The Company’s results of operations for the 12 months ended November 30, 2004 (“fiscal 2004”), November 30, 2003 (“fiscal 2003”), and November 30, 2002 (“fiscal 2002”) and November 30, 2001 (“fiscal 2001”) are discussed below.

 

24

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Results of Operations.

 

Executive Summary.

 

Financial Information.

 

		Fiscal Year(1)
		2003				2002				2001
Net revenues (dollars in millions):
Institutional Securities		$	11,211			$	9,111			$	11,280
Individual Investor Group			4,017				4,069				4,671
Investment Management			2,509				2,721				3,040
Credit Services			3,427				3,557				3,559
Intersegment Eliminations			(307	)			(338	)			(445	)
Consolidated net revenues		$	20,857			$	19,120			$	22,105
Net income (dollars in millions):
Institutional Securities		$	2,437			$	1,664			$	2,335
Individual Investor Group			265				59				23
Investment Management			326				418				425
Credit Services			688				760				689
Intersegment Eliminations			71				87				49
Consolidated net income		$	3,787			$	2,988			$	3,521
Basic earnings per common share		$	3.52			$	2.76			$	3.21
Diluted earnings per common share		$	3.45			$	2.69			$	3.11
Statistical Data (Unaudited).
Return on average common equity			16.5	%			14.1	%			18.0	%
Effective income tax rate			29.0	%			34.4	%			36.1	%
Worldwide employees			51,196				55,726				61,319
Institutional Securities:
Mergers and acquisitions announced transactions(2):
Rank			2				3				2
Global equity and related issues(2):
Rank			3				4				4
Global investment grade debt issues(2):
Rank			4				4				4
Individual Investor Group:
Global financial advisors			11,086				12,546				13,690
Total client assets (dollars in billions)		$	565			$	516			$	595
Fee-based assets as a percentage of total client assets			23	%			21	%			19	%
Investment Management:
Assets under management or supervision (dollars in billions)(3)		$	462			$	420			$	459
Percent of fund assets in top half of Lipper rankings(4)			57	%			62	%			61	%
Credit Services(5):
Period-end credit card loans—Owned (dollars in millions)		$	18,930			$	22,153			$	19,654
Period-end credit card loans—Managed (dollars in millions)		$	48,358			$	51,143			$	49,332
Average credit card loans—Owned (dollars in millions)		$	19,531			$	20,659			$	20,285
Average credit card loans—Managed (dollars in millions)		$	50,864			$	49,835			$	49,432
Net principal charge-off rate—Owned			6.05	%			6.06	%			4.86	%
Net principal charge-off rate—Managed			6.60	%			6.19	%			5.36	%
Transaction volume (dollars in billions)		$	97.9			$	97.3			$	93.3

		Fiscal Year
		2004				2003(1)				2002(1)
Net revenues (dollars in millions):
Institutional Securities		$	13,063			$	11,211			$	9,119
Individual Investor Group			4,615				4,242				4,268
Investment Management			2,738				2,276				2,506
Credit Services			3,634				3,427				3,557
Intersegment Eliminations			(285	)			(299	)			(323	)
Consolidated net revenues		$	23,765			$	20,857			$	19,127
Income before taxes(2) (dollars in millions):
Institutional Securities		$	4,097			$	3,645			$	2,655
Individual Investor Group			371				464				120
Investment Management			827				482				656
Credit Services			1,272				1,093				1,178
Intersegment Eliminations			118				121				129
Consolidated income before taxes		$	6,685			$	5,805			$	4,738
Consolidated net income (dollars in millions)		$	4,486			$	3,787			$	2,988
Basic earnings per common share:
Income from continuing operations		$	4.17			$	3.54			$	2.77
Loss from discontinued operations			(0.02	)			(0.02	)			(0.01	)
Basic earnings per common share		$	4.15			$	3.52			$	2.76
Diluted earnings per common share:
Income from continuing operations		$	4.08			$	3.47			$	2.70
Loss from discontinued operations			(0.02	)			(0.02	)			(0.01	)
Diluted earnings per common share		$	4.06			$	3.45			$	2.69
Statistical Data.
Book value per common share(3)		$	25.95			$	22.93			$	20.24
Return on average common equity			16.8	%			16.5	%			14.1	%
Effective income tax rate			28.5	%			29.0	%			34.4	%
Consolidated assets under management or supervision (dollars in billions):
Equity		$	251			$	207			$	172
Fixed income			130				123				127
Money market			87				64				66
Other(4)			79				68				55
Total(5)		$	547			$	462			$	420
Worldwide employees			53,284				51,196				55,726

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Statistical Data (Continued).		Fiscal Year
		2004				2003(1)				2002(1)
Institutional Securities:
Mergers and acquisitions completed transactions (dollars in billions)(6):
Global market volume		$	353.0			$	207.8			$	347.8
Market share			25.4	%			19.2	%			28.3	%
Rank			2				3				2
Mergers and acquisitions announced transactions (dollars in billions)(6):
Global market volume		$	385.1			$	241.9			$	193.6
Market share			21.7	%			20.0	%			18.3	%
Rank			4				2				3
Global equity and equity-linked issues (dollars in billions)(6):
Global market volume		$	54.3			$	39.6			$	25.2
Market share			10.7	%			10.2	%			7.9	%
Rank			1				3				4
Global debt issues (dollars in billions)(6):
Global market volume		$	359.5			$	367.0			$	270.2
Market share			6.9	%			7.4	%			6.9	%
Rank			2				3				5
Pre-tax profit margin(7)			31	%			31	%			28	%
Individual Investor Group:
Global representatives			10,962				11,086				12,546
Total client assets (dollars in billions)		$	602			$	565			$	516
Fee-based assets as a percentage of total client assets			26	%			23	%			21	%
Pre-tax profit margin(7)			8	%			11	%			3	%
Investment Management:
Assets under management or supervision (dollars in billions)		$	424			$	357			$	337
Percent of fund assets in top half of Lipper rankings(8)			71	%			57	%			62	%
Pre-tax profit margin(7)			30	%			21	%			26	%
Pre-tax profit margin(7) (excluding private equity)			26	%			22	%			28	%
Credit Services (dollars in millions, unless otherwise noted)(9):
Period-end credit card loans—Owned		$	19,724			$	18,930			$	22,153
Period-end credit card loans—Managed		$	48,261			$	48,358			$	51,143
Average credit card loans—Owned		$	17,608			$	19,531			$	20,659
Average credit card loans—Managed		$	47,387			$	50,864			$	49,835
Net principal charge-off rate—Owned			5.53	%			6.05	%			6.06	%
Net principal charge-off rate—Managed			6.00	%			6.60	%			6.19	%
Transaction volume (dollars in billions)		$	99.6			$	97.9			$	97.3
Pre-tax profit margin(7)			35	%			32	%			33	%

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(1)	Certain prior-period information has been reclassified to conform to the current year’s presentation.

(2)	Source: Thomson Financial—January 1Amounts represent income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to December 31, for each respective period.mandatory redemption and discontinued operations.

(3)

Book value per common share equals shareholders’ equity of $28,206 million at November 30, 2004, $24,867 million at November 30, 2003 and $21,885 million at November 30, 2002, divided by common shares outstanding of 1,087 million at November 30, 2004, 1,085 million at November 30, 2003 and 1,081 million at November 30, 2002.

(4)	Amounts include alternative investment vehicles.

(5)	Revenues and expenses associated with certain of these assets are included in the Company’s Investment Management, Individual Investor Group and Institutional Securities segments.

(4)(6)

Source: Lipper. One-yearThomson Financial, data as of January 7, 2005—The data for fiscal 2004, fiscal 2003 and fiscal 2002 are for the periods from January 1 to December 31, 2004, January 1 to December 31, 2003 and January 1 to December 31, 2002, respectively, as Thomson Financial presents these data on a calendar-year basis.

(7)	Percentages represent income before taxes and discontinued operations, excluding losses from unconsolidated investees, as a percentage of net revenues.

(8)	Source: Lipper, one-year performance as of November 30, for each respective period.2004, November 30, 2003 and November 30, 2002, respectively.

(5)(9)

Managed data include owned and securitized credit card loans. For an explanation of managed data and a reconciliation of credit card loan and asset quality data, see “Credit Services—Managed General Purpose Credit Card Loan Data” herein.

 

25

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Fiscal 20032004 Performance.

 

Company Results.  The Company recorded net income of $3,787$4,486 million in fiscal 2003, a 27% increase from the prior year, and diluted earnings per share of $3.45, a 28% increase$4.06 in fiscal 2004, both 18% increases from the prior year. Net revenues (total revenues less interest expense and the provision for consumer loan losses) rose 9%14% to $20.9$23.8 billion in fiscal 2004, and the return on average common equity was 16.5% as16.8% compared with 14.1%16.5% in the prior year.

 

Fiscal 2003’s results included a benefitNon-interest expenses of $17.1 billion increased 13% from changes implementedthe prior year, primarily due to the Company’s equity-based compensation program. The net effect of these changes reducedhigher compensation expense by $262 million,and professional services expense associated with increased net income by $177 million, or $0.16 per share,business activity and increased return on average common equity by 0.8%additional legal and regulatory costs. Compensation and benefits expense in fiscal 2004 reflected an additional year of amortization of equity-based awards (see “Equity-Based Compensation Program” herein). Fiscal 2003’s results included a lower

The Company’s effective tax rate primarily reflecting lower taxes attributablewas 28.5% in fiscal 2004 compared with 29.0% in fiscal 2003. The decrease reflected higher domestic tax credits and certain miscellaneous items, partially offset by higher tax rates applicable to non-U.S. earnings as well as an increase in the utilization of domestic tax credits related(see Note 16 to the Company’s investments in the production of synthetic fuel (see “Investments in Unconsolidated Investees” herein). The year’s results also included approximately $280 million in legal expenses related to various litigation costs and settlements, reflecting the continued legal and regulatory focus on theconsolidated financial services industry.statements).

 

At fiscal year-end, the Company had approximately 51,00053,284 employees worldwide, a decreasean increase of 8%4% from the prior year, reflecting the Company’s continuing efforts to manage costs in light of the weakenedrecovering global economy, and reducedincreased business activity, and additional personnel associated with increased regulatory and compliance efforts that existed in the first half of the year.fiscal 2004.

 

Subsequent to fiscal year-end, the Company’s Board of Directors declared a $0.25$0.27 quarterly dividend per common share, a 9%an 8% increase from the $0.23$0.25 per common share declared for the previous quarter.

Business activity increased in the second half of fiscal 2003 as compared with the first half of the fiscal year. The Company ended the year with increased market shares in many key areas of its business and believes that its focus on enhancing client relationships and managing expenses has positioned it well for any improvement in the business environment.

 

Institutional Securities.  The Company’s Institutional Securities business recorded net income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations of $2,437 million, an$4.1 billion, a 12% increase of 46% from a year ago. Net revenues rose 23%17% to $11.2$13.1 billion, driven by record resultsrevenues in fixed income and an improved environmentsignificant increases in advisory fees and equity underwriting during the second half of the year. Total non-interestrevenues. Non-interest expenses increased 17%rose 19% to $7.6$9.0 billion, largely reflecting the increase inhigher incentive-based compensation costs, professional services and other expense categories associated with increased business activity. This year’s expenses included $323 million in aircraft impairment-related charges, while prior-year expenses included $117 million in restructuring charges and $74 million in aircraft impairment charges (see “Restructuring and Other Charges” herein and Note 18 to the consolidated financial statements).

 

In investment banking, total underwritingAdvisory revenues rose 18%75% from last year to $1.4$1.2 billion, benefiting fromreflecting a significant increase in the Company’s improved market share in completed merger and increased industry-wide fixed income underwriting activity. Advisory revenues fell 31%acquisition transactions from 19% to $662 million, partially reflecting25% and a decline29% increase in industry-wide completed merger and acquisition transaction volume. Inactivity (according to Thomson Financial). Underwriting revenues rose 29% from last year to $1.9 billion with equity, high-yield and securitized products driving the Company’s fixedincrease in revenues. Equity underwriting revenues rose 55% compared with the prior year.

Fixed income sales and trading business, revenues increased by 65%were $5.6 billion, up 4% from a year ago to $5.4 billion. Thisrecord performance in the prior year. The increase was broad-based across thedriven by a record year in commodities and improved results in credit products. Commodities benefited from tight oil supplies, growing demand and global political instability that drove energy prices and volatilities higher. Credit products benefited from increased customer flows and favorable trading conditions. Revenues from interest rate and currency products credit productsdeclined slightly from last year’s record revenues, primarily due to lower revenues from cash and commodities groups. All three product areas benefited from strong customer flows and high levels of market volatility. In equityderivative products. Equity sales and trading revenues rose 13% from last year to $4.1 billion. Prime brokerage had a record year driven by robust growth in client asset balances. Revenues from equity cash products increased, 2% to $3.6 billion as the benefit of rising indices was partially offset by the negative impact of lower U.S.reflecting higher market volumes, and a decline in market volatility during the second halfwhile revenues from equity derivatives increased modestly despite continued low levels of the year.

In recent years, Institutional Securities took steps to streamline its business and better manage costs in light of difficult market and economic conditions. Investment banking headcount was reduced, and the debt and equity capital market areas were combined to better serve clients and take advantage of synergies. Institutional Securities continued to emphasize client service, including solving complex client problems through an integrated approach, with the goal of building and maintaining long-lasting client relationships. Institutional

26

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Securities also focused on improving market share. At calendar year-end, the Company ranked No. 2 with a market share of approximately 20% in announced global merger and acquisition transactions. In addition, the Company improved its market share and ranked No. 2 in U.S. investment grade debt underwriting and No. 3 in worldwide equity and equity-related underwritings. The Company believes that it also improved market share in secondary equity and debt trading, although market share data in these areas are less transparent. The Company believes that the improved performance of Institutional Securities in fiscal 2003 indicates that the foregoing actions have begun to yield results and that Institutional Securities is well-positioned for a business upturn.volatility.

 

Individual Investor Group.The Individual Investor Group recorded netpre-tax income of $265$371 million, as compared with $59 million in the prior year. Net revenues were essentially unchanged at $4.0 billion, as retail participation in the equity markets increased over the second half of the year after declining in the first half. The second half upswing was consistent with a stronger economy and improving investor confidence. Total non-interest expense decreased 10%down 20% from the prior year, which included $112largely driven by higher non-interest expenses. In the fourth quarter of fiscal 2004, the Company changed its method of accounting to recognize certain asset management and account fees and related expenses over the relevant contract period as compared with when billed. This change decreased net revenues by

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$107 million, non-interest expenses by $27 million and pre-tax income by $80 million for both the full year and quarterly results (see “Asset Management and Account Fees” herein).

Net revenues for fiscal 2004 were $4.6 billion, a 9% increase over a year ago, reflecting higher asset management, distribution and administration fees driven primarily by an increase in restructuring charges (see “Restructuringclient assets in fee-based accounts. Commission revenues also increased from the prior year due to higher equity market volumes. Total non-interest expenses were $4.2 billion, a 12% increase from a year ago. The increase was driven by higher compensation expense and Other Charges” herein).higher professional services expense, including sub-advisory, consulting and legal costs. Total client assets of $565increased to $602 billion, rose 9%up 7% from the end of the prior year.fiscal year-end. In addition, client assets in fee-based accounts increased 21% from the prior fiscal year-end to $130$157 billion and represented 23%increased as a percentage of total client assets as compared with 21%to 26% from 23% a year ago. At fiscal year-end, the number of global financial advisorsrepresentatives was 11,086,10,962, a decline of 124 over the past year of 1,460.

The Company believes it is near the end of a process to substantially reorganize and transform its Individual Investor Group business. During the process, the Company re-evaluated almost every aspect of the business, including the cost base, management structure, client approach, financial advisor training and hiring, and growth strategy. As part of the process, the Individual Investor Group significantly reduced non-compensation expenses, closed 76 branches domestically and decreased financial advisor headcount by 12%. In addition, financial advisor training was focused on financial planning, retention, productivity and services to the high net worth client segment. As a result of these changes in cost structure and financial advisor training, the Company believes that the Individual Investor Group is well-positioned to capitalize on any improvement in the equity markets.year.

 

Investment Management.  Investment Management reported netrecorded pre-tax income of $326$827 million, 22% lower than $418 million in the priora 72% increase from last year. The decline wasincrease reflected a 20% increase in net revenues to $2.7 billion driven by an 8% decreaseincrease in net revenues, reflecting a declineasset management fees and higher investment gains. Non-interest expenses increased 7% from the prior year to $1.9 billion, largely due to higher compensation expense and an increase in average assets under managementprofessional services expense driven by higher consulting, sub-advisory and a less favorable average asset mix.legal costs. Assets under management at fiscal year-end were $462$424 billion, up $42$67 billion, or 10%,19% from a year ago—primarilyago as a result of both market appreciation.appreciation and positive net flows. At fiscal year-end, the percentpercentage of the Company’s fund assets performing in the top half of the Lipper rankings forwas 71% over one year, 75% over three years and 73% over five years. Performance for the one- and three-year time periods was 57% as compared with 62%significantly better than a year ago.

Investment Management also reorganized its business over Principal transaction investment gains for the past few years, combining four distinct asset management complexes and eliminating money management style redundancies. Investment Management will continue to focus on improving investment performance across all asset classes, improving mutual fund flows and consolidating assetsyear were $248 million, a $229 million increase from a year ago, with the best performing managers. Investment Management will also focus onlargest gains associated with the pensionCompany’s holdings in Vanguard Health Systems, Inc. and separately managed account business by building more alternative investment products and multi-disciplinary accounts. OnePing An Insurance (Group) Company of Investment Management’s primary challenges is the potential impact that legal and regulatory developments will have on its business, although this potential impact cannot be fully predicted and quantified at this time.China, Ltd.

 

Credit Services.  Credit Services netpre-tax income was $688a record $1,272 million, down 9%an increase of 16% from the prior year’s recordlast year. The increase in earnings of $760 million. The current year’s results included pre-tax severance and facilities closing charges of $35 million. The decline in earningson a managed basis was driven by lower non-interest revenues and net interest income,a decline in the provision for loan losses, reflecting improved credit quality, which more than offset lower net interest income and merchant and cardmember fees. Non-interest expenses were relatively flat from the prior year as higher marketing and business developmentexpenses were offset by lower compensation costs. The managed credit card net charge-off rate increased 41decreased 60 basis points from a year ago to 6.60%.6.00%, benefiting from the effect of the Company’s credit quality and collection initiatives and an industry-wide improvement in credit quality. The managed over-30-day-delinquencyover 30-day delinquency rate increased onedecreased 142 basis pointpoints to 5.97%,4.55% from a year ago, and the managed over-90-day-delinquencyover 90-day delinquency rate increased 16was 64 basis points to 2.82%. Relatively high levels of unemployment and record levels of U.S. bankruptcy filings along with changes in the Company’s re-age policy—which tightened terms under which delinquent accounts are returned tolower than a current status—negatively

27

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affected charge-off and delinquency rates.year ago at 2.18%. Managed credit card loans were $48.4$48.3 billion at year-end, 5% lower thanvirtually unchanged from a year ago. Total transaction volume roseOn a managed basis, net interest income fell $246 million from a year ago to a record $97.9 billion.

During fiscal 2003, Credit Services faced a difficult credit environment and intense competition. In response to these challenges, Credit Services continued to focus on the credit quality of its$4.4 billion, reflecting lower average credit card portfolio, which contributed toloan balances, partially offset by an increase in the interest rate spread. Merchant and cardmember fees decreased $136 million on a lower level of loan growth. Asmanaged basis, largely as a result the effect of rising losses was magnified by lower receivableslate and charge-offs as a percentage of the portfolio increased. Improving credit quality will continue to be a primary area of management focus. Credit Services expects to increase marketing activities in fiscal 2004 if the economy continues to improve. These marketing initiatives will focus on increasing cardmember usage by leveraging the Discover brand and the Cashback Bonus^® and expanding its merchant base.overlimit fees.

 

Business Challenges.Fiscal 2005 Performance Priorities.    One of the performance priorities of the Company in fiscal 2005 is to regain a premium return on equity as compared with its competitors by focusing on areas of business with strong potential for growth and leveraging the strengths and capabilities of the Company’s business segments. Each of the Company’s businesses segments will also focus on key initiatives in fiscal 2005.

Institutional Securities will continue to focus on enhancing client relationships, maintaining or improving market share and increasing profitability through investing in growth markets and improving capital and risk efficiency.

The Individual Investor Group will focus on generating revenue growth and gathering assets. One of the group’s top priorities is margin improvement over the next two years.

Investment Management’s primary objective will be to improve operating leverage through revenue growth. Investment Management will focus on building key growth areas where it is currently underrepresented, including separately managed accounts, multi-discipline accounts and alternative investment products; capturing

		33

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more flows, primarily as a result of improved fund performance and standings; and continuing to concentrate assets under the best performing managers. In fiscal 2005, Investment Management may experience slower growth in fee revenues due to fee reductions across certain products and because a large percentage of product sales in fiscal 2004 were in institutional fixed income and liquidity fund products, which generally generate lower fees than equity products. In addition, lower principal investment gains are expected going forward as the Company reduces its private equity business.

Credit Services will continue to focus on growing both profitability and customer receivable balances and creating a competitive advantage with its proprietary network. The Company believes that investor trustthere is potential to capitalize on the recent U.S. Supreme Court decision, rejecting an appeal by Visa and confidence remains criticalMasterCard inU.S. v. Visa/MasterCard, which allows financial institutions to issue credit and debit cards on the success of the financial services industry and the Company’s franchise. The Company is taking appropriate measures to ensure that serving the interests of its clients remains its top priority, including reviews of potential conflicts, business and disclosure practices and product suitability.

Global financial services firms such asDiscover Network. In January 2005, the Company continueannounced that it had signed its first third-party issuance with GE Consumer Finance to experience increased competition from firms that have commercial banking capabilities (see “Certain Factors Affecting Results of Operations” herein). Corporate clients continue to request thatissue the Wal-Mart Discover card on the Discover Network. In addition, the Company provide loans or lending commitments in connection with certain investment banking activities, and this activity will continue in the future. The Company has augmented its lending infrastructure and continues to lend on a select and limited basis in support of clients when appropriate. The Company strives to syndicate loans that it originates and uses derivatives to hedge a portion of its credit exposure (see “Liquidity and Capital Resources” herein). The Company continues to believebelieves that its current business modelacquisition of PULSE EFT Association, Inc. (“PULSE^®”), which was completed in January 2005, will allow the Company to achieve its strategic goalsresult in a leading electronic payments company offering a full range of products and objectives.services for financial institutions, consumers and merchants.

 

Global Market and Economic Conditions in Fiscal 2003.2004.

 

Global market and economic conditions improved during the latter halfgrowth was generally favorable for most of fiscal 2003 from2004, particularly driven by the difficult conditions that existed duringU.S. and China. The level of activity in the first half of fiscal 2003 andglobal capital markets was also higher than in fiscal 2002. Fiscal 2003 began amid significant2003. Significant investor uncertainty, however, persisted throughout the fiscal year due to concerns about weak globalthe pace of economic conditionsgrowth, inflationary pressures, higher oil prices and higher levels of geopolitical risk. At the impact of numerous corporate accounting and governance irregularities that emerged during fiscal 2002. In addition, geopolitical tensions escalated in early 2003 as military operations in Iraq seemed imminent. However, conditions improved steadily in fiscal 2003. The conclusion of major military operations in Iraq in the second quarterend of fiscal 2003 eased geopolitical tensions that existed at the beginning of the year. In addition, during the latter half of fiscal 2003,2004, most global financial markets rallied in response to positive economic developments, primarily in the U.S. As fiscal 2003 concluded, there were increased expectations that the long-awaited global economic recovery was beginning to materialize.

 

In the U.S., market and economic conditions improved significantly as the year progressed. During the first half of fiscal 2003,2004, the rate of U.S. economic growth remained weak. Consumer and investor confidence were adversely affected by a relatively high unemployment rate and increased geopolitical concerns, including the mobilization of U.S. military forces in the Middle East, and heightened risk aversion that caused U.S. Treasury yields to fall significantly. However,economy benefited from accommodative fiscal and monetary policies, contributedsupported by productivity gains. Corporate earnings were generally strong, and consumer confidence rose as the U.S. labor market strengthened due to improved economic performancejob creation and a decline in the latterunemployment. The second half of fiscal 2003, including improved2004 began with a mid-year slowdown due, in part, to soaring energy prices, the expected pace of inflation and cautious business investment before regaining momentum at the end of fiscal 2004. Major equity market indices had a mixed year, declining mid-year due to higher energy prices, concern over continued turmoil in Iraq and consumer spending, as well as robust growth in productivity.global geopolitical tension, which depressed market sentiment and activity. The rate of unemployment appeared to stabilize, while inflation remained low. As a result of these improved conditions, U.S. financialequity markets rallied duringat the latter halfend of fiscal 2003.the year due to positive economic developments, a positive earnings outlook and the resolution of the U.S. presidential election. During fiscal 2003,2004, the unemployment rate declined to 5.4%, its lowest level since September 2001. In response to indications of inflationary pressures, the Federal Reserve Board (the “Fed”) loweredraised both the overnight lending rate and the discount rate on four separate occasions by an aggregate of 1.00% during the fiscal year. Subsequent to fiscal year-end, the Fed raised both the overnight lending rate and the discount rate by 0.25%an aggregate of 0.50%.

 

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In Europe, marketthe recovery of economic activity continued despite consistently higher oil prices, which had a considerable impact on inflation rates. The recovery in Europe was led by productivity gains in France and Spain, while economic conditions in Germany and Italy were generally difficultless robust. The European Central Bank (the “ECB”) left the benchmark interest rate unchanged during mostfiscal 2004 as the level of fiscal 2003. Atinterest rates remained low by historical standards. The ECB remains concerned about the beginninglevel of inflation and the strength of the year, geopolitical tensions and the anticipation of a military conflict with Iraq contributed to investor uncertainty and weak conditions in the financial markets. Consumer and business spending were generally weak, particularly in the first half of the fiscal year, although there were indications of improvement during the fourth quarter. During fiscal 2003, the euro appreciated relative to the U.S. dollar raising concern about price competitiveness of euroand its negative impact on demand for exports. In addition, the paceU.K., the labor market continued to strengthen, and strengthbusiness investment continued to grow. There were, however, some indications of Europe’s economic recovery remained uncertain as certain countries experienced negative economica slowdown in the housing market, while the growth during the year, including Germany.in consumer spending moderated. During fiscal 2003,2004, the European Central Bank (the “ECB”) lowered the benchmark interest rate on three separate occasions by an aggregate of 1.25%. The Bank of England reduced itsraised the benchmark interest rate by an aggregate of 0.50% in two separate actions but then increased its benchmark interest rate by 0.25% toward the end of the fiscal year.1.00%.

 

In Japan, economic conditions generally improved during fiscal 2003. Japan’s economy gained momentumdemonstrated signs of recovery during the first half of fiscal 2004, primarily driven by higher exports, consumer spending and industrial production. In the second half of fiscal 2004, the increase in exports and production showed signs of abating, as a resultrising Japanese yen against the U.S. dollar and higher oil prices

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diminished demand for exports. In China, there were signs that its economic growth rate may have been slowing, though the pace of improved investment spendingexpansion nevertheless remained rapid. Economies elsewhere in Asia also generally improved.

As fiscal 2005 began, global economic and market conditions continued to be generally favorable, including a strong level of announced merger and acquisition transactions. As fiscal 2005 progresses, investors will continue to be focused on a number of important developments, such as corporate profitability, as well as increased export growth. During the year, economies throughout Asia were adversely impacted by the sudden outbreak of Severe Acute Respiratory Syndrome (“SARS”), which primarily occurred during the second quarter. Toward the end of fiscal 2003, economic conditions within Asia began to recover from the slowdown in tourismearnings, inflation and consumer spending that was caused by SARS.interest rates, energy prices and geopolitical risks.

 

Business Segments.

 

During fiscal 2003, the Company reviewed its segment allocation methodology (see Note 17 to the consolidated financial statements). This review resulted in the reallocation of certain revenues, expenses and assets during fiscal 2003 among the Company’s business segments: Institutional Securities, Individual Investor Group, Investment Management and Credit Services. The Company believes that the results of these reallocations better reflect the economics of each business segment by representing transactions as if conducted between a segment and an external party. Prior periods have been restated to reflect these segment allocation changes. While the segment allocation changes had no effect on the Company’s consolidated net income, they affected the net income of each segment.

As a result of treating these intersegment transactions as transactions with external parties, the Company has included an “Intersegment Eliminations” category to reconcile the segment results to the Company’s consolidated results. The net income in Intersegment Eliminations represents, among other things, the effect of timing differences associated with the revenue and expense recognition of commissions paid by Investment Management to Individual Investor Group associated with sales of certain products and the related compensation costs paid to Individual Investor Group’s financial advisors. Net income recorded in Intersegment Eliminations was $71 million, $87 million and $49 million in fiscal 2003, fiscal 2002 and fiscal 2001, respectively.

The remainder of Results“Results of OperationsOperations” is presented on a business segment basis.basis before discontinued operations. Substantially all of the operating revenues and operating expenses of the Company can be directly attributed to its business segments. Certain revenues and expenses have been allocated to each business segment, generally in proportion to theirits 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 Investment Management to the Individual Investor Group associated with sales of certain products and the related compensation costs paid to Individual Investor Group’s representatives. Income before taxes recorded in Intersegment Eliminations was $118 million, $121 million and $129 million in fiscal 2004, fiscal 2003 and fiscal 2002, respectively.

 

Certain reclassifications have been made to prior-period segment amounts to conform to the current year’s presentation.

 

29

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INSTITUTIONAL SECURITIES

 

STATEMENTS OF INCOME

(dollars in millions) STATEMENT INFORMATION

 

												Fiscal 2004			Fiscal 2003			Fiscal 2002
		Fiscal 2003			Fiscal 2002			Fiscal 2001				(dollars in millions)
Revenues:
Investment banking		$	2,097		$	2,179		$	3,061			$	3,008		$	2,096		$	2,179
Principal transactions:
Trading			5,487			2,088			4,605				5,007			5,541			2,837
Investments			64			42			(216	)			269			63			42
Commissions			1,748			2,033			1,729				1,998			1,748			2,033
Asset management, distribution and administration fees			91			91			67				144			92			91
Interest and dividends			13,381			13,056			20,827				16,367			13,381			13,056
Other			289			396			436				392			283			396
Total revenues			23,157			19,885			30,509				27,185			23,204			20,634
Interest expense			11,946			10,774			19,229				14,122			11,993			11,515
Net revenues			11,211			9,111			11,280				13,063			11,211			9,119
Non-interest expenses			7,603			6,474			7,593				8,966			7,566			6,464
Income before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change			3,608			2,637			3,687
Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations													4,097			3,645			2,655
Losses from unconsolidated investees			279			77			30				328			279			77
Provision for income taxes			738			809			1,226
Dividends on preferred securities subject to mandatory redemption			154			87			50				45			154			87
Income before cumulative effect of accounting change			2,437			1,664			2,381
Cumulative effect of accounting change			—			—			(46	)
Income before taxes and discontinued operations												$	3,724		$	3,212		$	2,491
Net income		$	2,437		$	1,664		$	2,335

 

Institutional Securities achieved net revenues of $11,211 million and net income of $2,437 million in fiscal 2003, increases of 23% and 46%, respectively, from fiscal 2002. The increase in net revenues was primarily attributable to higher revenues from fixed income sales and trading activities, partially offset by lower investment banking revenues. The increase in net income primarily reflected higher net revenues, partially offset by higher non-interest expenses. Non-interest expenses in fiscal 2003 included charges of $323 million ($191 million after-tax) in connection with the Company’s aircraft financing activities. Compensation and benefits expense included a $220 million ($151 million after-tax) net benefit, composed of a $352 million ($242 million after-tax) benefit related to changes in the terms of the Company’s equity-based compensation program, partially offset by $132 million ($91 million after-tax) related to expensing stock options based on the fair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding this net benefit, compensation costs increased due to a higher level of net revenues. Net income for fiscal 2003 also reflected a decrease in the effective income tax rate, primarily reflecting lower tax rates attributable to non-U.S. earnings, as well as an increase in the utilization of domestic tax credits, which primarily resulted from the Company’s investments in the production of synthetic fuel (see “Investments in Unconsolidated Investees” herein).

In fiscal 2002, Institutional Securities net revenues and net income decreased 19% and 29%, respectively, from fiscal 2001. Institutional Securities net income for fiscal 2001 included a charge of $46 million from the cumulative effect of an accounting change associated with the Company’s adoption, on December 1, 2000, of Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. The decreases in net revenues and net income in fiscal 2002 were primarily attributable to lower revenues from the Company’s sales and trading and investment banking activities, partially offset by lower non-interest expenses.

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

 

		Fiscal 2003			Fiscal 2002			Fiscal 2001			Fiscal 2004			Fiscal 2003			Fiscal 2002
		(dollars in millions)									(dollars in millions)
Advisory fees from merger, acquisition and restructuring transactions		$	662		$	961		$	1,418		$	1,156		$	662		$	961
Equity underwriting revenues			640			526			764			993			640			543
Fixed income underwriting revenues			795			692			879			859			794			675
Total investment banking revenues		$	2,097		$	2,179		$	3,061		$	3,008		$	2,096		$	2,179

 

Investment banking revenues decreased 4%increased 44% in fiscal 2004, primarily reflecting higher revenues from merger, acquisition and restructuring and equity underwriting transactions. Higher revenues from fixed income underwriting transactions also contributed to the increase. In fiscal 2003, investment banking revenues decreased 4%, reflecting lower revenues from merger, acquisition and restructuring activities, partially offset by higher revenues from fixed income and equity underwriting transactions.

In fiscal 2002, investment banking revenues decreased 29%, reflecting lower revenues2004, advisory fees from merger, acquisition and restructuring activitiestransactions increased 75% to $1.2 billion, the first time advisory fees exceeded $1.0 billion since fiscal 2001. Conditions in the worldwide merger and acquisition markets rebounded throughout fiscal 2004, reflecting improved conditions in the global equity markets. There was $1.8 trillion of transaction activity announced during calendar-year 2004 (according to Thomson Financial, data as of January 7, 2005) as compared with $1.2 trillion in calendar-year 2003. During calendar-year 2004, the total amount of the Company’s announced merger and fixed income underwriting transactions.acquisition transaction volume was approximately $385 billion as compared with approximately $242 billion in the prior calendar year. The 59% increase primarily resulted from an increase in average transaction size and higher volumes as an improved global economy resulted in increased transaction activity. Industry-wide completion volumes also rose by 29% vs. the prior calendar-year period, while the Company’s volume of completed transactions increased nearly 70%.

 

		36

Conditions

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The Company’s fiscal 2004 revenues from merger and acquisition transactions were derived from several sectors, including financial services, technology, media and telecommunications, manufacturing and healthcare. In fiscal 2003, conditions in the worldwide merger and acquisition markets were difficult throughout most of fiscal 2003, with the fourth quarter of fiscal 2003 being the exception.year. Such conditions included weak corporate earnings as companies began the year focusing on cost reduction instead of business expansion. In addition, the depressed level of fiscal 2002 merger and acquisition announcements had a direct impact on completed volumes during fiscal 2003, resulting in reduced advisory revenues. These conditions improved during the fourth quarter of fiscal 2003, when the global economy demonstrated signs of recovery and the equity markets rallied. As a result, transaction volume increased in the fourth quarter of fiscal 2003. There was $1.4 trillion of transaction activity announced during calendar year 2003 (according to Thomson Financial) as compared with $1.2 trillion in calendar year 2002. During calendar year 2003, the Company’s volume of announced merger and acquisition transactions was approximately $241 billion as compared with approximately $193 billion in the prior year. The 25% increase primarily resulted from an increase in average transaction size, although volumes were still well below those reported in 2001. In fiscal 2002, increased concerns over corporate accounting and governance issues and declining global equity prices had a negative impact on the volume of advisory transactions as both the number of transactions and the average transaction size declined from the prior-year period.

 

The worldwide market for equity underwriting transactions was mixed in fiscal 2003. During the first half of2004 improved significantly from fiscal 2003, while the uncertainty in the global financial markets continued to adversely affect overall transaction volume. However, market conditions improved during the latter half of the year. The volume of fixed income underwritings remainedcontinued to remain steady throughout much of fiscal 2003, primarily due to a relatively low interest rate environment.2004.

 

Equity underwriting revenues increased 22%55% in fiscal 2004, largely due to the resurgence of the initial public offerings market. The global equity markets experienced renewed investor demand for initial public offerings, particularly in the U.S., and the Company’s participation in these transactions more than outpaced the industry-wide increase in transaction volume. The Company’s equity underwriting revenues reflected increases from the financial services, healthcare, media and telecommunications, and technology sectors. In fiscal 2003, and decreased 31% inequity underwriting revenues increased 18% from fiscal 2002. In the first half of fiscal 2003, equity underwriting revenues increased from relatively depressed levels, primarily led by a high level of convertible offerings. Rising equity markets contributed to a more favorable equity underwriting environment in the second half of fiscal 2003, with a significant increase in global transaction activity, particularly in the technology, financial services and utility sectors. In fiscal 2002, equity underwriting revenues decreased, reflecting significantly lower volumes of equity offerings in the global equity markets, principally in the U.S. and Europe. The decline in new issue volume reflected the difficult conditions that existed in the global equity markets, including the media and telecommunications sectors. The decrease in fiscal 2002 also was due to lower revenues from underwriting convertible securities.

 

Fixed income underwriting revenues increased 15%8% in fiscal 2004 and 18% in fiscal 2003, primarily reflecting favorable conditions in the global fixed income markets throughout both fiscal years. Although the year. Transaction activityFed increased overnight interest rates in fiscal 2004, longer-term interest rates remained steady throughoutat historically low levels. The attractive debt financing environment contributed to higher revenues as issuers continued to take advantage of low financing costs. The Company’s revenues from global high-yield and securitized fixed income transactions were higher in both periods. In fiscal 2003, as issuers took advantage of the lowest interest rates in nearly 45 years and relatively tight credit spreads. These conditions contributed to higher revenue from global high-yield, investment grade and securitized fixed income transactions. Fixed income underwriting revenues decreased 21% in fiscal 2002, primarily reflecting less

31

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favorable market conditions, including volatile credit spreads due to an increase in credit risks associated with certain issuers. These conditions contributed to a lower level of investment grade and structured credit underwriting transactions. This decrease was partially offset byFiscal 2003 also reflected higher revenues from underwriting municipal fixed income securities.investment grade products as compared with the prior year.

 

At the end of fiscal 2003, theThe 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 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 at the current time. At the end of fiscal 2004, the backlog of equity and fixed income underwriting transactions was higher as compared with the end of the prior fiscal year, generally reflecting improved global market and economic conditions. Although the merger, acquisition and restructuring transactions backlog was slightly lower at the end of fiscal 2004 as compared with the end of fiscal 2003, the calendar year-over-year comparison improved during the month of December 2004, as a result of the Company’s role advising on a number of significant transactions announced during the month.

 

Sales and Trading Revenues.    Sales and trading revenues are composed of principal transaction trading revenues, commissions and net interest revenues. In assessing the profitability of its sales and trading activities, the Company views principal trading, commissions and net interest revenues in the aggregate. In addition, decisions relating to principal transactions in securities 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 trade, including any associated commissions, and the interest income or expense associated with financing or hedging the Company’s positions.positions and other related expenses.

 

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

 

Principal Transactions.    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. The Company also engages in proprietary trading activities for its own account.

 

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Principal transaction trading revenues include changes in the fair value of embedded derivatives in the Company’s structured borrowings. Prior to fiscal 2004, such amounts were included in interest expense (see Note 8 to the consolidated financial statements). Prior period information has been reclassified to conform to the current year’s presentation. Principal transaction trading revenues included $54 million and $749 million that were previously recorded as decreases to interest expense in fiscal 2003 and fiscal 2002, respectively. These reclassifications had no impact on net revenues.

Commissions.    Commission revenues primarily arise from agency transactions in listed and over-the-counter (“OTC”) equity securities and options. In January 2002, the Company began implementing a commission-based pricing structure for executing transactions on the NASDAQ. Prior to January 2002, the Company operated its NASDAQ equity business through market-making activities, which were primarily based on earning a spread between the bid and ask prices, and the results of such market-making activities were reported in principal transaction trading revenues. As a result of the new pricing structure, revenues earned from NASDAQ equity trading activities now are included in commission revenues.

 

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. 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 7% in fiscal 2004 and 35% in fiscal 2003, reflecting higher equity and fixed income sales and trading revenues.

Sales and trading revenues include the following:

 

		Fiscal 2003			Fiscal 2002			Fiscal 2001			Fiscal 2004			Fiscal 2003			Fiscal 2002
		(dollars in millions)									(dollars in millions)
Equities		$	3,591		$	3,528		$	4,490		$	4,067		$	3,591		$	3,528
Fixed income(1)			5,356			3,245			3,813			5,555			5,356			3,245

---

(1)	Amounts include interest rate and currency products, credit products and commodities. Amounts exclude aircraft financing and corporate lending activities.

 

SalesEquity sales and trading revenues increased 35%13% in fiscal 2003, primarily reflecting2004 driven by record revenues in the prime brokerage business and higher fixed income salesrevenues from cash and tradingderivative products. The prime brokerage business experienced significant growth in global customer balances, which resulted in record-setting annual revenues. SalesRevenues from equity cash products rose, in part, due to increased cash flows into U.S. equity mutual funds. Revenues from equity derivatives increased modestly despite low levels of equity market volatility. Commission revenues increased slightly despite intense competition and trading revenues decreased 19% in fiscal 2002, reflecting lower equity and fixed income sales and trading revenues.a continued shift toward electronic trading.

 

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Equity sales and trading revenues increased 2% in fiscal 2003, reflecting higher revenues from derivative products, certain proprietary trading activities and prime brokerage services, offset by lower revenues from cash products. Toward the end of fiscal 2003, equity sales and trading revenues benefited from rising market indices, increased cash flows into equity mutual funds and higher equity new issue volume. However, forFor the full fiscal year, however, U.S. market volumes and market volatility were generally lower as compared with fiscal 2002, and commission revenues were impacted by a shift toward electronic trading.

 

EquityFixed income sales and trading revenues decreased 21%increased 4% to a record level in fiscal 2002, reflecting2004 driven by higher revenues from commodities and credit products, partially offset by lower revenues from interest rate and currency products. Commodities revenues increased 20% to record levels, primarily associated with activities in the energy sector where tight oil supplies, growing demand and global political instability drove energy prices and volatilities higher. Credit product revenues, which increased 6%, reflected record revenues from securitized products as the Company benefited from increased securitization flows in commercial and residential whole loans and favorable trading conditions. Lower revenues from investment grade products partially offset the increase. Interest rate and currency product revenues decreased 7% from last year’s record levels due to lower revenues from cash and derivative equity products due to lowerproducts. In addition, in the second half of fiscal 2004, mixed U.S. economic data coupled with higher global energy prices and concerns about the strength of economic growth resulted in market conditions that the Company did not take advantage of, which adversely affected revenues from certain

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interest rate products. These decreases were partially offset by record results in foreign exchange and emerging markets, reflecting higher levels of market volatility and lower trading opportunities related to new issue volume, decreased levels of inflows into equity mutual funds and lower revenues from certain proprietary trading activities.strong customer volume. In fiscal 2002, the sluggish global economy2004 and concerns regarding corporate bankruptciesfiscal 2003, 63% and accounting irregularities contributed to difficult conditions54% of fixed income sales and trading revenues were recorded in the equity markets, primarily in the U.S. and Europe.first half of each respective fiscal year.

 

Fixed income sales and trading revenues increased 65% to a record level in fiscal 2003, reflecting volatile markets, significant new issue activity and higher client transaction volumes. The increase in revenues was broad-based and included higher revenues from the Company’s credit product, interest rate and currency product, and commodities groups. Credit product revenues increased 67%, reflecting strong capital markets activity and higher revenues from residential and commercial mortgage loan securitization activities, investment grade corporate and global high-yield fixed income securities. Interest rate and currency product revenues increased 39%, primarily reflecting a generally favorable trading environment, a sharp rise in interest rates in the third quarter of fiscal 2003, higher derivative volumes and increased interest rate volatility in both the U.S. and European markets. Higher revenues from currency products, primarily due to higher market volatility and a declining U.S. dollar, also contributed to the increase. Commodities revenues increased 168% to record levels. The increase was primarily associated with activities in the energy sector, reflecting higher levels of volatility in certain energy markets, higher customer flow activity and increased trading activity in support of client securitizations.

 

Fixed income sales and trading revenues decreased 15% in fiscal 2002. The decrease was due to lower revenues from the Company’s interest rate and currency product, credit product and commodities groups, each of which had strong results in fiscal 2001. The decrease in interest rate and currency product revenues was primarily due to lower revenues from government fixed income securities, partially offset by higher revenues from currency products. The trading environment for government fixed income securities was difficult during fiscal 2002 due to lack of direction with respect to interest rates. The increase in trading revenues from currency products reflected higher market volatility as the U.S. dollar depreciated against the yen and the euro during much of fiscal 2002. The decrease in credit product revenues was primarily due to lower revenues from investment grade fixed income securities, partially offset by higher revenues from global high-yield fixed income products. The decrease in revenues from investment grade fixed income securities reflected a less favorable environment due to an increase in credit risks associated with certain issuers as corporate credit spreads widened due to concerns over corporate bankruptcies, corporate reporting and accounting issues, and credit downgrades. The increase in revenues from global high-yield fixed income products was primarily driven by distressed debt and emerging markets activities, as well as a lower level of markdowns as compared with the prior year. The decrease in the commodity revenues was primarily attributable to difficult conditions in the energy markets, particularly in the electricity and natural gas sectors. Lower levels of market liquidity and volatility existed during much of fiscal 2002, resulting in fewer trading opportunities. These conditions reflected increased energy regulation and a decline in the number of active market participants.

In addition to the equity and fixed income sales and trading revenues discussed above, sales and trading revenues include the net interest expense associated with the Company’s aircraft financing activities, as well as lossesnet revenues from corporate lending activities. In fiscal 2004, revenues from corporate lending activities increased by approximately $110 million, reflecting growth in the loan portfolio and improved conditions in the commercial lending market, partially offset by mark-to-market valuations associated with new loans made in fiscal 2004. Lower net interest expense associated with aircraft financing activities contributed to the Company’s corporate lending activities.increase in sales and trading revenues. In fiscal 2003, sales and trading revenues associated withfrom corporate lending activities increased by approximately $170 million due to lower markdowns as compared with fiscal 2002, reflecting tighter credit spreads as conditions in the credit market improved. In addition, lower net interest expense associated with aircraft financing activities contributed to the increase. In fiscal 2002,increase in sales

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and trading revenues associated with these activities decreased and continued to reflect losses in the Company’s corporate lending activities due to the difficult market conditions that existed during fiscal 2002, including the continued deterioration in the credit markets. These decreases were slightly offset by lower net interest expense associated with the Company’s aircraft financing activities.revenues.

 

Principal Investments.Transactions-Investments.    Principal transaction net investment revenue aggregating $64$269 million was recognized in fiscal 20032004 as compared with net revenue aggregating $42$63 million in fiscal 2002. Both periods’2003. The increase in fiscal 2004 was primarily related to gains associated with the Company’s real estate and principal investment activities. Fiscal 2004’s results included a gain on the sale of an investment in TradeWeb, an electronic trading platform. Fiscal 2003’s results primarily included gains on the Company’s real estate investments, partially offset by losses in other principal investments.

 

Financial instruments purchased in principal investment transactions generally are held for appreciation and are not readily marketable. 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 from asset management services, primarily fees associated with the Company’s real estate fund investment activities.

 

Asset management, distribution and administration fees increased 57% and 1% in fiscal 2004 and fiscal 2003, respectively. The increase in fiscal 2004 was due to higher fees associated with real estate investment and advisory activities, primarily due to the acquisition of a majority of the U.S. real estate equity investment management business of Lend Lease Corporation in November 2003 (see “Business Acquisitions and Asset Sales” herein).

Other.    Other revenues consist primarily of net rental and other revenues associated with the Company’s aircraft financing business.business, as well as revenues from providing benchmark indices and risk management analytics associated with Morgan Stanley Capital International Inc. (“MSCI”) and Barra, Inc. (“Barra”) (see “Business Acquisitions and Asset Sales” herein).

 

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Other revenues increased 39% in fiscal 2004. The increase was primarily attributable to Barra, which was acquired on June 3, 2004. Other revenues decreased 27%29% in fiscal 2003. The decrease was primarily attributable to lower revenues from the Company’s aircraft financing business, reflecting a decline in lease rates. The decrease also reflectsreflected the inclusion of a gain in fiscal 2002 (of which $53 million was allocated to the Institutional Securities segment) related to the Company’s sale of an office tower.

 

Other revenues decreased 9%Conditions in the commercial aircraft industry were generally more favorable in fiscal 2002. The decrease was primarily attributable to lower revenues from the Company’s aircraft financing business, reflecting lower lease rates and a higher number of unleased aircraft2004 as compared with the prior year. The decrease was partially offset by the inclusion of a gain of $53 million in the first quarter of fiscal 2002 related to the Company’s sale of an office tower.

Net revenuesOperating lease rates from the Company’s aircraft financing business continued to be adversely affected byactivities have shown improvement during the slowdown in the commercialsecond half of fiscal 2004 for many aircraft industry that began in 2001. In fiscal 2002 and fiscal 2003, declining aircraft passenger volume, overcapacity of aircraft and financial difficulties experienced by major airlines contributed significantly to a decline in lease rates for operating lessors, including the Company’s aircraft financing business. These conditions improved somewhat towardtypes. At the end of fiscal 2003. At fiscal year-end,the year, the number of the Company’s aircraft that were unleasedoff-lease or not committed to a lease transaction had decreased significantly from the endprior year. However, unanticipated events, including the sale of fiscal 2002. However, lease rates had generally declined during fiscal 2003.additional aircraft or impairment charges, could have an adverse impact on the results of the aircraft financing business. For additional information on the aircraft financing business, see “Discontinued Operations” herein.

 

Non-Interest Expenses.    Non-interest expenses increased 19% in fiscal 2004. Compensation and benefits expense increased 23% due to higher incentive-based compensation resulting from higher net revenues and higher amortization expense related to equity-based awards (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses increased 12%. Occupancy and equipment expense increased 16%, primarily due to higher rental costs, primarily in London. Brokerage, clearing and exchange fees increased 16%, primarily reflecting increased trading activity. Professional services expense increased 43%, primarily due to higher consulting costs including the implementation of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”) and the Consolidated Supervised Entities Rule (the “CSE Rule”) (see “Regulatory Developments” herein). Legal and employee recruitment costs increased due to higher business activity. There were also increased costs for outside legal counsel due to certain regulatory and litigation matters. Marketing and business development expense increased 24% due to higher travel and entertainment costs. Other expenses decreased 16%, primarily reflecting a lower aircraft impairment charge of $107 million in fiscal 2004 as compared with $271 million in fiscal 2003. Fiscal 2003 also included a $17 million charge to adjust the carrying value of previously impaired aircraft to market value (see Note 18 to the consolidated financial statements). Other expenses also included approximately $25 million relating to Institutional Securities’ share of the costs associated with a failure to deliver certain prospectuses pursuant to regulatory requirements and a fine associated with a settlement with the New York Stock Exchange, Inc. (the “NYSE”) relating to the prospectus delivery requirements, operational deficiencies, employee defalcations and other matters. In addition, other expenses included legal accruals of approximately $110 million related to the Parmalat Matterand IPO Allocation Matters(see “Legal Proceedings” in Part I, Item 3).

Fiscal 2003’s total non-interest expenses increased 17%. Compensation and benefits expense increased 20%. Compensation and benefits expense included a $220 million net benefit related to changes in the termsadoption of the Company’sStatement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123.” This net benefit was composed of a $352 million benefit related to expensing equity-based compensation program andawards over a longer service period, partially offset by a $132 million charge relating to expensing stock options based on the expensingfair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding this benefit, compensation and benefits expense increased 26%, primarily due to higher incentive-based compensation, reflecting higher net revenues. Excluding compensation and benefits expense, non-interest expenses increased 14%13% from fiscal 2002. Brokerage, clearing and exchange fees increased 13%, primarily reflecting higher global securities trading volumes. Other expenses increased 114%111%, primarily reflecting higher costs associated with the Company’s aircraft financing business, including a higher asset impairment charge of $287$271 million (as compared with $74$70 million in fiscal 2002) and higher aircraft repossession costs, as well as a $36$17 million charge to adjust the carrying value of previously

34

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impaired aircraft to market value (see Note 18 to the consolidated financial statements). The increase in other expenses also reflected accruals of approximately $180 million for loss contingencies related toIPO Allocation Matters and theLVMH Litigation (see “Legal Proceedings” in Part I, Item 3). The increase in non-interest expenses was partially offset by restructuring and other charges of $117 million that were recorded in fiscal 2002 (see “Restructuring and Other Charges” herein).

 

Fiscal 2002’s total non-interest expenses decreased 15%. Compensation and benefits expense decreased 21%, principally reflecting lower incentive-based compensation due to lower revenues and earnings and reduced employment levels attributable to the Company’s focus on managing costs. Excluding compensation and benefits expense, non-interest expenses decreased 4%. Brokerage, clearing and exchange fees increased 8%, primarily reflecting increased global securities trading volume, particularly in Europe and the U.S. Marketing and business development expense decreased 6%, primarily reflecting a lower level of travel and entertainment costs, which reflected the overall decline in business activity in the global financial markets. Professional services expense decreased 22%, primarily reflecting lower consulting costs, as well as lower temporary service costs and lower recruiting fees. Other expense decreased 24%, primarily reflecting lower costs associated with the Company’s aircraft financing business, including a lower impairment charge of $74 million (as compared with $87 million in fiscal 2001) and lower maintenance and other aircraft-related costs in fiscal 2002 (see Note 18 to the consolidated financial statements). The decrease in Other expense also reflected a loss of $50 million recorded in fiscal 2001 related to the early extinguishment of certain long-term borrowings (see “New Accounting Developments—Gains and Losses from Extinguishment of Debt” herein). Non-interest expenses also included restructuring and other charges of $117 million (see “Restructuring and Other Charges” herein).

35

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INDIVIDUAL INVESTOR GROUP

 

STATEMENTS OF INCOME

(dollars in millions) STATEMENT INFORMATION

 

		Fiscal 2003			Fiscal 2002				Fiscal 2001
Revenues:
Investment banking		$	304		$	267			$	320
Principal transactions:
Trading			651			642				904
Investments			—			(45	)			(11	)
Commissions			1,276			1,330				1,623
Asset management, distribution and administration fees			1,413			1,409				1,367
Interest and dividends			368			443				889
Other			155			218				63
Total revenues			4,167			4,264				5,155
Interest expense			150			195				484
Net revenues			4,017			4,069				4,671
Non-interest expenses			3,563			3,960				4,613
Income before income taxes			454			109				58
Provision for income taxes			189			50				35
Net income		$	265		$	59			$	23

��

Individual Investor Group net revenues were $4,017 million in fiscal 2003, a decrease of 1% from fiscal 2002. Individual Investor Group net income was $265 million in fiscal 2003 as compared with $59 million in fiscal 2002. The decrease in net revenues was primarily attributable to lower commissions, net interest and other revenues, partially offset by the absence of principal investment losses and higher investment banking revenues. The increase in net income was primarily due to lower non-interest expenses, including lower compensation and benefits and other expenses. Compensation and benefits expense included a $28 million ($17 million after-tax) net benefit, composed of a $55 million ($32 million after-tax) benefit related to changes in the terms of the Company’s equity-based compensation program, partially offset by $27 million ($15 million after-tax) related to expensing stock options based on the fair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein).

		Fiscal 2004				Fiscal 2003			Fiscal 2002
		(dollars in millions)
Revenues:
Investment banking		$	290			$	305		$	267
Principal transactions:
Trading			518				651			642
Investments			(5	)			4			(42	)
Commissions			1,327				1,231			1,278
Asset management, distribution and administration fees			2,038				1,613			1,577
Interest and dividends			409				370			446
Other			194				217			294
Total revenues			4,771				4,391			4,462
Interest expense			156				149			194
Net revenues			4,615				4,242			4,268
Non-interest expenses			4,244				3,778			4,148
Income before taxes		$	371			$	464		$	120

 

Individual Investor Group net revenues were $4,069 million in fiscal 2002, a decrease of 13% from fiscal 2001. Individual Investor Group net income was $59 million in fiscal 2002 as compared with $23 million in fiscal 2001. The decrease in net revenues in fiscal 2002 was primarily attributable to lower net interest, principal trading and commission revenues. The increase in net income was due to lower non-interest expenses, including lower compensation and benefits costs, and a net gain of approximately $50 million from the sale of the Company’s self-directed online brokerage accounts, partially offset by restructuring and other charges of $112 million (see “Restructuring and Other Charges” herein). In fiscal 2002, the Company sold its self-directed online brokerage accounts to Bank of Montreal’s Harrisdirect.The transaction closed during the third quarter of fiscal 2002. The Company recorded gross proceeds of approximately $100 million (included within Other revenues) and related costs of approximately $50 million (included within Non-interest expenses).

The results for the Individual Investor Group improved in the second half of fiscal 2003 as compared with the first half, reflecting higher individual investor participation in the U.S. equity markets and positive inflows into equity mutual funds. Approximately 25% of the increase in client assets, which rose $49 billion to $565 billion at November 30, 2003, was due to net new customer inflows.

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Investment Banking.    Investment banking revenues are derived from the Individual Investor Group’s distribution of equity and fixed income securities underwritten by the Institutional Securities business, as well as underwritings of Unit Investment Trust products. Investment banking revenues decreased 5% in fiscal 2004 and increased 14% in fiscal 2003 and decreased 17%2003. The decrease in fiscal 2002.2004 was primarily due to lower revenues from fixed income underwriting transactions, partially offset by higher revenues from underwriting Unit Investment Trust products. The increase in fiscal 2003 was primarily due to higher revenues from equity underwriting transactions reflecting higher volumes and from the underwriting of Unit Investment Trust products. The decrease in fiscal 2002 was primarily due to a decrease in Unit Investment Trust sales volume.

 

Principal Transactions.    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 positions. The Company maintains certain inventory positions primarily to facilitate customer transactions. Principal transaction trading revenues decreased 20% in fiscal 2004, primarily due to lower revenues from fixed income products, reflecting lower customer transaction activity in corporate, municipal and government fixed income securities. Principal transaction trading revenues increased 1% in fiscal 2003, reflecting higher revenues from fixed income products, partially offset by lower revenues from equity products. The increase in fixed income products reflected higher revenues from investment grade corporate fixed income securities, as individual investor activity increased. The decrease in revenues from equity products reflected the difficult conditions that existed in the equity markets during the first half of fiscal 2003. In

Principal transaction net investment losses aggregating $5 million were recorded in fiscal 2002, principal transaction trading revenues decreased 29%, reflecting lower equity and fixed income trading revenues. The decrease in equity revenues reflected the difficult conditions that existed in the equity markets during fiscal 2002. Fixed income trading revenues decreased during fiscal 20022004 as compared with relatively high levels in fiscal 2001, reflecting less favorable market conditions in government and corporate fixed income securities. In both fiscal 2003 and fiscal 2002, equity revenues were negatively affected by the Company’s new pricing structure for executing transactions on the NASDAQ (see “Commissions” herein).

The Company recorded no principal transaction net investment gains or lossesof $4 million in fiscal 2003. Principal transaction net investment losses aggregating $45$42 million were recorded in fiscal 2002 as compared with net losses of $11 million in fiscal 2001.2002. Fiscal 2002’s results primarily reflected the write-down of an equity investment related to the Company’s European individual securities business.

 

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 increased 8% in fiscal 2004 and decreased 4% in fiscal 2003 and 18%2003. The increase in fiscal 2002.2004 reflected higher customer trading volumes as compared with fiscal 2003 due to improved equity market conditions. The decrease in both periodsfiscal 2003 was due to lower customer trading volumes as individual investor participation in the U.S. equity markets declined. In fiscal 2003, this decline was partially offset by higher customer trading volumes in the second half of the year, as individual investor participation in the U.S. equity markets increased. In both periods, the decrease was partially offset by the impact of a new commission-based pricing structure for executing transactions on the NASDAQ.

 

In January 2002, the Company began implementing a commission-based pricing structure for executing transactions on the NASDAQ. Prior to January 2002, the Company operated its NASDAQ equity business through market-making activities, which were primarily based on earning a spread between the bid and ask prices, and the results of such market-making activities were reported in principal transaction trading revenues. As a result of the new pricing structure, revenues earned from NASDAQ equity trading activities now are included in commission revenues.

		41

The Company offers various account options for its individual clients. For clients who prefer fee-based pricing, the Company offers the Morgan Stanley Choice^SM account, which charges a percentage of assets rather than a per-transaction fee. Clients can also choose to have a fee-based separately managed account. As a result, revenues recorded within the Commissions and Asset management, distribution and administration fees income statement categories are affected by the number of the Company’s clients electing a fee-based pricing arrangement.

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Net Interest.Interest and dividend revenues and interest expense are a function of the level and mix of total assets and liabilities, including customer margin loans and securities borrowed and securities loaned transactions. Net interest revenues increased 14% in fiscal 2004 and decreased 12% in fiscal 2003 and 39%2003. The increase in fiscal 2002. The decrease in both periods2004 was primarily due to lowerhigher net interest revenues from brokerage services provided to individual customers as a result of decreasesan increase in the level of margin loans. The decrease in fiscal 2003 was primarily due to lower net interest revenues as a result of a decrease in the level of margin loans, partially offset by a decline in interest expense due to a decrease in the Company’s average cost of borrowings.

 

37

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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 under Morgan Stanley Choice.arrangement. Asset management, distribution and administration fees also include revenues from asset management services and fees for investment management services provided to segregated customer accounts pursuant to various contractual arrangements in connection with the Company’s Investment Consulting Services (“ICS”) business. The Company receives fees for services it provides in distributing certain open-ended mutual funds. These 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 increased marginally26% in fiscal 20032004 and increased 3%2% in fiscal 2002.2003. In fiscal 2004, an increase in client asset balances resulted in higher fees from investors electing fee-based pricing arrangements, including separately managed and Morgan Stanley Choice^SM accounts. The slightchange in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein) partially offset the increase in fiscal 2004 by $67 million. The increase in fiscal 2003 was primarily attributable to higher fees from investors electing fee-based pricing arrangements, including separately managed and Morgan Stanley Choice accounts, reflecting an increase in client assets toward the end of fiscal 2003. This increase was offset by lower fees from promoting and distributing mutual funds, reflecting a decrease in individual investors’ average mutual fund asset levels and a less favorable asset mix that generated lower fees. The increase in fiscal 2002 was primarily attributable to higher ICS fees, partially offset by lower fees from promoting and distributing mutual funds and lower client asset balances.

In fiscal 2003,2004, client asset balances increased to $602 billion at November 30, 2004 from $565 billion at November 30, 2003 from $516 billion at November 30, 2002.2003. At November 30, 2001,2002, client asset balances were $595$516 billion. The increase in client asset balances in fiscal 2003both periods was primarily due to market appreciation, reflecting improvement in the global financial markets during the latter halfmarkets. Client assets in fee-based accounts rose 21% to $157 billion at November 30, 2004 and increased as a percentage of fiscal 2003, as well as net new inflows oftotal client assets. The decrease in client asset balances in fiscal 2002 was primarily dueassets to market depreciation, reflecting declines26% from 23% in the global financial markets.prior year. Client assets in fee-based accounts rose 21% to $130 billion at November 30, 2003 and increased as a percentage of total client assets to 23% from 21% in the prior year.

 

Other.Other revenues primarily include customer account fees and other miscellaneous service fees. Other revenues decreased 29%11% in fiscal 2004 and 26% in fiscal 2003. The change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein) decreased other revenues by $40 million in fiscal 2004, which was partially offset by higher revenues from customer service and account fees. The decrease in fiscal 2003 was primarily due to approximately $100 million of proceeds received in connection with the sale of the Company’s self-directed online brokerage accounts (see “Business Acquisitions and Asset Sales” herein) in fiscal 2002. The decrease was partially offset by higher revenues from other miscellaneouscustomer service and account fees. Other revenues were $218 million in fiscal 2002 as compared with $63 million in fiscal 2001. The increase primarily reflected approximately $100 million of proceeds received in connection with the sale of the Company’s self-directed online brokerage accounts. The increase also was due to higher revenues from customer account fees.

 

Non-Interest Expenses.Non-interest expenses increased 12% in fiscal 2004. The increase was primarily due to higher compensation and benefits expense, which increased 9%. The increase reflected higher incentive-based compensation costs due to higher net revenues and higher amortization expense related to equity-based awards (see “Equity-Based Compensation Program” herein). This increase was partially offset by a reduction in compensation expense of $27 million associated with the change in the method of accounting for certain asset management and account fees (see “Asset Management and Account Fees” herein). Excluding compensation and benefits expense, non-interest expenses increased 19%. Marketing and business development expense increased 20% due to an increase in advertising costs. Professional services expense increased 48%, largely due to higher sub-advisory fees associated with increased asset and revenue growth, as well as higher consulting and legal fees

		42

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resulting from the implementation of SOX 404 and the CSE Rule and an increase in costs for outside legal counsel due to regulatory and litigation matters. Information processing and communications expense decreased 11% due to lower data processing costs. Other expenses increased 46%, primarily resulting from an increase in legal and regulatory expenses, including approximately $25 million relating to the Individual Investor Group’s share of the costs associated with a failure to deliver certain prospectuses pursuant to regulatory requirements and a fine associated with a settlement with the NYSE relating to the prospectus delivery requirements, operational deficiencies, employee defalcations (including theCarlos Soto matter) and other matters (see “Legal Proceedings” in Part I, Item 3).

Non-interest expenses decreased 10%9% in fiscal 2003. The decrease was attributable to lower compensation and benefits expense, which decreased 6%7%, principally reflecting lower employment levels, as well as a net benefit of $28 million related to changes in the termsadoption of the Company’sSFAS No. 123. This net benefit was composed of a $55 million benefit related to expensing equity-based compensation program andawards over a longer service period, partially offset by $27 million related to expensing stock options based on the expensingfair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses decreased 17%13%. Occupancy and equipment expense decreased 13%12%, reflecting the results of the Company’s initiative to consolidate its branch locations. Information processing and communications expense decreased 8%10%, reflecting lower data processing and telecommunications expenses. Marketing and business development expense decreased 33%30% due to lower advertising costs. Other expenses were relatively unchanged.increased 7%. Litigation costs increased, reflecting higher costs in fiscal 2003 due to mutual fund regulatory settlements, coupled with a benefit in fiscal 2002 from the resolution of a mutual fund litigation matter. These increases were partially offset by costs recorded in fiscal 2002 associated with the sale of the Company’s self-directed online brokerage accounts.accounts (see “Business Acquisitions and Asset Sales” herein). The decrease in non-interest expenses was also due to restructuring and other charges of $112 million in fiscal 2002 (see “Restructuring and Other Charges” herein).

 

Non-interest expenses decreased 14% in fiscal 2002. The majority of the decrease was attributable to lower compensation and benefits expense, which decreased 12%, principally reflecting lower incentive-based compensation due to lower levels of revenues and earnings, as well as lower employment levels. Excluding compensation and benefits expense, non-interest expenses decreased 17%. Occupancy and equipment expense decreased 9%, reflecting lower maintenance and repair costs, as well as lower rent expense resulting from the utilization of alternate facilities after the loss of the World Trade Center complex. Information processing and

38

		43

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communications expenses decreased 17% due to lower telecommunications, market data and outsourced data processing costs. Professional services expense decreased 41%, primarily reflecting lower consulting costs. Other expenses decreased 40% due to the benefit from the resolution of a mutual fund litigation matter, offset in part by increased exposure to other litigation matters. The decrease also reflected the elimination of goodwill amortization due to the Company’s adoption of SFAS No. 142, “Goodwill and Other Intangible Assets.” These decreases were partially offset by costs associated with the Company’s sale of its self-directed online brokerage accounts (see “Business Acquisitions and Asset Sales” herein). Fiscal 2002’s non-interest expenses also included restructuring and other charges of $112 million (see “Restructuring and Other Charges” herein).

39

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INVESTMENT MANAGEMENT

 

STATEMENTS OF INCOME

(dollars in millions) STATEMENT INFORMATION

 

		Fiscal 2003			Fiscal 2002				Fiscal 2001
Revenues:
Investment banking		$	39		$	32			$	54
Principal transactions:
Investments			22			(28	)			(89	)
Commissions			56			52				52
Asset management, distribution and administration fees			2,361			2,598				2,922
Interest and dividends			2			17				54
Other			34			51				58
Total revenues			2,514			2,722				3,051
Interest expense			5			1				11
Net revenues			2,509			2,721				3,040
Non-interest expenses			2,018			2,054				2,308
Income before income taxes			491			667				732
Provision for income taxes			165			249				307
Net income		$	326		$	418			$	425

Investment Management net revenues for fiscal 2003 were $2,509 million, a decrease of 8% from fiscal 2002. Investment Management net income for fiscal 2003 was $326 million, a decrease of 22% from fiscal 2002. The decrease in net revenues primarily reflected lower fee-based revenues due to a decline in average assets under management or supervision and a less favorable average asset mix, partially offset by higher principal investment revenues. The decrease in average assets under management was primarily attributable to market depreciation, reflecting declines in the global financial markets during the first half of fiscal 2003. The decrease in net income in fiscal 2003 was primarily due to lower net revenues, partially offset by a decline in non-interest expenses, including lower compensation costs. Compensation and benefits expense included a $12 million ($8 million after-tax) net benefit, composed of a $24 million ($16 million after-tax) benefit related to changes in the terms of the Company’s equity-based compensation program, partially offset by $12 million ($8 million after-tax) related to expensing stock options based on the fair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein).

Investment Management net revenues for fiscal 2002 were $2,721 million, a decrease of 10% from fiscal 2001. Investment Management net income for fiscal 2002 was $418 million, a decrease of 2% from fiscal 2001. The decrease in net revenues in fiscal 2002 primarily reflected lower fee-based revenues due to a decline in average assets under management and a less favorable asset mix. The decrease in the level of average assets under management was primarily attributable to market depreciation, reflecting declines in the global financial markets. The decrease in net income in fiscal 2002 was primarily due to lower net revenues, partially offset by lower non-interest expenses, including lower incentive-based compensation and a lower effective income tax rate.

The Company enters fiscal 2004 with assets under management or supervision at November 30, 2003 higher than fiscal 2003’s average asset level due to improved conditions in the global equity markets during the latter half of the year. In fiscal 2004, the Company will continue to focus on improving fund performance across all asset classes and increasing net inflows of customer assets.

		Fiscal 2004			Fiscal 2003			Fiscal 2002
		(dollars in millions)
Revenues:
Investment banking		$	43		$	39		$	32
Principal transactions:
Investments			248			19			(31	)
Commissions			27			18			17
Asset management, distribution and administration fees			2,390			2,177			2,435
Interest and dividends			8			—			14
Other			28			29			40
Total revenues			2,744			2,282			2,507
Interest expense			6			6			1
Net revenues			2,738			2,276			2,506
Non-interest expenses			1,911			1,794			1,850
Income before taxes		$	827		$	482		$	656

 

Investment Banking.    Investment Management primarily generates investment banking revenues primarily from the underwriting of Unit Investment Trust products. Investment banking revenues increased 10% in fiscal 2004 and 22% in fiscal 2003 and decreased 41% in fiscal 2002.2003. The increase in fiscal 2003 reflectedboth periods was primarily due to a higher volume of Unit Investment Trust sales. The decrease in fiscal 2002 was primarily related to a lower volume of Unit Investment Trust sales. Unit

40

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Investment Trust sales volume increased 28% to $5.5 billion in fiscal 2004 and increased 10% to $4.3 billion in fiscal 2003 and declined 43% to $3.9 billion in fiscal 2002.2003.

 

Principal Transactions.Investment Management principal transaction revenues consist primarily of gains and losses on investments associated with the Company’s private equity activities and net gains and losses on capital investments in certain of the Company’s investment funds.

 

Principal transaction net investment gains aggregating $22$248 million were recognized in fiscal 20032004 as compared with lossesgains of $28$19 million in fiscal 2002.2003. Fiscal 2004’s results were primarily related to net gains on certain investments in the Company’s private equity portfolio, including Vanguard Health Systems, Inc. and Ping An Insurance (Group) Company of China, Ltd. Fiscal 2003’s results were primarily related to realized gains in the Company’s private equity portfolio and reflected improved market conditions from the difficult market conditions that existed in fiscal 2002. Fiscal 2002’s results were primarily related to unrealized losses in the Company’s private equity portfolio and reflected difficult market conditions in the technology and telecommunications sectors.

 

Financial instruments purchased in principal investment transactions generally are held for appreciation and are not readily marketable. 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.

 

During fiscal 2004, a team of investment professionals from the private equity business established an independent private equity firm that will manage, through a long-term sub-advisory role, the Morgan Stanley Capital Partners (“MSCP”) funds. The Company will continue as general partner for the MSCP funds and retain its limited partner interests. The Company will operate its other existing principal and real estate investment vehicles (that are included in the Investment Management and Institutional Securities business segments) as before and will actively pursue additional principal investing opportunities for its clients.

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Commissions.Investment Management primarily generates commission revenues from dealer and distribution concessions on sales of certain funds as well as certain allocated commission revenues. Commission revenues increased 8%50% in fiscal 20032004 and were unchanged6% in fiscal 2002 from the prior year.2003. The increase in fiscal 2004 reflected an increase in commissionable sales of certain fund products. In fiscal 2003, the increase was associated with a higher sales volume of insurance products.

 

Asset Management, Distribution and Administration Fees.Asset management, distribution and administration fees primarily include revenues from the management and supervision of assets, including fees for distributing certain open-ended mutual funds and management fees associated with the Company’s private equity activities. These 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 quarterly assets for other vehicles.

 

The Company’sInvestment Management’s period-end and average customer assets under management or supervision at fiscal year-end were as follows:

 

		At November 30,									At November 30,									Average for
	��	2003			2002			2001			2004			2003(1)			2002(1)			Fiscal 2004			Fiscal 2003			Fiscal 2002
		(dollars in billions)									(dollars in billions)
Assets under management or supervision by distribution channel:
Retail		$	277		$	256		$	285		$	202		$	193		$	186		$	199		$	186		$	197
Institutional			185			164			174			222			164			151			191			152			155
Total(1)		$	462		$	420		$	459
Total											$	424		$	357		$	337		$	390		$	338		$	352
Assets under management or supervision by asset class:
Equity		$	207		$	172		$	199		$	200		$	167		$	138		$	185		$	142		$	150
Fixed income			123			127			128			114			111			118			114			116			119
Money market			64			66			70			83			60			64			68			63			67
Other(2)			68			55			62			27			19			17			23			17			16
Total(1)		$	462		$	420		$	459
Total											$	424		$	357		$	337		$	390		$	338		$	352

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(1)

Revenues and expenses associated with customer assets of $37 billion, $38 billion and $46 billion for fiscal 2003, fiscal 2002 and fiscal 2001, respectively, are included inCertain prior-year information has been reclassified to conform to the Company’s Individual Investor Group segment, and $14 billion, $3 billion and $3 billion for fiscal 2003, fiscal 2002 and fiscal 2001, respectively, are included in the Company’s Institutional Securities segment.current year’s presentation.

(2)	Amounts include alternative investment vehicles.

 

41Activity in Investment Management’s customer assets under management or supervision during fiscal 2004 and fiscal 2003 were as follows (dollars in billions):

Balance at November 30, 2002		$	337
Net flows excluding money markets			(9	)
Net flows from money markets			(6	)
Net market appreciation			35
Total net increase			20
Balance at November 30, 2003			357
Net flows excluding money markets			8
Net flows from money markets			21
Net market appreciation			38
Total net increase			67
Balance at November 30, 2004		$	424

		45

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Asset management, distribution and administration fees decreased 9%increased 10% in fiscal 20032004 and decreased 11% in fiscal 2002.2003. The increase in fiscal 2004 reflected higher fund management and administration fees associated with a 15% increase in average assets under management or supervision. The increase in revenues also reflected a more favorable average asset mix, including a greater percentage of equity assets under management, partially offset by an increase in institutional fixed income and liquidity fund products, which generate lower fees than equity products. In fiscal 2003, the decrease primarily reflected lower distribution, fund management, and administration and redemption fees resulting from lower average assets under management or supervision, a less favorable average asset mix and lower redemptions of certain open-ended funds. In fiscal 2002, the decrease in revenues primarily reflected lower management fees and other revenues resulting from a decline in the level of average assets under management or supervision and a less favorable asset mix, primarily due to a shift from equity products to fixed income and money market products.

As of November 30, 2003, customer assets under management or supervision increased $42 billion from fiscal year-end 2002. As of November 30, 2002, customer assets under management or supervision decreased $39 billion from fiscal year-end 2001. The increase in fiscal 2003 was primarily due to market appreciation, reflecting improvement in the global equity markets during the latter half of fiscal 2003, as well as the addition of approximately $11 billion of assets under management resulting from the Company’s acquisition of the U.S. real estate equity advisory business of Lend Lease Corporation; the revenues and expenses associated with this acquisition will be included within the Institutional Securities segment (see “Business Acquisitions and Asset Sales” herein). The decrease in fiscal 2002 was primarily attributable to market depreciation, reflecting declines in the global financial markets. The decline also was attributable to lower net flows of customer assets, as redemptions were marginally higher than new sales.

 

Non-Interest Expenses.    Fiscal 2004’s total non-interest expenses increased 7%. Compensation and benefits expense increased 21%, primarily reflecting higher incentive-based compensation costs due to higher net revenues and higher amortization expense related to equity-based awards (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses were relatively unchanged from fiscal 2003. Professional services expense increased 45%, primarily reflecting an increase in sub-advisory, legal and consulting fees, including costs associated with the establishment of the independent private equity firm that will manage the MSCP funds through a long-term sub-advisory role. Marketing and business development expense decreased 22%, primarily due to lower promotional costs. Brokerage, clearing and exchange fees decreased 7%, reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in recent periods due to a decrease in sales of certain open-ended funds.

Fiscal 2003’s total non-interest expenses decreased 2%3%. Compensation and benefits expense decreased 5%4%, principally reflecting a decrease in employment levels, as well as a net benefit of $12 million related to changes in the termsadoption of the Company’sSFAS No. 123. This net benefit was composed of a $24 million benefit related to expensing equity-based compensation program andawards over a longer service period, partially offset by $12 million related to expensing stock options based on the expensingfair value of stock options granted in fiscal 2003 (see “Equity-Based Compensation Program” herein). Excluding compensation and benefits expense, non-interest expenses were relatively unchangeddecreased 3% from fiscal 2002. Brokerage, clearing and exchange fees decreased 8%10%, reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in the current year due to a decrease in past sales. Other expenses increased 163%126%, primarily due to legal accruals associated with mutual fund regulatory settlements in fiscal 2003. In addition, fiscal 2002’s other expenses included the net benefit from certain legal matters, including the resolution of a mutual fund litigation matter.

 

Fiscal 2002’s total non-interest expenses decreased 11%. Compensation and benefits expense decreased 15%, principally reflecting lower incentive-based compensation, lower benefits expense and lower employment levels. Excluding compensation and benefits expense, non-interest expenses decreased 9%. Occupancy and equipment expense decreased 11%, reflecting lower rental expense due to the utilization of alternate facilities after the loss of the World Trade Center complex. Marketing and business development expense decreased 11%, primarily driven by lower advertising, travel and entertainment, and fund organization costs. Other expense decreased 71%, primarily reflecting a decline in goodwill amortization as a result of the Company’s adoption of SFAS No. 142, as well as the net benefit from certain legal matters, including the resolution of a mutual fund litigation matter. Non-interest expenses also included restructuring and other charges of $6 million (see “Restructuring and Other Charges” herein).

42

		46

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CREDIT SERVICES

 

STATEMENTS OF INCOME

(dollars in millions) STATEMENT INFORMATION

 

		Fiscal 2003			Fiscal 2002			Fiscal 2001
Fees:
Merchant and cardmember		$	1,379		$	1,420		$	1,349
Servicing			2,015			2,080			1,888
Other			15			30			17
Total non-interest revenues			3,409			3,530			3,254
Interest revenue			2,091			2,413			2,593
Interest expense			806			1,050			1,236
Net interest income			1,285			1,363			1,357
Provision for consumer loan losses			1,267			1,336			1,052
Net credit income			18			27			305
Net revenues			3,427			3,557			3,559
Non-interest expenses			2,334			2,379			2,432
Income before income taxes and cumulative effect of accounting change			1,093			1,178			1,127
Provision for income taxes			405			418			425
Income before cumulative effect of accounting change			688			760			702
Cumulative effect of accounting change			—			—			(13	)
Net income		$	688		$	760		$	689

Credit Services net revenues were $3,427 million in fiscal 2003, a decrease of 4% from fiscal 2002. Credit Services net income was $688 million in fiscal 2003, a decrease of 9% from fiscal 2002. The decrease in net revenues in fiscal 2003 was primarily attributable to lower non-interest revenues and lower net interest income, partially offset by a lower provision for consumer loan losses. The decrease in net income reflected lower net revenues, partially offset by lower non-interest expenses. Non-interest expenses included a charge of $35 million (pre-tax) associated with workforce reductions and facility consolidations that were conducted during the fourth quarter. The charge reflected several actions in response to slower industry growth and difficult consumer credit conditions, and consisted of severance-related costs of $29 million and space-related and other costs of $6 million. The majority of these costs will be paid by the end of the first quarter of fiscal 2004. The fiscal year’s results were also adversely affected by record levels of personal bankruptcy filings and a relatively high unemployment rate, both of which peaked during the middle of fiscal 2003. In response to these conditions, during fiscal 2003 the Company reduced marketing expenses and intensified its focus on the credit quality of its credit card loan portfolio, which contributed to the lower level of loan growth.

In fiscal 2002, Credit Services net revenues were $3,557 million, a marginal decline from fiscal 2001. Credit Services achieved record net income of $760 million in fiscal 2002, an increase of 10% from fiscal 2001. Net income for fiscal 2001 included a charge of $13 million from the cumulative effect of an accounting change associated with the Company’s adoption of SFAS No. 133 on December 1, 2000. In fiscal 2002, an increase in non-interest revenues was offset by a higher provision for consumer loan losses. The increase in the provision for consumer loan losses reflected the impact of a difficult economic environment on the Company’s credit card portfolio, including an adverse trend in bankruptcy filings. Lower non-interest expenses and a lower effective income tax rate contributed to the increase in net income in fiscal 2002.

		Fiscal 2004			Fiscal 2003			Fiscal 2002
		(dollars in millions)
Fees:
Merchant and cardmember		$	1,318		$	1,379		$	1,420
Servicing			1,993			2,015			2,080
Other			17			15			30
Total non-interest revenues			3,328			3,409			3,530
Interest revenue			1,893			2,091			2,413
Interest expense			662			806			1,050
Net interest income			1,231			1,285			1,363
Provision for consumer loan losses			925			1,267			1,336
Net credit income			306			18			27
Net revenues			3,634			3,427			3,557
Non-interest expenses			2,362			2,334			2,379
Income before taxes		$	1,272		$	1,093		$	1,178

 

Merchant and Cardmember Fees.    Merchant and cardmember fees include revenues from fees charged to merchants on credit card sales, as well as charges to cardmembers for late payment fees, overlimit fees, balance transfer fees, credit protection fees and cash advance fees, net of cardmember rewards. Cardmember rewards

43

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include various reward programs, including the Cashback Bonus award program, pursuant to which the Company pays certain cardmembers a percentage of their purchase amounts based upon a cardmember’s level and type of purchases.

 

Merchant and cardmember fees decreased 4% in fiscal 2004 and 3% in fiscal 2003 and increased 5%2003. The decrease in fiscal 2002.2004 was due to lower late payment and overlimit fees and higher cardmember rewards, net of estimated future forfeitures, partially offset by higher balance transfer fees and merchant discount revenues. The decline in late payment and overlimit fees reflected fewer late fee occurrences and a decline in the number of accounts charged an overlimit fee, partially offset by lower charge-offs of such fees. Late fee occurrences were lower primarily due to a decline during fiscal 2004 in the over 30-day delinquency rates. Overlimit fees declined due to fewer overlimit accounts and the Company’s modification of its overlimit fee policies and procedures in response to industry-wide regulatory guidance. The increase in net cardmember rewards reflected the impact of promotional programs and record sales volume. Balance transfer fees increased as a result of the Company’s continued focus on improving balance transfer profitability. The increase in merchant discount revenue was due to record sales volume. The decrease in merchant and cardmember fees in fiscal 2003 was due to a decline in late payment fees and higher cardmember rewards, partially offset by higher merchant discount revenue. The decline in late payment fees reflected fewer late fee occurrences and higher charge-offs of late payment fees. The increase in cardmember rewards reflected higher Cashback Bonus costs due to merchant partner programs and recordincreased sales volume. The increase in merchant discount revenue was due to recordincreased sales volume and an increase in the average merchant discount rate. The increase in merchant and cardmember fees in fiscal 2002 was due to higher merchant discount revenue associated with increased sales volume, coupled with a slight increase in the average merchant discount rate. In fiscal 2002, the increase in merchant and cardmember fees also was due to higher late payment fees and lower cardmember rewards incentives, partially offset by lower overlimit and cash advance fees. Late payment fees increased due to the implementation of a tiered fee and the elimination of certain payment features that previously mitigated late charges. Cardmember rewards incentives were lower due to modifications in the Cashback Bonus program and higher estimated future forfeitures of such rewards, partially offset by higher sales volume. Overlimit fees decreased due to fewer occurrences. Cash advance fees decreased due to lower cash advance transaction volume.

In response to new regulatory guidance on the management of overlimit accounts, the Company will suppress the assessment of overlimit fees on accounts that meet specific criteria beginning in fiscal 2004. The suppression of overlimit fees will lower merchant and cardmember fee revenue in the future.

 

Servicing Fees.    Servicing fees are revenues derived from consumer loans that have been sold to investors through asset securitizations and mortgage whole loan sales. Cash flows from the interest yield and cardmember fees generated by securitized general purpose credit card loans and the interest yield generated by securitized mortgage loans are used to pay investors in these loans a predetermined fixed or floating rate of return on their investment, to reimburse investors for losses of principal resulting from charged-off loans and to pay the Company a fee for servicing the loans. Any excess cash flows remaining are paid to the Company. The servicing fees and excess net cash flows paid to the Company are reported as servicing fees in the consolidated statements

		47

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of income. The sale of general purpose credit card and mortgage loans through asset securitizations, therefore, has the effect of converting portions of net credit income and fee income to servicing fees. The Company completed credit card asset securitizations of $5.7 billion in fiscal 2003 and $3.6 billion in fiscal 2002 and mortgage loan securitizations of $1.2 billion in fiscal 2003 and $0.5 billion in fiscal 2002. The credit card asset securitization transactions completed in fiscal 2003 have expected maturities ranging from approximately two to seven years from the date of issuance. The mortgage loan securitization transactions completed in fiscal 2003 have expected maturities ranging from approximately eight to nine years from the date of issuance.

 

The table below presents the components of servicing fees:

 

		Fiscal 2003				Fiscal 2002				Fiscal 2001				Fiscal 2004			Fiscal 2003			Fiscal 2002
		(dollars in millions)												(dollars in millions)
Merchant and cardmember fees		$	727			$	690			$	651			$	652		$	727		$	690
Other revenue															33			94			50
Total non-interest revenues															685			821			740
Interest revenue			4,174				4,061				4,336				3,910			4,174			4,061
Other revenue			94				50				74
Interest expense			(802	)			(887	)			(1,511	)			730			802			887
Net interest income															3,180			3,372			3,174
Provision for consumer loan losses			(2,178	)			(1,834	)			(1,662	)			1,872			2,178			1,834
Net credit income															1,308			1,194			1,340
Servicing fees		$	2,015			$	2,080			$	1,888			$	1,993		$	2,015		$	2,080

 

Servicing fees are affected by the level of securitized loans and mortgage whole loan sales, the spread between the net interest yield on the securitized loans and the yield paid to the investors, the rate of credit losses on securitized loans and the level of cardmember fees earned from securitized general purpose credit card loans.

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Servicing fees decreased 1% in fiscal 2004 and 3% in fiscal 2003 and increased 10% in fiscal 2002.2003. The decrease in fiscal 2004 reflected lower cardmember fees, net interest cash flows and other revenue, partially offset by a lower provision for consumer loan losses. Cardmember fees declined due to lower late payment and overlimit fees, partially offset by higher balance transfer fees and lower fee net charge-offs. The decrease in net interest cash flows was largely attributable to a lower level of average securitized general purpose credit card loans. The decrease in the provision for consumer loan losses was attributable to a lower rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio and a lower level of average securitized general purpose credit card loans. In fiscal 2003, reflectedthe decrease in servicing fees was due to higher credit losses associated with a higher level of average securitized general purpose credit card loans and a higher rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio. The decrease was partially offset by higher net interest cash flows and cardmember fees on securitized general purpose credit card loans associated with a higher level of average securitized general purpose credit card loans. The increase in servicing fees in fiscal 2002 was due to aloans and higher level of net interest cash flows driven primarily by the lower interest rate environment. The increase was partially offset by higher credit losses resulting from a higher rate of charge-offs related to the securitized general purpose credit card loan portfolio.other revenue.

 

The Other revenue component of servicing fees is primarily composed ofincludes net securitization gains and losses on general purpose credit card loans and mortgage loans, as well asgains and losses on mortgage whole loan sales and net revenues from mortgage servicing rights on mortgage whole loan sales. Net gainsThe decrease in the Other revenue component of $68 million, $36 million and $65 million were recordedservicing fees in fiscal 2003,2004 was attributable to lower levels of general purpose credit card and mortgage loan securitization transactions and higher net gain amortization related to prior securitization transactions, partially offset by higher gains associated with mortgage whole loan sales as compared with fiscal 2002 and fiscal 2001, respectively.2003. The increase in Other revenue in fiscal 2003 was attributable to higher levels of general purpose credit card and mortgage loan securitization transactions, offset, in part, by higher net gain amortization related to prior securitization transactions.

The decreasefollowing table presents net proceeds received from consumer loan sales:

		Fiscal 2004			Fiscal 2003
		(dollars in millions)
General purpose credit card asset securitizations		$	3,714		$	5,666
Mortgage loan securitization transactions			—			1,191
Mortgage whole loan sales			3,876			4,007
Net proceeds from consumer loan sales		$	7,590		$	10,864

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The credit card asset securitization transactions completed in fiscal 2002 was attributable2004 have expected maturities ranging from approximately three to lower levelsseven years from the date of general purpose credit card securitization transactions and modifications to certain assumptions in the gain calculations made during fiscal 2001. The assumptions modified by the Company in fiscal 2001 were the net interest rate spread and the net charge-off rate. The assumed net interest rate spread increased, reflecting the projection of a lower interest rate environment and the resulting lower interest expense (i.e., cost of funding) on variable rate securitizations, partially offset by an estimated lower yield on credit card receivables attributable to estimated lower interest rates and higher charge-offs of interest. The assumed net charge-off rate increased, reflecting an increase in the projected charge-off rate attributable to weakening economic conditions and its impact on the Company’s credit card portfolio. The decrease in fiscal 2002 was partially offset by an increase in net securitization gains on mortgage loans and gains on mortgage whole loan sales due to higher levels of mortgage whole loan sales driven by a higher level of mortgage loan originations.issuance.

 

Net Interest Income.    Net interest income represents the difference between interest revenue derived from consumer loans and short-term investment assets and interest expense incurred to finance those loans and assets. Assets, consisting primarily of consumer loans, currently earn interest revenue at both fixed rates and market-indexed variable rates. The Company incurs interest expense at fixed and floating rates. Interest expense also includes the effects of any interest rate contracts entered into by the Company as part of its interest rate risk management program. This program is designed to reduce the volatility of earnings resulting from changes in interest rates by having a financing portfolio that reflects the existing repricing schedules of consumer loans as well as the Company’s right, with notice to cardmembers, to reprice certain fixed rate consumer loans to a new interest rate in the future.

Net interest income decreased 4% in fiscal 2004 from fiscal 2003 due to a decline in interest revenue that was partially offset by lower interest expense. The decline in interest revenue was primarily due to a decrease in average general purpose credit card loans. The decrease in interest expense was primarily due to a lower level of average interest bearing liabilities and a decrease in the Company’s average cost of borrowings. The Company’s average cost of borrowings was 4.01% for fiscal 2004 as compared with 4.33% for fiscal 2003. The decline in the average cost of borrowings reflected the favorable impact of replacing certain maturing fixed rate debt with lower cost financing.

 

Net interest income decreased 6% in fiscal 2003 from the prior-year period, as a decline in interest revenue was partially offset by lower interest expense. The decline in interest revenue was due to a lower yield on general purpose credit card loans and a decrease in average general purpose credit card loans. The lower yield on general purpose credit card loans was primarily due to lower interest rates offered to new cardmembers and certain existing cardmembers and a higher level of net interest charge-offs. The decrease in average general purpose credit card loans was primarily due to a higher level of securitized loans and higher payments by cardmembers, partially offset by record levels of sales volume. The decrease in interest expense was primarily due to a decrease in the Company’s average cost of borrowings and a lower level of average interest bearing liabilities. The Company’s average cost of borrowings was 4.33% for fiscal 2003 as compared with 5.29% for fiscal 2002. The decline in the average cost of borrowings reflected the Fed’s aggressive easing of interest rates that began in fiscal 2001 and the favorable impact of replacing certain maturing fixed rate debt with lower cost financing, reflecting the lower interest rate environment.environment in fiscal 2003.

 

Net interest income in fiscal 2002 increased slightly from the prior-year period. In fiscal 2002, a decline in interest expense and an increase in general purpose credit card loans were offset by a lower yield on these loans. The lower yield on general purpose credit card loans was primarily due to lower interest rates offered to new

45

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cardmembers and certain existing cardmembers, as well as higher charge-offs of interest. The decrease in interest expense was primarily due to a decrease in the Company’s average cost of borrowings. The Fed’s aggressive interest rate easing that began in fiscal 2001 continued to benefit the Company’s average cost of borrowings in fiscal 2002. The Company’s average cost of borrowings was 5.29% for fiscal 2002 as compared with 6.26% for fiscal 2001.

The following tables present analyses of Credit Services average balance sheets and interest rates in fiscal 2004, fiscal 2003 and fiscal 2002 and fiscal 2001 and changes in net interest income during those fiscal years:

 

Average Balance Sheet Analysis.

 

		Fiscal 2003											Fiscal 2002(3)											Fiscal 2001(3)											Fiscal 2004											Fiscal 2003											Fiscal 2002
		Average Balance				Rate			Interest				Average Balance				Rate			Interest				Average Balance				Rate			Interest				Average Balance				Rate			Interest				Average Balance				Rate			Interest				Average Balance				Rate			Interest
		(dollars in millions)																																	(dollars in millions)
ASSETS
Interest earning assets:
General purpose credit card loans		$	19,531			10.02	%		$	1,956			$	20,659			11.03	%		$	2,279			$	20,285			11.73	%		$	2,379			$	17,608			10.05	%		$	1,770			$	19,531			10.02	%		$	1,956			$	20,659			11.03	%		$	2,279
Other consumer loans			1,530			5.45				83				1,229			5.99				73				808			7.83				63				1,304			5.33				69				1,530			5.45				83				1,229			5.99				73
Investment securities			73			0.88				1				60			1.46				1				444			5.09				23				116			0.66				1				73			0.88				1				60			1.46				1
Other			2,668			1.90				51				2,451			2.45				60				2,389			5.37				128				2,527			2.11				53				2,668			1.90				51				2,451			2.45				60
Total interest earning assets			23,802			8.79				2,091				24,399			9.89				2,413				23,926			10.84				2,593				21,555			8.78				1,893				23,802			8.79				2,091				24,399			9.89				2,413
Allowance for loan losses			(967	)										(890	)										(790	)										(972	)										(967	)										(890	)
Non-interest earning assets			2,511											2,534											2,586											2,582											2,511											2,534
Total assets		$	25,346										$	26,043										$	25,722										$	23,165										$	25,346										$	26,043
LIABILITIES AND SHAREHOLDER’S EQUITY
Interest bearing liabilities:
Interest bearing deposits
Savings		$	810			1.01	%		$	8			$	1,018			1.56	%		$	16			$	1,516			4.29	%		$	65			$	688			1.05	%		$	7			$	810			1.01	%		$	8			$	1,018			1.56	%		$	16
Brokered			10,523			5.28				556				9,732			6.01				584				8,891			6.63				590				8,601			5.07				436				10,523			5.28				556				9,732			6.01				584
Other time			1,620			4.38				71				2,037			5.10				104				3,058			5.99				183				2,154			3.33				72				1,620			4.38				71				2,037			5.10				104
Total interest bearing deposits			12,953			4.90				635				12,787			5.51				704				13,465			6.22				838				11,443			4.50				515				12,953			4.90				635				12,787			5.51				704
Other borrowings			5,676			3.02				171				7,053			4.91				346				6,299			6.33				398				5,078			2.90				147				5,676			3.02				171				7,053			4.91				346
Total interest bearing liabilities			18,629			4.33				806				19,840			5.29				1,050				19,764			6.26				1,236				16,521			4.01				662				18,629			4.33				806				19,840			5.29				1,050
Shareholder’s equity/other liabilities			6,717											6,203											5,958											6,644											6,717											6,203
Total liabilities and shareholder’s equity		$	25,346										$	26,043										$	25,722										$	23,165										$	25,346										$	26,043
Net interest income									$	1,285										$	1,363										$	1,357										$	1,231										$	1,285										$	1,363
Net interest margin(1)										5.40	%										5.59	%										5.67	%										5.71	%										5.40	%										5.59	%
Interest rate spread(2)						4.46	%										4.60	%										4.58	%										4.77	%										4.46	%										4.60	%

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(1)	Net interest margin represents net interest income as a percentage of total interest earning assets.

(2)	Interest rate spread represents the difference between the rate on total interest earning assets and the rate on total interest bearing liabilities.

(3)	Certain prior-year information has been reclassified to conform to the current year’s presentation.
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Rate/Volume Analysis.

 

		Fiscal 2003 vs. Fiscal 2002												Fiscal 2002 vs. Fiscal 2001(1)
Increase/(Decrease) due to Changes in:		Volume				Rate				Total				Volume			Rate				Total
		(dollars in millions)
Interest Revenue
General purpose credit card loans		$	(125	)		$	(198	)		$	(323	)		$ 44			$	(144	)		$	(100	)
Other consumer loans			17				(7	)			10			33				(23	)			10
Investment securities			—				—				—			(20	)			(2	)			(22	)
Other			5				(14	)			(9	)		3				(71	)			(68	)
Total interest revenue			(59	)			(263	)			(322	)		51				(231	)			(180	)
Interest Expense
Interest bearing deposits:
Savings			(3	)			(5	)			(8	)		(21	)			(28	)			(49	)
Brokered			48				(76	)			(28	)		55				(61	)			(6	)
Other time			(21	)			(12	)			(33	)		(61	)			(18	)			(79	)
Total interest bearing deposits			9				(78	)			(69	)		(42	)			(92	)			(134	)
Other borrowings			(68	)			(107	)			(175	)		48				(100	)			(52	)
Total interest expense			(64	)			(180	)			(244	)		5				(191	)			(186	)
Net interest income		$	5			$	(83	)		$	(78	)		$ 46			$	(40	)		$	6

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(1)	Certain prior-year information has been reclassified to conform to the current year’s presentation.

		Fiscal 2004 vs. Fiscal 2003												Fiscal 2003 vs. Fiscal 2002
Increase/(Decrease) due to Changes in:		Volume				Rate				Total				Volume				Rate				Total
		(dollars in millions)
Interest Revenue
General purpose credit card loans		$	(191	)		$	5			$	(186	)		$	(125	)		$	(198	)		$	(323	)
Other consumer loans			(12	)			(2	)			(14	)			17				(7	)			10
Other			(3	)			5				2				5				(14	)			(9	)
Total interest revenue			(196	)			(2	)			(198	)			(59	)			(263	)			(322	)
Interest Expense
Interest bearing deposits:
Savings			(1	)			—				(1	)			(3	)			(5	)			(8	)
Brokered			(102	)			(18	)			(120	)			48				(76	)			(28	)
Other time			23				(22	)			1				(21	)			(12	)			(33	)
Total interest bearing deposits			(74	)			(46	)			(120	)			9				(78	)			(69	)
Other borrowings			(18	)			(6	)			(24	)			(68	)			(107	)			(175	)
Total interest expense			(91	)			(53	)			(144	)			(64	)			(180	)			(244	)
Net interest income		$	(105	)		$	51			$	(54	)		$	5			$	(83	)		$	(78	)

 

In response to industry-wide regulatory guidance, issued in the beginning of fiscal 2003, the Company is reviewing thehas increased minimum payment requirements on itscertain general purpose credit card loans. A changeThe Company believes that the adjustments made in fiscal 2004 comply with the minimum payment requirements mayguidance. However, bank regulators have broad discretion on the application of the guidance, and changes in such guidance or its application by the regulators could impact future levels of general purpose credit card loans and related interest and fee revenuesrevenue and charge-offs.

 

Provision for Consumer Loan Losses.    The provision for consumer loan losses is the amount necessary to establish the allowance for consumer loan losses at a level that the Company believes is adequate to absorb estimated losses in its consumer loan portfolio at the balance sheet date. The Company’s provision for consumer loan losses was $1,267 million and $1,336 million for fiscal 2003 and fiscal 2002, respectively. The Company’s allowance for consumer loan losses was $1,002 million at November 30, 2003 and $928 million at November 30, 2002.

The allowance for consumer loan losses is a significant estimate that represents management’s estimate of probable losses inherent in the consumer loan portfolio. The allowance for consumer loan losses is primarily applicable to the owned homogeneous consumer credit card loan portfolio that is evaluated quarterly for adequacy and is established through a charge to the provision for consumer loan losses.

In calculating the allowance for consumer loan losses, the Company uses a systematic and consistently applied approach. The Company regularly performs a migration analysis (a technique used to estimate the likelihood that a consumer loan will progress through the various stages of delinquency and ultimately charge-off) of delinquent and current consumer credit card accounts in order to determine the appropriate level of the allowance for consumer loan losses. The migration analysis considers uncollectible principal, interest and fees reflected in consumer loans. In addition, the Company estimates the losses inherent in the consumer loan portfolio based on coverage of a rolling average of historical credit losses. In evaluating the adequacy of the allowance for consumer loan losses, management also considers factors that may impact future credit loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties. A

The Company’s provision for consumer loan losses is charged against earningswas $925 million and $1,267 million for fiscal 2004 and fiscal 2003, respectively. The Company’s allowance for consumer loan losses was $943 million at November 30, 2004 and $1,002 million at November 30, 2003.

The provision for consumer loan losses decreased 27% in fiscal 2004, primarily due to maintainlower net principal charge-offs resulting from an improvement in credit quality, including lower bankruptcy charge-offs driven by a decline in U.S. personal bankruptcy filings. The decrease was also due to a lower level of average general purpose credit card loans. The Company reduced the allowance for consumer loan losses at an appropriate level.by approximately $60

 

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The provision for consumer loan losses is affected by net principal charge-offs, delinquencies, bankruptcy filingsmillion in fiscal 2004 due to improvement in credit quality, including lower delinquency rates and loan growth as well as changes in the amount of consumer loans estimated to be uncollectible.dollars. In fiscal 2003, the provision for consumer loan losses decreased 5%, primarily due to a lower level of average general purpose credit card loans. In fiscal 2002, the provision for consumer loan losses increased 27%, primarily due to higher net charge-off rates. In response to unfavorable trends in U.S. consumer bankruptcy filings and relatively high unemployment levels, the Company recorded a provision for consumer loan losses that exceeded the amount of net consumer loans charged off by approximately $70 million in fiscal 2003 and approximately $75 million in fiscal 2002.2003.

 

Delinquencies and Charge-offs.  General purpose credit card loans are considered delinquent when interest or principal payments become 30 days past due. General purpose credit card loans are charged off at the end of the month during which an account becomes 180 days past due, except in the case of bankruptcies, deceased cardmembers and fraudulent transactions, where loans are charged off earlier. Loan delinquencies and charge-offs are affected by changes in economic conditions, account collection management and policy changes and may vary throughout the year due to seasonal consumer spending and payment behaviors.

 

In fiscal 2004, net principal charge-off rates decreased in both the owned and managed portfolios as compared with fiscal 2003, reflecting improvements in portfolio credit quality and a lower level of bankruptcy filings (see “Managed General Purpose Credit Card Loan Data” herein). Delinquency rates in both the over 30- and over 90-day categories were lower in both the owned and managed portfolios at November 30, 2004 as compared with November 30, 2003, also reflecting improvements in portfolio credit quality.

In the second quarter of fiscal 2003, the Company changed its policy related to deceased cardmember accounts to charge off 60 days after notification as compared with charging off 180 days past due. This change accelerated charge-offs beginning in the third quarter of fiscal 2003 and increased charge-offs in the second half of fiscal 2003.

The practice of re-aging an account also may affect general purpose credit card loan delinquencies and charge-offs. A re-age is intended to assist delinquent cardmembers who have experienced financial difficulties by returning the account to current status. An account is re-aged when the Company and the cardmember agree on a temporary repayment schedule, which may include short-term concessionary terms, and the cardmember has demonstrated a willingness and ability to repay. Cardmembers may also qualify for a workout re-age, which restructures the account to incorporate permanent concessionary terms, when either a longer term or permanent hardship exists.

During the second half of fiscal 2002 and the first half of fiscal 2003, the Company changed its re-age policy in response to industry-wide regulatory guidelines. A re-age is intended to assist delinquent cardmembers who have experienced financial difficulties by returning the account to current status. This change in the re-age policy, along with the ongoing economic challenges as evidenced by high levels of unemployment and U.S. bankruptcy filings, have resulted in a significant decrease in the number of cardmembers eligible for re-age versusvs. comparable periods in fiscal 2002. During fiscal 2003, the Company’s re-age volume decreased by approximately 40% from fiscal 2002. The reduction in re-age volume was a contributing factor to the higher delinquencies and charge-off levels experienced in fiscal 2003.2003 as compared with fiscal 2002.

 

In fiscal 2003, net principal charge-off rates increased in the managed portfolio as compared with fiscal 2002, reflecting the impact of lower re-age volume and the change in the Company’s deceased cardmember policy discussed above (see “Managed General Purpose Credit Card Loan Data” herein). In the U.S., high levels of unemployment, the seasoning of the Company’s general purpose credit card loan portfolio, a high level of bankruptcy filings and policy changes contributed to the higher net principal charge-off rate in the managed portfolio during fiscal 2003. In addition, these conditions impacted the Company’s delinquency rates in both the over 30- and over 90-day categories, which were higher in both the owned and managed portfolio at November 30, 2003 as compared with November 30, 2002. A lower level of general purpose credit card loan balances also negatively impacted delinquency and net principal charge-off rates.rates in fiscal 2003.

 

In fiscal 2002, net principal charge-offs increased in both the owned and managed portfolios as compared with the prior-year periods. Despite the increase in net charge-off rates, the Company’s delinquency rates in both the over 30- and over 90-day categories were lower at November 30, 2002 as compared with November 30, 2001, reflecting the Company’s increased focus on collections in the earlier stages of delinquency. Weak economic conditions and a higher level of bankruptcy filings in the U.S., coupled with the seasoning of the Company’s general purpose credit card loan portfolio, contributed to the higher net principal charge-off rates during fiscal 2002.

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The Company’s future charge-off rates and credit quality are subject to uncertainties that could cause actual results to differ materially from what has been discussed above. Factors that influence the provision for consumer loan losses include the level and direction of general purpose credit card loan delinquencies and charge-offs, changes in consumer spending and payment behaviors, bankruptcy trends, the seasoning of the Company’s general purpose credit card loan portfolio, interest rate movements and their impact on consumer behavior, and the rate and magnitude of changes in the Company’s general purpose credit card loan portfolio, including the overall mix of accounts, products and loan balances within the portfolio.

 

Non-Interest Expenses.    Non-interest expenses increased 1% in fiscal 2004 from fiscal 2003. Compensation and benefits expense decreased 5% due to lower employee benefit costs, as well as lower salaries resulting from lower

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employment levels due, in part, to workforce reductions conducted during the fourth quarter of fiscal 2003. Excluding compensation and benefits expense, non-interest expenses increased 5%. Marketing and business development expense increased 20% due to increased marketing costs associated with account acquisition, merchant initiatives and advertising. Other expenses decreased 9%, primarily reflecting a decrease in certain operating expenses, including lower losses associated with cardmember fraud.

Fiscal 2003’s total non-interest expenses decreased 2% from fiscal 2002. Compensation and benefits expense increased 6%, reflecting an increase in personnel costs, including salaries and benefits, as well as costs associated with the workforce reductions conducted during the fourth quarter.quarter of fiscal 2003. These costs included a charge of $35 million (pre-tax) associated with workforce reductions and facility consolidations that were conducted during the fourth quarter of fiscal 2003. The charge reflected several actions in response to slower industry growth and difficult consumer credit conditions and consisted of severance-related costs of $29 million and space-related and other costs of $6 million. The majority of these costs were paid by the end of the first quarter of fiscal 2004. Excluding compensation and benefits expense, non-interest expenses decreased 6%. Marketing and business development expense decreased 11% due to lower direct mail costs. Other expenses decreased 11%, primarily reflecting a decrease in certain operating expenses, including lower costs associated with cardmember fraud and merchant bankruptcies.

Other Matters.    On October 4, 2004, the U.S. Supreme Court rejected an appeal by Visa and MasterCard inU.S. v. Visa/MasterCard. The trial and appellate courts found that Visa and MasterCard rules and policies that prevented virtually all U.S. financial institutions from doing business with competing networks violated the antitrust laws. Now that these rules have been struck down as illegal, financial institutions (in addition to Discover Bank) will be able to issue credit and debit cards on the Discover Network. Following the Supreme Court decision, Credit Services filed a lawsuit in federal court in New York seeking damages for harm caused by the anti-competitive rules. In January 2005, the Company announced that it had signed its first third-party issuance with GE Consumer Finance to issue the Wal-Mart Discover card on the Discover Network.

 

Fiscal 2002’s total non-interest expenses decreased 2%, primarily due to lower marketing and business development expense, partially offset by increases in professional services and compensation and benefits expense. Compensation and benefits expense increased 3% in fiscal 2002, principally reflecting increases in salaries and benefits. Excluding compensation and benefits expense, non-interest expenses decreased 4%. Marketing and business development expense decreased 13% in fiscal 2002 due to lower marketing and advertising expense asOn January 12, 2005, the Company shiftedcompleted its focus from account growth to credit quality. Professional services expense increased 12%, attributable to higher consulting expensesacquisition of PULSE (see “Business Acquisitions and increased costs associated with enhanced credit and collection strategies.Asset Sales” herein).

 

Seasonal Factors.    The credit card lending activities of Credit Services are affected by seasonal patterns of retail purchasing. Historically, a substantial percentage of general purpose credit card loan growth occurs in the fourth calendar quarter, followed by a flattening or decline of these loans in the following calendar quarter. Merchant fees, therefore, historically have tended to increase in the first fiscal quarter, reflecting higher sales activity in the month of December. Additionally, higher cardmember rewards incentives historically have been accrued for as a reduction of merchant and cardmember fee revenues in the first fiscal quarter, reflecting seasonal growth in retail sales volume.

 

Managed General Purpose Credit Card Loan Data.    The Company analyzes its financial performance on both a “managed” loan basis and as reported under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”) (“owned” loan basis). Managed loan data assume that the Company’s securitized loan receivables have not been sold and present the results of the securitized loan receivables in the same manner as the Company’s owned loans. The Company operates its Credit Services business and analyzes its financial performance on a managed basis. Accordingly, underwriting and servicing standards are comparable for both owned and securitized loans. The Company believes that managed loan information is useful to investors because it provides information regarding the quality of loan origination and credit performance of the entire managed portfolio and allows investors to understand the related credit risks inherent in owned loans and retained interests in securitizations. In addition, investors often request information on a managed basis, which provides a more meaningful comparison towith industry competitors.

 

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The following table provides a reconciliation of owned and managed average loan balances, interest yields and interest rate spreads for the periods indicated. Certain reclassifications have been made to prior-period amounts to conform to the current year’s presentation:indicated:

 

Reconciliation of General Purpose Credit Card Loan Data (dollars in millions)

 

		Fiscal 2003									Fiscal 2002									Fiscal 2001									Fiscal 2004									Fiscal 2003									Fiscal 2002
		Average Balance			Interest Yield			Interest Rate Spread			Average Balance			Interest Yield			Interest Rate Spread			Average Balance			Interest Yield			Interest Rate Spread			Average Balance			Interest Yield			Interest Rate Spread			Average Balance			Interest Yield			Interest Rate Spread			Average Balance			Interest Yield			Interest Rate Spread
General Purpose Credit Card Loans:
Owned		$	19,531		10.02	%		5.69	%		$	20,659		11.03	%		5.74	%		$	20,285		11.73	%		5.47	%		$	17,608		10.05	%		6.04	%		$	19,531		10.02	%		5.69	%		$	20,659		11.03	%		5.74	%
Securitized			31,333		13.13	%		10.64	%			29,176		13.79	%		10.78	%			29,147		14.66	%		9.54	%			29,779		12.90	%		10.56	%			31,333		13.13	%		10.64	%			29,176		13.79	%		10.78	%
Managed		$	50,864		11.93	%		8.77	%		$	49,835		12.64	%		8.71	%		$	49,432		13.45	%		7.88	%		$	47,387		11.84	%		8.92	%		$	50,864		11.93	%		8.77	%		$	49,835		12.64	%		8.71	%

 

The following tables present a reconciliation of owned and managed general purpose credit card loans and delinquency and net charge-off rates:

 

Reconciliation of General Purpose Credit Card Loan Asset Quality Data (dollars in millions)

 

		Fiscal 2003									Fiscal 2002									Fiscal 2001									Fiscal 2004									Fiscal 2003									Fiscal 2002
					Delinquency Rates									Delinquency Rates									Delinquency Rates						Period- End Loans			Delinquency Rates						Period- End Loans			Delinquency Rates						Period- End Loans			Delinquency Rates
		Period End Loans			Over 30 Days			Over 90 Days			Period End Loans			Over 30 Days			Over 90 Days			Period End Loans			Over 30 Days			Over 90 Days					Over 30 Days			Over 90 Days						Over 30 Days			Over 90 Days						Over 30 Days			Over 90 Days
General Purpose Credit Card Loans:
Owned		$	18,930		5.36	%		2.53	%		$	22,153		5.32	%		2.41	%		$	19,654		6.15	%		2.73	%		$	19,724		4.08	%		1.97	%		$	18,930		5.36	%		2.53	%		$	22,153		5.32	%		2.41	%
Securitized			29,428		6.36	%		3.01	%			28,990		6.45	%		2.85	%			29,678		7.32	%		3.21	%			28,537		4.87	%		2.34	%			29,428		6.36	%		3.01	%			28,990		6.45	%		2.85	%
Managed		$	48,358		5.97	%		2.82	%		$	51,143		5.96	%		2.66	%		$	49,332		6.85	%		3.02	%		$	48,261		4.55	%		2.18	%		$	48,358		5.97	%		2.82	%		$	51,143		5.96	%		2.66	%

 

		Fiscal 2003			Fiscal 2002			Fiscal 2001			Fiscal 2004			Fiscal 2003			Fiscal 2002
Net Principal Charge-offs
Net Principal Charge-offs:
Owned		6.05	%		6.06	%		4.86	%		5.53	%		6.05	%		6.06	%
Securitized		6.95	%		6.29	%		5.70	%		6.28	%		6.95	%		6.29	%
Managed		6.60	%		6.19	%		5.36	%		6.00	%		6.60	%		6.19	%
		Fiscal 2003			Fiscal 2002			Fiscal 2001
Net Total Charge-offs (inclusive of interest and fees)
Owned		8.33	%		7.97	%		6.41	%
Securitized		9.75	%		8.51	%		7.69	%
Managed		9.20	%		8.28	%		7.16	%

 

		Fiscal 2004			Fiscal 2003			Fiscal 2002
Net Total Charge-offs (inclusive of interest and fees):
Owned		7.68	%		8.33	%		7.97	%
Securitized		9.01	%		9.75	%		8.51	%
Managed		8.51	%		9.20	%		8.28	%

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Equity-Based Compensation Program.Business Acquisitions and Asset Sales.

 

Effective December 1,On January 12, 2005, the Company completed the acquisition of PULSE, an Automated Teller Machine/debit network currently serving banks, credit unions and savings institutions in the U.S. The Company believes that the combination of the PULSE and Discover Network will create a leading electronic payments company offering a full range of products and services for financial institutions, consumers and merchants. As of the date of acquisition, the results of PULSE will be included within the Credit Services business segment.

On June 3, 2004, the Company completed the acquisition of Barra, a global leader in delivering risk management systems and services to managers of portfolio and firm-wide investment risk. The Company believes that the combination of MSCI, a majority-owned subsidiary of the Company, and Barra created a leading global provider of benchmark indices and risk management analytics. Since the date of acquisition, the results of Barra have been included within the Institutional Securities business segment. The acquisition price was $41.00 per share in cash, or an aggregate consideration of approximately $800 million. The Company recorded goodwill and other intangible assets totaling $663 million in connection with the acquisition (see Note 24 to the consolidated financial statements).

In fiscal 2003, the Company acquired selected components of the U.S. real estate equity advisory businesses of Lend Lease Corporation, an Australia-based company. The financial statement impact related to this acquisition, which is included in the Company’s Institutional Securities segment, was not significant.

In fiscal 2002, the Company adoptedsold its self-directed online brokerage accounts to Bank of Montreal’s Harrisdirect.The Company recorded gross proceeds of approximately $100 million (included within Other revenues) and related costs of approximately $50 million (included within Non-interest expenses) in the Individual Investor Group segment.

In fiscal 2002, the Company recorded a pre-tax gain of $73 million related to the sale of a 1 million square-foot office tower in New York City. The pre-tax gain is included within the Institutional Securities ($53 million), Individual Investor Group ($7 million) and Investment Management ($13 million) segments. The allocation was based upon occupancy levels originally planned for the building.

Discontinued Operations.

As described in Note 25 to the consolidated financial statements, in the third quarter of fiscal 2004, the Company recorded a pre-tax loss of $42 million in its Institutional Securities business related to the write-down of certain aircraft that were subject to a probable sale and, accordingly, have been designated as “held for sale” in accordance with SFAS No. 123,144, “Accounting for Stock-Based Compensation,the Impairment or Disposal of Long-Lived Assets.” The revenues and expenses associated with these aircraft have been classified as amended by SFAS No. 148, “Accountingdiscontinued operations for Stock-Based Compensation—Transitionall periods presented. As of February 3, 2005, all of the aircraft referred to above were sold.

The table below provides information regarding the pre-tax loss on discontinued operations and Disclosure, an amendmentthe aircraft impairment charges that are included in these amounts (dollars in millions):

		Fiscal Year
		2004			2003			2002
Pre-tax loss on discontinued operations		$	38		$	38		$	18
Aircraft impairment charges			2			16			4

The pre-tax loss on discontinued operations for fiscal 2003 also included a $19 million charge to adjust the carrying value of FASB Statement No. 123,” using the prospective adoption methodpreviously impaired aircraft to market value (see Note 218 to the consolidated financial statements). The Company now records compensation expense based upon the fair value of stock-based awards (both deferred stock and stock options). In prior years, the Company accounted for its stock-based awards under the intrinsic value approach in accordance with Accounting Principles Board (“APB”) Opinion No. 25 (“APB 25”), “Accounting for Stock Issuedmay sell additional aircraft from time to Employees.” Under the approach in APB 25 and the terms of the Company’s plans in prior years, the Company recognized compensation expense for deferred stock awards in the year of grant; however, no compensation expense was generally recognized for stock option grants.time.

 

During the third quarter of fiscal 2003, the Company completed an extensive analysis of its stock-based compensation program and revised elements of its program to further encourage and incent long-term performance, enhance employee retention, and better align employee and shareholder interests. The revisions to fiscal 2003 awards included extending the time period over which vesting and non-compete provisions apply and raising the eligibility requirements to participate in such awards.

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As a result of the revisions to its stock-based compensation program, the Company will recognize the fair value of stock-based awards granted in fiscal 2003 over service periods of three and four years, including the year of grant. Historically, the service period for stock-based awards was deemed to be the year of grant.Income Tax Examinations.

 

The effect of expensing stock-based awards over a longer period of service reduced compensation expense recordedCompany is under continuous examination by the Internal Revenue Service (the “IRS”) and other tax authorities in certain countries, such as Japan and the United Kingdom, and states in which the Company has significant business operations, such as New York. The tax years under examination vary by jurisdiction; for deferred stock awards by $438 millionexample, the current IRS examination covers 1994-1998. Assuming current progress, the Company expects this IRS examination to be completed in fiscal 2003. In addition,2005. The Company regularly assesses the likelihood of additional assessments in connection witheach of the adoption of SFAS No. 123,taxing jurisdictions resulting from these and subsequent years’ examinations. Tax reserves have been established, which the Company recorded compensation expensebelieves to be adequate in relation to the potential for additional assessments. Once established, reserves are adjusted only when there is more information available or when an event occurs necessitating a change to the reserves. The resolution of $176 million basedtax matters will not have a material effect on the fair valueconsolidated financial condition of stock options granted in fiscal 2003. The netthe Company, although a resolution could have a material impact of these revisions reducedon the Company’s compensationconsolidated statement of income for a particular future period and benefits expense by $262 million in fiscal 2003 and increased net income by $177 million (or $0.16 per share) in fiscal 2003 as compared with fiscal 2002.on the Company’s effective tax rate.

 

Restructuring and Other Charges.

 

In the fourth quarter of fiscal 2002, the Company recognized restructuring and other charges of $235 million (pre-tax). The charge reflected several actions that were intended to resize and refocus certain business areas in order to address the difficult conditions then existing in the global financial markets. Such conditions, including significantly lower levels of investment banking activity and decreased retail investor participation in the equity markets, had an adverse impact on the Company’s results of operations, particularly in its Institutional Securities and Individual Investor Group businesses.

 

The fiscal 2002 charge consisted of space-related costs of $162 million and severance-related costs of $73 million. The space-related costs were attributable to the closure or subletting of excess office space, primarily in the U.S. and the U.K., as well as the Company’s decision to consolidate its Individual Investor Group branch locations. The majority of the space-related costs consisted of rental charges and the write-off of furniture, fixtures and other fixed assets at the affected office locations. The severance-related costs were attributable to workforce reductions. The Company reduced the number of its employees by approximately 2,200 during the fourth quarter of fiscal 2002, primarily in the Institutional Securities and Individual Investor Group businesses. The majority of the severance-related costs consisted of severance payments provided to the affected individuals.

 

At November 30, 2003,2004, the remaining liability associated with these charges was approximately $100$75 million, which was included in Other liabilities and accrued expenses in the Company’s consolidated statement of financial condition. The majority of the decrease from the original liability of $235 million was due to cash payments of severance-related costs made by the Company during fiscal 2003. The decline in the liability balance during fiscal 2003 also reflected net rental payments associated with the office locations referred to

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above. In fiscal 2004, the liability is expected to decline by an additional $50 million due to the continuing payment of net rentals on these locations. The liability will continue to be reduced through 2012 as the leases on the office locations referred to above expire.

Equity-Based Compensation Program.

Effective December 1, 2002, the Company adopted SFAS No. 123, as amended by SFAS No. 148, using the prospective adoption method (see Note 2 to the consolidated financial statements). The Company now records compensation expense based upon the fair value of stock-based awards (both deferred stock and stock options). Prior to fiscal 2003, the Company accounted for its stock-based awards under the intrinsic value approach in accordance with Accounting Principles Board (“APB”) Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the approach in APB 25 and the terms of the Company’s plans in prior years, the Company recognized compensation expense for deferred stock awards in the year of grant; however, no compensation expense was generally recognized for stock option grants.

As a result of the adoption of SFAS No. 123, the Company is recognizing the fair value of equity-based awards granted in fiscal 2003 and fiscal 2004 over service periods of three and four years, including the year of grant. Prior to fiscal 2003, the service period for stock-based awards was deemed to be the year of grant. The effect of expensing stock-based awards over a longer period of service reduced compensation expense recorded for deferred stock awards by $438 million in fiscal 2003 as compared with fiscal 2002. In addition, in connection with the adoption of SFAS No. 123, the Company recorded compensation expense of $176 million based on the

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fair value of stock options granted in fiscal 2003. The net impact of these leases expire.revisions reduced the Company’s compensation and benefits expense by $262 million in fiscal 2003 and increased net income by $177 million (or $0.16 per share) in fiscal 2003 as compared with fiscal 2002.

As a result of amortizing the cost of equity-based awards over their respective service periods (including the year of grant), fiscal 2004’s compensation and benefits expense included the amortization of equity-based awards granted in both fiscal 2004 and fiscal 2003. Fiscal 2003’s compensation and benefits expense only included the amortization of equity-based awards granted in fiscal 2003. The net amount of compensation and benefits expense recognized by the Company related to its equity-based awards (deferred stock and stock options) was approximately $650 million in fiscal 2004 and approximately $285 million in fiscal 2003.

In December 2004, the Financial Accounting Standards Board (the “FASB”) made certain revisions to SFAS No. 123 that will impact the Company’s compensation and benefits expense in fiscal 2005 and future periods (see “New Accounting Developments – Stock-Based Compensation” herein).

Asset Management and Account Fees.

Prior to the fourth quarter of fiscal 2004, the Company was improperly recognizing certain management fees, account fees and related compensation expense paid at the beginning of the relevant contract periods, which is when such fees were billed. In the fourth quarter of fiscal 2004, the Company changed its method of accounting for such fees to properly recognize such fees and related expenses over the relevant contract period, generally quarterly or annually. As a result of the change, the Company’s results in the fourth quarter of fiscal 2004 included an adjustment to reflect the cumulative impact of the deferral of certain management fees, account fees and related compensation expense paid to representatives. The impact of this change reduced net revenues by $107 million, non-interest expenses by $27 million and income before taxes by $80 million, at both the Company and the Individual Investor Group segment in the fourth quarter of fiscal 2004. Such adjustment reduced net income by approximately $50 million and basic and diluted earnings per share by $0.05. If the above referenced fees and expenses had been recognized over the relevant contract period in the past, pre-tax income for the Company and the Individual Investor Group segment would have been lower by the following amounts:

		Decrease in Pre-tax Income
		(dollars in millions)
Quarter ended:
February 28, 2002		$	(4.1	)
May 31, 2002			(3.7	)
August 31, 2002			(2.1	)
November 30, 2002			(0.8	)
Fiscal 2002 total			(10.7	)
February 28, 2003			(5.2	)
May 31, 2003			(1.3	)
August 31, 2003			(4.2	)
November 30, 2003			(2.0	)
Fiscal 2003 total			(12.7	)
February 29, 2004			(3.1	)
May 31, 2004			(2.6	)
August 31, 2004			(2.3	)

 

Investments in Unconsolidated Investees.

 

The Company invests in unconsolidated investees that own synthetic fuel production plants. The Company accounts for these investments under the equity method of accounting. The Company’s share of the operating

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losses generated by these investments is recorded within Losses from unconsolidated investees, and the tax credits and the tax benefits associated with these operating losses are recorded within the Company’s Provision for income taxes.

In fiscal 2004, fiscal 2003 and fiscal 2002, and fiscal 2001, the Company recorded Losseslosses from unconsolidated investees of $279 million, $77 million and $30 million, respectively. These losses were more than offset by the respective tax credits of $308 million, $109 million and $48 million in fiscal 2003, fiscal 2002 and fiscal 2001, respectively, and tax benefits on the losses. The table below provides information regarding the losses of $112 million, $31 millionfrom unconsolidated investees, tax credits and $12 million in fiscal 2003, fiscal 2002 and fiscal 2001, respectively.tax benefits on the losses:

 

Business Acquisitions and Asset Sales.

		Fiscal Year
		2004			2003			2002
		(dollars in millions)
Losses from unconsolidated investees		$	328		$	279		$	77
Tax credits			351			308			109
Tax benefits on losses			132			112			31

 

On November 20, 2003,IRS field auditors are contesting the Company acquired selected componentsplaced-in-service date of several synthetic fuel facilities owned by one of the U.S. real estate equity advisory businessesCompany’s unconsolidated investees (the “LLC”). To qualify for the tax credits under Section 29 of Lend Lease Corporation,the Internal Revenue Code, the production facility must have been placed in service before July 1, 1998. The LLC is vigorously contesting the IRS proposed position. If the IRS ultimately prevails, it could have an Australia-based company. The financial statement impact related to this acquisition, which is included inadverse effect on the Company’s Institutional Securities segment, was not significant.

In fiscal 2002, the Company sold its self-directed online brokerage accounts to Banktax liability or results of Montreal’s Harrisdirect.The transaction closed during the third quarter of fiscal 2002.operations. The Company recorded gross proceedshas recognized cumulative tax credits of approximately $100$110 million (included within Other revenues) and related costs of approximately $50 million (included within Non-interest expenses) inassociated with the Individual Investor Group segment.

In fiscal 2002, the Company recorded a pre-tax gain of $73 million related to the sale of a 1 million square-foot office tower in New York City that had been under construction since 1999. The pre-tax gain is included within the Institutional Securities ($53 million), Individual Investor Group ($7 million) and Investment Management ($13 million) segments. The allocation was based upon occupancy levels originally planned for the building.

In fiscal 2001, the Company acquired Quilter Holdings Limited (“Quilter”), a U.K.-based private client investment management business providing segregated account management and advisory services to individuals, pension funds and trusts. The Company’s fiscal 2001 results include the operations of Quilter since March 13, 2001, the date of acquisition.LLC’s synthetic fuel facilities.

 

Pension Plans.

 

The Company made contributions of $239$120 million and $463$239 million to its defined benefit pension plans (U.S. and non-U.S.) in fiscal 20032004 and fiscal 2002,2003, respectively. These contributions were funded with cash from operations and were recorded as a component of prepaid pension benefit cost in the Company’s consolidated statements of financial condition. In addition, the Company, in consultation with its independent actuaries, lowered its expected long-term rate of return on U.S. plan assets (from 8.5%7.50% to 7.5%7.25%) for fiscal 20032004 (see Note 15 to the consolidated financial statements). The impact of this change was not material to the Company’s consolidated results of operations in fiscal 2003.2004.

 

The Company determines the amount of its pension contributions by considering the interaction of several factors. Such factors include the range of potential contributions (i.e., the Employee Retirement Income Security Act of 1974 (“ERISA”) minimum required contribution up to the maximum tax-deductible amount), the level of plan assets relative to plan liabilities, expected plan liquidity needs and expected future contribution requirements. The Company currently hasAt November 30, 2004, there were no known or expectedminimum required ERISA contributions for the Company’s pension plan that is qualified under Section 401(a) of the Internal Revenue Code (the “Qualified Plan”). For its non-U.S. plans, the Company’s policy is to fund at least the amounts sufficient to meet minimum funding obligationsrequirements under applicable employee benefit and tax regulations. Liabilities for any ofbenefits payable under its pension plans.unfunded supplementary plans (the “Supplemental Plans”) are accrued by the Company and are funded when paid to the beneficiaries.

 

In accordance with U.S. GAAP, the Company recognizes pension expense before the payment of benefits to retirees occurs. As a result, the recording of pension expenseThis process involves making certain estimates and assumptions, that must be made, including the discount rate and the expected long-term rate of return on plan assets.

 

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The assumed discount rate, which reflects the rates at which pension benefits could be effectively settled, is used in the measurement ofto measure the projected and accumulated benefit obligations and into calculate the calculation of service cost and interest cost. The assumed discount rate should reflectreflects the rates of return on available high-quality fixed-income investments that reflect the timing and amount of expected benefit payments. For its U.S. pension plans,Qualified Plan, which comprised approximately 95%94% of the total assets of the Company’s pension plans at November 30, 2003,2004, the Company

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estimates its discount rate based on both the absolute levels of and year-to-year changes in various high-quality bond indices, including the Moody’s Aa long-term rate bond yield (both absolute levels and year-to-year changes).yield.

 

The Company uses the expected long-term rate of return on plan assets to compute the expected return on assets. For its U.S. pension plans,Qualified Plan, the Company estimatesannually reviews the expected long-term return by utilizingbased on changes in the target investment mix and economic environment from the previous year. It then compares its initial estimate (and adjusts, if necessary) with a portfolio return calculator model (the “Portfolio Model”) that produces thea range of expected returnreturns for athe portfolio. Return assumptions are forward-looking gross returns that are not developed solely by an examination of historical returns. The Portfolio Model begins with the current U.S. Treasury yield curve, recognizing that expected returns on bonds are heavily influenced by the current level of yields. Corporate bond spreads and equity risk premiums, based on current market conditions, are then added to develop the return expectations for each asset class. Expenses that are expected to be paid from the investment return are reflected in the Portfolio Model as a percentage of plan assets. This includes investment and transaction fees that typically are paid from plan assets, added to the cost basis or subtracted from sale proceeds, as well as administrative expenses paid from the pension plan.Qualified Plan.

 

The Company’s expected long-term rate of return on assets for its U.S. pension plansQualified Plan for fiscal 20032004 was based on the following expected asset allocation:

 

		Target Investment Mix			Expected Annual Return
Domestic Equity:
Large Capitalization		30.00	%		8.5	%
Small Capitalization		15.00	%		9.0	%
International Equity:
Emerging Markets		1.25	%		9.2	%
Global Equity		20.00	%		9.0	%
Fixed Income:
Aggregate		32.50	%		5.2	%
High Yield		1.25	%		7.8	%

		Target Investment Mix			Expected Annual Return(1)
Domestic equity:
Large capitalization		30	%		8.0	%
Small capitalization		10	%		8.6	%
International equity		15	%		8.5	%
Fixed income:
Intermediate government/corporate		22	%		4.1	%
Long-term government/corporate		23	%		5.5	%

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(1)	These amounts do not include the impact of diversification on the overall expected portfolio return.

 

For its U.S. pension plans,Qualified Plan, expected returns are computed using a market-related value of assets. For the market-related value of assets, a smoothed actuarial value of assets is used, equal to a moving average of market values in which investment income is recognized over a five-year period. Investment income equal to the expected return on the prior year’s market-related value of plan assets is recognized immediately. Any difference between the actual investment income (on a market-value basis) and the expected return is recognized over a five-year period in accordance with SFAS No. 87, “Employers’ Accounting for Pensions.” In addition, the market-related value of assets must be no greater than 120% and no less than 80% of the market value of assets.

 

The Company amortizes (as a component of pension expense) unrecognized net gains and losses over the average future service (generally 11 to 1318 years) of active participants in each plan to the extent that the gain/loss exceeds 10% of the greater of the projected benefit obligation or the market-related value of plan assets. The loss amortization component of fiscal 20032004 pension expense was approximately $23$38 million, and future amortization is not expected to have a material impact on the Company’s pension expense.

 

Insurance Recovery.

53

On September 11, 2001, the U.S experienced terrorist attacks targeted against New York City and Washington, D.C. The attacks in New York resulted in the destruction of the World Trade Center complex, where approximately 3,700 of the Company’s employees were located, and the temporary closing of the debt and equity financial markets in the U.S. Through the implementation of its business recovery plans, the Company relocated its displaced employees to other facilities.

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The Company has recognized costs related to the terrorist attacks pertaining to write-offs of leasehold improvements and destroyed technology and telecommunications equipment in the World Trade Center complex, employee relocation and certain other employee-related expenditures, and other business recovery costs. The costs were offset by estimated insurance recoveries.

The Company continues to be in negotiations with its insurance carriers related to the events of September 11, 2001. At the conclusion of these negotiations, the Company currently believes that the amounts it will recover under its insurance policies will be in excess of costs recognized for accounting purposes related to the terrorist attacks. As of November 30, 2004, the Company had not recorded a gain for the anticipated excess recovery.

Internal Control Over Financial Reporting.

SOX 404 requires that the Company make an assertion as to the effectiveness of its internal control over financial reporting beginning with its fiscal 2004 Annual Report on Form 10-K. The Company’s independent registered public accounting firm must attest to management’s assertion. In order to make its assertion, the Company was required to identify material financial and operational processes, document internal controls supporting the financial reporting process and evaluate the design and effectiveness of these controls. See “Management’s Report on Internal Control Over Financial Reporting” and “Report of Independent Registered Public Accounting Firm” in Part I, Item 9A.

The Company began preparing for its SOX 404 initiative prior to fiscal 2004. The Company formed a Project Management Office to facilitate ongoing internal control reviews, coordinate the process for these reviews, provide direction to the business and control groups involved in the initiative and assist in the assessment of internal control over financial reporting. The Company also formed a Steering Committee, comprised of senior personnel from its control groups, to set uniform guiding principles and policies, review the progress of the initiative, direct the efforts of the Project Management Office and update the Audit Committee of the Board of Directors on an ongoing basis. The Company also retained an accounting firm other than its independent registered public accounting firm to assist in its compliance with SOX 404.

The SOX 404 effort involved many of the Company’s employees around the world, including participation by the business areas and control groups. The Company viewed this evaluation of its internal control over financial reporting as more than a regulatory exercise—it was an opportunity to assess critically the financial control environment and make it even stronger. The Company incurred initial costs associated with its SOX 404 initiative in fiscal 2004 and expects to incur costs in the future, particularly as it coordinates the SOX 404 evaluation with other regulatory requirements to review and evaluate the control environment.

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Critical Accounting Policies.

 

The consolidated financial statements are prepared in accordance with U.S. GAAP, which require 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 may involve a higher degree of judgment and complexity.

 

Fair Value.    Financial instruments owned of $201 billion at November 30, 2003 and $173 billion at November 30, 2002 and financialFinancial instruments sold, not yet purchased, of $111 billion at November 30, 2003 and $86 billion at November 30, 2002, which include cash and derivative products, are recorded at fair value in the consolidated statements of financial condition, and gains and losses are reflected in principal trading revenues in the consolidated statements of income. Fair value is the amount at which financial instruments could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.

The fair value of the Company’s Financial instruments owned and Financial instruments sold, not yet purchased are generally based on observable market prices, observable market parameters or derived from such prices or parameters based on bid prices or parameters for Financial instruments owned and ask prices or parameters for Financial instruments sold, not yet purchased. In the case of financial instruments transacted on recognized exchanges, the observable prices represent quotations for completed transactions from the exchange on which the financial instrument is principally traded. Bid prices represent the highest price a buyer is willing to pay for a financial instrument at a particular time. Ask prices represent the lowest price a seller is willing to accept for a financial instrument at a particular time.

A substantial percentage of the fair value of the Company’s Financial instruments owned and Financial instruments sold, not yet purchased is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary from product to product. Where available, observable market prices and pricing parameters in a product (or a related product) may be used to derive a price without requiring significant judgment. In certain markets, observable market prices or market parameters are not available for all products, and fair value is determined using techniques appropriate for each particular product. These techniques involve some degree of judgment.

 

The price transparency of the particular product will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of product, whether it is a new product and not yet established in the marketplace, and the characteristics particular to the transaction. Products for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, products that are thinly traded or not quoted will generally have reduced to no price transparency. Even in normally active markets, the price transparency for actively quoted instruments may be reduced for periods of time during periods of market dislocation. Alternatively, in thinly quoted markets, the participation of market-makers willing to purchase and sell a product provides a source of transparency for products that otherwise are not actively quoted or during periods of market dislocation.

 

A substantial percentage of the fair value of the Company’s financial instruments owned and financial instruments sold, not yet purchased is based on observable market prices, observable market parameters, or is derived from such prices or parameters. The availability of observable market prices and pricing parameters can vary from product to product. Where available, observable market prices and pricing parameters in a product (or a related product) may be used to derive a price without requiring significant judgment. In certain markets, observable market prices or market parameters are not available for all products, and fair value is determined using techniques appropriate for each particular product. These techniques involve some degree of judgment.

The Company’s cash products include securities issued by the U.S. government and its agencies and instrumentalities, other sovereign debt obligations, corporate and other debt securities, corporate equity securities, exchange traded funds and physical commodities. The fair value of these products is based principally on observable market prices or is derived using observable market parameters. These products generally do not entail a significant degree of judgment in determining fair value. Examples of products for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters include securities issued by the U.S. government and its agencies and instrumentalities, exchange traded corporate equity securities, most municipal debt securities, most corporate debt securities, most high-yield debt securities, physical commodities, certain tradedtradable loan products and most mortgage-backed securities.

 

By contrast,In certain circumstances, principally involving loan products and other financial instruments held for securitization transactions, the Company determines fair value from within the range of bid and ask prices such

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that fair value indicates the value likely to be realized in a current market transaction. Bid prices reflect the price that the Company and others pay, or stand ready to pay, to originators of such assets. Ask prices represent the prices that the Company and others require to sell such assets to the entities that acquire the financial instruments for purposes of completing the securitization transactions. Generally, the fair value of such acquired assets is based upon the bid price in the market for the instrument or similar instruments. In general, the loans and similar assets are valued at bid pricing levels until structuring of the related securitization is substantially complete and such that the value likely to be realized in a current transaction is consistent with the price that a securitization entity will pay to acquire the financial instruments. Factors affecting securitized value and investor demand relating specifically to loan products include, but are not limited to, loan type, underlying property type and geographic location, loan interest rate, loan to value ratios, debt service coverage ratio, investor demand and credit enhancement levels.

In addition, some cash products exhibit little or no price transparency, and the determination of the fair value requires more judgment. Examples of cash products with little or no price transparency include certain high-yield debt, certain collateralized mortgage obligations, certain tradedtradable loan products, distressed debt securities (i.e., securities of issuers encountering financial difficulties, including bankruptcy or insolvency) and equity securities that are not publicly traded. Generally, the fair value of these types of cash products is determined using one of several valuation techniques appropriate for the product, which can include cash flow analysis, revenue or net income analysis, default recovery analysis (i.e., analysis of the likelihood of default and the potential for recovery) and other analyses applied consistently. At November 30, 2003,

The following table presents the fair valuevaluation of the Company’s cash products with little or noby level of price transparency recorded(dollars in financial instruments owned and financial instruments sold, not yetmillions):

 

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purchased was $9.9 billion and $0.1 billion, respectively. At November 30, 2002, the fair value of cash products with little or no price transparency recorded in financial instruments owned and financial instruments sold, not yet purchased was $7.6 billion and $0.5 billion, respectively.

		At November 30, 2004						At November 30, 2003
		Assets			Liabilities			Assets			Liabilities
Observable market prices, parameters or derived from observable prices or parameters		$	145,975		$	66,948		$	147,228		$	75,058
Reduced or no price transparency			9,725			827			9,942			148
Total		$	155,700		$	67,775		$	157,170		$	75,206

 

The Company’s derivative products include listedexchange-traded and OTC derivatives. ListedExchange-traded derivatives have valuation attributes similar to the cash products valued using observable market prices or market parameters described above. Fair values for listedOTC derivatives, recorded as financial instruments owned and financial instruments sold, not yet purchased amounted to $3 billion and $3 billion, respectively, at November 30, 2003 and $2 billion and $2 billion, respectively, at November 30, 2002. OTC derivativeswhose fair value is derived using pricing models, include a wide variety of instruments, such as interest rate swap and option contracts, foreign currency option contracts, credit and equity swap and option contracts, and commodity swap and option contracts. Fair values for

The following table presents the fair value of the Company’s exchange traded and OTC derivative products recorded as financial instruments ownedassets and financial instruments sold, not yet purchased, which amounted to $42 billion and $33 billion, respectively, at November 30, 2003 and $34 billion and $27 billion, respectively, at November 30, 2002, were derived using pricing models.liabilities (dollars in millions):

		At November 30, 2004						At November 30, 2003
		Assets			Liabilities			Assets			Liabilities
Exchange traded		$	2,754		$	4,815		$	2,306		$	3,091
OTC			64,338			51,005			42,346			33,151
Total		$	67,092		$	55,820		$	44,652		$	36,242

 

The fair value of OTC derivative contracts is derived primarily using pricing models, which may require multiple market input parameters. Where appropriate, valuation adjustments are made to account for credit quality and market liquidity. These adjustments are applied on a consistent basis and are based upon observable market data where available. In the absence of observable market prices or parameters in an active market, observable prices

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or parameters of other comparable current market transactions, or other observable data supporting a fair value based on a pricing model at the inception of a contract, fair value is based on the transaction price. The Company also uses pricing models to manage the risks introduced by OTC derivatives. The term “model” typically refers to a mathematical calculation methodology based on accepted financial theories. Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be modeled using a series of techniques, including closed form analytic formulae, such as the Black-Scholes option pricing model, simulation models or a combination thereof, applied consistently. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. Pricing models take into account the contract terms, including the maturity, as well as observable market parameters such as interest rates, volatility and the creditworthiness of the counterparty.

 

Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swap and option contracts. A substantial majority of OTC derivative products valued by the Company using pricing models fallsfall into this category. Other derivative products, typically the newest and most complex products, will require more judgment in the implementation of the modeling technique applied due to the complexity of the modeling assumptions and the reduced price transparency surrounding the model’s market parameters. The Company manages its market exposure for OTC derivative products primarily by entering into offsetting derivative contracts or other related financial instruments. The Company’s trading divisions, the ControllersFinancial Control Department and the Market Risk Department continuously monitor the price changes of the OTC derivatives in relation to the hedges. For a further discussion of the price transparency of the Company’s OTC derivative products, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management—Credit Risk” in Part II, Item 7A.

 

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 market prices or market-based parameters wherever possible. In the event that market prices or parameters are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and 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 ControllersFinancial Control and Market 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.

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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.

 

Transfers of Financial Assets.    The Company engages in securitization activities in connection with certain of its businesses. Gains and losses from securitizations are recognized in the consolidated statements of income when the Company relinquishes control of the transferred financial assets in accordance with SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125,” and other related pronouncements. The gain or loss on the sale of financial assets depends, in part, on the previous carrying amount of the assets involved in the transfer, allocated between the assets sold and the retained interests based upon their respective fair values at the date of sale.

 

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In connection with its Institutional Securities business, the Company engages in securitization transactions to facilitate client needs and as a means of selling financial assets. The Company recognizes any interests in the transferred assets and any liabilities incurred in securitization transactions in its consolidated statements of financial condition at fair value. Subsequently, changes in the fair value of such interests are recognized in the consolidated statements of income. The use of different pricing models or assumptions could produce different financial results.

 

In connection with its Credit Services business, the Company periodically sells consumer loans through asset securitizations and continues to service these loans. The present value of the future net servicing revenues that the Company estimates it will receive over the term of the securitized loans is recognized in income as the loans are securitized. A corresponding asset also is recorded and then amortized as a charge to income over the term of the securitized loans. The securitization gain or loss involves the Company’s best estimates of key assumptions, including forecasted credit losses, payment rates, forward yield curves and appropriate discount rates. The use of different estimates or assumptions could produce different financial results.

 

Allowance for Consumer Loan Losses.    The allowance for consumer loan losses in the Company’s Credit Services business is established through a charge to the provision for consumer loan losses. Provisions are made to reserve for estimated losses in outstanding loan balances. The allowance for consumer loan losses is a significant estimate that represents management’s estimate of probable losses inherent in the consumer loan portfolio. The allowance for consumer loan losses is primarily applicable to the owned homogeneous consumer credit card loan portfolio that is evaluated quarterly for adequacy.

 

In calculating the allowance for consumer loan losses, the Company uses a systematic and consistently applied approach. The Company regularly performs a migration analysis (a technique used to estimate the likelihood that a consumer loan will progress through the various stages of delinquency and ultimately charge-off) of delinquent and current consumer credit card accounts in order to determine the appropriate level of the allowance for consumer loan losses. The migration analysis considers uncollectible principal, interest and fees reflected in consumer loans. In addition, the Company estimates the losses inherent in the consumer loan portfolio based on coverage of a rolling average of historical credit losses. In evaluating the adequacy of the allowance for consumer loan losses, management also considers factors that may impact future credit loss experience, including current economic conditions, recent trends in delinquencies and bankruptcy filings, account collection management, policy changes, account seasoning, loan volume and amounts, payment rates and forecasting uncertainties. A provision for consumer loan losses is charged against earnings to maintain the allowance for consumer loan losses at an appropriate level. The use of different estimates or assumptions could produce different provisions for consumer loan losses (see “Credit Services—Provision for Consumer Loan Losses” herein).

 

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Aircraft under Operating Leases.    The Company’s aircraft portfolio consists of aircraft to be held and used and aircraft that are to be disposed of by sale (“held for sale”).

Aircraft under operating leases that are to be held and used are stated at cost less accumulated depreciation.depreciation and impairment charges. Depreciation is calculated on a straight-line basis over the estimated useful life of the aircraft asset, which is generally 25 years from the date of manufacture. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which the Company adopted on December 1, 2002, the Company’s aircraft that are to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of the aircraft may not be recoverable. Under SFAS No. 144, the carrying value of an aircraft may not be recoverable if its projected undiscounted cash flows are less than its carrying value. If an aircraft’s projected undiscounted cash flows are less than its carrying value, the Company will recognize an impairment charge equal to the excess of the carrying value over the fair value of the aircraft. The fair value of the Company’s impaired aircraft is based upon valuation informationthe average market appraisal values obtained from independent appraisal companies. Estimates of future cash flows associated with the aircraft assets as well as the appraisals of fair value are critical to the determination of whether an impairment exists and the amount of the impairment charge, if any (see Note 18 to the consolidated financial statements).

Aircraft under operating leases that fulfill the criteria to be classified as held for sale in accordance with SFAS No. 144 are stated at the lower of carrying value (i.e., cost less accumulated depreciation and impairment

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charges) or fair value less estimated cost to sell. Depreciation expense is not recorded for aircraft that are classified as held for sale. The Company will recognize a charge for any initial or subsequent write-down to fair value less estimated cost to sell (see Notes 18 and 25 to the consolidated financial statements). A gain would be recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized (for a write-down to fair value less cost to sell).

 

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, economic and market conditions; the availability and cost of capital; 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; and investor sentiment and confidence in the financial markets. In addition, there has been a heightened level of legislative, legal and regulatory developments related to the financial services industry that potentially could increase costs, thereby affecting future results of operations. Such factors also may have an impact on the Company’s ability to achieve its strategic objectives on a global basis.

 

The Company’s Institutional Securities business, particularly its involvement in primary and secondary markets for all types of financial products, including derivatives, is subject to substantial positive and negative fluctuations due to a variety of factors that the Company cannot control or predict with great certainty, including variations in the fair value of securities and other financial products and the volatility and liquidity of global trading markets. 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 realization of returns from the Company’s principal investments. Such factors also affect the level of individual investor participation in the financial markets, which impacts the results of the Individual Investor Group. The level of global market activity also could impact the flow of investment capital into or from assets under management and supervision and the way in which such capital is allocated among money market, equity, fixed income or other investment alternatives, which could cause fluctuations to occur in the Company’s Investment Management business. In the Company’s Credit Services business, changes in economic variables, such as the number and size of personal bankruptcy filings, the rate of unemployment, and the level of consumer confidence and consumer debt, may substantially affect consumer loan levels and credit quality, which, in turn, could impact the results of Credit Services.

 

The Company’s results of operations also may be materially affected by competitive factors. Included among the principal competitive factors affecting the Institutional Securities and Individual Investor Group businesses are the Company’s reputation, the quality of its personnel, its products, services and advice, capital commitments, relative pricing and innovation. Competition in the Company’s Investment Management business is affected by a number of factors, including the Company’s reputation, investment objectives, quality of investment professionals, relative performance of investment products, advertising and sales promotion efforts, fee levels, distribution channels, and types and quality of services offered. In the Credit Services business, competition centers on merchant acceptance of credit and debit cards, account acquisition and customer utilization of credit and debit cards, all of which are impacted by the types of fees, interest rates and other features offered.

 

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The Company strives to increase market share in all of its businesses and evaluates the competitive position of its businesses by, among other things, monitoring various market share data. For example, in the Institutional Securities investment banking business, the Company monitors its market share in key areas such as announced and completed worldwide mergers and acquisitions, worldwide equity underwritings and worldwide investment grade debt underwritings. In the Institutional Securities sales and trading business, the Company monitors its market share via independent client surveys as well as its market share of global exchange and non-exchange volumes. In the Individual Investor Group business, the Company monitors its market share of client assets and the number of financial advisors.representatives. In the

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Investment Management business, the Company monitors its market share of assets under management or supervision and mutual fund flows among mutual fund managers. It also monitors the relative performance of its funds as determined by organizations such as Morningstar and Lipper. In the Credit Services business, the Company monitors its ranking in the number of merchant and cash access locations, the level of general purpose credit card loan balances outstanding, transaction volume and the credit quality of its loan portfolio.

 

Besides competition from firms traditionally engaged in the financial services business, competition exists from other sources, such asThe Company competes 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. The Company competes with some of its competitors globally and with others on a regional or product basis. Certain sectors of the financial services industry has experienced consolidation and convergence,have become considerably more concentrated, as financial institutions involved in a broad range of financial services industries have merged.been acquired by or merged into other firms. Such convergence has continued and could result in the Company’s competitors gaining greater capital and other resources, such as a broader range of products and services and geographic diversity. It is possible that competition may become even more intense as the Company continues to compete with financial institutions that may be larger, or better capitalized, or may have a stronger local presence in certain areas. In addition, the Company has experienced competition for qualified employees. The Company’s ability to sustain or improve its competitive position will substantially depend on its ability to continue to attract and retain qualified employees while managing compensation costs.

 

As a result of the above economic and competitive factors, net income and revenues in any particular period may not be representative of full-year results and may vary significantly from year to year and from quarter to quarter. The Company intends to manage its business for the long term and to mitigate the potential effects of market downturns by strengthening its competitive position in the global financial services industry through diversification of its revenue sources, enhancement of its global franchise, and management of costs and its capital structure. The Company’s overall financial results will continue to be affected by its ability and success in addressing client goals; maintaining high levels of profitable business activities; emphasizing fee-based products that are designed to generate a continuing stream of revenues; evaluating product pricing; managing risks, costs and its capital position; and maintaining its strong reputation and franchise. In addition, the complementary trends in the financial services industry of consolidation and globalization present, among other things, technological, risk management and other infrastructure challenges that will require effective resource allocation in order for the Company to remain competitive.

 

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Liquidity and Capital Resources.

 

The Company’s senior management establishes the overall 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. These committees, along with the Company’s Treasury Department and other control groups, also assist in evaluating, monitoring and controlling the impact that the Company’s business activities have on its consolidated balance sheet, liquidity and capital structure, thereby helping to ensure that its business activities are integrated with the Company’s liquidity and capital policies. For a description of the Company’s other principal risks and how they are monitored and managed, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A.

 

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 when they come due without material, adverse 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 ongoing and sufficient liquidity through the business cycle and during periods of financial distress. The principal elements of the Company’s liquidity framework are the cash capital policy, the liquidity reserve and stress testing through the contingency funding plan. Comprehensive financing guidelines (collateralized funding, long-term funding strategy, surplus capacity, diversification, staggered maturities, committed credit facilities) support the Company’s target liquidity profile.

The Balance Sheet.

 

The Company monitors and evaluates the composition and size of its balance sheet. Given the nature of the Company’s total assets increased to $602.8 billion at November 30, 2003 from $529.5 billion at November 30, 2002. The increase was primarily attributable to increases in financial instruments owned, largely driven by corporatemarket making and other debt inventories and increases in the value of derivatives. Growth in equitycustomer financing activities, including securities borrowed and receivablesthe overall size of the balance sheet fluctuates from customers, also contributedtime to the increase.time. A substantial portion of the Company’s total assets consists of highly liquid marketable securities and short-term receivables arising principally from its Institutional Securities sales and trading activities. The highly liquid nature of these assets provides the Company with flexibility in financing and managing its business.

The Company’s total assets increased to $775.4 billion at November 30, 2004 from $602.8 billion at November 30, 2003. The increase was primarily due to increases in securities borrowed, securities purchased under agreements to resell, financial instruments owned (largely driven by derivative contracts), receivables from customers and cash and securities segregated under federal and other regulations. The increase in securities borrowed, securities purchased under agreements to resell and receivables from customers was largely due to growth in the Company’s equity financing related activities. The increase in derivative contracts was associated with interest rate, currency, equity and commodity derivative products due to increased customer flow and market activity. Cash and securities segregated under federal and other regulations increased due to increased levels of customer activity.

 

Balance sheet leverage ratios are one indicator of capital adequacy when viewed in the context of a company’s overall liquidity and capital policies. The Company views the adjusted leverage ratio as a more relevant measure of financial risk when comparing financial services firms and evaluating leverage trends. This ratio isThe Company has adopted a definition of adjusted assets that excludes certain self-funded assets considered to reflect thehave minimal market, credit and/or liquidity risk. These low-risk nature of assets generally are attributable to the Company’s matched reverse repurchasebook and securities lending businesses. Adjusted assets are calculated by reducing gross assets by aggregate resale agreements certainand securities borrowed transactionsless non-derivative short positions and segregated customer cash balances. In addition, theassets recorded under certain provisions of SFAS No. 140 and FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), as revised. The adjusted leverage ratio reflects the deduction from shareholders’ equity of the amount of equity used to support goodwill asand intangible assets (as the Company does not view this amount of equity as available to support its risk capital needs.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. These

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characteristics include the long dated nature (final maturity at issuance of 30 years extendible at the Company’s option by a further 19 years), the Company’s ability to defer coupon interest for up to 20 consecutive quarters 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, adjusted assets and leverage ratios as of November 30, 2004 and book value per share:November 30, 2003 and for the average month-end balances during fiscal 2004:

 

		At November 30,
		2003				2002
		(dollars in millions, except ratio and per share data)
Total assets		$	602,843			$	529,499
Less:
Lesser of securities purchased under agreements to resell or securities sold under agreements to repurchase			(78,205	)			(76,910	)
Assets recorded under certain provisions of SFAS No. 140 and Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (“FIN 46”)			(35,217	)			(19,224	)
Lesser of securities borrowed or securities loaned			(64,375	)			(43,229	)
Segregated customer cash and securities balances			(20,705	)			(30,217	)
Goodwill			(1,514	)			(1,449	)
Adjusted assets		$	402,827			$	358,470
Shareholders’ equity		$	24,867			$	21,885
Preferred securities subject to mandatory redemption			2,810				1,210
Subtotal			27,677				23,095
Less: Goodwill			(1,514	)			(1,449	)
Tangible shareholders’ equity		$	26,163			$	21,646
Leverage ratio(1)			23.0	x			24.5	x
Adjusted leverage ratio(2)			15.4	x			16.6	x
Book value per share(3)		$	22.93			$	20.24

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		Balance at								Average Month-End Balance
		November 30, 2004				November 30, 2003				Fiscal 2004
		(dollars in millions, except ratio data)
Total assets		$	775,410			$	602,843			$	713,992
Less: Securities purchased under agreements to resell			(123,041	)			(78,205	)			(98,485	)
Securities borrowed			(208,349	)			(153,813	)			(191,767	)
Add:  Financial instruments sold, not yet purchased			123,595				111,448				128,681
Less: Derivative contracts sold, not yet purchased			(55,820	)			(36,242	)			(43,433	)
Subtotal			511,795				446,031				508,988
Less: Segregated customer cash and securities balances			(26,534	)			(20,705	)			(25,596	)
Assets recorded under certain provisions of SFAS No. 140 and FIN 46, as revised			(44,895	)			(35,217	)			(39,728	)
Goodwill and intangible assets			(2,199	)			(1,523	)			(1,761	)
Adjusted assets		$	438,167			$	388,586			$	441,903
Shareholders’ equity		$	28,206			$	24,867			$	26,718
Junior subordinated debt issued to capital trusts			2,897				2,810				2,877
Subtotal			31,103				27,677				29,595
Less: Goodwill and intangible assets			(2,199	)			(1,523	)			(1,761	)
Tangible shareholders’ equity		$	28,904			$	26,154			$	27,834
Leverage ratio(1)			26.8	x			23.0	x			25.7	x
Adjusted leverage ratio(2)			15.2	x			14.9	x			15.9	x

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

(2)	Adjusted leverage ratio equals adjusted assets divided by tangible shareholders’ equity.

(3)	Book value per share equals shareholders’ equity divided by common shares outstanding of 1,085 million at November 30, 2003 and 1,081 million at November 30, 2002.

The Company’s total capital consists of equity capital combined with long-term borrowings (debt obligations scheduled to mature in more than 12 months), junior subordinated debt issued to capital trusts, and Capital Units. At November 30, 2004, total capital was $110.8 billion, an increase of $28.0 billion from November 30, 2003.

During the 12 months ended November 30, 2004, the Company issued senior notes aggregating $38.2 billion, including non-U.S. dollar currency notes aggregating $8.3 billion. In connection with the note issuances, the Company has entered into certain transactions to obtain floating interest rates based primarily on short-term London Interbank Offered Rates (“LIBOR”) trading levels. At November 30, 2004, the aggregate outstanding principal amount of the Company’s Senior Indebtedness (as defined in the Company’s public debt shelf registration statements) was approximately $121 billion (including guaranteed obligations of the indebtedness of subsidiaries). The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.2 years at November 30, 2004. Subsequent to fiscal year-end and through February 4, 2005, the Company’s long-term borrowings (net of repayments) increased by approximately $8.6 billion.

 

Equity Capital Management Policies.The Company’s senior management views equity capital as an important source of financial strength and, therefore, pursues a strategy of ensuring that the Company’s equity base

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adequately reflects and provides some protection from the economic risks inherent in its businesses. Capital is required for, among other things, the Company’s securities inventories, underwritings, principal investments, private equity activities, consumer loans, bridge loans and other financings, and investments in fixed assets, including aircraft assets. The Company also considers return on common equity to be an important measure of its performance, in the context of both the particular business environment in which the Company is operating and its peer group’s results. In this regard, 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 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.

The Company uses an economic capital model to determine the amount of equity capital needed to support the risk of the Company’s business activities and to ensure that the Company remains adequately capitalized. Economic capital is defined as the amount of capital needed to run the business through the business cycle and satisfy the requirements of the market, regulators and rating agencies. The Company assigns economic capital to each business unit based primarily on regulatory capital usage and potential stress losses across various dimensions of market, credit, business and operational risks. Additional capital is assigned for goodwill, intangible assets, principal investment risk, and balance sheet usage as required to meet the Company’s leverage ratio targets. The Company’s framework for allocating economic capital is intended to align equity capital with the risks in each business, provide business managers with tools for measuring and managing risk, and allow senior management to evaluate risk-adjusted returns to facilitate resource allocation decisions. At November 30, 2003,2004, the Company’s equity capital (which includes shareholders’ equity and preferred securities subjectjunior subordinated debt issued to mandatory redemption)capital trusts) was $27.7$31.1 billion, an increase of $4.6$3.4 billion from November 30, 2002.2003.

 

The Company returns internally generated equity capital that is in excess of the needs of its businesses to its shareholders through common stock repurchases and dividends. The Board of Directors has authorized the Company to purchase, subject to market conditions and certain other factors, shares of common stock for capital management purposes. There were no repurchases made under the capital management authorization during fiscal 2004. The unused portion of this authorization at January 31, 20042005 was approximately $600 million. The Company also has an ongoing repurchase authorization in connection with awards granted under its equity-based compensation plans. During fiscal 2004, the Company purchased approximately $1,132 million of its common stock (approximately 23 million shares) through open market purchases at an average cost of $50.31 (see also “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” in Part II, Item 5). The Company currently anticipates that it will increase common stock repurchases pursuant to its equity anti-dilution program and expects that these repurchases will be between 35 million and 80 million shares for fiscal 2005. The actual amount of repurchases will be subject to market conditions and certain other factors. The Board of Directors determines the declaration and payment of dividends on a quarterly basis. In December 2003,2004, the Board of Directors increased the quarterly dividend per common share by 9%8% to $0.25.$0.27.

 

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Liquidity Management Policies.    The primary goal of the Company’s fundingliquidity and liquidityfunding activities is to ensure adequate financing over a wide range of potential credit ratings and market environments. Given the highly liquid nature of the Company’s balance sheet, day-to-day funding requirements are largely fulfilled through the use of stable collateralized financing. The Company has centralized management of credit-sensitive unsecured funding sources in the Treasury Department. In order to meet target liquidity requirements and withstand an unforeseen contraction in credit availability, the Company has designed a liquidity management framework. This framework is intended to ensure that the Company maintains sufficient liquidity to continue to fund its ongoing business and to meet all of its financial obligations maturing within a one-year period without issuing any new unsecured debt.

 

Liquidity Management Framework: Framework:		Designed to:
Contingency Funding Plan		Ascertain the Company’s ability to manage a prolonged liquidity contraction and provide a course of action over a one-year time period to ensure orderly functioning of the businesses. The contingency funding plan sets forth the process and the internal and external communication flows necessary to ensure effective management of the contingency event. Analytical processes exist to periodically evaluate and report the liquidity risk exposures of the organization under management-defined scenarios.
Cash Capital Policy		Ensure that the Company can fund its balance sheet while repaying its financial obligations maturing within one year without issuing new unsecured debt. The Company attempts to achieve this by maintaining sufficient Cash Capitalcash capital (long-term debt and equity capital) to finance illiquid assets and the portion of its securities inventory that is not expected to be financed on a secured basis in a credit-stressed environment.
Liquidity Reserve		Maintain, at all times, a liquidity reserve in the formcomposed of immediately available cash and cash equivalents and a pool of unencumbered securities that can be sold or pledged to cover volatility in day-to-day funding needs.provide same-day liquidity to the Company. The reserve is periodically assessed and determined based on day-to-day funding volatilityrequirements and strategic liquidity targets andtargets. The liquidity reserve averaged approximately $20$28 billion during fiscal 2003.
Contingency Planning		Maintain the Company’s Contingency Funding Plan to ascertain the Company’s ability to manage a prolonged liquidity contraction and provide a course of action over a one-year time period to ensure orderly functioning of the Company’s businesses. The Company’s Contingency Funding Plan sets forth the process and the internal and external communication flows necessary to ensure effective management of the contingency event.
2004.

 

60Contingency Funding Plan.

The Company’s Contingency Funding Plan (“CFP”) model incorporates 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; (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 ratings downgrade; (v) higher haircuts on or lower availability of secured funding; (vi) client cash withdrawals; (vii) drawdowns on unfunded commitments provided to third parties; and (viii) discretionary unsecured debt buybacks.

The Company’s CFP is developed at the legal entity level in order to capture specific cash requirements and availability for the parent company and each of its major operating subsidiaries. The CFP assumes that the parent company does not have access to cash that may be trapped at subsidiaries due to regulatory, legal or tax constraints. In addition, the CFP assumes that the parent company does not draw down on its committed credit facilities.

Bank subsidiaries that operate in a deposit-protected environment are not expected to be impacted by a Company-specific credit event and are expected to continue to provide reliable funding for assets held in these entities. These entities include Discover Bank, which primarily funds credit card receivables, and Morgan Stanley Bank, which funds senior loans and certain mortgage assets. Discover Bank also accesses the asset-backed financing market for a significant portion of its funding requirements.

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The Company also pursues a strategy of diversification of funding sources (by products and markets) and attempts to ensure that the tenor of the Company’s liabilities equals or exceeds the expected holding period of the assets being financed. Maturities of financings are designed to manage exposure to refinancing risk in any one period. Cash Capital.

The Company maintains a surplus of unused short-termcash capital model that measures long-term funding sources at all timesagainst requirements. Sources of cash capital include the parent company’s equity and the non-current portion of certain long-term borrowings. Uses of cash capital include the following: (i) illiquid assets such as buildings, aircraft, equipment, goodwill and intangible assets, exchange memberships, deferred tax assets and principal investments; (ii) a portion of securities inventory that is not expected to withstand any unforeseen contractionbe financed on a secured basis in credit capacity. In addition, the Company attempts to maintain casha credit-stressed environment; i.e., stressed haircuts; and unhypothecated marketable securities equal to at least 110% of its outstanding short-term unsecured borrowings. The Company also maintains committed credit facilities (described below) to support its ongoing borrowing programs.(iii) expected drawdowns on unfunded commitments.

 

The levelCompany seeks to maintain a surplus cash capital position. The Company’s equity capital of $31.1 billion (including junior subordinated debt issued to capital trusts), long-term borrowings (debt obligations scheduled to mature in more than 12 months) of $79.6 billion and Capital Units of $66 million comprised the Company’s borrowings is continually adjustedtotal capital of $110.8 billion as of November 30, 2004, which substantially exceeded cash capital requirements.

Liquidity Reserve.

The Company seeks to maintain thea target cash liquidity reserve after meeting the Company’swhich is sized to cover daily funding requirements.needs and to meet strategic liquidity targets, including coverage of a significant portion of expected cash outflows over a short-term horizon in a potential liquidity crisis. Prior to fiscal 2004, this liquidity reserve was held in the form of cash deposited with banks. Beginning in late fiscal 2004, this liquidity reserve was increased and separated into a cash component and a pool of unencumbered securities. The pool of unencumbered securities, against which funding can be raised, is managed on a global basis, and securities for the pool are chosen accordingly. The U.S.-held component consists largely of U.S. government bonds and at November 30, 2004 totaled $10.0 billion. The non-U.S. component consists of European government bonds and other high-quality collateral. The Company believes that diversifying the form in which its liquidity reserve (cash and securities) is maintained enhances its ability to quickly and efficiently source funding in a stressed environment. The Company’s funding requirements willand target liquidity reserve may vary based on changes in the level and composition of its balance sheet, timing of specific transactions, client financing activity, market conditions and seasonal factors.

Committed Credit Facilities.

The maintenance of committed credit facilities serves to further diversify the Company’s funding sources. The Company values committed credit as a secondary component of its liquidity management framework.

The Company maintains a senior revolving credit agreement with a group of banks to support general liquidity needs, including the issuance of commercial paper, which consists of two separate tranches: a U.S. dollar tranche with the Company as borrower and a Japanese yen tranche with Morgan Stanley Japan Limited (“MSJL”) as borrower and the Company as guarantor. Under this combined facility (the “MS-MSJL Facility”), the banks are committed to provide up to $5.5 billion under the U.S. dollar tranche and 70 billion Japanese yen under the Japanese yen tranche. At November 30, 2004, the Company had a $12.0 billion surplus shareholders’ equity as compared with the MS-MSJL Facility’s covenant requirement.

The Company maintains a master collateral facility that enables Morgan Stanley & Co. Incorporated (“MS&Co.”), one of the Company’s U.S. broker-dealer subsidiaries, to pledge certain collateral to secure loan arrangements, letters of credit and other financial accommodations (the “MS&Co. Facility”). As part of the MS&Co. Facility, MS&Co. also maintains a secured committed credit agreement with a group of banks that are parties to the master collateral facility under which such banks are committed to provide up to $1.8 billion. At November 30, 2004, MS&Co. had a $2.8 billion surplus consolidated stockholder’s equity and a $0.9 billion surplus Net Capital, each as defined in the MS&Co. Facility and as compared with the MS&Co. Facility’s covenant requirements.

The Company also maintains a revolving credit facility that enables Morgan Stanley & Co. International Limited (“MSIL”), the Company’s London-based broker-dealer subsidiary, to obtain committed funding from a syndicate

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of banks (the “MSIL Facility”) by providing a broad range of collateral under repurchase agreements for a secured repo facility and a Company guarantee for an unsecured facility. The syndicate of banks is committed to provide up to an aggregate of $1.5 billion, available in six major currencies. At November 30, 2004, MSIL had a $1.7 billion surplus Shareholder’s Equity and a $2.0 billion surplus Financial Resources, each as defined in the MSIL Facility and as compared with the MSIL Facility’s covenant requirements.

The Company anticipates that it may utilize the MS-MSJL Facility, the MS&Co. Facility or the MSIL Facility (the “Credit Facilities”) for short-term funding from time to time (see Note 7 to the consolidated financial statements). The Company does not believe that any of the covenant requirements in any of its Credit Facilities will impair its ability to obtain funding under the Credit Facilities, to pay its current level of dividends, or to secure loan arrangements, letters of credit or other financial accommodations. At November 30, 2004, no borrowings were outstanding under any of the Credit Facilities.

The Company and its subsidiaries also maintain a series of committed bilateral credit facilities to support general liquidity needs. These facilities are expected to be drawn from time to time to cover short-term funding needs.

The committed credit facilities demonstrate the diversity of lenders to the Company covering geographic regions, including North America, Europe and Asia.

On a yearly basis, the Company’s committed credit strategy is reviewed and approved by its senior management. This strategy takes the Company’s total liquidity sources into consideration when determining the appropriate size and mix of committed credit.

The Company, through one of its subsidiaries, maintains several funded committed credit facilities to support the collateralized commercial and residential mortgage whole loan business. Lenders to these facilities provided an aggregate of $10.7 billion in financing at November 30, 2004.

 

Funding Management Policies.

 

The Company funds its balance sheet on a global basis through diverse sources. These sources include the Company’s equity capital; long-term debt; repurchase agreements; U.S., Canadian, Euro, Japanese and Australian commercial paper; asset-backed securitizations; letters of credit; unsecured bond borrowings; securities lending; buy/sell agreements; municipal reinvestments; promissory notes; master notes; and committed and uncommitted lines of credit. Repurchase agreement transactions, securities lending and a portion of the Company’s bank borrowings are made on a collateralized basis and, therefore, provide a more stable source of funding than short-term unsecured borrowings. The Company has active financing programs for both standard and structured products in the U.S., European and Asian markets, targeting global investors and currencies such as the U.S. dollar, euro, British pound, Australian dollar and Japanese yen.

 

The Company’s bank subsidiaries solicit deposits from consumers, purchase Federal Funds, issue short-term institutional certificates of deposits and issue bank notes. Interest bearing deposits are classified by type as savings, brokered and other time deposits. Savings deposits consist primarily of money market deposit accounts sold nationally and savings deposits from individual securities clients. Brokered deposits consist primarily of certificates of deposits issued by the Company’s bank subsidiaries. Other time deposits include individual and institutional certificates of deposits.

 

The Company’s funding management policies are designed to provide for financings that are executed in a manner that reduces the risk of disruption to the Company’s operations that would result from an interruption in the availability of the Company’s funding sources. The Company pursues a strategy of diversification of funding sources (by product, by investor and by region) and attempts to ensure that the tenor of the Company’s liabilities equals or exceeds the expected holding period of the assets being financed. Maturities of financings are designed to manage exposure to refinancing risk in any one period. The Company maintains a surplus of unused short-term funding sources at all times to withstand any unforeseen contraction in credit capacity. In addition, the Company attempts to maintain cash and unhypothecated marketable securities equal to at least 110% of its

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outstanding short-term unsecured borrowings. The Company also maintains committed credit facilities (described above) to support its ongoing borrowing programs.

Secured Financing.    A substantial portion of the Company’s total assets consists of highly liquid marketable securities and short-term receivables arising principally from its Institutional Securities sales and trading activities. The highly liquid nature of these assets provides the Company with flexibility in financing these assets with stable collateralized borrowing, while the securitization market allows for the securitization of the credit card receivables arising from the Company’s Credit Services business.

The Company’s goal is to maximize funding through less credit sensitive collateralized borrowings and asset securitizations in order to reduce reliance on unsecured financing. The Institutional Securities business emphasizes the use of collateralized short-term borrowings to limit the growth of short-term unsecured funding which is more typically subject to disruption during periods of financial stress. As part of this effort, the Institutional Securities business continually seeks to expand its global secured borrowing capacity. Similarly, Credit Services, through its use of the securitization market, reduces the need for other unsecured parent company financing.

Unsecured Debt and Borrowings.Financing.    The Company views long-term debt as a stable source of funding for core inventories, consumer loans and illiquid assets. In general, securities inventories not financed by secured funding sources and the majority of current assets are financed with a combination of short-term funding, floating rate long-term debt or fixed rate long-term debt swapped to a floating rate. Fixed assets are financed with fixed rate long-term debt. Both fixed rate and floating rate long-term debt (in addition to sources of funds accessed directly by the Company’s Credit Services business) are used to finance the Company’s consumer loan portfolio. Consumer loan financing is targeted to match the repricing and duration characteristics of the loans financed. The Company uses derivative products (primarily interest rate, currency and equity swaps) to assist in asset and liability management, reduce borrowing costs and hedge interest rate risk (see Note 8 to the consolidated financial statements).

 

The Company issues long-term debt in excess of the amount necessary to meet the needs of its securities inventory and less liquid assets as determined by its Cash Capital Policy. In addition to these needs, long-term debt funding is employed to enhance the Company’s liquidity position by reducing reliance on short-term credit sensitive instruments (e.g., commercial paper and other unsecured short-term borrowings). Availability and cost of financing to the Company can vary depending on market conditions, the volume of certain trading and lending activities, the Company’s credit ratings and the overall availability of credit.

 

The Company has a portfolio approach for managing the unsecured debt issued by the parent company. This approach gives the Company flexibility to manage the unsecured debt portfolio across maturities, currencies, investors, and regions, taking into account market capacity and pricing. Down-lending to subsidiaries is managed to ensure that inter-company borrowings mature before those of the parent company. Liquidity and funding policies recognize potential constraints on the Company’s ability to transfer funds between regulated entities and the parent company.

During fiscal 2003,2004, the Company’s long-term financing strategy was driven, in part, by its continued focus on improved balance sheet strength (evaluated through enhanced capital and liquidity positions), a significant factor in the maintenance of strong credit ratings. As a result, for fiscal 2003, approximately $202004, $38.2 billion of unsecured

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debt was issued (excluding certain equity and credit-linked products not considered to be a component of the Company’s cash capital) with over 70% of these transactions having a maturity of five years or longer.. Financing transactions were structured to ensure staggered maturities, thereby mitigating refinancing risk, whileand a diversified investor base was targeted through sales to domestic as well as international institutional and retail clients. Unsecured debt issuance activity resulted in a net increase in the long-term debt component of the cash capital portfolio of approximately $12 billion and a corresponding $15 billion reduction in the level of short-term commercial paper outstanding at fiscal year-end.$24 billion.

 

The Company’s total capital base primarily consists of equity capital combined with long-term borrowings (debt obligations scheduled to mature in more than 12 months) and preferred securities subject to mandatory redemption. At November 30, 2003, total capital was $83 billion, an increase of $17 billion from November 30, 2002.

The Company maintains borrowing relationships with a broad range of banks, financial institutions, counterparties and others from which it draws funds in a variety of currencies. The Company values committed credit as a significant component of its liquidity policy.

Committed Credit Facilities.    The Company maintains a senior revolving credit agreement with a group of banks to support general liquidity needs, including the issuance of commercial paper, which consists of two separate tranches: a U.S. dollar tranche with the Company as borrower and a Japanese yen tranche with Morgan Stanley Japan Limited (“MSJL”) as borrower and the Company as guarantor. Under this combined facility (the “MS-MSJL Facility”), the banks are committed to provide up to $5.5 billion under the U.S. dollar tranche and 70 billion Japanese yen under the Japanese yen tranche. At November 30, 2003, the Company had a $10.6 billion surplus shareholders’ equity as compared with the MS-MSJL Facility’s covenant requirement.

The Company maintains a master collateral facility that enables Morgan Stanley & Co. Incorporated (“MS&Co.”), one of the Company’s U.S. broker-dealer subsidiaries, to pledge certain collateral to secure loan arrangements, letters of credit and other financial accommodations (the “MS&Co. Facility”). As part of the MS&Co. Facility, MS&Co. also maintains a secured committed credit agreement with a group of banks that are parties to the master collateral facility under which such banks are committed to provide up to $1.8 billion. At November 30, 2003, MS&Co. had a $2.5 billion surplus consolidated stockholder’s equity and a $1.6 billion surplus Net Capital, each as defined in the MS&Co. Facility and as compared with the MS&Co. Facility’s covenant requirements.

The Company also maintains a revolving credit facility that enables Morgan Stanley & Co. International Limited (“MSIL”), the Company’s London-based broker-dealer subsidiary, to obtain committed funding from a syndicate of banks (the “MSIL Facility”) by providing a broad range of collateral under repurchase agreements for a secured repo facility and a Company guarantee for an unsecured facility. The syndicate of banks is committed to provide up to an aggregate of $1.5 billion, available in six major currencies. At November 30, 2003, MSIL had a $1.2 billion surplus Shareholder’s Equity and a $1.9 billion surplus Financial Resources, each as defined in the MSIL Facility and as compared with the MSIL Facility’s covenant requirements.

The Company anticipates that it may utilize the MS-MSJL Facility, the MS&Co. Facility or the MSIL Facility (the “Credit Facilities”) for short-term funding from time to time (see Note 7 to the consolidated financial statements). The Company does not believe that any of the covenant requirements in any of its Credit Facilities will impair its ability to obtain funding under the Credit Facilities, to pay its current level of dividends, or to secure loan arrangements, letters of credit or other financial accommodations. At November 30, 2003, no borrowings were outstanding under any of the Credit Facilities.

The Company and its subsidiaries also maintain a series of committed bilateral credit facilities to support general liquidity needs. These facilities are expected to be drawn from time to time to cover short-term funding needs.

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The committed credit facilities demonstrate the diversity of lenders to the Company covering geographic regions including North America, Europe and Asia Pacific.

Credit Ratings.

 

The Company’s reliance on external sources to finance a significant portion of its day-to-day operations makes access to global sources of financing important. The cost and availability of unsecured financing generally are dependent on the Company’s short-term and long-term credit ratings. Factors that are significant to the determination of the Company’s credit ratings or otherwise affect the ability of the Company to raise short-term and long-term financing include its: level and volatility of earnings, relative positions in the markets in which it operates, globalgeographic and product diversification, risk management policies, cash liquidity, and capital structure. In addition, the agencies that rate the Company’s debt have focused on changes in the market that may require financial services firms to assume morestructure, corporate lending credit risk, in connection with their corporate lending activities and recent legal and regulatory developments. A deterioration in any of the previously mentioned factors or combination of these factors may lead rating agencies to downgrade the credit ratings of the Company, thereby increasing the cost to the Company in obtaining unsecured financings.funding. In addition, the Company’s debt ratings can have a significant impact on certain trading revenues, particularly in those businesses where longer term counterparty performance is critical, such as OTC derivative transactions, including credit derivatives and interest rate swaps.

 

In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business, the Company would be required to provide additional collateral to certain counterparties in the event of a downgrade by either Moody’s Investors Service or Standard & Poor’s or Moody’s Investors Service.Poor’s. At November 30, 2003,2004, the amount of additional collateral that would be required in the event of a one-notch downgrade of the Company’s senior debt credit rating was approximately $945$860 million. Of this amount, $367 million (approximately 43%) relates to bilateral arrangements between the Company and other parties where upon the downgrade of one party, the downgraded party must deliver incremental collateral to the other. These bilateral downgrade arrangements are a risk management tool used extensively by the Company as credit exposures are reduced if counterparties are downgraded.

 

As of January 31, 2004,2005, the Company’s credit ratings were as follows:

 

		Commercial Paper Paper		Senior Debt Debt
Dominion Bond Rating Service Limited		R-1 (middle)		AA (low)
Fitch Ratings		F1+		AA-
Moody’s Investors Service		P-1		Aa3
Rating and Investment Information, Inc.		a-1+		AA
Standard & Poor’sPoor’s(1)		A-1		A+

Fiscal 2003 Activity.

During the 12 months ended November 30, 2003, the Company issued senior notes aggregating $22.0 billion, including non-U.S. dollar currency notes aggregating $6.9 billion. The Company has entered into certain transactions to obtain floating interest rates based primarily on short-term London Interbank Offered Rates (“LIBOR”) trading levels. At November 30, 2003, the aggregate outstanding principal amount of the Company’s Senior Indebtedness (as defined in the Company’s public debt shelf registration statements) was approximately $94.9 billion (including Senior Indebtedness consisting of guaranteed obligations of the indebtedness of subsidiaries). Subsequent to fiscal year-end and through January 31, 2004, the Company’s long-term borrowings (net of repayments) increased by approximately $8.4 billion.

During fiscal 2003, the Company purchased approximately $350 million of its common stock through open market purchases at an average cost of $39.12.

During fiscal 2003, Morgan Stanley Capital Trust III, a consolidated Delaware statutory trust (the “Capital Trust III”), all of the common securities of which are owned by the Company, issued $880 million of 6.25% Capital Securities (the “Capital Securities III”) that are guaranteed by the Company. The Capital Trust III issued the Capital Securities III and invested the proceeds in 6.25% Junior Subordinated Deferrable Interest Debentures issued by the Company, which are due March 1, 2033.

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During fiscal 2003, Morgan Stanley Capital Trust IV, a consolidated Delaware statutory trust (the “Capital Trust IV”), all of the common securities of which are owned by the Company, issued $620 million of 6.25% Capital Securities (the “Capital Securities IV”) that are guaranteed by the Company. The Capital Trust IV issued the Capital Securities IV and invested the proceeds in 6.25% Junior Subordinated Deferrable Interest Debentures issued by the Company, which are due April 1, 2033.

During fiscal 2003, Morgan Stanley Capital Trust V, a consolidated Delaware statutory trust (the “Capital Trust V”), all of the common securities of which are owned by the Company, issued $500 million of 5.75% Capital Securities (the “Capital Securities V”) that are guaranteed by the Company. The Capital Trust V issued the Capital Securities V and invested the proceeds in 5.75% Junior Subordinated Deferrable Interest Debentures issued by the Company, which are due July 15, 2033.

During fiscal 2003, the Company redeemed all $400 million of its 7.10% Junior Subordinated Deferrable Interest Debentures held by MSDW Capital Trust I. The Company also simultaneously redeemed all of the outstanding 7.10% Capital Securities of MSDW Capital Trust I at a redemption price of $25 per share.

(1)	On September 29, 2004, Standard & Poor’s placed the Company’s senior debt ratings on Positive Outlook.

 

Off-Balance Sheet Arrangements.

 

The Company enters into various arrangements with unconsolidated entities, including variable interest entities, primarily in connection with its Institutional Securities and Credit Services businesses.

 

Institutional Securities Activities.    The Company utilizes special purpose entities (“SPEs”SPE”) primarily in connection with securitization activities. The Company engages in securitization activities related to commercial and residential mortgage loans, corporate bonds and loans, U.S. agency collateralized mortgage obligations, corporate bonds and loans, municipal bonds and other types of financial assets. The Company may retain interests in the securitized financial assets as one or more tranches of the securitization. These retained interests are included in the consolidated statements of financial condition at fair value. Any changes in the fair value of such retained interests are recognized in the consolidated statements of income. Retained interests in securitized financial assets associated with the Company’s Institutional Securities business were approximately $2.4$3.9 billion at November 30, 2003,2004, the majority of which were related to residential mortgage loan, U.S. agency collateralized mortgage obligation commercial mortgage loan and residentialcommercial mortgage loan securitization transactions. For further information about the Company’s Institutional Securities securitization activities, see Notes 2 and 4 to the consolidated financial

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statements. In addition, see Note 19 to the consolidated financial statements for information about variable interest entities, the Company’s arrangements with these entities and its adoption of FIN 46.46, as revised.

 

The Company has entered into liquidity facilities with SPEs and other counterparties, whereby the Company is required to make certain payments if losses or defaults occur. The Company often may have recourse to the underlying assets held by the SPEs in the event payments are required under such liquidity facilities (see Note 20 to the consolidated financial statements).

 

Credit Services Activities.    The asset securitization market is a significant source of funding for the Company’s Credit Services business. By utilizing this market, the Company further diversifies its funding sources, realizes cost-effective funding and reduces reliance on the Company’s other funding sources, including unsecured debt. The securitization transaction structures utilized for the Credit Services business are accounted for as sales; i.e., off-balance sheet transactions in accordance with U.S. GAAP (see Notes 2 and 5 to the consolidated financial statements). In connection with its credit card securitization program, the Company transfers credit card receivables, on a revolving basis, to the trusts, which issue asset-backed securities that are registered with the Securities and Exchange Commission (the “SEC”), are used to support the issuance of publicly listed notes or are privately placed. This structure includes certain features designed to protect the investors that could result in earlier-than-expected amortization of the transactions, potentially resulting in the need for the Company to obtain alternative funding arrangements. The primary feature relates to the availability and adequacy of cash flows in the securitized pool of receivables to meet contractual requirements (“economic early amortization”).

 

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Economic early amortization risk reflects the possibility of negative net securitization cash flows (which would occur if the coupon, contractual servicing fee and net charge-offs exceeded the collections of finance charges and cardmember fees on securitized credit card receivables) and is driven primarily by the trusts’ credit card receivables performance (in particular, receivables yield, cardmember fees and credit losses incurred) as well as the contractual rate of return of the asset-backed securities. In the event of an economic early amortization, receivables that otherwise would have been subsequently purchased by the trusts from the Company would instead continue to be recognized on the Company’s consolidated statements of financial condition since the cash flows generated in the trusts would instead be used to repay investors in the asset-backed securities. These recognized receivables would require the Company to obtain alternative funding. Although the Company believes that the combination of factors that would result in an economic early amortization event is remote, the Company also believes its access to alternative funding sources would mitigate this potential liquidity risk.

 

A group of banks areis committed to provide up to $1.3 billion under a credit facility that supports the short-term extendible asset-backed certificate program issued by the Discover Card Master Trust I. Such credit facility was renewed in the first quarter of fiscal 2005.

Guarantees.    FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect of Indebtedness of Others,” requires the Company to disclose information about its obligations under certain guarantee arrangements. FIN 45 defines guarantees as contracts and indemnification agreements that contingently require a guarantor to make payments to the guaranteed party based on changes in an underlying (such as an interest or foreign exchange rate, security or commodity price, an index or the occurrence or non-occurrence of a specified event) related to an asset, liability or equity security of a guaranteed party. FIN 45 also defines guarantees as contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity’s failure to perform under an agreement as well as indirect guarantees of the indebtedness of others.

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The table below summarizes certain information regarding derivative contracts, financial guarantees to third parties, market value guarantees and liquidity facilities at November 30, 2004:

		Maximum Potential Payout/Notional															Carrying Amount			Collateral/ Recourse
		Years to Maturity
Type of Guarantee		Less than 1			1-3			3-5			Over 5			Total
		(dollars in millions)
Derivative contracts		$	473,598		$	281,033		$	294,873		$	254,354		$	1,303,858		$	16,970		$	120
Standby letters of credit and other financial guarantees			337			196			95			27			655			7			161
Market value guarantees			51			17			286			536			890			46			57
Liquidity facilities			922			889			—			176			1,987			—			—

See Note 20 to the consolidated financial statements for information on indemnities, exchange/clearinghouse member guarantees, general partner guarantees, securitized asset guarantees, merchant chargeback guarantees and other guarantees.

 

Contractual Obligations and Contingent Liabilities and Commitments.

 

In connection with its operating activities, the Company enters into certain contractual obligations, as well as commitments to fund certain fixed assets and other less liquid investments.

 

In the normal course of business, the Company enters into various contractual obligations that may require future cash payments. Contractual obligations at November 30, 2004, include long-term borrowings, operating leases and purchase obligations. The Company’s future cash payments associated with its contractual obligations pursuant to its long-term debt and operating leases as of November 30, 20032004 are summarized below:

 

		Payments due in:															Payments due in:
		Fiscal 2004			Fiscal 2005-2006			Fiscal 2007-2008			Thereafter			Total			Fiscal 2005			Fiscal 2006-2007			Fiscal 2008-2009			Thereafter			Total
		(dollars in millions)															(dollars in millions)
Long-term borrowings(1)		$	10,574		$	21,802		$	9,636		$	23,588		$	65,600		$	12,764		$	33,283		$	14,866		$	34,373		$	95,286
Operating leases(2)			490			926			684			2,502			4,602			500			870			698			2,209			4,277
Purchase obligations(3)																		707			466			173			62			1,408
Total		$	11,064		$	22,728		$	10,320		$	26,090		$	70,202		$	13,971		$	34,619		$	15,737		$	36,644		$	100,971

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(1)	See Note 8 to the consolidated financial statements.

(2)	See Note 9 to the consolidated financial statements.

(3)

Purchase obligations for goods and services include payments for, among other things, consulting, outsourcing, advertising, sponsorship, business acquisitions, and computer and telecommunications maintenance agreements. Purchase obligations at November 30, 2004 reflect the minimum contractual obligation under legally enforceable contracts with contract terms that are both fixed and determinable. These amounts exclude obligations for goods and services that already have been incurred and are reflected on the Company’s consolidated balance sheet.

 

The Company’s commitments associated with outstanding letters of credit, principal investments and private equity and other principal investment activities, and lending and financing commitments as of November 30, 20032004 are summarized below by period of expiration. Since commitments associated with letters of credit and lending and financing arrangements may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:

 

		Fiscal 2004			Fiscal 2005-2006			Fiscal 2007-2008			Thereafter			Total			Fiscal 2005			Fiscal 2006-2007			Fiscal 2008-2009			Thereafter			Total
		(dollars in millions)															(dollars in millions)
Letters of credit(1)(2)		$	7,703		$	—		$	—		$	—		$	7,703
Private equity and other principal investments(1)(3)			242			112			8			105			467
Letters of credit(2)																	$	8,433		$	85		$	—		$	—		$	8,518
Principal investment and private equity activities																		89			10			79			7			185
Investment grade lending commitments(6)(5)			8,161			2,229			3,729			125			14,244			6,281			3,536			7,943			1,229			18,989
Non-investment grade lending commitments(6)(5)			317			462			432			658			1,869			240			550			336			283			1,409
Commitments for secured lending transactions(5)(4)			6,465			3,175			—			185			9,825			7,273			673			136			176			8,258
Commitments to purchase mortgage loans(6)																		5,957			—			—			—			5,957
Total		$	22,888		$	5,978		$	4,169		$	1,073		$	34,108
Total(1)																	$	28,273		$	4,854		$	8,494		$	1,695		$	43,316

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(1)	See Note 9 to the consolidated financial statements.

(2)	This amount represents the Company’s outstanding letters of credit, which are primarily used to satisfy various collateral requirements.

(3)	This amount represents the Company’s commitments in connection with its private equity and other principal investment activities.

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(4)	The Company’s investment grade and non-investment grade lending commitments are made in connection with its corporate lending activities. See “Less Liquid Assets—Lending Activities” herein.

(5)(4)

This amount represents lending commitments extended by the Company to companies that are secured by assets of the borrower. Loans made under these arrangements typically are at variable rates and generally provide for over-collateralization based upon the creditworthiness of the borrower.

(6)(5)

Credit ratings are determined by the Company’s Institutional Credit Department using methodologies generally consistent with those employed by external rating agencies. Credit ratings of BB+ or lower are considered non-investment grade.

(6)	This amount represents the Company’s forward purchase contracts involving mortgage loans.

 

The table above does not include commitments to extend credit for consumer loans of approximately $263$259 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards, provided there is no violation of conditions established in the related agreement. These commitments, substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage and customer creditworthiness (see Note 5 to the consolidated financial statements). In addition, in the ordinary course of business, the Company guarantees the debt and/or certain trading obligations (including obligations associated with derivatives, foreign exchange contracts and the settlement of physical commodities) of certain subsidiaries. These guarantees generally are entity or product specific and are required by investors or trading counterparties. The activities of the subsidiaries covered by these guarantees (including any related debt or trading obligations) are included in the Company’s consolidated financial statements.

 

At November 30, 2003,2004, the Company had commitments to enter into reverse repurchase and repurchase agreements of approximately $45$75 billion and $30$60 billion, respectively.

 

Less Liquid Assets.

 

At November 30, 2003,2004, certain assets of the Company, such as real property, equipment and leasehold improvements of $2.4$2.6 billion, aircraft assets of $4.4$3.9 billion, and goodwill and intangible assets of $1.5$2.2 billion, were illiquid. Certain equity investments made in connection with the Company’s private equity and other principal investment activities, certain high-yield debt securities, certain collateralized mortgage obligations and mortgage-related loan products, bridge financings, and certain senior secured loans and positions also are not highly liquid.

 

At November 30, 2003,2004, the Company had aggregate principal investments associated with its private equity and other principal investment activities (including direct investments and partnership interests) with a carrying value of approximately $850$910 million, of which approximately $300 million represented the Company’s investments in its real estate funds.

 

High-Yield Instruments.    In connection with the Company’s fixed income securities activities, the Company underwrites, trades, invests and makes markets in non-investment grade instruments (“high-yield instruments”). For purposes of this discussion, high-yield instruments are defined as fixed income, emerging market, preferred equity securities and distressed debt rated BB+ or lower (or equivalent ratings by recognized credit rating agencies) as well as non-rated securities which, in the opinion of the Company, contain credit risks associated with non-investment grade instruments. For purposes of this discussion, positions associated with the Company’s credit derivatives business are not included because reporting gross market value exposures would not accurately reflect the risks associated with these positions due to the manner in which they are risk-managed. High-yield instruments generally involve greater risk than investment grade securities due to the lower credit ratings of the issuers, which typically have relatively high levels of indebtedness and, therefore, are more sensitive to adverse economic conditions. In addition, the market for high-yield instruments can be characterized byas having periods of higher volatility and illiquidity.reduced liquidity. The Company monitors total inventory positions and risk concentrations for high-yield instruments in a manner consistent with the Company’s market risk management policies and

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control structure. The Company manages its aggregate and single-issuer net exposure through the use of derivatives and other financial instruments. The Company records high-yield instruments at fair value. Unrealized gains and losses are recognized currently in the Company’s consolidated statements of income. At November 30, 2003 and

 

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November 30, 2002,The market value of the Company hadCompany’s high-yield instruments owned with a market value of approximately $3.7 billion and $2.6 billion, respectively, and had high-yield instruments sold, not yet purchased with a market value of $0.8 billion and $0.7 billion, respectively.are shown below:

		At November 30, 2004			At November 30, 2003
		(dollars in billions)
High-yield instruments owned		$	7.2		$	3.7
High-yield instruments sold, not yet purchased			2.4			0.8

 

Lending Activities.    In connection with certain of its Institutional business activities, the Company provides to corporate clients, on a selective basis, through subsidiaries (including Morgan Stanley Bank), loans or lending commitments including(including bridge financing.financing) to selected clients. The borrowers may be rated investment grade or non-investment grade. These loans and commitments have varying terms, may be senior or subordinated, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated or traded by the Company. At November 30, 2003For further information on these activities, see “Quantitative and November 30, 2002, the aggregate value of investment grade loans and positions was $1.0 billion and $1.3 billion, respectively, and the aggregate value of non-investment grade loans and positions was $0.7 billion and $1.2 billion, respectively. At November 30, 2003 and November 30, 2002, the aggregate value of loans and positions and lending commitments (see the table on page 65) outstanding was $17.8 billion and $17.6 billion, respectively. In connection with these business activities (including the loans and positions and the lending commitments), the Company had hedges with a notional amount of $5.5 billion at November 30, 2003 and $4.4 billion at November 30, 2002. At January 31, 2004, the aggregate value of investment grade loans and positions was $2.3 billion and the aggregate value of non-investment grade loans and positions was $1.4 billion. At January 31, 2004, the aggregate value of investment grade lending commitments was $16.0 billion and the aggregate value of non-investment grade lending commitments was $4.9 billion. Requests to provide loans or lending commitmentsQualitative Disclosures about Market Risk—Credit Risk” in connection with investment banking activities will continue in the future.Part II, Item 7A.

 

New Office Facility.Regulatory Developments.

In fiscal 2002,April 2004, the SEC approved the CSE Rule that establishes a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies by the SEC. The framework is designed to minimize the duplicative regulatory requirements on U.S. securities firms resulting from the European Union (“EU”) Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. The CSE Rule also would allow MS&Co., one of the Company’s U.S. broker-dealers, to use an alternative method, based on mathematical models, to calculate net capital charges for market and derivatives-related credit risk. Under the CSE Rule, the SEC will regulate the holding company and any unregulated affiliate of a registered broker-dealer, including subjecting the holding company to capital requirements generally consistent with the standards of the Basel Committee on Banking Supervision (“Basel II”). In December 2004, the Company purchased an office facilityapplied to the SEC for permission to operate under the CSE Rule and expects to be approved in Westchester County, New Yorkfiscal 2005.

The Company continues to work with its regulators to understand and incurred costsassess the impact of approximately $55 million, including the purchase price. During fiscal 2003,CSE Rule and Basel II capital standards. The Company cannot fully predict the Company incurredimpact that these changes will have on its businesses; however, compliance with consolidated supervision and the imposition of revised capital standards are likely to impose additional costs of approximately $120 million. The Company expects to incur additional project costs of approximately $135 million in fiscal 2004. The Company intends to complete the project and occupy the building in fiscal 2004.may affect capital raising and allocation decisions.

 

Regulatory Capital Requirements.

 

MS&Co. and Morgan Stanley DW Inc. (“MSDWI”) are registered broker-dealers and registered futures commission merchants and, accordingly, are subject to the minimum net capital requirements of the SEC, the New York Stock Exchange and the Commodity Futures Trading Commission. MSIL, a London-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Authority, and MSJL, a Tokyo-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Agency. MS&Co., MSDWI, MSIL and MSJL have consistently operated in excess of their respective regulatory capital requirements (see Note 13 to the consolidated financial statements).

 

Under regulatory capital requirements adopted by the Federal Deposit Insurance Corporation (the “FDIC”) and other bank regulatory agencies, FDIC-insured financial institutions must maintain (a) 3% to 5% of Tier 1 capital,

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as defined, to average assets (“leverage ratio”), (b) 4% of Tier 1 capital, as defined, to risk-weighted assets (“Tier 1 risk-weighted capital ratio”) and (c) 8% of total capital, as defined, to risk-weighted assets (“total risk-weighted capital ratio”). At November 30, 2003,2004, the leverage ratio, Tier 1 risk-weighted capital ratio and total risk-weighted capital ratio of each of the Company’s FDIC-insured financial institutions exceeded these regulatory minimums.

In fiscal 2002, the FDIC, in conjunction with other bank regulatory agencies, issued guidance requiring FDIC-insured financial institutions to treat accrued interest receivable related to credit card securitizations as a subordinated retained interest, which required holding higher regulatory capital beginning December 31, 2002. The Company’s FDIC-insured financial institutions have maintained capital ratios in excess of the regulatory minimums since implementing this revised guidance.

 

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

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countries in which they operate. These subsidiaries have consistently operated in excess of their local capital adequacy requirements. Morgan Stanley Derivative Products Inc., the Company’s triple-A rated derivative products subsidiary, maintains certain operating restrictions that have been reviewed by various rating agencies.

 

Effects of Inflation and Changes in Foreign Exchange Rates.

 

Because theThe Company’s assets to a large extent are liquid in nature, they areand, therefore, not significantly affected by inflation. However,inflation, although inflation may result in increases in the Company’s expenses, which may not be readily recoverable in the price of services offered. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, upon the value of financial instruments and upon the markets for consumer credit services, it may adversely affect the Company’s financial position and profitability.

 

A significant portion of the Company’s business is conducted in currencies other than the U.S. dollar, and changes in foreign exchange rates relative to the U.S. dollar can therefore affect the value of non-U.S. dollar net assets, revenues and expenses. Potential exposures as a result of these fluctuations in currencies are closely monitored, and, where cost-justified, strategies are adopted that are designed to reduce the impact of these fluctuations on the Company’s financial performance. These strategies may include the financing of non-U.S. dollar assets with direct or swap-based borrowings in the same currency and the use of currency forward contracts or the spot market in various hedging transactions related to net assets, revenues, expenses or cash flows.

 

New Accounting Developments.

 

Variable Interest Entities.    In January 2003, the FASB issued FIN 46, which clarifiesclarified the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties (“variable interest entities”). Variable interest entities (“VIE”) are required to be consolidated by their primary beneficiaries if they do not effectively disperse risks among parties involved. Under FIN 46, the primary beneficiary of a VIE is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests. FIN 46 also requires new disclosures about VIEs (see Note 19 to the consolidated financial statements).

 

The Company is involved with various entities in the normal course of business that may be deemed to be VIEs and may hold interests therein, including debt securities, interest-only strip investments and derivative instruments that may be considered variable interests. Transactions associated with these entities include assetasset- and mortgage-backed securitizations and structured financings (including collateralized debt, bond or loan obligations and credit-linked notes). The Company engages in these transactions principally to facilitate client needs and as a means of selling financial assets. The Company currently consolidates entities in which it has a controlling financial interest in accordance with accounting principles generally accepted in the U.S. GAAP. For those entities deemed to be qualifying special purpose entities (as defined in SFAS No. 140), which includes the credit card asset securitization master trusts (see Note 5 to the consolidated financial statements), the Company does not consolidate the entity.

 

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On February 1, 2003, the Company adopted FIN 46 for VIEs created after January 31, 2003 and for VIEs in which the Company obtains an interest after January 31, 2003. In October 2003, the FASB deferred the effective date of FIN 46 for arrangements with VIEs existing prior to February 1, 2003 to fiscal periods ending after December 15, 2003. In December 2003, the FASB issued a revision of FIN 46 (“FIN 46R”) to address certain technical corrections and implementation issues that have arisen. The Company anticipates adopting FIN 46R asAs of February 29, 2004, for VIEs in which it holds a variable interest that it had acquired before February 1, 2003 in addition to those VIEs for which the Company has previously appliedadopted FIN 46. The Company will apply46 or FIN 46R for all of its variable interests obtained after February 29, 2004.interests. For these variable interests, the Company will

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consolidateconsolidated those VIEs (including financial asset-backed securitization, mortgage-backed securitization, collateral debt obligation, credit-linked note, structured note, municipal bond trust, equity-linked note and exchangeable trust entities) in which the Company iswas the primary beneficiary. This accounting change is not expected to have a material effect on the Company’s consolidated results of operations or consolidated financial position. In limited instances, the Company may deconsolidatedeconsolidated VIEs for which it iswas not the primary beneficiary as a result of the adoption of FIN 46R. This is further discussed in Note 12 to the consolidated financial statements with respect to the statutory trusts associated with the issuance ofthat had issued preferred securities subject to mandatory redemption. As of May 31, 2004, the Company adopted FIN 46R for those variable interests that were previously accounted for under FIN 46. The effect of adopting FIN 46 and FIN 46R as of February 29, 2004 and May 31, 2004 did not have a material effect on the Company’s consolidated results of operations or consolidated financial position.

 

Gains and Losses from ExtinguishmentAmerican Jobs Creation Act of Debt.2004.    In April 2002,December 2004, the FASB issued Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004”. The American Jobs Creation Act of 2004 (the “Act”), signed into law on October 22, 2004, provides for a special one-time tax deduction, or dividend received deduction (“DRD”), of 85% of qualifying foreign earnings that are repatriated in either a company’s last tax year that began before the enactment date or the first tax year that begins during the one-year period beginning on the enactment date. FSP 109-2 provides entities additional time to assess the effect of repatriating foreign earnings under the Act for purposes of applying SFAS No. 145, “Rescission109, “Accounting for Income Taxes,” which typically requires the effect of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” Under SFAS No. 145, gains and losses from extinguishment of debt area new tax law to be presented as part of an entity’s recurring operations unless they meet the specific criteria of APB Opinion No. 30 for classification as an extraordinary item. As a result, the Company has reclassified an extraordinary loss from the early extinguishment of certain long-term borrowings of $30 million, net of income taxes, previously reportedrecorded in the third quarterperiod of enactment. The Company will elect, if applicable, to apply the DRD to qualifying dividends of foreign earnings repatriated in its fiscal 2001 to income from operations. The pre-tax loss ($50 million) was recorded in Other expenses, and the related tax benefit ($20 million) was recorded in Provision for income taxes.year ending November 30, 2005.

 

Pensions and Other Postretirement Benefits.    In December 2003,The Company is awaiting further clarifying guidance from the FASB madeU.S. Treasury Department on certain revisions to SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” The revised statement requires additional disclosures about employers’ pension and other postretirement plans while also retainingprovisions of the disclosures originally required by SFAS No. 132. The new required disclosures include information describing the types of plan assets, investment strategy, measurement dates, plan obligations and cash flows. In addition, the revised statement requires certain disclosures during interim periods. The revised statementAct. Once this guidance is generally effective for fiscal years ending after December 15, 2003. However,received, the Company has includedexpects to complete its evaluation of the disclosures required byeffects of the revised statement in Note 15 to the consolidated financial statements.

Derivative Financial Instruments.    During the fourth quarter ofAct during fiscal 2002, the Company adopted the provisions of Emerging Issues Task Force (“EITF”) Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.”2005. Under the provisionslimitations on the amount of EITF Issue No. 02-3, individends qualifying for the absenceDRD of observable market prices or parameters in an active market, observable prices or parametersthe Act, the maximum repatriation of other comparable current market transactions, or other observable data supporting a fair value based on a pricing model at the inceptionCompany’s foreign earnings that may qualify for the special one-time DRD is approximately $4.0 billion. Therefore, the range of a contract, profit recognition atpossible amounts of qualifying dividends of foreign earnings is between zero and approximately $4.0 billion. Because the inception of an OTC derivative financial instrumentevaluation is ongoing, it is not permitted.yet practical to estimate a range of possible income tax effects of potential repatriations.

 

Stock-Based Compensation.    Effective December 1, 2002, the Company adopted SFAS No. 123, as amended by SFAS No. 148, using the prospective adoption method. The Company nowcurrently records compensation expense based upon the fair value of stock-based awards (both deferred stock and stock options). In prior years, in accordance with SFAS No. 123. Prior to fiscal 2003, the Company accounted for its stock-based awards under the intrinsic value approach in accordance with APB 25 (see “Equity-Based Compensation Program” herein and Notes 2 and 14 to the consolidated financial statements).

 

69In December 2004, the FASB issued SFAS No. 123 (revised) (“SFAS No. 123R”), “Share-Based Payment”. SFAS No. 123R eliminates the intrinsic value method under APB 25 as an alternative method of accounting for stock-based awards. SFAS No. 123R also revises the fair value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies SFAS No. 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to reporting periods. In addition, SFAS No. 123R amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid, which is included within operating cash flows.

The Company is required to adopt SFAS No. 123R for the interim period beginning September 1, 2005 using a modified version of prospective application or may elect to apply a modified version of retrospective application.

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Item 7A.     QuantitativeThe Company currently expects to early adopt SFAS No. 123R using the modified prospective method with an effective date of December 1, 2004. The Company’s past practice for recognizing compensation expense for equity-based awards included the recognition of a portion of the award in the year of grant. Based upon the terms of the Company’s equity-based compensation program, the Company will no longer be able to recognize a portion of the award in the grant year under SFAS No. 123R. This will have the effect of reducing compensation expense in fiscal 2005. As a result, fiscal 2005 compensation expense will include the amortization of fiscal 2003 and Qualitative Disclosures about Market Risk.fiscal 2004 awards but will not include any amortization for fiscal 2005 awards. If SFAS No. 123R was not in effect, fiscal 2005’s compensation expense would have included three years of amortization (i.e., for awards granted in fiscal 2003, fiscal 2004 and fiscal 2005). In addition, the fiscal 2005 awards, which will begin to be amortized in fiscal 2006, will be amortized over a shorter period (2 and 3 years) as compared with awards granted in fiscal 2004 and fiscal 2003 (3 and 4 years).

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Item 7A.

Quantitative and Qualitative Disclosures about Market Risk.

 

Risk Management.

 

Risk Management Policy and Control Structure.

 

Risk is an inherent part of the Company’s business and activities. The extent to which the Company properly and effectively identifies, assesses, monitors and manages each of the various types of risk involved in its activities is critical to its soundness and profitability. The Company’s broad-based portfolio of business activities helps reduce the impact that volatility in any particular area or related areas may have on its net revenues as a whole. The Company seeks to identify, assess, monitor and manage, in accordance with defined policies and procedures, the following principal risks involved in the Company’s business activities: market, risk, credit, risk, operational, risk, legal, riskand liquidity and funding risk. FundingLiquidity and funding risk is discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” in Part II, Item 7. The Company’s currency exposure relating to its net monetary investments in non-U.S. dollar functional currency subsidiaries is discussed in Note 13 to the consolidated financial statements.

 

The cornerstone of the Company’s risk management philosophy is protection of the Company’s franchise and reputation. Guardianship is based on three key principles: accountability, transparency and independent oversight. Given the importance of effective risk management to the Company’s reputation, senior management requires thorough and frequent communication and appropriate escalation of risk matters.

Risk management at the Company is a multi-faceted process withrequires independent Company-level oversight, that requiresaccountability of the Company’s business segments, constant communication, judgment, and knowledge of specialized products and markets. The Company’s senior management takes an active role in the risk management process and has developed policies and procedures that require specific administrative and business functions to assist in the identification, assessment and controlmanagement of various risks.risks at both the Company and business segment level. In recognition of the increasingly varied and complex nature of the global financial services business, the Company’s risk management philosophy, with its attendant policies, procedures and methodologies, areis evolutionary in nature and are subject to ongoing review and modification.

 

The Managementnature of the Company’s risks, coupled with this risk management philosophy, informs the Company’s risk governance structure. The Company’s risk governance structure includes the Firm Risk Committee and the Capital Committee, the Chief Administrative and Risk Officer, the Internal Audit Department, independent control groups and various risk control managers, committees and groups located within the business segments.

The Firm Risk Committee, composed of the Company’s most senior officers, establishesoversees the Company’s overall risk management policies and reviews its performance relative to these policies.structure. The Management Committee has authorized the SecuritiesFirm Risk Committee to assist in monitoring and reviewing the risk management practicesCommittee’s responsibilities include comprehensive oversight of the Company’s Institutional Securities business.risk management principles, procedures and limits, and monitoring of material financial, operational and franchise risks. The SecuritiesFirm Risk Committee has created subcommittees that report on specificis overseen by the Audit Committee of the Board of Directors (the “Audit Committee”). The Capital Committee oversees alignment of the Company’s resource allocation with strategic priorities. The Capital Committee’s responsibilities include: approving acquisitions and divestitures and making recommendations to the Board of Directors (when appropriate); directing capital to the business segments; approving technical capital recommendations; approving capital exceptions; and approving methodologies for capital allocation for the Company and the business segments.

The Chief Administrative and Risk Officer, a member of the Firm Risk Committee, oversees compliance with Company risk limits; approves certain excessions of Company risk limits; reviews material market, credit, and liquidity and funding risks; and reviews results of risk management matters associatedprocesses with the Institutional Securities business. In addition,Audit Committee.

The Internal Audit Department provides independent risk and control assessment and reports to the Audit Committee and administratively to the Chief Legal Officer. The Internal Audit Department periodically examines the Company’s other business areas have established committees to manage and monitor specific risks. These committees and subcommittees review the risk monitoring and risk management policies and procedures relating to the Company’s market and credit risk profile, sales practices, pricing of consumer loans and reserve adequacy, reputation, legal enforceability, and operational and technology risks. Representation on these committees by senior management of both the business unitscontrol environment and the relevant independent control functions helps ensure thatconducts audits designed to cover all major risk policies and procedures, exceptions to risk limits, new products and business ventures, and transactions with risk elements undergo a thorough review.categories.

 

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The Market Risk, Credit, Controllers,Financial Control, Treasury and Law Departments (collectively, the “Control“Company Control Groups”), which are all independent of the Company’s business units, assist senior management and the risk committeesFirm Risk Committee in monitoring and controlling the Company’s risk profile. The Market Risk and Credit Departments have operational responsibility for measuring and monitoring aggregate market and credit risk, respectively, with respect to the Company’s institutional trading activities and are responsible for risk policy development, risk analysis and risk reporting to senior management and the risk committees. In addition, the Internal Audit Department, which reports to senior management and the Company’s Audit Committee, periodically examines and evaluates the Company’s operations andthrough a number of control environment.processes. The Company is committed to employing qualified personnel with appropriate expertise in each of its various administrative and business areas to implement effectively the Company’s risk management and monitoring systems and processes.

 

Each business segment has a Risk Committee that is responsible for ensuring that the business segment, as applicable: adheres to established limits for market, credit and other risks; implements risk measurement, monitoring, and management policies and procedures that are consistent with the risk framework established by the Firm Risk Committee; and reviews, on a periodic basis, its aggregate risk exposures, risk exception experience, and the efficacy of its risk identification, measurement, monitoring, and management policies and procedures, and related controls.

Each of the Company’s business segments also has designated risk managers, committees and groups, including operations and information technology groups (collectively, “Segment Control Groups” and, together with the Company Control Groups, the “Control Groups”) to manage and monitor specific risks and report to the business segment Risk Committee. The Control Groups work together to review the risk monitoring and risk management policies and procedures relating to, among other things, the segment’s market and credit risk profile, sales practices, pricing of consumer loans and reserve adequacy, reputation, legal enforceability, and operational and technological risks. Participation by the senior officers of the Control Groups helps ensure that risk policies and procedures, exceptions to risk limits, new products and business ventures, and transactions with risk elements undergo a thorough review that is overseen by the business segment Risk Committees and ultimately by the Firm Risk Committee.

The following is a discussion of the Company’s risk management policies and procedures for its principal risks (other than liquidity and funding risk). The discussion focuses on the Company’s securities tradingactivities (primarily its institutional trading activities) and consumer lending and related activities. The Company believes that these activities generate a substantial portion of its principal risks. This discussion and the estimated amounts of the Company’s

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market risk exposure generated by the Company’s statistical analyses are forward-looking statements. However, the analyses used to assess such risks are not predictions of future events, and actual results may vary significantly from such analyses due to events in the markets in which the Company operates and certain other factors described below.

 

Market Risk.

 

Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, implied volatilities (the price volatility of the underlying instrument imputed from option prices), correlations or other market factors, such as liquidity, will result in losses for a position or portfolio. Generally, the Company incurs market risk as a result of trading and client facilitation activities, principally within the Institutional Securities business where the substantial majority of the Company’s Value-at-Risk (“VaR”) for market risk exposures is generated. In addition, the Company incurs trading-related market risk within the Individual Investor Group and Investment Management businesses. The Company also incurs non-trading related market risk principally through its consumer lending activities within the Credit Services business.

 

Sound market risk management is an integral part of the Company’s culture. The various business units and trading desks are responsible for ensuring that market risk exposures are well-managed and prudent. The Control Groups help ensure that these risks are measured and closely monitored and are made transparent to senior management. The Market Risk Department is responsible for ensuring transparency of material market risks, monitoring compliance with established limits, and escalating risk concentrations to appropriate senior management. To execute these responsibilities, the Market Risk Department monitors the Company’s risk against limits on aggregate risk exposures, performs a variety of risk analyses, routinely reports risk summaries

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and maintains the Company’s VaR system. A variety of limits are designed to control price and liquidity risk. Market risk is monitored through various measures: statistically (using Value-at-Risk (“VaR”)VaR and related analytical measures); by measures of position sensitivity; and through routine stress testing and scenario analysisanalyses conducted by the Market Risk Department in collaboration with the business units. The material risks identified by these processes are summarized in reports produced by the Market Risk Department that are circulated to, and discussed with, senior management.

 

Sales and Trading and Related Activities.

 

Primary Market Risk Exposures and Market Risk Management.    During fiscal 2003,2004, the Company had exposures to a wide range of interest rates, equity prices, foreign exchange rates and commodity prices—and the associated implied volatilities and spreads—related to the global markets in which it conducts its trading activities. The Company is exposed to interest rate and credit spread risk as a result of its market-making activities and proprietary trading in interest rate sensitive financial instruments (e.g., risk arising from changes in the level or implied volatility of interest rates, the timing of mortgage prepayments, the shape of the yield curve and credit spreads). The Company is exposed to equity price and implied volatility risk as a result of making markets in equity securities and derivatives and maintaining proprietary positions. The Company is exposed to foreign exchange rate and implied volatility risk as a result of making markets in foreign currencies and foreign currency options and from maintaining foreign exchange positions. The Company is exposed to commodity price and implied volatility risk as a result of market-making activities and maintaining positions in physical commodities (such as crude and refined oil products, natural gas, electricity, and precious and base metals) and related derivatives.

 

The Company manages its trading positions by employing a variety of risk mitigation strategies. These strategies include diversification of risk exposures and hedging throughhedging. Hedging activities consist of the purchase or sale of positions in related securities and financial instruments, including a variety of derivative products (e.g., futures, forwards, swaps and options). The Company manages the market risk associated with its trading activities on a Company-wide basis, on a worldwide trading division level and on an individual product basis. The Company manages and monitors its market risk exposures in such a way as to maintain a portfolio that the Company believes is well-diversified in the aggregate with respect to market risk factors and that reflects the Company’s aggregate risk tolerance as established by the Company’s senior management.

 

Aggregate market risk limits have been approved for the Company and for its major trading divisions worldwide (equity and fixed income, which includes interest rate products, credit products, foreign exchange and commodities). Additional market risk limits are assigned to trading desks and, as appropriate, products and regions. Trading division risk managers, desk risk managers, traders and the Market Risk Department monitor market risk measures against limits in accordance with policies set by senior management.

 

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The Market Risk Department independently reviews the Company’s trading portfolios on a regular basis from a market risk perspective utilizing VaR and other quantitative and qualitative risk measures and analyses. The Company’s trading businesses and the Market Risk Department also use, as appropriate, measures such as sensitivity to changes in interest rates, prices, implied volatilities and time decay to monitor and report market risk exposures. Stress testing, which measures the impact on the value of existing portfolios of specified changes in market factors for certain products, is performed periodically and is reviewed by trading division risk managers, desk risk managers and the Market Risk Department. The Market Risk Department also conducts scenario analysis,analyses, which estimatesestimate the Company’s revenue sensitivity to a seriesset of specific, predefined market and geopolitical events. Reports summarizing material risk exposures are produced by the Market Risk Department and are disseminated to senior management, including the Management Committee and the Securities Risk Committee.

 

Value-at-Risk (VaR).    The Company uses the statistical technique known as VaR as one of the tools used to measure, monitor and review the market risk exposures of its trading portfolios. The Market Risk Department calculates and distributes daily VaR-based risk measures to various levels of management.

 

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VaR Methodology, Assumptions and Limitations.    The Company estimates VaR using a model based on historical simulation for major market risk factors and Monte Carlo simulation for name-specific risk in certain equity and fixed income exposures. Historical simulation involves constructing a distribution of hypothetical daily changes in the value of trading portfolios based on two sets of inputs: historical observation of daily changes in key market indices or other market factors (“market risk factors”); and information on the sensitivity of the portfolio values to these market risk factor changes. The Company’s VaR model uses approximately four years of historical data to characterize potential changes in market risk factors. The Company’s 99%/one-day VaR corresponds to the unrealized loss in portfolio value that, based on historically observed market risk factor movements, would have been exceeded with a frequency of 1%, or once in every 100 trading days, if the portfolio waswere held constant for one day.

 

The Company’s VaR model generally takes into account linear and non-linear exposures to price risk and linear exposures to implied volatility risks. Market risks that are incorporated in the VaR model include equity and commodity prices, interest rates, foreign exchange rates and associated implied volatilities. As a supplement to the use of historical simulation for major market risk factors, the Company’s VaR model uses Monte Carlo simulation to capture name-specific risk in equities and credit products (i.e., corporate bonds and credit derivatives).

 

The Company’s VaR models evolve over time in response to changes in the composition of trading portfolios and to improvements in modeling techniques and systems capabilities. As part of regular process improvement, additional systematic and name-specific risk factors may be added to improve the VaR model’s ability to more accurately estimate risks to specific asset classes or industry sectors.

 

Among their benefits, VaR models permit estimation of a portfolio’s aggregate market risk exposure, incorporating a range of varied market risks; reflect risk reduction due to portfolio diversification or hedging activities; and can cover a wide range of portfolio assets. However, VaR risk measures should be interpreted carefully in light of the methodology’s limitations, which include the following: past changes in market risk factors may not always yield accurate predictions of the distributions and correlations of future market movements; changes in portfolio value in response to market movements (especially for complex derivative portfolios) may differ from the responses calculated by a VaR model; VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day; the historical market risk factor data used for VaR estimation may provide only limited insight into losses that could be incurred under market conditions that are unusual relative to the historical period used in estimating the VaR; and published VaR results reflect past trading positions while future risk depends on future positions. The Company

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is aware of these and other limitations and, therefore, uses VaR as only one component in its risk management oversight process. As explained above, this process also incorporates stress testing and scenario analysisanalyses and extensive risk monitoring, analysis, and control at the trading desk, division and Company levels.

 

VaR for Fiscal 20032004.    The table below presents the Company’s VaR for each of the Company’s primary market risk exposures and on an aggregate basis at November 30, 20032004 and November 30, 2002,2003, incorporating substantially all financial instruments generating market risk that are managed by the Company’s trading businesses. This measure of VaR incorporates most of the Company’s trading-related market risks. However, a small proportion of trading positions generating market risk is not included in VaR (e.g., certain credit default baskets), and the modeling of the risk characteristics of some positions relies upon approximations that, under certain circumstances, could produce significantly different VaR results from those produced using more precise measures. For example, risks associated with residential mortgage-backed securities have been approximated as it is difficult to capture precisely these risks within a VaR context.

 

Aggregate Trading and Non-trading VaR also incorporates (a) the funding liabilities related to institutional trading positions and (b) public-company equity positions recorded as principal investments by the Company. Principal investments made by the Company that are not publicly traded are not reflected in the VaR results reported below. As of November 30, 2003,2004, the aggregate carrying value of such investments was approximately $460$400 million.

 

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Since the VaR statistics reported below are estimates based on historical position and market data, VaR should not be viewed as predictive of the Company’s future revenues or financial performance or its ability to monitor and manage risk. There can be no assurance that the Company’s actual losses on a particular day will not exceed the VaR amounts indicated below or that such losses will not occur more than once in 100 trading days.

 

The table below presents VaR for each of the Company’s primary risk exposures and on an aggregate basis at November 30, 20032004 and November 30, 2002:2003:

 

		Trading and Non-trading						Trading						Trading and Non-trading						Trading
Table 1: 99% Aggregate VaR		99%/One-Day VaR at November 30,						99%/One-Day VaR at November 30,						99%/One-Day VaR at November 30,						99%/One-Day VaR at November 30,
Primary Market Risk Category		2003			2002			2003			2002			2004			2003			2004			2003
		(dollars in millions, pre-tax)												(dollars in millions)
Interest rate and credit spread		$	52		$	41		$	45		$	45		$	71		$	52		$	53		$	45
Equity price			32			14			30			14			42			32			38			30
Foreign exchange rate			7			6			7			6			10			7			10			7
Commodity price			22			22			22			22			27			22			27			22
Subtotal			113			83			104			87			150			113			128			104
Less diversification benefit(1)			50			35			46			34			56			50			48			46
Aggregate VaR		$	63		$	48		$	58		$	53		$	94		$	63		$	80		$	58

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(1)

Diversification benefit equals the difference between Aggregate VaR and the sum of the VaRs for the four risk categories. This benefit arises because the simulated 99%/one-day losses for each of the four primary market risk categories occur on different days; similar diversification benefits also are taken into account within each such category.

 

The Company’s Aggregate Trading and Non-trading VaR, and Aggregate Trading VaR at November 30, 2003 increased from the prior year, driven predominantly by increases in interest rate2004 were $94 million and credit spread and equity price VaR.$80 million, respectively. The increase in year-end interest rate and credit spread VaR was primarily related to increased exposure to credit sensitive products, including investment grade corporate debt and high-credit-quality asset-backed products. The increase in year-end equity price VaR was primarily related to increased diversified exposures to liquid securities in global equity markets. For a more representative summary ofCompany views average VaR over the course of the fiscal year please refer to averageas more representative of trends in the business than VaR at any single point in Table 3 below.time.

 

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The tableTable 2 below, represents 95% VaR on a one-day time horizon, which may be used to facilitate comparisons with other global financial services firms that report VaR at a 95% confidence interval:

		Trading and Non-trading						Trading
Table 2: 95% Aggregate VaR		95%/One-Day VaR at November 30,						95%/One-Day VaR at November 30,
Primary Market Risk Category		2003			2002			2003			2002
		(dollars in millions, pre-tax)
Interest rate and credit spread		$	30		$	26		$	29		$	28
Equity price			22			10			21			10
Foreign exchange rate			5			4			5			4
Commodity price			15			15			15			15
Subtotal			72			55			70			57
Less diversification benefit			30			23			30			22
Aggregate VaR		$	42		$	32		$	40		$	35

In order to facilitate comparisons with other global financial services firms that report VaR with respect to a 10-business day holding period, the Company’s One-Day Aggregate Trading and Non-trading VaR for a two-week time horizon at November 30, 2003 was $134 million at a 95% confidence interval and $200 million at a 99% confidence interval.

The tables below presentpresents the high, low and average 99% and 95%/one-day Aggregate tradingTrading VaR over the course of fiscal 2004 and fiscal 2003, forrepresents substantially all of the Company’s trading activities. Certain market risks included in the year-end Aggregate Trading and Non-trading VaR discussed above are excluded from this measurethese measures (e.g., equity price risk in public company equity positions recorded as principal investments by the Company and certain funding liabilities related to trading positions):.

 

Table 3: 99% High/Low/Average Trading VaR		Daily 99%/One-Day VaR for Fiscal 2003
Primary Market Risk Category		High			Low			Average
		(dollars in millions, pre-tax)
Interest rate and credit spread		$	54		$	33		$	43
Equity price			50			14			25
Foreign exchange rate			32			3			11
Commodity price			42			21			27
Aggregate trading VaR		$	73		$	45		$	55

Average Aggregate Trading VaR for fiscal 2004 increased to $73 million from $55 million in fiscal 2003, reflecting an increase in all primary risk categories except foreign exchange. The increase in interest rate and credit spread VaR was predominantly driven by increased exposures to credit-sensitive instruments (e.g., corporate debt securities) and to interest rate levels. The increase in equity price VaR was predominantly driven by increased directional exposure to global equity markets. The increase in commodity price VaR was predominantly driven by increased exposures to oil products.

 

Table 4: 95% High/Low/Average Trading VaR		Daily 95%/One-Day VaR for Fiscal 2003
Table 2: 99% High/Low/Average Trading VaR											Daily 99%/One-Day VaR for Fiscal 2004									Daily 99%/One-Day VaR for Fiscal 2003
Primary Market Risk Category		High			Low			Average			High			Low			Average			High			Low			Average
		(dollars in millions, pre-tax)									(dollars in millions)
Interest rate and credit spread		$	33		$	20		$	26		$	80		$	39		$	50		$	54		$	33		$	43
Equity price			35			10			18			48			24			34			50			14			25
Foreign exchange rate			20			2			7			21			6			11			32			3			11
Commodity price			27			13			18			49			22			33			42			21			27
Aggregate trading VaR		$	50		$	32		$	38
Aggregate Trading VaR											$	97		$	55		$	73		$	73		$	45		$	55

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VaR Statistics for Comparisons with Other Global Financial Services Firms

VaR statistics are not readily comparable across firms because firms differ in the statistical assumptions they make when simulating changes in market factors as well as in the methods they use to approximate the portfolio revaluations under the simulations. These differences can result in materially different VaR estimates for similar portfolios. As a result, VaR statistics are more reliable and relevant when used as indicators of trends in risk-taking within a firm rather than as a basis for inferring differences in risk-taking across firms. Table 3 below presents the VaR statistics that would result if the Company were to adopt alternative parameters for its calculations, such as the reported confidence level (99% vs. 95%) for the VaR statistic or a shorter historical time series (four years vs. one year) for market data upon which it bases its simulations:

Table 3: Average 99% and 95% Trading VaR with Four-Year/One-Year Historical Time Series		Average 99%/One-Day VaR						Average 95%/One-Day VaR
		for Fiscal 2004						for Fiscal 2004
Primary Market Risk Category		Four-Year Factor History			One-Year Factor History			Four-Year Factor History			One-Year Factor History
		(dollars in millions)
Interest rate and credit spread		$	50		$	57		$	31		$	36
Equity price			34			31			24			22
Foreign exchange rate			11			11			7			7
Commodity price			33			25			21			16
Aggregate Trading VaR		$	73		$	72		$	50		$	49

In addition, if the Company were to report Trading VaR (using a four-year historical time series) with respect to a 10-day holding period, the Company’s 99% and 95% Average Aggregate Trading VaR for fiscal 2004 would have been $232 million and $159 million, respectively.

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Distribution of VaR Statistics and Net Revenues for 2004

 

As shown in Table 32 above, the Company’s average 99%/one-day Aggregate tradingTrading VaR for fiscal 20032004 was $55$73 million. Around this average, the Company’s Aggregate tradingTrading VaR varied from day to day. The histogram below presents the distribution of the Company’s daily 99%/one-day Aggregate tradingTrading VaR for its trading activities and showsillustrates that for more than 90% of fiscal 20032004 trading days, Aggregate tradingTrading VaR ranged between $49$60 million and $65$90 million. The days where Aggregate trading VaR exceeded $65 million occurred during the fourth quarter of fiscal 2003 and were primarily the result of a concentrated single-name equity exposure that was reduced prior to that quarter’s end.

 

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One method of evaluating the reasonableness of the Company’s VaR model as a measure of the Company’s potential volatility of net revenuesrevenue is to compare the VaR with actual trading revenues. Forrevenue. Assuming no intra-day trading, for a 99%/one-day VaR, the expected number of times that trading losses should exceed VaR during the fiscal year is three, and, in general, if trading losses were to exceed VaR more than five times in a year, the accuracy of the VaR model could be questioned. Accordingly, the Company evaluates the reasonableness of its VaR model by comparing the potential declines in portfolio values generated by the model with actual trading results. The histogram below shows the distribution of daily net revenuesrevenue during fiscal 20032004 for the Company’s institutional trading businesses (including net interest and commissions andbut excluding primary and prime brokerage revenue credited to the institutional trading businesses). There were no days during fiscal 20032004 in which the Company incurred daily trading losses (even when excluding primary revenues) in its institutional trading businessbusinesses in excess of the 99%/one-day Aggregate tradingTrading VaR. Additionally, there were no trading days in fiscal 2003 where the largest one-day loss exceeded the low 99%/one-day Aggregate trading VaR (as reported in the High/Low/Average table).

 

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Consumer Lending and Related Activities.

 

Interest Rate Risk and Management.    In its consumer lending activities, the Company is exposed to market risk primarily from changes in interest rates. Such changes in interest rates impact interest earning assets, principally credit card and other consumer loans and net excess servicing fees received in connection with consumer loans sold through asset securitizations, as well as the interest sensitive liabilities that finance these assets, including asset-backed securitizations, long-term borrowings, deposits and Federal Funds.

 

The Company’s interest rate risk management policies are designed to reduce the potential volatility of earnings that may arise from changes in interest rates by having a financing portfolio that reflects the existing repricing schedules of consumer loans as well as the Company’s right, with notice to cardmembers, to reprice certain fixed rate consumer loans to a new interest rate in the future. To the extent that asset and related financing repricing characteristics of a particular portfolio are not matched effectively, the Company utilizes interest rate derivative contracts, such as swap agreements, to achieve its objectives. Interest rate swap agreements effectively convert the underlying asset or financing from fixed to variable repricing or from variable to fixed repricing.

 

Sensitivity Analysis Methodology, Assumptions and Limitations.    For its consumer lending activities, the Company uses a variety of techniques to assess its interest rate risk exposure, one of which is interest rate sensitivity simulation. For purposes of presenting the possible earnings effect of a hypothetical, adverse change in interest rates over the 12-month period from its fiscal year-end, the Company assumes that all interest rate sensitive assets and liabilities will be impacted by a hypothetical, immediate 100-basis-point increase in interest rates as of the beginning of the period.

 

Interest rate sensitive assets are assumed to be those for which the stated interest rate is not contractually fixed for the next 12-month period. A portion of the Company’s credit card receivables has a fixed interest rate, although the Company has the right, with notice to cardmembers, to subsequently reprice these receivables to a new interest rate. Therefore, the Company considers the receivables with a fixed interest rate to be interest rate sensitive. The Company measured the earnings sensitivity for these assets from the expected repricing date, which takes into

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consideration the required notice period and billing cycles. In addition, assets that have a market-based index, such as the prime rate, which will reset before the end of the 12-month period, or assets with rates that are fixed at fiscal year-end but which will mature, or otherwise contractually reset to a market-based indexed or other fixed rate prior to the end of the 12-month period, are rate sensitive. The latter category includes certain credit card loans that may be offered at below-market rates for an introductory period, such as for balance transfers and special promotional programs, after which the loans will contractually reprice in accordance with the Company’s normal market-based pricing structure. For purposes of measuring rate sensitivity for such loans, only the effect of the hypothetical 100-basis-point change in the underlying market-based indexed or other fixed rate has been considered rather than the full change in the rate to which the loan would contractually reprice. For assets that have a fixed interest rate at fiscal year-end but which contractually will, or are assumed to, reset to a market-based indexed or other fixed rate during the next 12 months, earnings sensitivity is measured from the expected repricing date. In addition, for all interest rate sensitive assets, earnings sensitivity is calculated net of expected loan losses.

 

Interest rate sensitive liabilities are assumed to be those for which the stated interest rate is not contractually fixed for the next 12-month period. Thus, liabilities that have a market-based index, such as the prime, commercial paper or LIBOR rates, which will reset before the end of the 12-month period, or liabilities whose rates are fixed at fiscal year-end but which will mature and are assumed to be replaced with a market-based indexed rate prior to the end of the 12-month period, are rate sensitive. For these fixed rate liabilities, earnings sensitivity is measured from the expected repricing date.

 

Assuming a hypothetical, immediate 100-basis-point increase in the interest rates affecting all interest rate sensitive assets and liabilities as of November 30, 2003,2004, it is estimated that the pre-tax income of consumer lending and related activities over the following 12-month period would be reduced by approximately $55$60 million. The comparable reduction of pre-tax income for the 12-month period following November 30, 2002

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2003 was estimated to be approximately $10$55 million. The increase in the reduction in pre-tax income at November 30, 20032004 was due to a higher level of variable rate financing, as fixed financings matured. The increase is partially offset by a higher level of variable interest rate assets as compared with the prior-year period.

 

The hypothetical model assumes that the balances of interest rate sensitive assets and liabilities at fiscal year-end will remain constant over the next 12-month period. It does not assume any growth, strategic change in business focus, change in asset pricing philosophy or change in asset/liability funding mix. Thus, this model represents a static analysis that cannot adequately portray how the Company would respond to significant changes in market conditions. Furthermore, the analysis does not necessarily reflect the Company’s expectations regarding the movement of interest rates in the near term, including the likelihood of an immediate 100-basis-point change in market interest rates, nor necessarily the actual effect on earnings if such rate changes were to occur.

 

Credit Risk.

 

Credit risk refers to the risk of loss arising from borrower or counterparty default when a borrower, counterparty or obligor is unable to meet its financial obligations. The Company is exposed to three distinct types of credit risk in its businesses. The Company incurs significant, “single-name” credit risk exposure through the Institutional Securities business. This type of risk requires significant credit analysis of specific counterparties, both initially and on an ongoing basis. The Company incurs “consumer portfolio” credit risk in the Credit Services business primarily through cardholder receivables. Credit risk in a pool of credit card receivables is generally highly diversified, without significant individual exposures, and, accordingly, is managed on a portfolio and not a single-name basis. The Company incurs “individual consumer” credit risk in the Individual Investor Group business through margin loans to individual investors and loans to small businesses, both of which are generally collateralized.

The Company has structured its credit risk management framework to reflect that each of these businesses generates unique credit risks that are appropriately managed separately. The Institutional Credit Department (“Institutional Credit”) manages credit risk exposure for the Institutional Securities business. Institutional Credit is responsible for

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ensuring transparency of material credit risks, ensuring compliance with established limits, approving material extensions of credit, and escalating risk concentrations to appropriate senior management. Credit risk exposure in the Individual Investor Group business is managed through various credit risk departments and committees. The Individual Investor Group Risk Management Department is responsible for monitoring, measuring and analyzing credit risk exposures, including margin loans and credit sensitive, higher risk transactions. Credit risk exposure in the Credit Services business is managed through the Credit Services Credit and Market Risk Committee, which is, in turn, supported by business line specific risk committees and the Credit Risk Management Department, which is responsible for the development, validation and implementation of credit policy criteria, for predictive models and for monitoring performance for both new and existing products and overseeing adherence to existing policies and limits.

Institutional Securities Activities.

Lending.  In connection with certain of its Institutional Securities business activities, the Company provides loans or lending commitments (including bridge financing) to selected clients. These loans and commitments have varying terms, may be senior or subordinated, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated or traded by the Company. The borrowers may be rated investment grade or non-investment grade. Credit risk iswith respect to loans and lending commitments arises from the riskfailure of lossa borrower to perform according to the terms of the loan agreement.

Securitized Products.  The Company arising from possiblealso extends loans and lending commitments to clients that are secured by assets of the borrower or counterparty default on a contractual financial commitment.and generally provide for over-collateralization, including commercial real estate, loans secured by loan pools, corporate and operating company loans, and secured lines of revolving credit. Credit risk arisingwith respect to these loans and lending commitments arises from the failure of a borrower to perform according to the terms of the loan agreement and a decline in connectioncollateral value.

Other.  In addition to the activities performed by Institutional Credit, there are credit risks managed by various business areas within Institutional Securities. For example, certain businesses with heightened settlement risk monitor compliance with established settlement risk limits. Certain risk management activities for the Company’s Institutional Securities activitiesprime brokerage and securitized product businesses are primarily monitored within those areas in that they determine the appropriate collateral level for each strategy or position. In addition, a collateral management group monitors collateral levels against requirements and oversees the administration of the collateral function.

Derivative Contracts.  In the normal course of business, the Company enters into a variety of derivative contracts related to financial instruments and commodities. The Company uses these instruments for trading and investment purposes, as well as for asset and liability management. These instruments generally represent future commitments to swap interest payment streams, exchange currencies, or purchase or sell commodities and other financial instruments on specific terms at specified future dates. Many of these products have maturities that do not extend beyond one year, although swaps, options and warrants on equities typically have longer maturities.

The Company incurs credit risk as a dealer in OTC derivatives. Credit risk with respect to derivative instruments arises from the failure of a counterparty to perform according to the terms of the contract. The Company’s exposure to credit risk at any point in time is managedrepresented by the fair value of the derivative contracts reported as assets. The fair value of derivatives represents the amount at which the derivative could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale, and is further described in Note 2 to the consolidated financial statements. Future changes in interest rates, foreign currency exchange rates, or the fair values of the financial instruments, commodities, or indices underlying these contracts ultimately may result in cash settlements exceeding fair value amounts recognized in the consolidated statements of financial condition.

Analyzing Credit Department and various business lines, within parameters set by the Company’s senior management.Risk.  Credit risk management takes place at the transaction, obligorcounterparty and portfolio levels. At the transaction level,In order to help protect the Company seeksfrom losses resulting from these activities, Institutional Credit ensures that all material lending and derivative transactions are prudently analyzed prior to mitigateapproval, that the creditworthiness of

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the Company’s counterparties and borrowers is reviewed regularly, and that credit risk through managementexposure is actively monitored and managed. Institutional Credit assigns obligor credit ratings to the Company’s counterparties and borrowers. These credit ratings are intended to assess a counterparty’s probability of key risk elements such as size, tenor, senioritydefault and collateral. Atare derived using methodologies generally consistent with those employed by external rating agencies. Credit ratings of “BB+” or below are considered non-investment grade. Additionally, Institutional Credit assigns a facility rating to lending facilities. The facility rating incorporates the obligor level, the Company makes use of: credit syndication, assignment and sale; netting agreements and collateral arrangements; and derivatives and other financial instruments. In addition, the Credit Department periodically reviews the financial soundness of obligorsrelative position of the Company. For portfolios of credit exposure,particular obligation in the Company, as appropriate, assesses credit risk concentrationsborrower’s capital structure and purchases portfolio credit hedges.

relative recovery prospects. The Company has credit guidelines that limit current and potential credit exposure to any one borrower or counterparty and to aggregates of borrowers or counterparties by type of business activity. TheInstitutional Credit Department administers these limits and monitors and reports credit exposure relative to limits.

 

Risk Mitigation.The Company incursmay seek to mitigate credit risk from its lending and derivatives transactions in multiple ways. At the transaction level, the Company seeks to mitigate risk through management of key risk elements such as size, tenor, seniority and collateral. The Company actively hedges its lending and derivatives exposure through various financial instruments which may include single name, portfolio and structured credit derivatives. Additionally, the Company may sell, assign, or sub-participate lending commitments and funded loans to other financial institutions in the primary and secondary loan market. In connection with its derivatives trading activities, the Company may enter into master netting agreements and collateral arrangements with counterparties. These agreements may provide the Company with the ability to offset a counterparty’s rights and obligations, request additional collateral when necessary or liquidate the collateral in the event of counterparty default.

Credit Exposure-Lending.  At November 30, 2004 and November 30, 2003, the aggregate value of investment grade loans and positions was $1.2 billion and $1.0 billion, respectively, and the aggregate value of non-investment grade loans and positions was $0.5 billion and $0.7 billion, respectively. At November 30, 2004 and November 30, 2003, the aggregate value of lending commitments outstanding was $20.4 billion and $16.1 billion, respectively. In connection with these business activities (which include funded loans and lending commitments), the Company had hedges with a notional amount of $11.6 billion and $7.3 billion at November 30, 2004 and November 30, 2003, respectively, including both internal and external hedges utilized by the lending business. The table below shows the Company’s credit exposure from its lending positions and commitments as a dealer in OTC derivatives activities.of November 30, 2004:

Lending Commitments and Funded Loans

		Years to Maturity												Total Lending Exposure(2)			Funded Loans
Credit Rating(1)		Less than 1			1-3			3-5			Over 5
		(dollars in millions)
AAA		$	252		$	45		$	253		$	—		$	550		$	30
AA			1,743			269			930			277			3,219			—
A			3,271			1,066			3,959			185			8,481			153
BBB			1,308			2,724			3,084			813			7,929			1,007
Non-investment grade			360			625			503			381			1,869			460
Total		$	6,934		$	4,729		$	8,729		$	1,656		$	22,048		$	1,650
Notional amount of hedges owned														$	11,621

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(1)	Obligor credit ratings are determined by Institutional Credit using methodologies generally consistent with those employed by external rating agencies.

(2)	Total Lending Exposure includes both lending commitments and funded loans.

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Credit Exposure-Derivatives.  The table below presents a summary by counterparty credit rating and remaining contract maturity of the fair value of OTC derivatives in a gain position at November 30, 2003.2004. Fair value is shown taking into accountrepresents the risk reduction arising from master netting agreements where applicable and, in the final column, net of collateral received (principally cash and U.S. government and agency securities):

 

OTC Derivative Products—Financial Instruments Owned(1)

 

		Years to Maturity																						Years to Maturity												Cross-Maturity Netting(3)				Net Exposure Pre- collateral			Net Exposure Post- collateral
Credit Rating(2)		Less than 1			1-3			3-5			Over 5			Cross-Maturity Netting(3)				Net Exposure Pre-collateral			Net Exposure Post-collateral			Less than 1			1-3			3-5			Over 5
		(dollars in millions)																						(dollars in millions)
AAA		$	632		$	2,077		$	1,675		$	5,425		$	(2,566	)		$	7,243		$	3,621		$	2,322		$	2,539		$	1,816		$	6,635		$	(3,059	)		$	10,253		$	5,815
AA			6,153			3,509			2,729			7,903			(5,609	)			14,685			8,745			7,861			4,390			3,664			11,828			(5,625	)			22,118			13,594
A			3,953			2,563			2,221			4,092			(2,496	)			10,333			5,702			3,641			3,927			2,199			5,240			(2,157	)			12,850			8,007
BBB			2,347			1,616			1,194			2,374			(1,147	)			6,384			4,433			3,315			2,939			1,716			5,741			(1,577	)			12,134			6,909
Non-investment grade			1,125			521			298			597			(232	)			2,309			1,366			2,828			982			827			1,024			(494	)			5,167			2,249
Unrated(4)			950			353			46			54			(11	)			1,392			82			1,243			405			111			100			(43	)			1,816			165
Total		$	15,160		$	10,639		$	8,163		$	20,445		$	(12,061	)		$	42,346		$	23,949		$	21,210		$	15,182		$	10,333		$	30,568		$	(12,955	)		$	64,338		$	36,739

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(1)

Fair values shown present the Company’s exposure to counterparties relatingrelated to the Company’s OTC derivative products. The table does not include the effect of any related hedges utilized by the Company. The table also excludes fair values corresponding to other credit exposures, such as those arising from the Company’s lending activities.

77

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(2)	CreditObligor credit ratings are determined by the Company’sInstitutional Credit Department, using methodologies generally consistent with those employed by external rating agencies.

(3)	Amounts represent the netting of receivable balances with payable balances for the same counterparty across maturity categories. Receivable and payable balances with the same counterparty in the same maturity category are netnetted within such maturity category where appropriate.

(4)

In lieu of making an individual assessment of the creditcreditworthiness of unrated counterparties,companies, the Company makes a determination that the collateral held with respect to such obligations is sufficient to cover a substantial portion of its exposure. In making this determination, the Company takes into account various factors, including legal uncertainties and market volatility.

 

The following tables summarize the fair values of the Company’s OTC derivative products recorded in Financial instruments owned and Financial instruments sold, not yet purchased by product category and maturity at November 30, 2003,2004, including on a net basis, where applicable, reflecting the fair value of related collateral for financial instruments owned:

 

OTC Derivative Products—Financial Instruments Owned

 

		Years to Maturity																						Years to Maturity												Cross-Maturity Netting(1)				Net Exposure Pre- collateral			Net Exposure Post- collateral
Product Type		Less than 1			1-3			3-5			Over 5			Cross-Maturity Netting(1)				Net Exposure Pre-collateral			Net Exposure Post-collateral			Less than 1			1-3			3-5			Over 5
		(dollars in millions)																						(dollars in millions)
Interest rate and currency swaps and options, credit derivatives and other fixed income securities contracts		$	3,962		$	7,382		$	6,998		$	19,823		$	(11,080	)		$	27,085		$	12,193		$	5,136		$	7,366		$	8,424		$	27,821		$	(10,676	)		$	38,071		$	18,934
Foreign exchange forward contracts and options			5,554			442			101			12			(151	)			5,958			5,384			8,809			698			128			5			(125	)			9,515			7,824
Equity securities contracts (including equity swaps, warrants and options)			1,375			737			329			185			(161	)			2,465			964			1,610			917			533			1,236			(310	)			3,986			956
Commodity forwards, options and swaps			4,269			2,078			735			425			(669	)			6,838			5,408			5,655			6,201			1,248			1,506			(1,844	)			12,766			9,025
Total		$	15,160		$	10,639		$	8,163		$	20,445		$	(12,061	)		$	42,346		$	23,949		$	21,210		$	15,182		$	10,333		$	30,568		$	(12,955	)		$	64,338		$	36,739

 

OTC Derivative Products—Financial Instruments Sold, Not Yet Purchased

		93

		Years to Maturity
Product Type		Less than 1			1-3			3-5			Over 5			Cross- Maturity Netting(1)				Total
		(dollars in millions)
Interest rate and currency swaps and options, credit derivatives and other fixed income securities contracts		$	5,096		$	7,142		$	5,607		$	12,139		$	(11,080	)		$	18,904
Foreign exchange forward contracts and options			5,226			381			85			16			(151	)			5,557
Equity securities contracts (including equity swaps, warrants and options)			1,007			1,148			434			367			(161	)			2,795
Commodity forwards, options and swaps			4,231			1,628			532			173			(669	)			5,895
Total		$	15,560		$	10,299		$	6,658		$	12,695		$	(12,061	)		$	33,151

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(1)	Amounts represent the netting of receivable balances with payable balances for the same counterparty across maturity and product categories. Receivable and payable balances with the same counterparty in the same maturity category are netted within the maturity category where appropriate.

 

78OTC Derivative Products—Financial Instruments Sold, Not Yet Purchased

		Years to Maturity												Cross-Maturity Netting(1)				Total
Product Type		Less than 1			1-3			3-5			Over 5
		(dollars in millions)
Interest rate and currency swaps and options, credit derivatives and other fixed income securities contracts		$	5,238		$	7,560		$	7,756		$	18,171		$	(10,676	)		$	28,049
Foreign exchange forward contracts and options			8,804			457			85			25			(125	)			9,246
Equity securities contracts (including equity swaps, warrants and options)			1,255			1,172			664			332			(310	)			3,113
Commodity forwards, options and swaps			5,165			5,202			1,244			830			(1,844	)			10,597
Total		$	20,462		$	14,391		$	9,749		$	19,358		$	(12,955	)		$	51,005

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(1)	Amounts represent the netting of receivable balances with payable balances for the same counterparty across maturity and product categories. Receivable and payable balances with the same counterparty in the same maturity category are netted within the maturity category where appropriate.

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The Company’s derivatives (both listed and OTC) at November 30, 2004 and November 30, 2003 are summarized in the table below, showing the fair value of the related assets and liabilities by product:

		At November 30, 2004						At November 30, 2003
Product Type		Assets			Liabilities			Assets			Liabilities
		(dollars in millions)
Interest rate and currency swaps and options, credit derivatives and other fixed income securities contracts		$	38,172		$	28,100		$	27,280		$	18,950
Foreign exchange forward contracts and options			9,521			9,249			5,964			5,561
Equity securities contracts (including equity swaps, warrants and options)			6,587			7,549			4,503			5,781
Commodity forwards, options and swaps			12,812			10,922			6,905			5,950
Total		$	67,092		$	55,820		$	44,652		$	36,242

Each category of OTC derivative products in the above tabletables includes a variety of instruments, which can differ substantially in their characteristics. Instruments in each category can be denominated in U.S. dollars or in one or more non-U.S. currencies.

 

The fair values recorded in the above tables are determined by the Company using various pricing models. For a discussion of fair value as it affects the Company’s consolidated financial statements, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Critical Accounting Policies” in Part II, Item 7 and Note 2 to the consolidated financial statements. As discussed under “Critical Accounting Policies,” the structure of the transaction, including its maturity, is one of several important factors that may impact the price transparency. The impact of maturity on price transparency can differ significantly

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among product categories. For example, single currency and multi-currency interest rate derivative products involving highly standardized terms and the major currencies (e.g., the U.S. dollar or the euro) will generally have greater price transparency from published external sources even in maturity ranges beyond 20 years. Credit derivatives with highly standardized terms and liquid underlying reference instruments can have price transparency from published external sources in a maturity ranging up to 10 years, while equity and foreign exchange derivative products with standardized terms in major currencies can have price transparency from published external sources within a two-year maturity range. Commodity derivatives with standardized terms and delivery locations can have price transparency from published external sources within various maturity ranges up to 10 years, depending on the commodity. In most instances of limited price transparency based on published external sources, dealers in these markets, in their capacities as market-makers and liquidity providers, provide price transparency beyond the above maturity ranges.

 

Country Exposure.  The Company monitors its credit exposure and risk to individual countries. Credit exposure to a country arises from the Company’s lending activities and derivatives activities in a country. At November 30, 2004, less than 5% of the Company’s total credit exposure (including loans, lending commitments and derivative contracts) was to emerging markets, and no one emerging market country accounted for more than 1% of the Company’s total credit exposure. The Company defines emerging markets to include all countries that are not members of the Organization for Economic Co-operation and Development (“OECD”), excluding the Cayman Islands and the Channel Islands, and those OECD countries rated below “A” by Institutional Credit. These country credit ratings are derived using methodologies generally consistent with those employed by external rating agencies.

Industry Exposure.  The Company also monitors its credit exposure and risk to individual industries. At November 30, 2004, the Company’s material credit exposure (including loans, lending commitments and derivative contracts) was to financial institutions, sovereign-related entities and the energy sector.

Individual Investor Activities.    With respect to the Company’s Individual Investor Group, credit risk committees, composed of senior managers from various departments, monitor credit risk and exposure that originates from retail customers.    Customer margin accounts, the primary source of retail credit exposure, are collateralized in accordance with internal and regulatory guidelines. The Company monitors required margin levels and established credit limits daily and, pursuant to such guidelines, requires customers to deposit additional collateral, or reduce positions, when necessary. Factors considered in the review of all margin loans are the amount of the loan, the intended purpose, the degree of leverage being employed in the account, and overall evaluation of the portfolio to ensure proper diversification or, in the case of concentrated positions, possible hedging strategies. Additionally, all transactions relating to concentrated or restricted positions require a review of any legal impediments to liquidation of the underlying collateral. Underlying collateral for margin loans is reviewed with respect to the liquidity of the proposed collateral positions, historic trading range, volatility analysis and an evaluation of industry concentrations. At November 30, 2004, there were approximately $6.8 billion of customer margin loans outstanding. In addition, the Individual Investor Group is engaged in commercial lending to small businesses (“BusinesScape^SM”) in the forms of revolving lines of credit, standby letters of credit, term loans and owner occupied commercial real estate mortgages. BusinesScape clients are required to submit a formal credit application, including the borrower’s financial statements. Once the credit information is obtained, a comprehensive financial analysis is performed to determine proper structure, debt capacity, cash flow coverage to service debt, liquidity analysis and collateral analysis. In addition, financial reporting requirements and financial covenants are proposed and negotiated between the lender and the borrower.

 

Consumer Lending Activities.    With respect to its consumer lending activities, potential credit card holderscardholders undergo credit reviews by the Credit Department of Discover Financial Services to establish that they meet standards of ability and willingness to pay. Credit card applications are evaluated using scoring models (statistical evaluation models) based on information obtained from applicants and credit bureaus. The Company’s credit scoring systems include both industry and customized models using the Company’s criteria and historical data. Each cardmember’s credit line is reviewed at least annually, and actions resulting from such review may include raising or lowering a cardmember’s credit line or closing the account. In addition, the Company, on a portfolio basis, performs periodic monitoring and review of consumer behavior and risk profiles. The Company

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also reviews the creditworthiness of prospective Discover Business ServicesNetwork merchants and conducts annual reviews of merchants, with the greatest scrutiny given to merchants with substantial sales volume. With respect to first mortgages and home equity lines of credit (“mortgage lending”), a credit process is adopted within a framework of credit underwriting policies, together with industry standard credit scoring models (e.g., FICO scores). The Company’s underwriting policy is designed to ensure that all loans pass a capacity, willingness and collateral value model that, in addition to a FICO score, includes debt ratios, loan-to-collateral value ratios, and independent third-party appraisal/valuations and ownership reports. As part of the mortgage lending business strategy, almost all loans are sold in the secondary market through securitizations and home loan sales. These sales and securitizations pass the risk of credit loss onto the purchaser/investor. For further information on the Company’s consumer loans, see Note 5 to the consolidated financial statements.

 

Operational Risk.

 

Operational risk refers generally to the risk of loss resulting fromthat inadequate or failed internal processes, personnel resources and/or systems will result in losses to the Company’s operations, including, but not limitedbusiness. Operational risk also refers to improperthe risk that external events, such as external changes, failures or unauthorized execution and processing of transactions, deficienciesfrauds, will result in losses to the Company’s operating systems, inadequacies or breaches in the Company’s control processes and business interruptions.business. The Company performs the functions required to operate its different businesses either by itself or through agreements with third parties. The Company relies on the ability of its employees, its internal systems and systems at technology centers operated by third parties to process high numbers of transactions. These transactions may cross multiple markets and involve different currencies. In the event of a breakdown or improper operation of the Company’s or third-party’s systems or improper action by third parties or employees, the Company could suffer financial loss, regulatory sanctions and damage to its reputation.

 

79In light of the pervasiveness of operational risk and the diversity and complexity of that risk as experienced by the individual business segments, Control Groups and other supporting functions, the Company manages operational risk through a combination of line management and Company-wide oversight responsibilities. As part of the Company’s line management structure for operational risk, each business segment has a designated Operational Risk Manager. In addition, business segment risk committees review operational risk matters and/or reports on a regular basis. Each Control Group and supporting function also has a designated Operational Risk Coordinator and a regular forum for discussing operational risk matters and/or reports with senior management within the area.

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The Company has developed and continues to enhance specific policies and procedures that are designed to identify and manage operational risk at appropriate levels. For example, the Company’s securities businesses have procedures that require: that all transactions are accurately recorded and properly reflected in the Company’s books and that records and are confirmed on a timely basis; that position valuations are subject to periodic independent review procedures; and that collateral and adequate documentation are obtained from counterparties in appropriate circumstances. With respect to its investment management activities, the Company manages operational risk related to its various data processing systems through, among other things, internal controls such as reconciliations and various backup procedures. With respect to its consumer lending activities, the Company manages operational risk through its system of internal controls that provides checks and balances to ensure that transactions and other account-related activity (e.g., new account solicitation, transaction authorization and processing, billing and collection of delinquent accounts) are properly approved, processed, recorded and reconciled. The Company also uses periodic self-assessments and Internal Audit reviews as a further check on operational risk. As new products and business activities are developed and as processes are designed and modified, operational risks are identified and control requirements are defined to mitigate the identified risks. These controls include the following range of risk categories: (i) internal fraud; (ii) external fraud; (iii) employment practices and workplace safety; (iv) clients, products and business practices; (v) damage to physical assets; (vi) business disruptions and system failures; and (vii) execution, delivery and process management.

 

Disaster recovery plans are in place for critical facilities and resources on a Company-wide basis, and redundancies are built into the systems as deemed appropriate. The key components of the Company’s disaster

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recovery plans include: crisis management; data and applications recovery; work area recovery; and other elements addressing management, analysis and training. The Company has also established policies, procedures and technologies to protect its computer and other assets from unauthorized access. Through organizations promoting information security, such as the Financial Services Information Sharing Analysis Center and various other resources focused on information security, the Company continues to enhance its ability to detect and defend against cyber threats.

 

The Company also utilizes the services of various external vendors whothat provide services in connection with the Company’s ongoing operations. These may include, for example, outsourced processing and support functions and consulting and other professional services. The Company manages its exposures to the quality of these services through a variety of means, including service level and other contractual agreements, service and quality reviews, and ongoing monitoring of the vendors’ performance. It is anticipated that the use of these services will continue and possibly increase in the future.

 

Legal Risk.

 

Legal risk includes 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. The Company is generally subject to extensive regulation in the different jurisdictions in which it conducts its business (see “Business—Regulation” in Part I, Item 1). The Company has established procedures based on legal and regulatory requirements on a worldwide basis that are designed to foster compliance with applicable statutory and regulatory requirements. The Company, principally through the Law Division, also has established procedures that are designed to require that the Company’s policies relating to conduct, ethics and business practices are followed globally. In connection with its businesses, the Company has and continuously develops various procedures addressing issues such as regulatory capital requirements, sales and trading practices, new products, potential conflicts of interest, structured transactions, use and safekeeping of customer funds and securities, credit granting, collection activities, money-laundering, privacy and recordkeeping. In addition, the Company has established procedures to mitigate the risk that a counterparty’s performance obligations will be unenforceable, including consideration of counterparty legal authority and capacity, adequacy of legal documentation, the permissibility of a transaction under applicable law and whether applicable bankruptcy or insolvency laws limit or alter contractual remedies. The current legal and regulatory focus on the financial services industry presents a continuing business challenge for the Company.

 

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98

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Item 8.

Financial Statements and Supplementary Data.

Item 8. Financial Statements and Supplementary Data.

REPORT OF INDEPENDENT AUDITORS’ REPORTREGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of

Morgan Stanley:

 

We have audited the accompanying consolidated statements of financial condition of Morgan Stanley and subsidiaries (the “Company”) as of fiscal years ended November 30, 20032004 and 2002,2003, and the related consolidated statements of income, comprehensive income, cash flows and changes in shareholders’ equity for each of the three fiscal years in the period ended November 30, 2003.2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditingthe standards generally accepted inof the United States of America.Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the accompanyingsuch consolidated financial statements present fairly, in all material respects, the consolidated financial position of Morgan Stanley and subsidiaries at fiscal years endedas of November 30, 2004 and 2003, and 2002, and the consolidated results of their operations and their cash flows for each of the three fiscal years in the period ended November 30, 2003,2004, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 14, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123,” in 2003.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of November 30, 2004, based on the criteria established in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 7, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

New York, New York

February 23, 20047, 2005

 

81

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MORGAN STANLEY

 

Consolidated Statements of Financial Condition

(dollars in millions, except share data)

 

		November 30, 2003			November 30, 2002			November 30, 2004			November 30, 2003
Assets
Cash and cash equivalents		$	29,692		$	29,212		$	32,811		$	29,692
Cash and securities deposited with clearing organizations or segregated under federal and other regulations (including securities at fair value of $18,957 in 2003 and $27,721 in 2002)			28,526			38,411
Financial instruments owned (approximately $73 billion and $71 billion were pledged to various parties in 2003 and 2002, respectively):
Cash and securities deposited with clearing organizations or segregated under federal and other regulations (including securities at fair value of $27,219 in 2004 and $18,957 in 2003)									36,742			28,526
Financial instruments owned (approximately $91 billion and $73 billion were pledged to various parties at November 30, 2004 and November 30, 2003, respectively):
U.S. government and agency securities			24,133			32,474			26,201			24,133
Other sovereign government obligations			21,592			27,694			19,782			21,592
Corporate and other debt			80,594			55,254			80,336			80,594
Corporate equities			29,984			21,996			28,157			30,180
Derivative contracts			44,652			35,615			67,092			44,652
Physical commodities			671			355			1,224			671
Total financial instruments owned									222,792			201,822
Securities purchased under agreements to resell			78,205			76,910			123,041			78,205
Securities received as collateral			27,278			12,200			37,848			27,278
Securities borrowed			153,813			130,404			208,349			153,813
Receivables:
Consumer loans (net of allowances of $1,002 in 2003 and $928 in 2002)			19,382			23,014
Consumer loans (net of allowances of $943 in 2004 and $1,002 in 2003)									20,226			19,382
Customers, net			37,321			22,262			57,841			37,321
Brokers, dealers and clearing organizations			5,563			2,250			12,707			5,563
Fees, interest and other			4,349			4,892			5,801			4,349
Office facilities, at cost (less accumulated depreciation of $2,506 in 2003 and $2,206 in 2002)			2,433			2,270
Aircraft under operating leases (less accumulated depreciation of $1,041 in 2003 and $769 in 2002)			4,407			4,849
Goodwill			1,514			1,449
Office facilities, at cost (less accumulated depreciation of $2,780 in 2004 and $2,506 in 2003)									2,605			2,433
Aircraft under operating leases (less accumulated depreciation of $1,174 in 2004 and $984 in 2003)									3,926			4,407
Goodwill and intangible assets									2,199			1,523
Other assets			8,734			7,988			8,522			8,529
Total assets		$	602,843		$	529,499		$	775,410		$	602,843

 

82

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MORGAN STANLEY

 

Consolidated Statements of Financial Condition—(Continued)

(dollars in millions, except share data)

 

		November 30, 2003				November 30, 2002				November 30, 2004				November 30, 2003
Liabilities and Shareholders’ Equity
Commercial paper and other short-term borrowings		$	28,386			$	50,789			$	36,303			$	28,386
Deposits			12,839				13,757				13,777				12,839
Financial instruments sold, not yet purchased:
U.S. government and agency securities			17,072				13,235				12,664				17,072
Other sovereign government obligations			17,505				11,679				14,787				17,505
Corporate and other debt			10,141				12,240				9,641				10,141
Corporate equities			25,615				18,320				27,332				25,615
Derivative contracts			36,242				28,985				55,820				36,242
Physical commodities			4,873				1,833				3,351				4,873
Total financial instruments sold, not yet purchased											123,595				111,448
Securities sold under agreements to repurchase			147,618				136,463				188,645				147,618
Obligation to return securities received as collateral			27,278				12,200				37,848				27,278
Securities loaned			64,375				43,229				97,146				64,375
Payables:
Customers			96,794				88,229				133,270				96,794
Brokers, dealers and clearing organizations			5,706				4,610				4,550				5,706
Interest and dividends			2,138				3,363				3,068				2,138
Other liabilities and accrued expenses			12,918				12,245				13,650				12,918
Long-term borrowings			65,600				55,161				95,286				65,600
			575,100				506,338				747,138				575,100
Capital Units			66				66				66				66
Preferred securities subject to mandatory redemption			2,810				1,210				—				2,810
Commitments and contingencies
Shareholders’ equity:
Common stock, $0.01 par value; Shares authorized: 3,500,000,000 in 2003 and 2002; Shares issued: 1,211,699,552 in 2003 and 1,211,685,904 in 2002; Shares outstanding: 1,084,696,446 in 2003 and 1,081,417,377 in 2002			12				12
Common stock, $0.01 par value; Shares authorized: 3,500,000,000 in 2004 and 2003; Shares issued: 1,211,701,552 in 2004 and 1,211,699,552 in 2003; Shares outstanding: 1,087,087,116 in 2004 and 1,084,696,446 in 2003											12				12
Paid-in capital			4,028				3,678				3,696				4,028
Retained earnings			28,038				25,250				31,426				28,038
Employee stock trust			3,008				3,003				3,824				3,008
Accumulated other comprehensive income (loss)			(156	)			(251	)			(56	)			(156	)
Subtotal			34,930				31,692				38,902				34,930
Note receivable related to ESOP			(4	)			(13	)			—				(4	)
Common stock held in treasury, at cost, $0.01 par value; 127,003,106 shares in 2003 and 130,268,527 shares in 2002			(6,766	)			(7,176	)
Common stock held in treasury, at cost, $0.01 par value; 124,614,436 shares in 2004 and 127,003,106 shares in 2003											(6,614	)			(6,766	)
Common stock issued to employee trust			(2,420	)			(2,618	)			(2,474	)			(2,420	)
Unearned stock-based compensation			(873	)			—				(1,608	)			(873	)
Total shareholders’ equity			24,867				21,885				28,206				24,867
Total liabilities and shareholders’ equity		$	602,843			$	529,499			$	775,410			$	602,843

 

See Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Income

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

 

		Fiscal Year											Fiscal Year
		2003			2002				2001				2004				2003				2002
Revenues:
Investment banking		$	2,440		$	2,478			$	3,413			$	3,341			$	2,440			$	2,478
Principal transactions:
Trading			6,138			2,730				5,503				5,525				6,192				3,479
Investments			86			(31	)			(316	)			512				86				(31	)
Commissions			2,970			3,278				3,159				3,264				2,887				3,191
Fees:
Asset management, distribution and administration			3,706			3,932				4,205				4,412				3,731				3,953
Merchant and cardmember			1,379			1,420				1,349				1,318				1,379				1,420
Servicing			2,015			2,080				1,888				1,993				2,015				2,080
Interest and dividends			15,744			15,879				24,132				18,590				15,744				15,879
Other			455			660				553				594				506				724
Total revenues			34,933			32,426				43,886				39,549				34,980				33,173
Interest expense			12,809			11,970				20,729				14,859				12,856				12,710
Provision for consumer loan losses			1,267			1,336				1,052				925				1,267				1,336
Net revenues			20,857			19,120				22,105				23,765				20,857				19,127
Non-interest expenses:
Compensation and benefits			8,545			7,940				9,376				9,880				8,545				7,940
Occupancy and equipment			794			825				881				849				794				825
Brokerage, clearing and exchange fees			838			779				712				932				838				779
Information processing and communications			1,288			1,375				1,455				1,310				1,288				1,375
Marketing and business development			967			1,105				1,249				1,129				967				1,105
Professional services			1,135			1,094				1,299				1,549				1,135				1,094
Other			1,523			1,047				1,449				1,431				1,485				1,036
Restructuring and other charges			—			235				—				—				—				235
Total non-interest expenses			15,090			14,400				16,421				17,080				15,052				14,389
Income before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and cumulative effect of accounting change			5,767			4,720				5,684
Income from continuing operations before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption														6,685				5,805				4,738
Losses from unconsolidated investees			279			77				30				328				279				77
Provision for income taxes			1,547			1,568				2,024				1,803				1,562				1,575
Dividends on preferred securities subject to mandatory redemption			154			87				50				45				154				87
Income before cumulative effect of accounting change			3,787			2,988				3,580
Cumulative effect of accounting change			—			—				(59	)
Income from continuing operations														4,509				3,810				2,999
Discontinued operations:
Loss from discontinued operations (including loss on disposal of $42 million in fiscal 2004)														(38	)			(38	)			(18	)
Income tax benefit														15				15				7
Loss on discontinued operations														(23	)			(23	)			(11	)
Net income		$	3,787		$	2,988			$	3,521			$	4,486			$	3,787			$	2,988
Preferred stock dividend requirements		$	—		$	—			$	32
Basic earnings per common share:
Income from continuing operations													$	4.17			$	3.54			$	2.77
Loss from discontinued operations														(0.02	)			(0.02	)			(0.01	)
Earnings applicable to common shares		$	3,787		$	2,988			$	3,489
Basic earnings per common share													$	4.15			$	3.52			$	2.76
Diluted earnings per common share:
Income from continuing operations													$	4.08			$	3.47			$	2.70
Loss from discontinued operations														(0.02	)			(0.02	)			(0.01	)
Earnings per common share:
Basic before cumulative effect of accounting change		$	3.52		$	2.76			$	3.26
Cumulative effect of accounting change			—			—				(0.05	)
Basic		$	3.52		$	2.76			$	3.21
Diluted before cumulative effect of accounting change		$	3.45		$	2.69			$	3.16
Cumulative effect of accounting change			—			—				(0.05	)
Diluted		$	3.45		$	2.69			$	3.11
Diluted earnings per common share													$	4.06			$	3.45			$	2.69
Average common shares outstanding:
Basic			1,076,754,740			1,083,270,783				1,086,121,508				1,080,121,708				1,076,754,740				1,083,270,783
Diluted			1,099,117,972			1,109,637,953				1,121,764,086				1,105,185,480				1,099,117,972				1,109,637,953

 

See Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Comprehensive Income

(dollars in millions)

 

		Fiscal Year												Fiscal Year
		2003				2002				2001				2004				2003				2002
Net income		$	3,787			$	2,988			$	3,521			$	4,486			$	3,787			$	2,988
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment			78				30				(59	)			76				78				30
Cumulative effect of accounting change			—				—				(13	)
Net change in cash flow hedges			26				—				(99	)			26				26				—
Minimum pension liability adjustment			(9	)			(19	)			—				(2	)			(9	)			(19	)
Comprehensive income		$	3,882			$	2,999			$	3,350			$	4,586			$	3,882			$	2,999

 

 

 

See Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Cash Flows

(dollars in millions)

 

		Fiscal Year												Fiscal Year
		2003				2002				2001				2004				2003				2002
CASH FLOWS FROM OPERATING ACTIVITIES
Net income		$	3,787			$	2,988			$	3,521			$	4,486			$	3,787			$	2,988
Adjustments to reconcile net income to net cash provided by (used for) operating activities:
Loss on discontinued operations															23				23				11
Income from continuing operations															4,509				3,810				2,999
Adjustments to reconcile net income to net cash (used for) provided by operating activities:
Non-cash charges (credits) included in net income:
Cumulative effect of accounting change			—				—				59
Aircraft-related charges			323				74				87				107				288				70
Gain on sale of building and sale of self-directed online brokerage accounts			—				(125	)			—				—				—				(125	)
Deferred income taxes			205				55				(427	)			(195	)			211				43
Compensation payable in common stock and options			309				400				653				663				309				400
Depreciation and amortization			637				787				729				805				619				766
Provision for consumer loan losses			1,267				1,336				1,052				925				1,267				1,336
Restructuring and other charges			—				235				—				—				—				235
Changes in assets and liabilities:
Cash and securities deposited with clearing organizations or segregated under federal and other regulations			9,885				7,915				2,311				(8,216	)			9,885				7,915
Financial instruments owned, net of financial instruments sold, not yet purchased			(4,256	)			(15,380	)			(16,288	)			(11,522	)			(4,452	)			(15,528	)
Securities borrowed, net of securities loaned			(2,263	)			(3,193	)			(13,962	)			(21,765	)			(2,263	)			(3,193	)
Receivables and other assets			(16,347	)			5,321				(3,603	)			(26,876	)			(16,151	)			5,469
Payables and other liabilities			8,808				(5,426	)			693				37,059				8,833				(5,400	)
Net cash provided by (used for) operating activities			2,355				(5,013	)			(25,175	)
Net cash (used for) provided by operating activities															(24,506	)			2,356				(5,013	)
CASH FLOWS FROM INVESTING ACTIVITIES
Net (payments for) proceeds from:
Office facilities and aircraft under operating leases			(603	)			(1,124	)			(1,998	)			(569	)			(604	)			(1,124	)
Purchase of Quilter Holdings Limited, net of cash acquired			—				—				(183	)
Purchase of Barra, Inc., net of cash acquired															(758	)			—				—
Net principal disbursed on consumer loans			(8,498	)			(11,447	)			(7,479	)			(9,359	)			(8,498	)			(11,447	)
Sale of self-directed online brokerage accounts			—				98				—				—				—				98
Sales of consumer loans			10,864				6,777				9,148				7,590				10,864				6,777
Sale of office building			—				—				709
Net cash provided by (used for) investing activities			1,763				(5,696	)			197
Net cash (used for) provided by investing activities															(3,096	)			1,762				(5,696	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net (payments for) proceeds from:
Net proceeds from (payments for):
Short-term borrowings			(22,403	)			17,947				5,088				7,917				(22,403	)			17,947
Securities sold under agreements to repurchase, net of securities purchased under agreements to resell and certain derivatives financing activities			10,360				(8,524	)			21,839				(1,914	)			10,360				(8,524	)
Deposits			(918	)			1,481				346				938				(918	)			1,481
Net proceeds from:
Issuance of common stock			222				179				197				322				222				179
Issuance of put options			—				6				5				—				—				6
Issuance of long-term borrowings			21,486				11,043				18,498				37,601				21,486				11,043
Issuance of Preferred securities subject to mandatory redemption			2,000				—				810
Issuance of preferred securities subject to mandatory redemption															—				2,000				—
Payments for:
Repayments of long-term borrowings			(12,641	)			(6,472	)			(11,201	)			(11,915	)			(12,641	)			(6,472	)
Redemption of Preferred securities subject to mandatory redemption			(400	)			—				—
Redemption of preferred securities subject to mandatory redemption															—				(400	)			—
Redemption of cumulative preferred stock			—				(345	)			(200	)			—				—				(345	)
Redemption of Capital Units			—				—				(4	)
Repurchases of common stock			(350	)			(990	)			(1,583	)			(1,132	)			(350	)			(990	)
Cash dividends			(994	)			(1,000	)			(1,040	)			(1,096	)			(994	)			(1,000	)
Net cash (used for) provided by financing activities			(3,638	)			13,325				32,755
Net cash provided by (used for) financing activities															30,721				(3,638	)			13,325
Net increase in cash and cash equivalents			480				2,616				7,777				3,119				480				2,616
Cash and cash equivalents, at beginning of period			29,212				26,596				18,819				29,692				29,212				26,596
Cash and cash equivalents, at end of period		$	29,692			$	29,212			$	26,596			$	32,811			$	29,692			$	29,212

 

See Notes to Consolidated Financial Statements.

 

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Consolidated Statements of Changes in Shareholders’ Equity

(dollars in millions)

 

		Preferred Stock				Common Stock			Paid-in Capital				Retained Earnings				Employee Stock Trust				Accumulated Other Comprehensive Income (Loss)				Note Receivable Related to ESOP				Common Stock Held in Treasury at Cost				Common Stock Issued to Employee Trust				Unearned Stock-Based Compensation				Total
BALANCE AT NOVEMBER 30, 2000		$	545			$	12		$	3,377			$	20,802			$	3,042			$	(91	)		$	(44	)		$	(6,024	)		$	(2,348	)		$	—			$	19,271
Net income			—				—			—				3,521				—				—				—				—				—				—				3,521
Dividends			—				—			—				(1,053	)			—				—				—				—				—				—				(1,053	)
Redemption of 7- 3/4% Cumulative Preferred Stock			(200	)			—			—				—				—				—				—				—				—				—				(200	)
Issuance of common stock			—				—			(926	)			—				—				—				—				1,123				—				—				197
Issuance of put options			—				—			5				—				—				—				—				—				—				—				5
Exercise of put options			—				—			(12	)			—				—				—				—				12				—				—				—
Repurchases of common stock			—				—			—				—				—				—				—				(1,583	)			—				—				(1,583	)
Compensation payable in common stock			—				—			666				—				44				—				13				96				(166	)			—				653
Tax benefits associated with stock-based awards			—				—			460				—				—				—				—				—				—				—				460
Employee tax withholdings and other			—				—			175				—				—				—				—				(559	)			—				—				(384	)
Cumulative effect of accounting change and net change in cash flow hedges			—				—			—				—				—				(112	)			—				—				—				—				(112	)
Translation adjustments			—				—			—				—				—				(59	)			—				—				—				—				(59	)
																																													Preferred Stock				Common Stock			Paid-in Capital				Retained Earnings				Employee Stock Trust				Accumulated Other Comprehensive Income (Loss)				Note Receivable Related to ESOP				Common Stock Held in Treasury at Cost				Common Stock Issued to Employee Trust				Unearned Stock-Based Compensation				Total
BALANCE AT NOVEMBER 30, 2001			345				12			3,745				23,270				3,086				(262	)			(31	)			(6,935	)			(2,514	)			—				20,716			$	345			$	12		$	3,745			$	23,270			$	3,086			$	(262	)		$	(31	)		$	(6,935	)		$	(2,514	)		$	—			$	20,716
Net income			—				—			—				2,988				—				—				—				—				—				—				2,988				—				—			—				2,988				—				—				—				—				—				—				2,988
Dividends			—				—			—				(1,008	)			—				—				—				—				—				—				(1,008	)			—				—			—				(1,008	)			—				—				—				—				—				—				(1,008	)
Redemption of Cumulative Preferred Stock			(345	)			—			—				—				—				—				—				—				—				—				(345	)			(345	)			—			—				—				—				—				—				—				—				—				(345	)
Issuance of common stock			—				—			(868	)			—				—				—				—				1,047				—				—				179				—				—			(868	)			—				—				—				—				1,047				—				—				179
Issuance of put options			—				—			6				—				—				—				—				—				—				—				6				—				—			6				—				—				—				—				—				—				—				6
Exercise of put options			—				—			(5	)			—				—				—				—				5				—				—				—				—				—			(5	)			—				—				—				—				5				—				—				—
Repurchases of common stock			—				—			—				—				—				—				—				(990	)			—				—				(990	)			—				—			—				—				—				—				—				(990	)			—				—				(990	)
Compensation payable in common stock			—				—			486				—				(83	)			—				18				83				(104	)			—				400				—				—			486				—				(83	)			—				18				83				(104	)			—				400
Tax benefits associated with stock-based awards			—				—			282				—				—				—				—				—				—				—				282				—				—			282				—				—				—				—				—				—				—				282
Employee tax withholdings and other			—				—			32				—				—				—				—				(386	)			—				—				(354	)			—				—			32				—				—				—				—				(386	)			—				—				(354	)
Minimum pension liability adjustment			—				—			—				—				—				(19	)			—				—				—				—				(19	)			—				—			—				—				—				(19	)			—				—				—				—				(19	)
Translation adjustments			—				—			—				—				—				30				—				—				—				—				30				—				—			—				—				—				30				—				—				—				—				30
BALANCE AT NOVEMBER 30, 2002			—				12			3,678				25,250				3,003				(251	)			(13	)			(7,176	)			(2,618	)			—				21,885				—				12			3,678				25,250				3,003				(251	)			(13	)			(7,176	)			(2,618	)			—				21,885
Net income			—				—			—				3,787				—				—				—				—				—				—				3,787				—				—			—				3,787				—				—				—				—				—				—				3,787
Dividends			—				—			—				(999	)			—				—				—				—				—				—				(999	)			—				—			—				(999	)			—				—				—				—				—				—				(999	)
Issuance of common stock			—				—			(977	)			—				—				—				—				1,199				—				—				222				—				—			(977	)			—				—				—				—				1,199				—				—				222
Repurchases of common stock			—				—			—				—				—				—				—				(350	)			—				—				(350	)			—				—			—				—				—				—				—				(350	)			—				—				(350	)
Compensation payable in common stock and options			—				—			923				—				5				—				16				40				198				(873	)			309				—				—			923				—				5				—				16				40				198				(873	)			309
Tax benefits associated with stock-based awards			—				—			333				—				—				—				—				—				—				—				333				—				—			333				—				—				—				—				—				—				—				333
Employee tax withholdings and other			—				—			71				—				—				—				(7	)			(479	)			—				—				(415	)			—				—			71				—				—				—				(7	)			(479	)			—				—				(415	)
Net change in cash flow hedges			—				—			—				—				—				26				—				—				—				—				26				—				—			—				—				—				26				—				—				—				—				26
Minimum pension liability adjustment			—				—			—				—				—				(9	)			—				—				—				—				(9	)			—				—			—				—				—				(9	)			—				—				—				—				(9	)
Translation adjustments			—				—			—				—				—				78				—				—				—				—				78				—				—			—				—				—				78				—				—				—				—				78
BALANCE AT NOVEMBER 30, 2003		$	—			$	12		$	4,028			$	28,038			$	3,008			$	(156	)		$	(4	)		$	(6,766	)		$	(2,420	)		$	(873	)		$	24,867				—				12			4,028				28,038				3,008				(156	)			(4	)			(6,766	)			(2,420	)			(873	)			24,867
Net income																																														—				—			—				4,486				—				—				—				—				—				—				4,486
Dividends																																														—				—			—				(1,098	)			—				—				—				—				—				—				(1,098	)
Issuance of common stock																																														—				—			(1,304	)			—				—				—				—				1,626				—				—				322
Repurchases of common stock																																														—				—			—				—				—				—				—				(1,132	)			—				—				(1,132	)
Compensation payable in common stock and options																																														—				—			563				—				816				—				4				69				(54	)			(735	)			663
Tax benefits associated with stock-based awards																																														—				—			331				—				—				—				—				—				—				—				331
Employee tax withholdings and other																																														—				—			78				—				—				—				—				(411	)			—				—				(333	)
Net change in cash flow hedges																																														—				—			—				—				—				26				—				—				—				—				26
Minimum pension liability adjustment																																														—				—			—				—				—				(2	)			—				—				—				—				(2	)
Translation adjustments																																														—				—			—				—				—				76				—				—				—				—				76
BALANCE AT NOVEMBER 30, 2004																																													$	—			$	12		$	3,696			$	31,426			$	3,824			$	(56	)		$	—			$	(6,614	)		$	(2,474	)		$	(1,608	)		$	28,206

 

See Notes to Consolidated Financial Statements.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.    Introduction and Basis of Presentation.

 

The Company.    Morgan Stanley (the “Company”) is a global financial services firm that maintains leading market positions in each of its business segments—Institutional Securities, Individual Investor Group, Investment Management and Credit Services. The Company’s Institutional Securities business includes securities underwriting and distribution; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; sales, trading, financing and market-making activities in equity securities and related products and fixed income securities and related products, including foreign exchange and commodities; principal investing and real estate investment management; aircraft financing activities.activities; providing benchmark indices and risk management analytics; and research. The Company’s Individual Investor Group business provides comprehensive financial planningbrokerage, investment and investment advisoryfinancial services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s financial advisors and investment representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s private equity activities also are included within the Investment Management business segment. The Company’s Credit Services business offers Discover^®-branded cards and other consumer finance products and services, including residential mortgage loans, and includes the operation of Discover Business Services,Network, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services business segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

 

Basis of Financial Information.    The consolidated financial statements for the 12 months ended November 30, 2004 (“fiscal 2004”), November 30, 2003 (“fiscal 2003”), and November 30, 2002 (“fiscal 2002”) and November 30, 2001 (“fiscal 2001”) are prepared in accordance with accounting principles generally accepted in the U.S., which require the Company to make estimates and assumptions regarding the valuations of certain financial instruments, consumer loan loss levels, the outcome of litigation, and other matters that affect the consolidated financial statements and related disclosures. The Company believes that the estimates utilized in the preparation of the consolidated financial statements are prudent and reasonable. Actual results could differ materially from these estimates.

 

The consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and other entities in which the Company has a controlling financial interest. The Company’s policy is to consolidate all entities in which it owns more than 50% of the outstanding voting stock unless it does not control the entity. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities” (“FIN 46”), for variable interests obtained after January 31, 2003,Entities,” as revised, the Company also consolidates any variable interest entities for which it is the primary beneficiary (see Note 19). For investments in companies in which the Company has significant influence over operating and financial decisions (generally defined as owning a voting or economic interest of 20% to 50%), the Company applies the equity method of accounting. In those cases where the Company’s investment is less than 20% and significant influence does not exist, such investments are carried at cost.

 

The Company’s U.S. and international subsidiaries include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley & Co. International Limited (“MSIL”), Morgan Stanley Japan Limited (“MSJL”), Morgan Stanley DW Inc. (“MSDWI”), Morgan Stanley Investment Advisors Inc. and NOVUS Credit Services Inc.

 

Certain reclassifications have been made to prior-year amounts to conform to the current year’s presentation. All material intercompany balances and transactions have been eliminated.

 

2.    SummaryDiscontinued Operations.    Revenues and expenses associated with certain aircraft designated as “held for sale” have been classified as discontinued operations for all periods presented in accordance with Statement of Significant Accounting Policies.

 

Consolidated Statements of Cash Flows.    For purposes of these statements, cash and cash equivalents consist of cash and highly liquid investments not held for resale with maturities, when purchased, of three months or less.

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MORGAN STANLEY

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

During fiscal 2003, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 149, “Amendment144, “Accounting for the Impairment or Disposal of Statement 133Long-Lived Assets.” See Note 25 for additional information on Derivative Instruments and Hedging Activities,” the Company modified its classification within the consolidated statement of cash flows of the activity associated with certain derivative financial instruments. The activity related to derivative financial instruments entered into or modified after June 30, 2003 and that have been determined to contain a financing element at inception where the Company is deemed the borrower is now included within “Cash flows from financing activities.” Prior to July 1, 2003, the activity associated with such derivative financial instruments is included within “Cash flows from operating activities.”discontinued operations.

 

In connection with the fiscal 2001 purchase2.    Summary of Quilter Holdings Limited (“Quilter”), the Company issued approximately $37 million of notes payable, including approximately $13 million of notes that are convertible into common shares of the Company.Significant Accounting Policies.

 

Revenue Recognition.

Investment Banking.    Underwriting revenues and fees for mergers, acquisitions and advisory assignments are recorded when services for the transactions are determined to be completed, generally as set forth under the terms of the engagement. Transaction-related expenses, primarily consisting of legal, travel and other costs directly associated with the transaction, are deferred to match revenue recognition. Underwriting revenues are presented net of related expenses. Non-reimbursed expenses associated with advisory transactions are recorded within Non-interest expenses.

Commissions.    The Company generates commissions from executing and clearing client transactions on stock, options and futures markets. Commission revenues are recorded in the accounts on trade date.

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees are recognized over the relevant contract period, generally quarterly or annually. In certain management fee arrangements, the Company is entitled to receive performance fees when the return on assets under management exceeds certain benchmark returns or other performance targets. Performance fee revenue is accrued quarterly based on measuring account/fund performance to date vs. the performance benchmark stated in the investment management agreement.

Merchant and Cardmember Fees.    Merchant and cardmember fees include revenues from fees charged to merchants on credit card sales, as well as charges to cardmembers for late payment fees, overlimit fees, balance transfer fees, credit protection fees and cash advance fees, net of cardmember rewards. Merchant and cardmember fees are recognized as earned. Cardmember rewards include various reward programs, including the Cashback Bonus award program, pursuant to which the Company pays certain cardmembers a percentage of their purchase amounts based upon a cardmember’s level and type of purchases. The liability for cardmember rewards, included in Other liabilities and accrued expenses, is accrued at the time that qualified cardmember transactions occur and is calculated on an individual cardmember basis. In determining the liability for cardmember rewards, the Company considers estimated forfeitures based on historical account closure, charge-off and transaction activity. The Company records its Cashback Bonus award program as a reduction of Merchant and cardmember fees.