================================================================================
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 2002
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-11758
Morgan Stanley
(Exact Name of Registrant as Specified in its Charter)
-----------------
Delaware 36-3145972
(State of Incorporation) (I.R.S. Employer Identification No.)
1585 Broadway
New York, NY 10036
(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code: (212) 761-4000
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
As of June 30, 2002, there were 1,095,913,509 shares of the Registrant's
Common Stock, par value $.01 per share, outstanding.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
MORGAN STANLEY
INDEX TO QUARTERLY REPORT ON FORM 10-Q
Quarter Ended May 31, 2002
Page
----
Part I--Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Financial Condition--May 31, 2002 (unaudited) and
November 30, 2001........................................................................ 1
Condensed Consolidated Statements of Income (unaudited)--Three and Six Months Ended
May 31, 2002 and 2001.................................................................... 2
Condensed Consolidated Statements of Comprehensive Income (unaudited)--Three and Six
Months Ended May 31, 2002 and 2001....................................................... 3
Condensed Consolidated Statements of Cash Flows (unaudited)--Six Months Ended May 31,
2002 and 2001............................................................................ 4
Notes to Condensed Consolidated Financial Statements (unaudited)........................... 5
Independent Accountants' Report............................................................ 20
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 21
Item 3. Quantitative and Qualitative Disclosures About Market Risk............................ 46
Part II--Other Information
Item 1. Legal Proceedings..................................................................... 49
Item 2. Changes in Securities and Use of Proceeds............................................. 50
Item 4. Submission of Matters to a Vote of Security Holders................................... 50
Item 6. Exhibits and Reports on Form 8-K...................................................... 50
i
Item 1.
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in millions, except share data)
May 31, November 30,
2002 2001
----------- ------------
(unaudited)
ASSETS
Cash and cash equivalents........................................................................... $ 22,212 $ 26,596
Cash and securities deposited with clearing organizations or segregated under federal and other
regulations (including securities at fair value of $36,181 at May 31, 2002 and $36,146 at November
30, 2001).......................................................................................... 46,127 46,326
Financial instruments owned (approximately $97 billion at May 31, 2002 and $74 billion at November
30, 2001 were pledged to various parties):
U.S. government and agency securities............................................................. 43,775 25,696
Other sovereign government obligations............................................................ 30,457 22,039
Corporate and other debt.......................................................................... 53,269 47,607
Corporate equities................................................................................ 22,948 23,143
Derivative contracts.............................................................................. 30,117 32,078
Physical commodities.............................................................................. 909 285
Securities purchased under agreements to resell..................................................... 79,826 54,618
Securities provided as collateral................................................................... 12,329 13,163
Securities borrowed................................................................................. 144,273 120,758
Receivables:
Consumer loans (net of allowances of $899 at May 31, 2002 and $847 at November 30, 2001).......... 20,422 20,108
Customers, net.................................................................................... 20,747 22,188
Brokers, dealers and clearing organizations....................................................... 4,044 6,462
Fees, interest and other.......................................................................... 6,062 5,283
Office facilities, at cost (less accumulated depreciation and amortization of $2,387 at May 31,
2002 and $2,124 at November 30, 2001).............................................................. 2,675 2,579
Aircraft under operating leases (less accumulated depreciation of $621 at May 31, 2002 and $479 at
November 30, 2001)................................................................................. 4,906 4,753
Goodwill............................................................................................ 1,441 1,438
Other assets........................................................................................ 7,385 7,508
-------- --------
Total assets........................................................................................ $553,924 $482,628
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Commercial paper and other short-term borrowings.................................................... $ 43,028 $ 32,842
Deposits............................................................................................ 13,337 12,276
Financial instruments sold, not yet purchased:
U.S. government and agency securities............................................................. 20,627 17,203
Other sovereign government obligations............................................................ 18,407 10,906
Corporate and other debt.......................................................................... 12,437 9,125
Corporate equities................................................................................ 19,298 13,046
Derivative contracts.............................................................................. 24,698 27,286
Physical commodities.............................................................................. 2,138 2,044
Securities sold under agreements to repurchase...................................................... 148,710 122,695
Obligation to return securities received as collateral.............................................. 12,329 13,163
Securities loaned................................................................................... 39,197 36,776
Payables:
Customers......................................................................................... 101,074 93,719
Brokers, dealers and clearing organizations....................................................... 5,031 4,331
Interest and dividends............................................................................ 3,619 2,761
Other liabilities and accrued expenses.............................................................. 11,997 12,795
Long-term borrowings................................................................................ 55,445 49,668
-------- --------
531,372 460,636
-------- --------
Capital Units....................................................................................... 66 66
-------- --------
Preferred Securities Subject to Mandatory Redemption................................................ 1,210 1,210
-------- --------
Commitments and contingencies
Shareholders' equity:
Preferred stock................................................................................... -- 345
Common stock ($0.01 par value, 3,500,000,000 shares authorized, 1,211,685,904 and 1,211,685,904
shares issued, 1,097,109,821 and 1,093,006,744 shares outstanding at May 31, 2002 and November
30, 2001, respectively)......................................................................... 12 12
Paid-in capital................................................................................... 3,670 3,745
Retained earnings................................................................................. 24,408 23,270
Employee stock trust.............................................................................. 2,980 3,086
Accumulated other comprehensive income (loss)..................................................... (212) (262)
-------- --------
Subtotal........................................................................................ 30,858 30,196
Note receivable related to ESOP................................................................... (29) (31)
Common stock held in treasury, at cost ($0.01 par value, 114,576,083 and 118,679,160 shares at
May 31, 2002 and November 30, 2001, respectively)............................................... (6,573) (6,935)
Common stock issued to employee trust............................................................. (2,980) (2,514)
-------- --------
Total shareholders' equity...................................................................... 21,276 20,716
-------- --------
Total liabilities and shareholders' equity.......................................................... $553,924 $482,628
======== ========
See Notes to Condensed Consolidated Financial Statements.
1
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(dollars in millions, except share and per share data)
Three Months Ended May 31, Six Months Ended May 31,
------------------------------ -----------------------------
2002 2001 2002 2001
-------------- -------------- -------------- --------------
(unaudited) (unaudited)
Revenues:
Investment banking................................... $ 655 $ 840 $ 1,339 $ 1,821
Principal transactions:
Trading.......................................... 704 2,070 1,826 3,755
Investments...................................... (16) (107) 17 (153)
Commissions.......................................... 900 838 1,677 1,689
Fees:
Asset management, distribution and
administration.................................. 1,054 1,074 2,070 2,183
Merchant and cardmember.......................... 359 325 700 638
Servicing........................................ 511 476 1,052 903
Interest and dividends............................... 3,874 6,950 7,706 14,186
Other................................................ 108 139 302 264
-------------- -------------- -------------- --------------
Total revenues................................... 8,149 12,605 16,689 25,286
Interest expense..................................... 2,844 6,406 5,780 12,578
Provision for consumer loan losses................... 340 231 685 444
-------------- -------------- -------------- --------------
Net revenues..................................... 4,965 5,968 10,224 12,264
-------------- -------------- -------------- --------------
Non-interest expenses:
Compensation and benefits........................ 2,234 2,732 4,722 5,571
Occupancy and equipment.......................... 210 230 410 448
Brokerage, clearing and exchange fees............ 176 177 355 344
Information processing and communications........ 335 368 655 720
Marketing and business development............... 259 331 510 697
Professional services............................ 250 336 475 670
Other............................................ 254 322 503 642
-------------- -------------- -------------- --------------
Total non-interest expenses................... 3,718 4,496 7,630 9,092
-------------- -------------- -------------- --------------
Income before income taxes, dividends on preferred
securities subject to mandatory redemption and
cumulative effect of accounting change.............. 1,247 1,472 2,594 3,172
Provision for income taxes........................... 428 535 905 1,153
Dividends on preferred securities subject to
mandatory redemption................................ 22 7 44 14
-------------- -------------- -------------- --------------
Income before cumulative effect of accounting
change.............................................. 797 930 1,645 2,005
Cumulative effect of accounting change............... -- -- -- (59)
-------------- -------------- -------------- --------------
Net income........................................... $ 797 $ 930 $ 1,645 $ 1,946
============== ============== ============== ==============
Preferred stock dividend requirements................ $ -- $ 9 $ -- $ 18
============== ============== ============== ==============
Earnings applicable to common shares................. $ 797 $ 921 $ 1,645 $ 1,928
============== ============== ============== ==============
Earnings per common share:
Basic before cumulative effect of accounting
change.......................................... $ 0.73 $ 0.85 $ 1.52 $ 1.83
Cumulative effect of accounting change........... -- -- -- (0.05)
-------------- -------------- -------------- --------------
Basic............................................ $ 0.73 $ 0.85 $ 1.52 $ 1.78
============== ============== ============== ==============
Diluted before cumulative effect of accounting
change.......................................... $ 0.72 $ 0.82 $ 1.48 $ 1.76
Cumulative effect of accounting change........... -- -- -- (0.05)
-------------- -------------- -------------- --------------
Diluted.......................................... $ 0.72 $ 0.82 $ 1.48 $ 1.71
============== ============== ============== ==============
Average common shares outstanding
Basic............................................ 1,084,993,202 1,085,305,558 1,084,223,242 1,087,205,706
============== ============== ============== ==============
Diluted.......................................... 1,113,949,482 1,120,687,197 1,113,925,043 1,127,129,224
============== ============== ============== ==============
See Notes to Condensed Consolidated Financial Statements.
2
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in millions)
Three Months Six Months
Ended Ended
May 31, May 31,
----------- -------------
2002 2001 2002 2001
---- ---- ------ ------
(unaudited) (unaudited)
Net income ................................... $797 $930 $1,645 $1,946
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment.... 25 (33) 17 (51)
Cumulative effect of accounting change..... -- -- -- (13)
Net change in cash flow hedges............. 26 13 33 (47)
---- ---- ------ ------
Comprehensive income.......................... $848 $910 $1,695 $1,835
==== ==== ====== ======
See Notes to Condensed Consolidated Financial Statements.
3
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in millions)
Six Months Ended May 31,
-----------------------
2002 2001
-------- --------
(unaudited)
Cash flows from operating activities:
Net income........................................................................... $ 1,645 $ 1,946
Adjustments to reconcile net income to net cash used for operating activities:
Non-cash charges included in net income:
Gain on sale of building........................................................ 73 --
Cumulative effect of accounting change.......................................... -- 59
Other non-cash charges included in net income................................... 1,146 937
Changes in assets and liabilities:
Cash and securities deposited with clearing organizations or segregated under
federal and other regulations................................................... 199 2,967
Financial instruments owned, net of financial instruments sold, not yet purchased. (12,677) (19,063)
Securities borrowed, net of securities loaned..................................... (21,094) (22,523)
Receivables and other assets...................................................... 3,499 (2,180)
Payables and other liabilities.................................................... 8,041 (4,609)
-------- --------
Net cash used for operating activities............................................... (19,168) (42,466)
-------- --------
Cash flows from investing activities:
Net (payments for) proceeds from:
Office facilities and aircraft under operating leases............................. (634) (819)
Purchase of Quilter Holdings Limited, net of cash acquired........................ -- (183)
Net principal disbursed on consumer loans......................................... (3,784) (6,783)
Sales of consumer loans........................................................... 2,787 7,112
-------- --------
Net cash used for investing activities............................................... (1,631) (673)
-------- --------
Cash flows from financing activities:
Net proceeds from short-term borrowings............................................. 10,186 18,348
Securities sold under agreements to repurchase, net of securities purchased under
agreements to resell.............................................................. 807 24,966
Net proceeds from:
Deposits.......................................................................... 1,061 576
Issuance of common stock.......................................................... 125 139
Issuance of put options........................................................... 6 5
Issuance of long-term borrowings.................................................. 9,841 16,162
Payments for:
Repurchases of common stock....................................................... (473) (994)
Repayments of long-term borrowings................................................ (4,291) (7,263)
Redemption of cumulative preferred stock.......................................... (345) --
Cash dividends.................................................................... (502) (523)
-------- --------
Net cash provided by financing activities............................................ 16,415 51,416
-------- --------
Net (decrease) increase in cash and cash equivalents................................. (4,384) 8,277
Cash and cash equivalents, at beginning of period.................................... 26,596 18,819
-------- --------
Cash and cash equivalents, at end of period.......................................... $ 22,212 $ 27,096
======== ========
See Notes to Condensed Consolidated Financial Statements.
4
MORGAN STANLEY
NOTES TO CONDENSED 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 three business
segments--Securities, Investment Management and Credit Services. The Company's
Securities business includes securities underwriting and distribution;
financial advisory services, including advice on mergers and acquisitions,
restructurings, real estate and project finance; full-service brokerage
services; 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,
including private equity activities; and aircraft financing activities. 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
Credit Services business includes the issuance of the Discover(R) Classic Card,
the Discover Gold Card, the Discover Platinum Card, the Morgan Stanley Card/SM/
and other proprietary general purpose credit cards; and the operation of
Discover Business Services, a proprietary network of merchant and cash access
locations in the U.S.
In June 2002, the Company's name changed from "Morgan Stanley Dean Witter &
Co." to "Morgan Stanley."
Basis of Financial Information
The condensed consolidated financial statements include the accounts of the
Company, its wholly-owned subsidiaries and other entities in which the Company
has a controlling financial interest. In determining whether to consolidate an
entity, the Company considers, among other factors, the nature and extent of
the Company's ownership and financial interests and other attributes of
control. 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.
The condensed consolidated financial statements are prepared in accordance
with accounting principles generally accepted in the U.S., which require the
Company to make estimates and assumptions regarding the valuations of certain
financial instruments, consumer loan loss levels, the potential outcome of
litigation and other matters that affect the condensed consolidated financial
statements and related disclosures. The Company believes that the estimates
utilized in the preparation of the condensed consolidated financial statements
are prudent and reasonable. Actual results could differ materially from these
estimates.
Certain reclassifications have been made to prior year amounts to conform to
the current presentation. All material intercompany balances and transactions
have been eliminated.
The condensed consolidated financial statements should be read in
conjunction with the Company's consolidated financial statements and notes
thereto included in the Company's Annual Report on Form 10-K for the fiscal
year ended November 30, 2001 (the "Form 10-K"). The condensed consolidated
financial statements reflect all adjustments (consisting only of normal
recurring adjustments) that are, in the opinion of management, necessary for
the fair statement of the results for the interim period. The results of
operations for interim periods are not necessarily indicative of results for
the entire year.
Financial instruments, including derivatives and loan products, used in the
Company's trading activities are recorded at fair value, and unrealized gains
and losses are reflected in principal trading revenues. Interest and dividend
revenue and interest expense arising from financial instruments used in trading
activities are reflected in
5
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
the condensed consolidated statements of income as interest and dividend
revenue or interest expense. The fair values of trading positions generally are
based on listed market prices. If listed market prices are not available or if
the liquidation of the Company's positions would reasonably be expected to
impact market prices, fair value is determined based on other relevant factors,
including dealer price quotations and price quotations for similar instruments
traded in different markets, including markets located in different geographic
areas. Fair values for certain derivative contracts are derived from pricing
models that consider current market and contractual prices for the underlying
financial instruments or commodities, as well as time value and yield curve or
volatility factors underlying the positions. To the extent financial
instruments have extended maturity dates, the Company's estimates of fair value
may involve greater subjectivity due to the lack of transparent market data
available upon which to base modeling assumptions. Purchases and sales of
financial instruments, as well as commission revenues and related expenses, are
recorded in the accounts on trade date. Unrealized gains and losses arising
from the Company's dealings in over-the-counter ("OTC") financial instruments,
including derivative contracts related to financial instruments and
commodities, are presented in the accompanying condensed consolidated
statements of financial condition on a net-by-counterparty basis, when
appropriate.
Equity securities purchased in connection with private equity and other
principal investment activities initially are carried in the condensed
consolidated financial statements at their original costs. The carrying value
of such equity securities is adjusted when changes in the underlying fair
values are readily ascertainable, generally as evidenced by listed market
prices or transactions that directly affect the value of such equity
securities. Downward adjustments relating to such equity securities are made in
the event that the Company determines that the eventual realizable value is
less than the carrying value. Investments made in connection with principal
real estate activities that do not involve equity securities, primarily
comprised of general partnership and limited partnership interests in real
estate funds sponsored by the Company, are included within other assets in the
Company's condensed consolidated statements of financial condition. Such
investments are recorded at fair value, based upon independent appraisals of
the funds' underlying real estate assets, estimates prepared by the Company of
discounted future cash flows of the underlying real estate assets or other
indicators of fair value.
The Company enters into various derivative financial instruments for
non-trading purposes. These instruments include interest rate swaps, foreign
currency swaps, equity swaps and foreign exchange forwards. The Company uses
interest rate and currency swaps and equity derivatives to manage interest
rate, currency and equity price risk arising from certain borrowings. The
Company also utilizes interest rate swaps to match the repricing
characteristics of consumer loans with those of the borrowings that fund these
loans. Certain of these derivative financial instruments are designated and
qualify as fair value hedges and cash flow hedges in accordance with Statement
of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities," as amended. The Company's designated fair
value hedges consist primarily of hedges of fixed rate borrowings, and its
designated cash flow hedges consist primarily of hedges of floating rate
borrowings. For qualifying fair value hedges, the changes in the fair value of
the derivative and the gain or loss on the hedged asset or liability relating
to the risk being hedged are recorded currently in earnings. These amounts are
recorded in interest expense and provide offset of one another. For qualifying
cash flow hedges, the changes in the fair value of the derivative are recorded
in accumulated other comprehensive income, net of tax effects, and amounts in
accumulated other comprehensive income are reclassified into earnings in the
same period or periods during which the hedged transaction affects earnings.
Ineffectiveness relating to fair value and cash flow hedges, if any, is
recorded within interest expense. The impact of hedge ineffectiveness on the
Company's condensed consolidated statements of income was not material for all
periods presented.
The Company also utilizes foreign exchange forward contracts to manage the
currency exposure relating to its net monetary investments in non-U.S. dollar
functional currency operations. The gain or loss from revaluing these contracts
is deferred and reported within accumulated other comprehensive income in
shareholders' equity, net of tax effects, with the related unrealized amounts
due from or to counterparties included in receivables from
6
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
or payables to brokers, dealers and clearing organizations. The interest
elements (forward points) on these foreign exchange forward contracts are
recorded in earnings.
The Company engages in securitization activities related to commercial and
residential mortgage loans, corporate bonds and loans, credit card loans and
other types of financial assets. The Company may retain interests in the
securitized financial assets as one or more tranches of the securitization, an
undivided seller's interest, cash collateral accounts, servicing rights, and
rights to any excess cash flows remaining after payments to investors in the
securitization trusts of their contractual rate of return and reimbursement of
credit losses. The exposure to credit losses from securitized loans is limited
to the Company's retained contingent risk, which represents the Company's
retained interest in securitized loans, including any credit enhancement
provided. 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, and each
subsequent transfer in revolving structures, allocated between the assets sold
and the retained interests based upon their respective fair values at the date
of sale. To obtain fair values, quoted market prices are used if available.
However, quoted market prices are generally not available for retained
interests, so the Company estimates fair value based on the present value of
expected future cash flows using its best estimates of the key assumptions,
including forecasted credit losses, payment rates, forward yield curves and
discount rates commensurate with the risks involved. The present value of
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, with actual net
servicing revenues continuing to be recognized in income as they are earned.
Retained interests in credit card asset securitizations associated with the
Company's Credit Services business were approximately $8.3 billion at May 31,
2002 (see Note 5). Retained interests in securitized financial assets
associated with the Company's Securities business were approximately $343
million at May 31, 2002. These retained interests are included in the condensed
consolidated statements of financial condition at fair value. Any changes in
the fair value of such retained interests are recognized in the condensed
consolidated statements of income. For the six months ended May 31, 2002, the
aggregate cash proceeds from securitizations were approximately $12 billion.
2. Cumulative Effect of Accounting Change.
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, which established accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, and for hedging activities. In June 1999, the FASB issued SFAS No.
137, "Accounting for Derivative Instruments and Hedging Activities--Deferral of
the Effective Date of FASB Statement No. 133," which deferred the effective
date of SFAS No. 133 for one year to fiscal years beginning after June 15,
2000. In June 2000, the FASB issued SFAS No. 138, "Accounting for Certain
Derivative Instruments and Certain Hedging Activities--an amendment of FASB
Statement No. 133." The Company adopted SFAS No. 133, as amended by SFAS No.
138, effective December 1, 2000. The Company recorded an after-tax charge to
net income from the cumulative effect of the adoption of SFAS No. 133, as
amended, of $59 million and an after-tax decrease to accumulated other
comprehensive income of $13 million. The Company's adoption of SFAS No. 133, as
amended, affects the accounting for, among other things, the Company's hedging
strategies, including those associated with certain financing activities.
3. Goodwill.
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." SFAS No. 142 no longer permits the amortization of goodwill and
indefinite-lived intangible assets. Instead, these assets must be reviewed
annually (or more frequently under certain conditions) for impairment.
Intangible assets that do not have indefinite lives will continue to be
amortized over their useful lives and reviewed for impairment. The
7
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Company early adopted the provisions of SFAS No. 142, and therefore
discontinued the amortization of goodwill effective December 1, 2001. During
the quarter ended May 31, 2002, the Company completed the initial transitional
goodwill impairment test, which did not indicate any goodwill impairment and
therefore did not have an effect on the Company's consolidated financial
condition or results of operations.
The following table presents a reconciliation of reported net income and
earnings per share to the amounts adjusted for the exclusion of goodwill
amortization, net of the related income tax effect:
Three Months Ended Six Months Ended
May 31, May 31,
------------------ ---------------
2002 2001 2002 2001
----- ----- ------ ------
(dollars in millions, except per share
amounts)
Net Income
Income before cumulative effect of accounting change.. $ 797 $ 930 $1,645 $2,005
Add: Goodwill amortization, net of tax................ -- 21 -- 38
----- ----- ------ ------
797 951 1,645 2,043
Cumulative effect of accounting change................ -- -- -- (59)
----- ----- ------ ------
Adjusted.............................................. $ 797 $ 951 $1,645 $1,984
===== ===== ====== ======
Basic earnings per common share
Basic before cumulative effect of accounting change... $0.73 $0.85 $ 1.52 $ 1.83
Add: Goodwill amortization, net of tax................ -- 0.02 -- 0.04
----- ----- ------ ------
0.73 0.87 1.52 1.87
Cumulative effect of accounting change................ -- -- -- (0.05)
----- ----- ------ ------
Adjusted.............................................. $0.73 $0.87 $ 1.52 $ 1.82
===== ===== ====== ======
Diluted earnings per common share
Diluted before cumulative effect of accounting change. $0.72 $0.82 $ 1.48 $ 1.76
Add: Goodwill amortization, net of tax................ -- 0.02 -- 0.03
----- ----- ------ ------
0.72 0.84 1.48 1.79
Cumulative effect of accounting change................ -- -- -- (0.05)
----- ----- ------ ------
Adjusted.............................................. $0.72 $0.84 $ 1.48 $ 1.74
===== ===== ====== ======
Changes in the carrying amount of the Company's goodwill for the six month
period ended May 31, 2002, were as follows:
Investment
Securities Management Total
---------- ---------- ------
(dollars in millions)
Balance as of November 30, 2001 $470 $968 $1,438
Translation adjustments........ 3 -- 3
---- ---- ------
Balance as of May 31, 2002..... $473 $968 $1,441
==== ==== ======
4. Securities Financing Transactions.
Securities purchased under agreements to resell ("reverse repurchase
agreements") and securities sold under agreements to repurchase ("repurchase
agreements"), principally government and agency securities, are treated
8
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
as financing transactions and are carried at the amounts at which the
securities subsequently will be resold or reacquired as specified in the
respective agreements; such amounts include accrued interest. Reverse
repurchase agreements and repurchase agreements are presented on a
net-by-counterparty basis, when appropriate. It is the Company's policy to take
possession of securities purchased under agreements to resell. Securities
borrowed and securities loaned also are treated as financing transactions and
are carried at the amounts of cash collateral advanced and received in
connection with the transactions.
The Company pledges its financial instruments owned to collateralize
repurchase agreements and other securities financings. Pledged securities that
can be sold or repledged by the secured party are identified as financial
instruments owned (pledged to various parties) on the condensed consolidated
statements of financial condition. The carrying value and classification of
securities owned by the Company that have been loaned or pledged to
counterparties where those counterparties do not have the right to sell or
repledge the collateral were as follows:
At At
May 31, November 30,
2002 2001
------- ------------
(dollars in millions)
Financial instruments owned:
U.S. government and agency securities $10,280 $ 9,310
Corporate and other debt............. 3,404 3,350
Corporate equities................... 2,857 2,850
------- -------
Total......................... $16,541 $15,510
======= =======
The Company enters into reverse repurchase agreements, repurchase
agreements, securities borrowed transactions and securities loaned transactions
to, among other things, finance the Company's inventory positions, acquire
securities to cover short positions and settle other securities obligations and
to accommodate customers' needs. The Company also engages in securities
financing transactions for customers through margin lending. Under these
agreements and transactions, the Company either receives or provides
collateral, including U.S. government and agency securities, other sovereign
government obligations, corporate and other debt, and corporate equities. The
Company receives collateral in the form of securities in connection with
reverse repurchase agreements, securities borrowed transactions and customer
margin loans. In many cases, the Company is permitted to sell or repledge these
securities held as collateral and use the securities to secure repurchase
agreements, to enter into securities lending transactions or for delivery to
counterparties to cover short positions. At May 31, 2002, the fair value of
securities received as collateral where the Company is permitted to sell or
repledge the securities was $421 billion, and the fair value of the portion
that has been sold or repledged was $386 billion.
The Company manages credit exposure arising from reverse repurchase
agreements, repurchase agreements, securities borrowed transactions and
securities loaned transactions by, in appropriate circumstances, entering into
master netting agreements and collateral arrangements with counterparties that
provide the Company, in the event of a customer default, the right to liquidate
collateral and the right to offset a counterparty's rights and obligations. The
Company also monitors the fair value of the underlying securities as compared
with the related receivable or payable, including accrued interest, and, as
necessary, requests additional collateral to ensure such transactions are
adequately collateralized. Where deemed appropriate, the Company's agreements
with third parties specify its rights to request additional collateral.
Customer receivables generated from margin lending activity are collateralized
by customer-owned securities held by the Company. For these transactions, the
Company's collateral policies significantly limit the Company's credit exposure
in the event of customer default. The Company may request additional margin
collateral from customers, if appropriate, and if necessary may sell securities
that have not been paid for or purchase securities sold but not delivered from
customers.
9
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. Consumer Loans.
Consumer loans were as follows:
At At
May 31, November 30,
2002 2001
------- ------------
(dollars in millions)
General purpose credit card, mortgage and consumer installment $21,321 $20,955
Less:
Allowance for consumer loan losses......................... 899 847
------- -------
Consumer loans, net........................................... $20,422 $20,108
======= =======
Activity in the allowance for consumer loan losses was as follows:
Three Months Six Months
Ended Ended
May 31, May 31,
---------- ----------
2002 2001 2002 2001
---- ---- ---- ----
(dollars in millions)
Balance beginning of period........... $873 $786 $847 $783
Additions:
Provision for consumer loan losses. 340 231 685 444
Deductions:
Charge-offs........................ 338 255 679 492
Recoveries......................... (24) (25) (46) (52)
---- ---- ---- ----
Net charge-offs....................... 314 230 633 440
---- ---- ---- ----
Balance end of period................. $899 $787 $899 $787
==== ==== ==== ====
Interest accrued on general purpose credit card loans subsequently charged
off, recorded as a reduction of interest revenue, was $53 million and $110
million in the quarter and six month period ended May 31, 2002, and $41 million
and $81 million in the quarter and six month period ended May 31, 2001.
At May 31, 2002, the Company had commitments to extend credit for consumer
loans of approximately $259 billion. Commitments to extend credit arise 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 do not necessarily represent future cash
requirements, are periodically reviewed based on account usage and customer
creditworthiness.
The Company received net proceeds from consumer loan asset securitizations
of $1,735 million and $2,787 million in the quarter and six month period ended
May 31, 2002 and $2,426 million and $7,112 million in the quarter and six month
period ended May 31, 2001.
The Company's retained interests in credit card asset securitizations
include an undivided seller's interest, cash collateral accounts, servicing
rights and rights to any excess cash flows ("Residual Interests") remaining
after payments to investors in the securitization trust of their contractual
rate of return and reimbursement of credit losses. The Company receives annual
servicing fees of 2% of the investor principal balance outstanding. At May 31,
2002, the Company had $8.3 billion of retained interests, including $6.0
billion of undivided seller's interest, in credit card asset securitizations.
The Company's undivided seller's interest ranks pari passu with
10
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
investors' interests in the securitization trust, and the remaining retained
interests are subordinate to investors' interests. The retained interests are
subject to credit, payment and interest rate risks on the transferred credit
card assets. The investors and the securitization trust have no recourse to the
Company's other assets for failure of cardmembers to pay when due.
During the six months ended May 31, 2002, the Company completed credit card
asset securitizations of $2.8 billion and recognized net securitization gains
of $19 million as servicing fees in the Company's condensed consolidated
statements of income. The uncollected balances of general purpose credit card
loans sold through asset securitizations were $29,153 million at May 31, 2002
and $29,247 million at November 30, 2001.
Key economic assumptions used in measuring the Residual Interests at the
date of securitization resulting from credit card asset securitizations
completed during the six months ended May 31, 2002 were as follows:
Weighted average life (in months) 6.1-6.2
Payment rate (rate per month).... 16.88%-17.25%
Credit losses (rate per annum)... 6.95%
Discount rate (rate per annum)... 14.0%-16.50%
Key economic assumptions and the sensitivity of the current fair value of
the Residual Interests to immediate 10% and 20% adverse changes in those
assumptions were as follows (dollars in millions):
At
May 31, 2002
------------
Residual Interests (carrying amount/fair value) $ 230
Weighted average life (in months).............. 6.2
Payment rate (rate per month).................. 17.25%
Impact on fair value of 10% adverse change.. $ (16)
Impact on fair value of 20% adverse change.. $ (30)
Credit losses (rate per annum)................. 6.95%
Impact on fair value of 10% adverse change.. $ (76)
Impact on fair value of 20% adverse change.. $ (150)
Discount rate (rate per annum)................. 14.00%
Impact on fair value of 10% adverse change.. $ (3)
Impact on fair value of 20% adverse change.. $ (5)
The sensitivity analysis in the table above is hypothetical and should be
used with caution. Changes in fair value based on a 10% or 20% variation in an
assumption generally cannot be extrapolated because the relationship of the
change in the assumption to the change in fair value may not be linear. Also,
the effect of a variation in a particular assumption on the fair value of the
Residual Interests is calculated independent of changes in any other
assumption; in practice, changes in one factor may result in changes in another
(for example, increases in market interest rates may result in lower payments
and increased credit losses), which might magnify or counteract the
sensitivities. In addition, the sensitivity analysis does not consider any
corrective action that the Company may take to mitigate the impact of any
adverse changes in the key assumptions.
The table below summarizes certain cash flows received from the
securitization master trust (dollars in billions):
Six Months Ended
May 31, 2002
----------------
Proceeds from new credit card asset securitizations............... $ 2.8
Proceeds from collections reinvested in previous credit card asset
securitizations................................................. $25.6
Contractual servicing fees received............................... $ 0.3
Cash flows received from retained interests....................... $ 1.0
11
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The table below presents quantitative information about delinquencies, net
credit losses and components of managed general purpose credit card loans,
including securitized loans:
At Six Months Ended
May 31, 2002 May 31, 2002
---------------------- ------------------
Loans Loans Average Net Credit
Outstanding Delinquent Loans Losses
----------- ---------- ------- ----------
(dollars in billions)
Managed general purpose credit card loans $49.4 $2.8 $49.9 $1.6
Less: Securitized general purpose credit
card loans............................. 29.2
-----
Owned general purpose credit card loans.. $20.2
=====
6. Long-Term Borrowings.
Long-term borrowings at May 31, 2002 scheduled to mature within one year
aggregated $10,307 million.
During the six month period ended May 31, 2002, the Company issued senior
notes aggregating $10,018 million, including non-U.S. dollar currency notes
aggregating $1,597 million. The Company has entered into certain transactions
to obtain floating interest rates based primarily on short-term LIBOR trading
levels. Maturities in the aggregate of these notes by fiscal year are as
follows: 2003, $1,122 million; 2004, $1,031 million; 2005, $3 million; and
thereafter, $7,862 million. In the six month period ended May 31, 2002, $4,291
million of senior notes were repaid.
The weighted average maturity of the Company's long-term borrowings, based
upon stated maturity dates, was approximately 5 years at May 31, 2002.
7. Preferred Stock, Capital Units and Preferred Securities Subject to
Mandatory Redemption.
Preferred stock of the Company was composed of the following issue:
Shares Outstanding at Balance at
-------------------- --------------------
May 31, November 30, May 31, November 30,
2002 2001 2002 2001
------- ------------ ------- ------------
(dollars in millions)
Series A Fixed/Adjustable Rate Cumulative Preferred Stock,
stated value $200 per share............................. -- 1,725,000 $ -- $345
On December 3, 2001, the Company redeemed all 1,725,000 outstanding shares
of its Series A Fixed/Adjustable Rate Cumulative Preferred Stock at a
redemption price of $200 per share. The Company also simultaneously redeemed
all corresponding Depositary Shares at a redemption price of $50 per Depositary
Share. Each Depositary Share represented 1/4 of a share of the Company's
Series A Fixed/Adjustable Rate Cumulative Preferred Stock.
The Company has Capital Units outstanding that were issued by the Company
and Morgan Stanley Finance plc ("MSF"), a U.K. subsidiary. A Capital Unit
consists of (a) a Subordinated Debenture of MSF guaranteed by the Company and
maturing in 2017 and (b) a related Purchase Contract issued by the Company,
which may be accelerated by the Company, requiring the holder to purchase one
Depositary Share representing shares (or fractional shares) of the Company's
Cumulative Preferred Stock. The aggregate amount of Capital Units outstanding
was $66 million at both May 31, 2002 and November 30, 2001.
12
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Preferred Securities Subject to Mandatory Redemption (also referred to as
"Capital Securities" herein) represent preferred minority interests in certain
of the Company's subsidiaries. Accordingly, dividends paid on Preferred
Securities Subject to Mandatory Redemption are presented as a deduction to
after-tax income (similar to minority interests in the income of subsidiaries)
in the Company's condensed consolidated statements of income.
MSDW Capital Trust I ("Capital Trust I") and Morgan Stanley Capital Trust II
("Capital Trust II") are consolidated Delaware statutory business trusts (all
of the common securities of which are owned by the Company) and have Capital
Securities outstanding. The trusts invested the proceeds of the Capital
Securities offerings and the proceeds from the sale of common securities to the
Company in junior subordinated deferrable interest debentures issued by the
Company, the terms of which parallel the terms of the Capital Securities. The
Capital Securities are fully and unconditionally guaranteed by the Company,
based on the Company's combined obligations under a guarantee, a trust
agreement and a junior subordinated debt indenture.
The significant terms of the Preferred Securities Subject to Mandatory
Redemption issued by Capital Trust I and Capital Trust II, and the
corresponding junior subordinated deferrable interest debentures issued by the
Company, are presented below:
Preferred Securities Subject to Mandatory Redemption Capital Trust I Capital Trust II
Issuance Date....................................... March 12, 1998 July 19, 2001
Preferred securities issued......................... 16,000,000 32,400,000
Liquidation preference per security................. $25 $25
Liquidation value (in millions)..................... $400 $810
Coupon rate......................................... 7.10% 7.25%
Distribution payable................................ Quarterly Quarterly
Distributions guaranteed by......................... Morgan Stanley Morgan Stanley
Mandatory redemption date........................... February 28, 2038 July 31, 2031(1)
Redeemable by issuer on or after(2)................. March 12, 2003 July 31, 2006
Junior Subordinated Deferrable Interest Debentures
Principal amount outstanding (in millions)(3)....... $412 $835
Coupon rate......................................... 7.10% 7.25%
Interest payable.................................... Quarterly Quarterly
Maturity date....................................... February 28, 2038 July 31, 2031(1)
Redeemable by issuer on or after(2)................. March 12, 2003 July 31, 2006
- --------
(1)May be extended to a date not later than July 31, 2050.
(2)Redeemable prior to this date in whole (but not in part) upon the occurrence
of certain events.
(3)Purchased by the trusts with the proceeds of the Capital Securities
offerings and the proceeds from the sale of common securities to the Company.
8. Common Stock and Shareholders' Equity.
MS&Co. and MSDWI are registered broker-dealers and registered futures
commission merchants and, accordingly, are subject to the minimum net capital
requirements of the Securities and Exchange Commission, the New York Stock
Exchange and the Commodity Futures Trading Commission. MS&Co. and MSDWI have
consistently operated in excess of these requirements. MS&Co.'s net capital
totaled $5,117 million at May 31, 2002, which exceeded the amount required by
$4,486 million. MSDWI's net capital totaled $1,275 million at May 31, 2002,
which exceeded the amount required by $1,151 million. 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, is subject
to the capital requirements of the Financial Services Agency. MSIL and MSJL
have consistently operated in excess of their respective regulatory capital
requirements.
Under regulatory capital requirements adopted by the Federal Deposit
Insurance Corporation ("FDIC") and other bank regulatory agencies, FDIC-insured
financial institutions must maintain (a) 3% to 5% of Tier 1 capital,
13
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 May 31, 2002, 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.
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
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.
The Company repurchased approximately 9 million and 14 million shares of its
common stock through open market purchases during the six month periods ended
May 31, 2002 and 2001, respectively. In an effort to enhance its ongoing stock
repurchase program, the Company may sell put options on shares of its common
stock to third parties. These put options entitle the holder to sell shares of
the Company's common stock to the Company on certain dates at specified prices.
As of May 31, 2002, put options were outstanding on an aggregate of 3.0 million
shares of the Company's common stock. These put options have expiration dates
that range from September 2002 through November 2002 with strike prices ranging
from $39.76 to $40.10. The Company may elect cash settlement of the put options
instead of taking delivery of the stock.
9. Earnings per Share.
Basic EPS reflects no dilution from common stock equivalents. Diluted EPS
reflects dilution from common stock equivalents and other dilutive securities
based on the average price per share of the Company's common stock during the
period. The following table presents the calculation of basic and diluted EPS
(in millions, except for per share data):
Three Months Six Months
Ended Ended
May 31, May 31,
------------- -------------
2002 2001 2002 2001
------ ------ ------ ------
Basic EPS:
Income before cumulative effect of accounting change...................... $ 797 $ 930 $1,645 $2,005
Cumulative effect of accounting change.................................... -- -- -- (59)
Preferred stock dividend requirements..................................... -- (9) -- (18)
------ ------ ------ ------
Net income available to common shareholders............................... $ 797 $ 921 $1,645 $1,928
====== ====== ====== ======
Weighted-average common shares outstanding................................ 1,085 1,085 1,084 1,087
====== ====== ====== ======
Basic EPS before cumulative effect of accounting change................... $ 0.73 $ 0.85 $ 1.52 $ 1.83
Cumulative effect of accounting change.................................... -- -- -- (0.05)
------ ------ ------ ------
Basic EPS..................................................................... $ 0.73 $ 0.85 $ 1.52 $ 1.78
====== ====== ====== ======
Diluted EPS:
Income before cumulative effect of accounting change...................... $ 797 $ 930 $1,645 $2,005
Cumulative effect of accounting change.................................... -- -- -- (59)
Preferred stock dividend requirements..................................... -- (9) -- (18)
------ ------ ------ ------
Net income available to common shareholders............................... $ 797 $ 921 $1,645 $1,928
====== ====== ====== ======
Weighted-average common shares outstanding................................ 1,085 1,085 1,084 1,087
Effect of dilutive securities:
Stock options.......................................................... 28 35 29 40
Convertible debt....................................................... 1 1 1 --
------ ------ ------ ------
Weighted-average common shares outstanding and common stock equivalents... 1,114 1,121 1,114 1,127
====== ====== ====== ======
Diluted EPS before cumulative effect of accounting change................. $ 0.72 $ 0.82 $ 1.48 $ 1.76
Cumulative effect of accounting change.................................... -- -- -- (0.05)
------ ------ ------ ------
Diluted EPS................................................................... $ 0.72 $ 0.82 $ 1.48 $ 1.71
====== ====== ====== ======
14
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
At May 31, 2002, there were approximately 64 million stock options
outstanding that were excluded from the computation of diluted EPS, as the
exercise price of such options exceeded the average price per share of the
Company's common stock for both the three and six month periods ended May 31,
2002.
10. Commitments and Contingencies.
At May 31, 2002 and November 30, 2001, the Company had approximately $4.7
billion and $4.5 billion, respectively, of letters of credit outstanding to
satisfy various collateral requirements.
The Company has commitments to fund certain fixed assets and other less
liquid investments, including at May 31, 2002, approximately $600 million in
connection with its private equity and other principal investment activities.
Additionally, the Company has provided and will continue to provide financing,
including margin lending and other extensions of credit to clients (including
subordinated loans on an interim basis to companies associated with its
investment banking and its private equity and other principal investment
activities), that may subject the Company to increased credit and liquidity
risks.
In connection with its aircraft financing business, the Company has entered
into agreements to purchase aircraft and related equipment. As of May 31, 2002,
the aggregate amount of such purchase commitments was $232 million. All of the
aircraft to be acquired under these purchase obligations are subject to
contractual lease arrangements.
In connection with certain of its business activities, the Company provides,
on a selective basis, through certain of its subsidiaries (including Morgan
Stanley Bank) financing or financing commitments to companies in the form of
senior and subordinated debt, including bridge financing. The borrowers may be
rated investment grade or non-investment grade. These loans and funding
commitments typically are secured against the borrower's assets (in the case of
senior loans), have varying maturity dates and are generally contingent upon
certain representations, warranties and contractual conditions applicable to
the borrower. As part of these activities, the Company may syndicate and trade
certain of these loans. At May 31, 2002, the Company provided commitments
associated with these activities to investment grade issuers aggregating $8.9
billion and commitments to non-investment grade issuers aggregating $1.2
billion. Since these commitments may expire unused, the total commitment amount
does not necessarily reflect the actual future cash funding requirements.
Financial instruments sold, not yet purchased, represent obligations of the
Company to deliver specified financial instruments at contracted prices,
thereby creating commitments to purchase the financial instruments in the
market at prevailing prices. Consequently, the Company's ultimate obligation to
satisfy the sale of financial instruments sold, not yet purchased, may exceed
the amounts recognized in the condensed consolidated statements of financial
condition.
In the normal course of business, the Company has been named as a defendant
in various legal actions, including arbitrations, arising in connection with
its activities as a global diversified financial services institution. Some of
the legal actions include claims for substantial compensatory and/or punitive
damages or claims for indeterminate amounts of damages. The Company is also
involved, from time to time, in investigations and proceedings by governmental
and self-regulatory agencies. Some of these legal actions, investigations and
proceedings may result in adverse judgments, penalties or fines. In view of the
inherent difficulty of predicting the outcome of such matters, particularly in
cases in which claimants seek substantial or indeterminate damages, the Company
cannot predict with certainty what the eventual loss or range of loss related
to such matters will be. The Company believes, based on current knowledge and
after consultation with counsel, that the outcome of such matters will not have
a material adverse effect on the condensed consolidated financial condition of
the Company, although the outcome could be material to the Company's operating
results for a particular period, depending, upon other things, on the level of
the Company's income for such period.
15
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
At May 31, 2002, the Company had commitments to enter into reverse
repurchase and repurchase agreements of approximately $29.0 billion and $41.9
billion, respectively.
11. 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 swap agreements and other derivatives in managing its interest
rate exposure. The Company also uses forward and option contracts, futures and
swaps in its trading activities; these derivative instruments also are used to
hedge the U.S. dollar cost of certain foreign currency exposures. In addition,
financial futures and forward contracts are actively traded by the Company and
are used to hedge proprietary inventory. The Company also enters into delayed
delivery, when-issued, and warrant and option contracts involving securities.
These instruments generally represent future commitments to swap interest
payment streams, exchange currencies or purchase or sell 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 and options
and warrants on equities typically have longer maturities. For further
discussion of these matters, refer to "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Derivative Financial
Instruments" and Note 10 to the consolidated financial statements for the
fiscal year ended November 30, 2001, included in the Form 10-K.
These derivative instruments involve varying degrees of market risk. 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 less than or exceeding fair value
amounts recognized in the condensed consolidated statements of financial
condition, which, as described in Note 1, are recorded at fair value,
representing the cost of replacing those instruments.
The Company's exposure to credit risk with respect to these derivative
instruments at any point in time is represented by the fair value of the
contracts reported as assets. These amounts are presented on a
net-by-counterparty basis (when appropriate), but are not reported net of
collateral, which the Company obtains with respect to certain of these
transactions to reduce its exposure to credit losses.
The credit quality of the Company's trading-related derivatives at May 31,
2002 and November 30, 2001 is summarized in the tables below, showing the fair
value of the related assets by counterparty credit rating. The actual credit
ratings are determined by external rating agencies or by equivalent ratings
used by the Company's Credit Risk Department:
Collateralized
Non- Other Non-
Investment Investment
AAA AA A BBB Grade Grade Total
------ ------- ------ ------ -------------- ---------- -------
(dollars in millions)
At May 31, 2002
Interest rate and currency swaps and options
(including caps, floors and swap options) and
other fixed income securities contracts............ $4,032 $ 6,675 $4,858 $1,818 $525 $ 459 $18,367
Foreign exchange forward contracts and options...... 199 1,735 1,165 249 -- 222 3,570
Equity securities contracts (including equity swaps,
warrants and options).............................. 1,367 786 580 57 37 198 3,025
Commodity forwards, options and swaps............... 264 1,112 1,581 922 384 892 5,155
------ ------- ------ ------ ---- ------ -------
Total............................................ $5,862 $10,308 $8,184 $3,046 $946 $1,771 $30,117
====== ======= ====== ====== ==== ====== =======
Percent of total.................................... 20% 34% 27% 10% 3% 6% 100%
====== ======= ====== ====== ==== ====== =======
16
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Collateralized
Non- Other Non-
Investment Investment
AAA AA A BBB Grade Grade Total
------ ------ ------ ------ -------------- ---------- -------
(dollars in millions)
At November 30, 2001
Interest rate and currency swaps and options
(including caps, floors and swap options) and
other fixed income securities contracts............ $4,465 $5,910 $6,144 $1,482 $488 $ 631 $19,120
Foreign exchange forward contracts and options...... 76 1,051 1,090 212 -- 269 2,698
Equity securities contracts (including equity swaps,
warrants and options).............................. 1,879 1,392 662 40 85 283 4,341
Commodity forwards, options and swaps............... 367 941 1,690 1,195 173 1,553 5,919
------ ------ ------ ------ ---- ------ -------
Total............................................ $6,787 $9,294 $9,586 $2,929 $746 $2,736 $32,078
====== ====== ====== ====== ==== ====== =======
Percent of total.................................... 21% 29% 30% 9% 2% 9% 100%
====== ====== ====== ====== ==== ====== =======
A substantial portion of the Company's securities and commodities
transactions are collateralized and are executed with and on behalf of
commercial banks and other institutional investors, including other brokers and
dealers. Positions taken and commitments made by the Company, including
positions taken and underwriting and financing commitments made in connection
with its private equity and other principal investment activities, often
involve substantial amounts and significant exposure to individual issuers and
businesses, including non-investment grade issuers. The Company seeks to limit
concentration risk created in its businesses through a variety of separate but
complementary financial, position and credit exposure reporting systems,
including the use of trading limits based in part upon the Company's review of
the financial condition and credit ratings of its counterparties.
See also "Risk Management" in the Form 10-K for discussions of the Company's
risk management policies and procedures for its Securities businesses.
12. Segment Information.
The Company structures its segments primarily based upon the nature of the
financial products and services provided to customers and the Company's
management organization. The Company operates in three business segments:
Securities, Investment Management and Credit Services, through which it
provides a wide range of financial products and services to its customers.
The Company's Securities business includes securities underwriting and
distribution; financial advisory services, including advice on mergers and
acquisitions, restructurings, real estate and project finance; full-service
brokerage services; 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,
including private equity activities; and aircraft financing activities. 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
Credit Services business includes the issuance of the Discover Classic Card,
the Discover Gold Card, the Discover Platinum Card, the Morgan Stanley Card and
other proprietary general purpose credit cards; and the operation of Discover
Business Services, a proprietary network of merchant and cash access locations
in the U.S.
Revenues and expenses directly associated with each respective segment are
included in determining their operating results. Other revenues and expenses
that are not directly attributable to a particular segment are
17
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
allocated based upon the Company's allocation methodologies, generally based on
each segment's respective revenues or other relevant measures. Selected
financial information for the Company's segments is presented in the table
below:
Investment Credit
Three Months Ended May 31, 2002 Securities Management Services Total
- ------------------------------- ---------- ---------- -------- -------
(dollars in millions)
All other net revenues............................... $2,807 $ 598 $ 530 $ 3,935
Net interest......................................... 680 6 344 1,030
------ ------ ------ -------
Net revenues......................................... $3,487 $ 604 $ 874 $ 4,965
====== ====== ====== =======
Income before income taxes and dividends on preferred
securities subject to mandatory redemption......... $ 708 $ 227 $ 312 $ 1,247
Provision for income taxes........................... 226 86 116 428
Dividends on preferred securities subject to
mandatory redemption............................... 22 -- -- 22
------ ------ ------ -------
Net income........................................... $ 460 $ 141 $ 196 $ 797
====== ====== ====== =======
Investment Credit
Three Months Ended May 31, 2001(1) Securities Management Services Total
- ---------------------------------- ---------- ---------- -------- -------
(dollars in millions)
All other net revenues............................... $4,229 $ 625 $ 570 $ 5,424
Net interest......................................... 198 14 332 544
------ ------ ------ -------
Net revenues......................................... $4,427 $ 639 $ 902 $ 5,968
====== ====== ====== =======
Income before income taxes and dividends on preferred
securities subject to mandatory redemption......... $ 977 $ 216 $ 279 $ 1,472
Provision for income taxes........................... 338 89 108 535
Dividends on preferred securities subject to
mandatory redemption............................... 7 -- -- 7
------ ------ ------ -------
Net income........................................... $ 632 $ 127 $ 171 $ 930
====== ====== ====== =======
Investment Credit
Six Months Ended May 31, 2002 Securities Management Services Total
- ----------------------------- ---------- ---------- -------- -------
(dollars in millions)
All other net revenues............................... $6,033 $1,196 $1,069 $ 8,298
Net interest......................................... 1,285 13 628 1,926
------ ------ ------ -------
Net revenues......................................... $7,318 $1,209 $1,697 $10,224
====== ====== ====== =======
Income before income taxes and dividends on preferred
securities subject to mandatory redemption......... $1,566 $ 461 $ 567 $ 2,594
Provision for income taxes........................... 523 178 204 905
Dividends on preferred securities subject to
mandatory redemption............................... 44 -- -- 44
------ ------ ------ -------
Net income........................................... $ 999 $ 283 $ 363 $ 1,645
====== ====== ====== =======
18
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Investment Credit
Six Months Ended May 31, 2001(1) Securities Management Services Total
- -------------------------------- ---------- ---------- -------- --------
(dollars in millions)
All other net revenues.............................. $ 8,268 $1,291 $ 1,097 $ 10,656
Net interest........................................ 907 36 665 1,608
-------- ------ ------- --------
Net revenues........................................ $ 9,175 $1,327 $ 1,762 $ 12,264
======== ====== ======= ========
Income before income taxes, dividends on preferred
securities subject to mandatory redemption and
cumulative effect of accounting change............ $ 2,191 $ 471 $ 510 $ 3,172
Provision for income taxes.......................... 765 191 197 1,153
Dividends on preferred securities subject to
mandatory redemption.............................. 14 -- -- 14
-------- ------ ------- --------
Income before cumulative effect of accounting change 1,412 280 313 2,005
Cumulative effect of accounting change.............. (46) -- (13) (59)
-------- ------ ------- --------
Net income.......................................... $ 1,366 $ 280 $ 300 $ 1,946
======== ====== ======= ========
Investment Credit
Total Assets(2) Securities Management Services Total
- --------------- ---------- ---------- -------- --------
(dollars in millions)
May 31, 2002........................................ $523,763 $4,958 $25,203 $553,924
======== ====== ======= ========
November 30, 2001................................... $452,421 $5,076 $25,131 $482,628
======== ====== ======= ========
- --------
(1)Certain reclassifications have been made to prior period amounts to conform
to the current presentation.
(2)Corporate assets have been fully allocated to the Company's business
segments.
13. Terrorist Attacks.
On September 11, 2001, the U.S. experienced terrorist attacks targeted
against New York City and Washington, D.C. The attacks in New York City
destroyed the World Trade Center complex, where approximately 3,700 of the
Company's employees were located. Through the implementation of its business
recovery plans, the Company relocated its displaced employees to other
facilities.
The Company has recognized costs related to the terrorist attacks, which
have been offset by an expected insurance recovery. These costs and the related
expected insurance recovery pertain 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. Such costs amounted to $28 million for the
quarter and $75 million for the six month period ended May 31, 2002 and $56
million for the fiscal year ended November 30, 2001.
14. Gain on Sale of Building.
During the six month period ended May 31, 2002, the Company recorded a 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 gain is included
within other revenues in the Company's condensed consolidated statements of
income. The Company allocated $60 million of the gain to its Securities segment
and $13 million of the gain to its Investment Management segment. The
allocation was based upon occupancy levels originally planned for the building.
15. Business Disposition.
In May 2002, the Company agreed to sell its self-directed online brokerage
accounts to Bank of Montreal's Harrisdirect. The transaction is expected to
close during the third quarter of fiscal 2002.
19
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Shareholders of
Morgan Stanley:
We have reviewed the accompanying condensed consolidated statement of
financial condition of Morgan Stanley and subsidiaries as of May 31, 2002, and
the related condensed consolidated statements of income and comprehensive
income for the three-month and six-month periods ended May 31, 2002 and 2001,
and condensed consolidated statements of cash flow for the six-month periods
ended May 31, 2002 and 2001. These condensed consolidated financial statements
are the responsibility of the management of Morgan Stanley.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and of making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted
in accordance with auditing standards generally accepted in the United States
of America, the objective of which is the expression of an opinion regarding
the financial statements taken as a whole. Accordingly, we do not express such
an opinion.
Based on our review, we are not aware of any material modifications that
should be made to such condensed consolidated financial statements for them to
be in conformity with accounting principles generally accepted in the United
States of America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated statement of
financial condition of Morgan Stanley and subsidiaries as of November 30, 2001,
and the related consolidated statements of income, comprehensive income, cash
flows and changes in shareholders' equity for the fiscal year then ended (not
presented herein) included in Morgan Stanley's Annual Report on Form 10-K for
the fiscal year ended November 30, 2001; and, in our report dated January 11,
2002, we expressed an unqualified opinion on those consolidated financial
statements. In our opinion, the information set forth in the accompanying
condensed consolidated statement of financial condition as of November 30, 2001
is fairly stated, in all material respects, in relation to the consolidated
statement of financial condition from which it has been derived.
/S/ DELOITTE & TOUCHE LLP
New York, New York
July 10, 2002
20
Item 2.
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 three business
segments--Securities, Investment Management and Credit Services. The Company's
Securities business includes securities underwriting and distribution;
financial advisory services, including advice on mergers and acquisitions,
restructurings, real estate and project finance; full-service brokerage
services; 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,
including private equity activities; and aircraft financing activities. 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
Credit Services business includes the issuance of the Discover(R) Classic Card,
the Discover Gold Card, the Discover Platinum Card, the Morgan Stanley Card/SM/
and other proprietary general purpose credit cards; and the operation of
Discover Business Services, a proprietary network of merchant and cash access
locations in the U.S.
In June 2002, the Company's name changed from "Morgan Stanley Dean Witter &
Co." to "Morgan Stanley."
Results of Operations*
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 (such as the use of the
Internet to conduct electronic commerce and the use of electronic
communications trading networks); the availability and cost of credit;
inflation; investor sentiment and confidence in the financial markets; and
legislative, legal and regulatory developments. Such factors also may have an
impact on the Company's ability to achieve its strategic objectives on a global
basis, including (without limitation) increased market share in its securities
activities, growth in assets under management and the expansion of its Credit
Services business.
The Company's 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 cannot be predicted 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 private equity and other principal investments. 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.
- --------
*This Management's Discussion and Analysis of Financial Condition and Results
of Operations contains forward-looking statements as well as a discussion of
some of the risks and uncertainties involved in the Company's businesses that
could affect the matters referred to in such statements.
21
The Company's results of operations also may be materially affected by
competitive factors. Included among the principal competitive factors affecting
the Securities business are the quality of its professionals and other
personnel, its products and services, relative pricing and innovation.
Competition in the Company's Investment Management business is affected by a
number of factors, including investment objectives and performance; advertising
and sales promotion efforts; and the level of fees, distribution channels and
types and quality of services offered. In the Credit Services business,
competition centers on merchant acceptance of credit cards, credit cardmember
acquisition and customer utilization of credit cards, all of which are impacted
by the type of fees, interest rates and other features offered.
In addition to competition from firms traditionally engaged in the financial
services business, there has been increased competition in recent years from
other sources, such as commercial banks, insurance companies, sponsors of
mutual funds and other companies offering financial services both in the U.S.
and globally and through the Internet. The financial services industry also has
continued to experience consolidation and convergence, as financial
institutions involved in a broad range of financial services industries have
merged. This convergence trend may continue 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. 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.
For a detailed discussion of the competitive and regulatory factors in the
Company's Securities, Investment Management and Credit Services businesses, see
the Company's Annual Report on Form 10-K for the fiscal year ended November 30,
2001 (the "Form 10-K").
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 maintaining
high levels of profitable business activities, emphasizing fee-based assets
that are designed to generate a continuing stream of revenues, evaluating
credit product pricing, and managing risks, costs and its capital position. 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.
Global Market and Economic Conditions in the Quarter and Six Month Period
ended May 31, 2002
Although the global economy demonstrated some initial signs of recovery,
conditions in the global financial markets remained difficult in the second
quarter of fiscal 2002. Such conditions contributed to the decline in the
Company's net revenues and net income as compared to the quarter and six month
period ended May 31, 2001.
In the U.S., the quarter began amid increased expectations of improved
economic growth. However, as the quarter progressed, conflicting economic
signals became apparent, including an increase in unemployment. In the
financial markets, participants remained uncertain about the strength and pace
of the global economic recovery, and investor confidence weakened due to
concerns relating to the quality of corporate earnings in light of several
significant corporate bankruptcies. As a result, the level of uncertainty
regarding the timing and sustainability of the nation's economic recovery
increased, and the Federal Reserve Board left both the discount rate and the
overnight lending rate unchanged during the quarter.
In Europe, economic conditions improved modestly, as business confidence and
export activity increased. During the quarter, the European Central Bank
("ECB") left the benchmark interest rate within the region unchanged, although
the ECB remained concerned about price stability, primarily due to rising oil
prices within the region. In the U.K., the levels of demand, inflation and
unemployment were generally stable, and business
22
survey data continued to suggest expectations of economic recovery. The Bank of
England left the benchmark interest rate unchanged during the quarter.
In Japan, the pace of economic deterioration moderated during the quarter,
primarily led by an increase in exports to the Far East and the U.S. As a
result, Japan's financial markets increased moderately during the quarter.
However, there were still lingering concerns over corporate earnings, the
banking sector, including the level of non-performing bank loans, the slow pace
of structural reforms and deflationary pressures. In addition, consumer
spending in Japan remained sluggish, reflecting a relatively high unemployment
rate and low consumer confidence. Certain nations elsewhere in the Far East,
such as Taiwan and Korea, continued to experience a recovery in the level of
exports and manufacturing output, primarily reflecting moderately improved
conditions within the global communications and technology sectors.
Results of the Company for the Quarter and Six Month Period ended May 31, 2002
The Company's net income in the quarter and six month period ended May 31,
2002 was $797 million and $1,645 million, respectively, a decrease of 14% and
15% from the comparable periods of fiscal 2001. The Company's net income for
the six month period ended May 31, 2001 included a charge of $59 million for
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. Excluding the cumulative effect of the accounting
change, the Company's net income for the six month period ended May 31, 2002
was 18% below the comparable period of fiscal 2001.
Diluted earnings per common share were $0.72 and $1.48 in the quarter and
six month period ended May 31, 2002 as compared to $0.82 and $1.71 in the
quarter and six month period ended May 31, 2001. Excluding the cumulative
effect of the accounting change in the six month period ended May 31, 2001, the
Company's diluted earnings per share was $1.76. The Company's annualized return
on common equity for the quarter and six month period ended May 31, 2002 was
15.1% and 15.7% as compared to 19.1% and 20.8% (excluding the cumulative effect
of the accounting change) in the comparable periods of fiscal 2001.
The decrease in net income in the quarter and six month period ended May 31,
2002 as compared to the prior year periods was primarily attributable to the
Company's Securities business, which recorded lower investment banking and
principal trading revenues, partially offset by lower non-interest expenses.
At May 31, 2002, the Company had approximately 59,000 employees worldwide, a
decrease of 7% from May 31, 2001. The reduction in staffing levels reflected
the Company's efforts to manage costs in light of the weakened global economy
and reduced business activity.
Business Disposition
In May 2002, the Company agreed to sell its self-directed online brokerage
accounts to Bank of Montreal's Harrisdirect. The transaction is expected to
close during the third quarter of fiscal 2002.
Business Segments
The remainder of Results of Operations is presented on a business segment
basis. Substantially all of the operating revenues and operating expenses of
the Company can be directly attributed to its three business segments:
Securities, Investment Management and Credit Services. Certain revenues and
expenses have been allocated to each business segment, generally in proportion
to their respective revenues or other relevant measures. Certain
reclassifications have been made to prior-period amounts to conform to the
current year's presentation.
Critical Accounting Policies
For a discussion of the Company's accounting policies that may involve a
higher degree of judgment and complexity, refer to "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Critical Accounting
Policies" included in the Form 10-K.
23
Securities
Statements of Income (dollars in millions)
Three Months Six Months
Ended May 31, Ended May 31,
--------------- ---------------
2002 2001 2002 2001
------ ------- ------- -------
(unaudited) (unaudited)
Revenues:
Investment banking................................................... $ 647 $ 825 $ 1,322 $ 1,787
Principal transactions:
Trading.......................................................... 704 2,070 1,826 3,755
Investments...................................................... (17) (106) 15 (153)
Commissions.......................................................... 888 829 1,654 1,668
Asset management, distribution and administration fees............... 478 476 935 962
Interest and dividends............................................... 3,266 6,279 6,537 12,819
Other................................................................ 107 135 281 249
------ ------- ------- -------
Total revenues................................................... 6,073 10,508 12,570 21,087
Interest expense..................................................... 2,586 6,081 5,252 11,912
------ ------- ------- -------
Net revenues..................................................... 3,487 4,427 7,318 9,175
------ ------- ------- -------
Non-interest expenses:
Compensation and benefits............................................ 1,872 2,346 3,993 4,788
Occupancy and equipment.............................................. 175 191 342 368
Brokerage, clearing and exchange fees................................ 119 127 245 244
Information processing and communications............................ 220 250 439 492
Marketing and business development................................... 125 126 228 275
Professional services................................................ 144 225 270 448
Other................................................................ 124 185 235 369
------ ------- ------- -------
Total non-interest expenses...................................... 2,779 3,450 5,752 6,984
------ ------- ------- -------
Income before income taxes, dividends on preferred securities subject to
mandatory redemption and cumulative effect of accounting change....... 708 977 1,566 2,191
Provision for income taxes.............................................. 226 338 523 765
Dividends on preferred securities subject to mandatory redemption....... 22 7 44 14
------ ------- ------- -------
Income before cumulative effect of accounting change.................... 460 632 999 1,412
Cumulative effect of accounting change.................................. -- -- -- (46)
------ ------- ------- -------
Net income........................................................... $ 460 $ 632 $ 999 $ 1,366
====== ======= ======= =======
Securities net revenues were $3,487 million and $7,318 million in the
quarter and six month period ended May 31, 2002, a decrease of 21% and 20% from
the comparable periods of fiscal 2001. Securities net income for the quarter
and six month period ended May 31, 2002 was $460 million and $999 million, a
decrease of 27% from both of the comparable periods of fiscal 2001. Securities
net income in the six month period ended May 31, 2001 included a charge of $46
million from the cumulative effect of an accounting change associated with the
Company's adoption of SFAS No. 133 on December 1, 2000. Excluding the
cumulative effect of the accounting change, Securities net income for the six
month period ended May 31, 2002 decreased 29% from the comparable period of
fiscal 2001. The decreases in net revenues and net income were primarily
attributable to lower revenues from the Company's investment banking and sales
and trading activities, as well as from the Company's individual securities
business. These decreases were partially offset by lower principal investment
losses in the quarter and principal investment gains in the six month period.
Net income in the quarter and six month period ended May 31, 2002 also
reflected lower non-interest expenses, including lower incentive-based
compensation costs, professional services costs and other expenses. Securities
net revenues and net income for the six month period ended May 31, 2002
included a gain (included within other revenues) on the sale of an office tower.
24
Investment Banking
Investment banking revenues are derived from the underwriting of securities
offerings and fees from advisory services. Investment banking revenues in the
quarter ended May 31, 2002 decreased 22% from the comparable period of fiscal
2001. The decrease was due to lower revenues from merger, acquisition and
restructuring activities and equity and fixed income underwriting transactions.
Revenues from merger, acquisition and restructuring activities decreased 14%
to $250 million in the quarter ended May 31, 2002 from the comparable period of
fiscal 2001. The decrease primarily reflected a sharp decline in the volume of
global merger and acquisition transaction activity. The global market for such
transactions continued to be affected negatively by the difficult global
economic conditions and uncertainty in the global financial markets. In
addition to the decline in transaction volume, the average transaction size
also decreased during the quarter ended May 31, 2002 as compared to the prior
year period.
Underwriting revenues declined 26% to $397 million in the quarter ended May
31, 2002 from the comparable period of fiscal 2001.
Equity underwriting revenues decreased in the quarter ended May 31, 2002 as
compared to the prior year period. The decrease was primarily due to a lower
volume of equity offerings, particularly in the technology sector, partially
offset by a higher volume of convertible equity offerings.
Fixed income underwriting revenues decreased in the quarter ended May 31,
2002 as compared to the prior year period, primarily due to a lower volume of
investment grade corporate transactions.
Investment banking revenues in the six month period ended May 31, 2002
decreased 26% to $1,322 million from the comparable period of fiscal 2001. The
decrease was attributable to lower revenues from merger, acquisition and
restructuring activities and from underwriting equity and fixed income
transactions, reflecting lower levels of transaction volume as a result of the
difficult conditions in the global financial markets.
Principal Transactions
Principal transactions include revenues from customers' purchases and sales
of securities in which the Company acts as principal and gains and losses on
the Company's securities positions. 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 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. The Company also
engages in proprietary trading activities for its own account. Principal
transaction trading revenues decreased 66% in the quarter ended May 31, 2002
from the comparable period of fiscal 2001. The decrease reflected lower levels
of equity, fixed income and commodity trading revenues.
Equity trading revenues decreased during the quarter ended May 31, 2002,
primarily reflecting lower revenues from trading derivative, cash and
convertible equity products, as well as lower revenues from certain proprietary
trading activities. Conditions in the equity markets were less favorable than
in the second quarter of fiscal 2001, particularly in the U.S. and in Europe,
as market volatility declined. A decline in the NASDAQ trading volume also
contributed to the unfavorable equity market conditions. The decrease in equity
trading revenues also reflected a decline in trading activity and fewer
opportunities related to lower new issue volume. Equity trading revenues were
also negatively affected by the Company's new pricing structure for executing
transactions on the NASDAQ (see "Commissions" herein).
25
Fixed income trading revenues decreased in the quarter ended May 31, 2002
from the comparable period of fiscal 2001, reflecting lower trading revenues
from commodities, government and investment grade fixed income securities,
partially offset by higher trading revenues from global high-yield fixed income
securities and foreign exchange products. Commodity trading revenues decreased
significantly as compared to the strong revenues recorded during the quarter
ended May 31, 2001. The sharp decline was primarily attributable to reduced
levels of volatility and liquidity in the energy markets, particularly in the
electricity and natural gas sectors. The decrease in government trading
revenues was primarily due to less favorable market conditions in comparison
with the prior year, reflecting relatively low trading volumes and a lack of
direction with respect to interest rates. The decrease in investment grade
fixed income revenues also reflected a less favorable trading environment, as
corporate credit spreads widened due to concerns over the quality of corporate
earnings. The increase in global high-yield trading revenues was primarily due
to improved market conditions as compared to the prior year period. Foreign
exchange trading revenues increased due to higher levels of market volatility,
as the U.S. dollar depreciated against the yen and the euro during the quarter.
Principal transaction net investment losses aggregating $17 million were
recorded in the quarter ended May 31, 2002, as compared to net losses of $106
million in the quarter ended May 31, 2001. Fiscal 2002's results primarily
include unrealized losses in certain of the Company's principal investments.
Fiscal 2001's results include unrealized losses in the Company's private equity
portfolio and certain other principal investments, primarily reflecting
markdowns of non-publicly traded investments.
Principal transaction trading revenues decreased 51% in the six month period
ended May 31, 2002 from the comparable period of fiscal 2001, primarily
reflecting a decline in equity, fixed income, and commodity trading revenues.
The decline in equity trading revenues reflected lower revenues from cash and
derivative equity products due to lower levels of market volatility and new
issue volume, as well as lower revenues from certain proprietary trading
activities. Fixed income trading revenues decreased due to lower government and
investment grade fixed income trading revenues, partially offset by higher
trading revenues from global high-yield fixed income securities. Commodity
trading revenues decreased significantly, primarily due to lower revenues from
trading energy products.
Principal transaction net investment gains aggregating $15 million were
recorded in the six month period ended May 31, 2002, as compared to net losses
of $153 million in the six month period ended May 31, 2001. Fiscal 2002's
results primarily included unrealized gains from investments in certain of the
Company's real estate funds, partially offset by unrealized losses in certain
of the Company's principal investments. Fiscal 2001's results included
unrealized losses in the Company's private equity portfolio and certain other
principal investments, primarily reflecting difficult market conditions in the
technology and telecommunications sectors.
Commissions
Commission revenues primarily arise from agency transactions in listed and
over-the-counter equity securities, and sales of mutual funds, futures,
insurance products and options. Commission revenues increased 7% in the quarter
and decreased 1% in the six month period ended May 31, 2002 from the comparable
periods of fiscal 2001. The increase in the quarter was due to higher
institutional commission revenues in the U.S. as a result of the impact of a
new commission-based pricing structure for executing transactions on the
NASDAQ. This increase was partially offset by lower levels of retail investor
participation in the equity markets. The decrease in the six month period was
due to lower levels of retail investor participation in the equity markets,
partially offset by higher institutional commission revenues in the U.S. and
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.
In prior periods, 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 are now included in
commission revenues.
26
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, reverse repurchase and repurchase agreements, trading strategies
associated with the Company's institutional securities business, customer
margin loans and the prevailing level, term structure and volatility of
interest rates. Interest and dividend revenues and interest expense are
integral components of trading activities. In assessing the profitability of
trading activities, the Company views net interest, commissions and principal
trading 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 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. 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. Net interest revenues increased 243% and 42% in the quarter and
six month period ended May 31, 2002 from the comparable periods of fiscal 2001,
partially reflecting the level and mix of interest earning assets and interest
bearing liabilities during the respective periods as well as certain trading
strategies utilized in the Company's institutional securities business. The
increase in both periods reflects higher net interest revenues from
mortgage-backed products, as well as a decline in interest expense due to a
decrease in the Company's average cost of borrowings. The increase in the six
month period was partially offset by lower net interest revenues from brokerage
services provided to individual customers, including a decrease in the level of
customer margin loans.
Asset Management, Distribution and Administration Fees
Asset management, distribution and administration fees include revenues from
asset management services, including fees for promoting and distributing mutual
funds ("12b-1 fees") 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 12b-1 fees for services it provides in promoting and
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 also include revenues from individual investors electing a fee-based
pricing arrangement under the Morgan Stanley Choice/SM/ service and technology
platform.
Asset management, distribution and administration revenues remained
relatively unchanged in the quarter and decreased 3% in the six month period
ended May 31, 2002 from the comparable periods of fiscal 2001. The decrease in
the six month period was primarily attributable to lower 12b-1 fees from
promoting and distributing mutual funds, reflecting a decrease in individual
investors' mutual fund asset levels, partially offset by an increase in
revenues from the Company's ICS business.
Other
Other revenues primarily consist of net rental and other revenues associated
with the Company's aircraft financing business, as well as account fees and
other miscellaneous service fees associated with the Company's individual
securities activities. Other revenues decreased 21% in the quarter and
increased 13% in the six month period ended May 31, 2002 from the comparable
periods of fiscal 2001. The decrease in the quarter was due to a decline in
revenues from the Company's aircraft financing business, reflecting lower lease
rates and a higher number of unleased aircraft. The increase in the six month
period reflects the inclusion of a gain (of which $60 million was allocated to
the Securities segment) related to the Company's sale of an office tower in the
first quarter of fiscal 2002, as well as higher customer account fees from the
Company's individual securities activities. These increases were partially
offset by a decline in revenues from the Company's aircraft financing business,
reflecting lower lease rates and a higher number of unleased aircraft.
27
The terrorist attacks on the U.S. that occurred in September 2001 have had
an adverse impact on the global aviation industry and on the results of the
Company's aircraft financing business. While there is still much uncertainty
regarding the potential long-term impact of the terrorist attacks, the Company
currently believes that the conditions caused by the attacks could continue to
have an adverse impact on the results of its aircraft financing business.
Non-Interest Expenses
Securities non-interest expenses decreased 19% and 18% in the quarter and
six month period ended May 31, 2002 from the comparable periods of fiscal 2001.
Compensation and benefits expense decreased 20% and 17% in the quarter and six
month period ended May 31, 2002, principally reflecting lower incentive-based
compensation due to lower levels of revenues and earnings. Excluding
compensation and benefits expense, non-interest expenses decreased 18% and 20%
in the quarter and six month period ended May 31, 2002. Occupancy and equipment
expense decreased 8% and 7% in the quarter and six month period ended May 31,
2002, due to lower maintenance and repair costs as well as lower rent expense
resulting from the continued utilization of business interruption facilities
after the loss of the World Trade Center complex in the fourth quarter of
fiscal 2001. These decreases were partially offset by rent increases associated
with retail securities branch offices. Brokerage, clearing and exchange fees
decreased 6% in the quarter and remained unchanged in the six month period
ended May 31, 2002. The decrease in the quarter was due to lower brokerage
costs associated with global securities trading volume. Information processing
and communications expense decreased 12% and 11% in the quarter and six month
period ended May 31, 2002, due to lower data processing and telecommunication
costs. The decrease in the six month period also reflected a decrease in market
data costs. Marketing and business development expense decreased 1% and 17% in
the quarter and six month period ended May 31, 2002, reflecting lower travel
and entertainment costs, partially offset by higher advertising costs in the
individual securities business. Professional services expense decreased 36% and
40% in the quarter and six month period ended May 31, 2002, reflecting lower
consulting and temporary services costs. Other expenses decreased 33% and 36%
in the quarter and six month period ended May 31, 2002, due to lower
consumption taxes, postage and other operating expenses. In addition, goodwill
amortization declined due to the Company's adoption of SFAS No. 142, "Goodwill
and Other Intangible Assets," on December 1, 2001.
28
Investment Management
Statements of Income (dollars in millions)
Three Months Six Months
Ended May 31, Ended May 31,
------------ -------------
2002 2001 2002 2001
---- ---- ------ ------
(unaudited) (unaudited)
Revenues:
Investment banking..................................... $ 8 $ 15 $ 17 $ 34
Principal transactions:
Investments........................................ 1 (1) 2 --
Commissions............................................ 12 9 23 21
Asset management, distribution and administration fees. 576 598 1,135 1,221
Interest and dividends................................. 6 17 14 41
Other.................................................. 1 4 19 15
---- ---- ------ ------
Total revenues..................................... 604 642 1,210 1,332
Interest expense....................................... -- 3 1 5
---- ---- ------ ------
Net revenues....................................... 604 639 1,209 1,327
---- ---- ------ ------
Non-interest expenses:
Compensation and benefits.............................. 170 197 349 406
Occupancy and equipment................................ 19 24 38 49
Brokerage, clearing and exchange fees.................. 57 50 110 100
Information processing and communications.............. 25 25 47 49
Marketing and business development..................... 32 42 61 77
Professional services.................................. 49 59 99 114
Other.................................................. 25 26 44 61
---- ---- ------ ------
Total non-interest expenses........................ 377 423 748 856
---- ---- ------ ------
Income before income taxes................................ 227 216 461 471
Provision for income taxes................................ 86 89 178 191
---- ---- ------ ------
Net income............................................. $141 $127 $ 283 $ 280
==== ==== ====== ======
Investment Management net revenues were $604 million and $1,209 million in
the quarter and six month period ended May 31, 2002, a decrease of 5% and 9%
from the comparable periods of fiscal 2001. Investment Management net income
for the quarter and six month period ended May 31, 2002 was $141 million and
$283 million, an increase of 11% and 1% from the comparable periods of fiscal
2001. In both periods, the increases in net income primarily reflected a
decline in non-interest expenses. The increase in the six month period also
reflects a gain of $13 million (included within other revenues) related to the
Company's sale of an office tower in the first quarter of fiscal 2002. In both
periods, these increases were partially offset by lower asset management,
distribution and administration fees and lower investment banking revenues.
Investment Banking
Investment Management primarily generates investment banking revenues from
the underwriting of Unit Investment Trust products. Investment banking revenues
decreased 47% and 50% in the quarter and six month period ended May 31, 2002
from the comparable prior year periods, primarily reflecting a lower volume of
Unit Investment Trust sales. Due to the emergence of alternate investment
products, the Company does not expect Unit Investment Trust sales volumes and
associated investment banking revenues to return to the levels achieved in
prior years.
Principal Transactions
Investment Management principal transaction revenues are primarily generated
from net gains and losses on capital investments in certain of the Company's
funds and other investments.
29
The Company recorded net principal investment gains of $1 million in the
quarter and $2 million in the six month period ended May 31, 2002. In fiscal
2001, the Company recorded net principal investment losses of $1 million in the
quarter and no gain or loss in the six month period ended May 31, 2001.
Commissions
Investment Management primarily generates commission revenues from dealer
and distribution concessions on sales of certain funds as well as allocated
commission revenues. Commission revenues increased 33% and 10% in the quarter
and six month period ended May 31, 2002 from the comparable periods of fiscal
2001. The increase in the quarter was due to increased sales of insurance
products. The increase in the six month period was due to a higher sales volume
of certain Van Kampen products.
Net Interest
Investment Management generates net interest revenues from certain
investment positions as well as from allocated interest revenues and expenses.
Net interest revenues declined 57% and 64% in the quarter and six month period
ended May 31, 2002 from the comparable periods of fiscal 2001 due to lower net
interest revenues earned on certain investment positions, as well as lower
allocated net interest revenues.
Asset Management, Distribution and Administration Fees
Asset management, distribution and administration fees primarily include
revenues from the management and administration of assets. These fees arise
from investment management services the Company provides to investment vehicles
pursuant to various contractual arrangements. Generally, the Company receives
fees primarily based upon mutual fund average net assets or quarterly assets
for other vehicles.
The Company's customer assets under management or supervision were as
follows:
At May 31,
---------------------
2002 2001
------- -------
(dollars in billions)
Products offered primarily to individuals:
Mutual funds:
Equity............................................... $ 80 $ 94
Fixed income......................................... 35 41
Money markets........................................ 61 63
---- ----
Total mutual funds................................ 176 198
ICS assets.................................................. 32 32
Separate accounts, unit trust and other arrangements........ 61 73
---- ----
Total individual.................................. 269 303
---- ----
Products offered primarily to institutional clients:
Mutual funds............................................. 37 39
Separate accounts, pooled vehicle and other arrangements. 145 145
---- ----
Total institutional............................... 182 184
---- ----
Total assets under management or supervision(1)............. $451 $487
==== ====
- --------
(1)Revenues and expenses associated with certain assets are included in the
Company's Securities segment.
30
In the quarter and six month period ended May 31, 2002, asset management,
distribution and administration fees decreased 4% and 7% from the comparable
periods of fiscal 2001. The decrease in revenues primarily reflects lower fund
management fees and other revenues resulting from a decline in the level of
average assets under management or supervision. The decrease in both periods
also reflects a less favorable asset mix due to a shift of customer assets from
equity products to money market products, which typically generate lower
management fees.
As of May 31, 2002, customer assets under management or supervision
decreased $36 billion from May 31, 2001. The decrease was attributable to
market depreciation, reflecting the declines in global financial markets,
coupled with net outflows of customer assets, as redemptions exceeded new sales
during the period from June 1, 2001 to May 31, 2002.
Non-Interest Expenses
Investment Management non-interest expenses decreased 11% and 13% in the
quarter and six month period ended May 31, 2002 from the comparable period of
fiscal 2001. Compensation and benefits expense decreased 14% in both the
quarter and six month period ended May 31, 2002, reflecting lower
incentive-based compensation costs as well as lower employment levels.
Excluding compensation and benefits expense, non-interest expenses decreased 8%
and 11% in the quarter and six month period ended May 31, 2002 from the
comparable periods of fiscal 2001. Occupancy and equipment expense decreased
21% and 22%, reflecting a reduction in rental expense due to the continued
utilization of business interruption facilities after the loss of the World
Trade Center complex in the fourth quarter of fiscal 2001. Brokerage, clearing
and exchange fees increased 14% and 10%, primarily reflecting a higher level of
deferred commission amortization associated with the sales of certain funds.
Information processing and communications expense remained unchanged in the
quarter and decreased 4% during the six month period ended May 31, 2002. The
decrease for the six month period was attributable to lower costs for market
data and telecommunication services. Marketing and business development expense
decreased 24% and 21%, primarily related to lower marketing and travel and
entertainment costs. Professional services expense decreased 17% and 13%,
primarily reflecting lower recruiting fees and consulting and temporary
services costs. Other expenses decreased 4% and 28%, reflecting a decline in
discretionary spending on various operating costs, lower allocated expenses and
a decline in goodwill amortization as a result of the Company's adoption of
SFAS No. 142 on December 1, 2001.
31
Credit Services
Statements of Income (dollars in millions)
Three Months Six Months
Ended May 31, Ended May 31,
------------- --------------
2002 2001 2002 2001
------ ------ ------ ------
(unaudited) (unaudited)
Fees:
Merchant and cardmember........................................... $ 359 $ 325 $ 700 $ 638
Servicing......................................................... 511 476 1,052 903
Other................................................................ -- -- 2 --
------ ------ ------ ------
Total non-interest revenues................................... 870 801 1,754 1,541
------ ------ ------ ------
Interest revenue..................................................... 602 654 1,155 1,326
Interest expense .................................................... 258 322 527 661
------ ------ ------ ------
Net interest income . ............................................ 344 332 628 665
Provision for consumer loan losses................................... 340 231 685 444
------ ------ ------ ------
Net credit income................................................. 4 101 (57) 221
------ ------ ------ ------
Net revenues.................................................. 874 902 1,697 1,762
------ ------ ------ ------
Non-interest expenses:
Compensation and benefits......................................... 192 189 380 377
Occupancy and equipment........................................... 16 15 30 31
Information processing and communications......................... 90 93 169 179
Marketing and business development................................ 102 163 221 345
Professional services ............................................ 57 52 106 108
Other ............................................................ 105 111 224 212
------ ------ ------ ------
Total non-interest expenses................................... 562 623 1,130 1,252
------ ------ ------ ------
Income before income taxes and cumulative effect of accounting change 312 279 567 510
Provision for income taxes........................................... 116 108 204 197
------ ------ ------ ------
Income before cumulative effect of accounting change................. 196 171 363 313
Cumulative effect of accounting change . ............................ -- -- -- (13)
------ ------ ------ ------
Net income ....................................................... $ 196 $ 171 $ 363 $ 300
====== ====== ====== ======
Credit Services net revenues were $874 million and $1,697 million in the
quarter and six month period ended May 31, 2002, a decrease of 3% and 4% from
the comparable periods of fiscal 2001. Credit Services net income was $196
million and $363 million in the quarter and six month period ended May 31,
2002, an increase of 15% and 21% from the comparable periods of fiscal 2001.
Net income for the six month period ended May 31, 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. Excluding the
cumulative effect of the accounting change, net income for the six month period
ended May 31, 2002 increased 16% from the comparable period of fiscal 2001. The
increase in net income for both periods was attributable to higher servicing
fees and merchant and cardmember fees and lower non-interest expenses,
partially offset by a higher provision for consumer loan losses. The sluggish
economic conditions in the U.S. and an increased focus on portfolio credit
quality have slowed the growth of transaction volume and consumer loans. In
addition, the less favorable economic conditions have affected the credit
quality of the consumer loan portfolio, resulting in a higher provision for
consumer loan losses.
Non-Interest Revenues
Total non-interest revenues increased 9% and 14% in the quarter and six
month period ended May 31, 2002 from the comparable periods of fiscal 2001.
32
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, insurance fees and cash advance fees, net of cardmember
rewards. Cardmember rewards include the Cashback Bonus(R) award program,
pursuant to which the Company pays Discover Classic Card, Discover Platinum
Card and Morgan Stanley Card cardmembers electing this feature a percentage of
their purchase amounts ranging up to 1% based upon a cardmember's level and
type of purchases. Merchant and cardmember fees increased 10% in both the
quarter and six month period ended May 31, 2002 from the comparable periods of
fiscal 2001. The increase was due to higher merchant discount revenue and late
payment fees, partially offset by lower cash advance and overlimit fees. The
increase in merchant discount revenue was due to an increase in the average
merchant discount rate coupled with a higher level of sales volume. The
increase in late payment fees resulted from the elimination of certain payment
features which previously mitigated late charges and the implementation of a
tiered fee. The decrease in cash advance fees was due to lower transaction
volume. The decrease in overlimit fees was due to fewer occurrences.
Servicing fees are revenues derived from consumer loans which have been sold
to investors through asset securitizations. Cash flows from the interest yield
and cardmember fees generated by securitized 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
condensed consolidated statements of income. The sale of consumer 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 $1.7 billion and $2.8 billion in the quarter and
six month period ended May 31, 2002. During the comparable periods of fiscal
2001, the Company completed credit card asset securitizations of $2.4 billion
and $6.8 billion. The credit card asset securitization transactions completed
during the six month period ended May 31, 2002 have expected maturities ranging
from approximately three to five years from the date of issuance.
The table below presents the components of servicing fees:
Three Months Six Months
Ended May 31, Ended May 31,
---------------- ----------------
2002 2001 2002 2001
------- ------- ------- -------
(dollars in millions)
Merchant and cardmember fees........ $ 193 $ 187 $ 393 $ 370
Interest revenue.................... 1,012 1,091 2,070 2,166
Interest expense.................... (222) (408) (452) (867)
Provision for consumer loan losses.. (472) (394) (959) (766)
------- ------- ------- -------
Servicing fees...................... $ 511 $ 476 $ 1,052 $ 903
======= ======= ======= =======
Servicing fees are affected by the level of securitized loans, the spread
between the interest yield on the securitized loans and the yield paid to the
investors, the rate of credit losses on securitized loans and the amount of
cardmember fees earned from securitized loans. Servicing fees increased 7% and
17% in the quarter and six month period ended May 31, 2002 from the comparable
periods of fiscal 2001. The increase in both periods was due to higher levels
of net interest cash flows as a result of a lower cost of funding and a higher
level of average securitized consumer loans. The increases in both periods were
partially offset by higher credit losses associated with a higher rate of
charge-offs related to the securitized portfolio. Net securitization gains on
general purpose credit card loans, included in servicing fees, were $11 million
and $19 million in the quarter and six month period ended May 31, 2002, a
decrease of $38 million and $55 million from the comparable periods of fiscal
2001. Approximately $3 million of the decrease in the quarter and $26 million
of the decrease in the six month period ended May 31, 2002 was attributable to
lower levels of new asset securitization transactions in each period. The
decrease in net securitization gains also reflected modifications to certain
assumptions in the gain calculations made during fiscal 2001, which increased
the gain in the quarter and the six month period ended May 31, 2001 by
approximately $24 million. The assumptions modified by the Company in fiscal
2001 were the net interest rate spread and the net charge-off rate. The net
interest rate spread increased, reflecting the projection
33
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 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. Additionally, net securitization gains were lower by
approximately $11 million in the quarter and $5 million in the six month period
ended May 31, 2002 due to a higher percentage of new securitization
transactions during the quarter with a fixed rate cost of funds. The net
securitization gains related to these fixed rate transactions were negatively
impacted by the higher assumed net charge-off rate without the offsetting
effect of the lower assumed cost of funds that positively impacted the new
securitization transactions issued at a variable rate.
Net Interest Income
Net interest income represents the difference between interest revenue
derived from Credit Services consumer loans and short-term investment assets
and interest expense incurred to finance those loans and assets. Credit
Services 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 increased 4% in the quarter and decreased 6% in the six
month period ended May 31, 2002 from the comparable periods of fiscal 2001. The
increase in the quarter was primarily due to a decline in interest expense,
partially offset by lower levels of average general purpose credit card loans
and a lower yield on these loans. The decrease in the six month period was
primarily due to lower levels of average general purpose credit card loans and
a lower yield on these loans, partially offset by a decline in interest
expense. The decrease in the level of average general purpose credit card loans
in both periods was due to higher levels of securitized loans. The Company's
increased focus on credit quality and decreased marketing efforts have also
contributed to the reduced growth of the consumer loan portfolio. The lower
yield on general purpose credit card loans for both periods was primarily due
to lower interest rates offered to new cardmembers and certain existing
cardmembers, as well as higher charge-offs of interest. The decrease in
interest expense for both periods was primarily due to a decrease in the
Company's average cost of borrowings, coupled with a lower level of interest
bearing liabilities. The Company's average cost of borrowings were 5.27% and
6.30% for the quarters and 5.34% and 6.46% for the six month periods ended May
31, 2002 and 2001, respectively. The decline in the average cost of borrowings
reflects the Fed's aggressive easing of interest rates during 2001.
34
The following tables present analyses of Credit Services average balance
sheets and interest rates for the quarters and six month periods ended May 31,
2002 and 2001 and changes in net interest income during those periods:
Average Balance Sheet Analysis
Three Months Ended May 31,
------------------------------------------------
2002 2001(3)
----------------------- -----------------------
Average Average
Balance Rate Interest Balance Rate Interest
------- ----- -------- ------- ----- --------
(dollars in millions)
ASSETS
Interest earning assets:
General purpose credit card loans.................... $20,747 10.88% $ 569 $21,301 11.13% $ 598
Other consumer loans................................. 1,163 5.97 17 731 8.08 15
Investment securities................................ 60 1.62 -- 650 4.70 7
Other................................................ 2,456 2.50 16 2,291 5.88 34
------- ----- ------- -----
Total interest earning assets.............. 24,426 9.78 602 24,973 10.39 654
Allowance for loan losses............................ (878) (788)
Non-interest earning assets.......................... 2,104 2,189
------- -------
Total assets............................... $25,652 $26,374
======= =======
LIABILITIES AND SHAREHOLDER'S
EQUITY
Interest bearing liabilities:
Interest bearing deposits
Savings........................................... $ 1,045 1.59% $ 4 $ 1,719 4.60% $ 20
Brokered.......................................... 9,357 6.11 144 9,001 6.72 152
Other time........................................ 1,798 5.07 23 3,007 6.10 46
------- ----- ------- -----
Total interest bearing deposits............ 12,200 5.57 171 13,727 6.32 218
Other borrowings..................................... 7,254 4.75 87 6,528 6.28 104
------- ----- ------- -----
Total interest bearing liabilities......... 19,454 5.27 258 20,255 6.30 322
Shareholder's equity/other liabilities............... 6,198 6,119
------- -------
Total liabilities and shareholder's
equity................................... $25,652 $26,374
======= =======
Net interest income.................................. $ 344 $ 332
===== =====
Net interest margin(1)............................... 5.58% 5.28%
Interest rate spread(2).............................. 4.51% 4.09%
- --------
(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.
35
Average Balance Sheet Analysis
Six Months Ended May 31,
--------------------------------------------------
2002 2001(3)
------------------------ ------------------------
Average Average
Balance Rate Interest Balance Rate Interest
-------- ----- -------- -------- ----- --------
(dollars in millions)
ASSETS
Interest earning assets:
General purpose credit card loans.................... $ 20,858 10.48% $1,090 $ 21,426 11.22% $ 1,199
Other consumer loans................................. 1,116 6.09 34 731 8.46 31
Investment securities................................ 60 1.71 -- 726 5.54 20
Other................................................ 2,521 2.48 31 2,334 6.53 76
-------- ------ -------- -------
Total interest earning assets.............. 24,555 9.44 1,155 25,217 10.55 1,326
Allowance for loan losses............................ (864) (787)
Non-interest earning assets.......................... 2,214 2,155
-------- --------
Total assets............................... $ 25,905 $ 26,585
======== ========
LIABILITIES AND SHAREHOLDER'S
EQUITY
Interest bearing liabilities:
Interest bearing deposits............................
Savings........................................... $ 1,090 1.62% $ 9 $ 1,746 5.17% $ 45
Brokered.......................................... 9,091 6.23 283 8,904 6.72 298
Other time........................................ 2,319 5.30 61 3,010 6.19 93
-------- ------ -------- -------
Total interest bearing deposits............ 12,500 5.66 353 13,660 6.40 436
Other borrowings..................................... 7,297 4.79 174 6,873 6.56 225
-------- ------ -------- -------
Total interest bearing liabilities......... 19,797 5.34 527 20,533 6.46 661
Shareholder's equity/other liabilities............... 6,108 6,052
-------- --------
Total liabilities and shareholder's
equity................................... $ 25,905 $ 26,585
======== ========
Net interest income.................................. $ 628 $ 665
====== =======
Net interest margin(1)............................... 5.13% 5.29%
Interest rate spread(2).............................. 4.10% 4.09%
- --------
(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.
36
Rate/Volume Analysis
Three Months Ended Six Months Ended
May 31, 2002 vs. 2001 May 31, 2002 vs. 2001
-------------------------- --------------------------
Increase/(Decrease) due to Increase/(Decrease) due to
Changes in: Changes in:
-------------------------- --------------------------
Volume Rate Total Volume Rate Total
------ ---- ----- ------ ----- -----
(dollars in millions)
INTEREST REVENUE
General purpose credit card loans.......... $(16) $(13) $(29) $(32) $ (77) $(109)
Other consumer loans....................... 8 (6) 2 16 (13) 3
Investment securities...................... (7) -- (7) (19) (1) (20)
Other...................................... 3 (21) (18) 6 (51) (45)
---- -----
Total interest revenue.................. (14) (38) (52) (35) (136) (171)
---- -----
INTEREST EXPENSE
Interest bearing deposits:
Savings................................. (8) (8) (16) (17) (19) (36)
Brokered................................ 6 (14) (8) 6 (21) (15)
Other time.............................. (18) (5) (23) (22) (10) (32)
---- -----
Total interest bearing deposits..... (24) (23) (47) (37) (46) (83)
Other borrowings........................... 11 (28) (17) 14 (65) (51)
---- -----
Total interest expense.............. (13) (51) (64) (24) (110) (134)
---- -----
Net interest income........................ $ (1) $ 13 $ 12 $(11) $ (26) $ (37)
==== ==== ==== ==== ===== =====
The supplemental table below provides average managed loan balance sheet and
rate information, which takes into account both owned and securitized loans:
Supplemental Average Managed Loan Balance Sheet Information
Three Months Ended May 31,
------------------------------------------------
2002 2001(1)
------------------------ -----------------------
Avg. Avg.
Bal. Rate Interest Bal. Rate Interest
------- ----- --------- ------- ----- --------
(dollars in millions)
General purpose credit card loans............... $49,379 12.64% $1,573 $49,658 13.34% $1,669
Total interest earning assets................... 53,624 11.94 1,614 54,240 12.76 1,745
Total interest bearing liabilities.............. 48,653 3.92 480 49,522 5.85 730
General purpose credit card interest rate spread 8.72 7.49
Interest rate spread............................ 8.02 6.91
Net interest margin............................. 8.39 7.42
Six Months Ended May 31,
------------------------------------------------
2002 2001(1)
------------------------ -----------------------
Avg. Avg.
Bal. Rate Interest Bal. Rate Interest
------- ----- --------- ------- ----- --------
(dollars in millions)
General purpose credit card loans............... $49,882 12.63% $3,142 $49,468 13.50% $3,329
Total interest earning assets................... 54,184 11.94 3,225 54,087 12.95 3,492
Total interest bearing liabilities.............. 49,425 3.97 979 49,404 6.20 1,528
General purpose credit card interest rate spread 8.66 7.30
Interest rate spread............................ 7.97 6.75
Net interest margin............................. 8.32 7.28
- --------
(1)Certain prior-year information has been reclassified to conform to the
current year's presentation.
37
Provision for Consumer Loan Losses
The provision for consumer loan losses is the amount necessary to establish
the allowance for 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 allowance for consumer loan losses was $899 million at May
31, 2002 and $847 million at November 30, 2001.
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 an allowance
applicable to the owned homogeneous consumer credit card loan portfolio. The
allowance for consumer loan losses is evaluated quarterly for adequacy and is
established through a charge to the provision for consumer loan losses.
The Company uses a systematic and consistently applied approach in
determining the allowance for consumer loan losses. The amount of the allowance
is established through a process that begins with estimates of the losses
inherent in the consumer loan portfolio based on coverage of a twelve month
rolling average of historical credit losses. In addition, 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. 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 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 provision for consumer loan losses, which is affected by net
charge-offs, loan volume and changes in the amount of consumer loans estimated
to be uncollectable, increased 47% in the quarter and 54% in the six month
period ended May 31, 2002 from the comparable periods of fiscal 2001. The
increase in both periods was due to higher net charge-off rates, partially
offset by lower levels of average general purpose credit card loans. In
addition, to reflect the impact of the difficult economic environment on the
Company's credit card portfolio, the Company recorded a provision for consumer
loan loss expense that exceeded the amount of net consumer loans charged off by
$25 million and $50 million in the quarter and six month periods ended May 31,
2002.
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 and fraudulent transactions,
where loans are charged off earlier. Loan delinquencies and charge-offs are
primarily affected by changes in economic conditions and may vary throughout
the year due to seasonal consumer spending and payment behaviors.
During the quarter and the six month period ended May 31, 2002, net
charge-offs increased in both the owned and managed portfolios as compared to
the fiscal 2001 periods. In the U.S., weak economic conditions, coupled with
the seasoning of the Company's general purpose credit card loan portfolio and a
higher level of bankruptcy filings, contributed to the higher net charge-off
rates. In addition, the Company's delinquency rates in the greater than 90-day
categories increased during the quarter and six month period ended May 31, 2002
as compared to the fiscal 2001 periods. If weak economic conditions continue to
persist, the rate of net charge-offs may be higher in future periods.
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
38
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.
The following table presents owned and managed general purpose credit card
loans, delinquency and net charge-off rates:
Asset Quality
May 31, 2002 May 31, 2001 November 30, 2001
---------------- ---------------- ----------------
Owned Managed Owned Managed Owned Managed
------- ------- ------- ------- ------- -------
(dollars in millions)
General purpose credit card loans at period-end... $20,224 $49,377 $20,909 $50,227 $20,085 $49,332
General purpose credit card loans contractually
past due as a percentage of period-end general
purpose credit card loans:
30 to 89 days.................................. 2.75 % 2.98 % 2.93 % 3.24 % 3.43 % 3.83 %
90 to 179 days................................. 2.49 % 2.65 % 2.32 % 2.60 % 2.74 % 3.02 %
Net charge-offs as a percentage of average
general purpose credit card loans (year-to-date) 6.08 % 6.40 % 4.11 % 4.88 % 4.76 % 5.36 %
Non-Interest Expenses
Credit Services non-interest expenses decreased 10% in both the quarter and
six month period ended May 31, 2002 from the comparable periods of fiscal 2001.
Compensation and benefits expense increased 2% in the quarter and 1% in the six
month period ended May 31, 2002 as compared to the prior year periods. In both
periods, the increase was due to a modest increase in fixed compensation costs.
Occupancy and equipment expense increased 7% in the quarter and decreased 3% in
the six month period ended May 31, 2002. The increase in the quarter was due to
additional depreciation expense related to domestic building improvements,
partially offset by a decrease in rent expense. The decrease in the six month
period was due to lower rent expense. Information processing and communications
expense decreased 3% and 6% in the quarter and six month period ended May 31,
2002. The decrease in both periods was due to a decrease in external data
processing costs and telecommunications expense. The decrease in the quarter
was partially offset by an increase in transaction processing costs related to
Credit Services international operations. Marketing and business development
expenses decreased 37% and 36% in the quarter and six month period ended May
31, 2002. The decrease in both periods was attributable to lower advertising,
telemarketing and direct mail costs. The Company currently expects advertising
and marketing expenses to increase in the third and fourth quarters of fiscal
2002 as compared to the first and second quarters of fiscal 2002. Professional
services expense increased 10% in the quarter and decreased 2% in the six month
period ended May 31, 2002. The increase in the quarter was due to higher
account collection and consumer credit counseling costs. The decrease in the
six month period was due to lower consulting costs, partially offset by higher
account collection and consumer credit counseling costs. Other expense
decreased 5% in the quarter and increased 6% in the six month period ended May
31, 2002. The decrease in the quarter was due to lower inquiry fees associated
with new account applications and lower postage costs, partially offset by
higher allocated costs. The increase in the six month period was due to higher
allocated costs and increases in certain collection costs, partially offset by
lower inquiry fees resulting from fewer new account applications and lower
postage costs.
39
Liquidity and Capital Resources
The Company's total assets increased to $553.9 billion at May 31, 2002 from
$482.6 billion at November 30, 2001, primarily attributable to increases in
financial instruments owned, including U.S. government and agency securities
and other sovereign government obligations, securities borrowed and securities
purchased under agreements to resell. A substantial portion of the Company's
total assets consists of highly liquid marketable securities and short-term
receivables arising principally from securities transactions. The highly liquid
nature of these assets provides the Company with flexibility in financing and
managing its business.
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 is adjusted to reflect the low risk nature of assets
attributable to matched resale agreements, certain securities borrowed
transactions and segregated customer cash balances. In addition, the adjusted
leverage ratio reflects the deduction from shareholders' equity of the amount
of equity used to support goodwill, as the Company does not view this amount of
equity as available to support its risk capital needs. The following table sets
forth the Company's total assets, adjusted assets, leverage ratios and book
value per share:
Balance at
-------------------------------------
May 31, May 31, November 30,
2002 2001 2001
---------- ---------- -------------
(dollars in millions, except ratio
and per share data)
Total assets.................. $553,924 $497,381 $482,628
======== ======== ========
Adjusted assets(1)............ $382,306 $354,927 $338,957
======== ======== ========
Leverage ratio(2)............. 26.3x 26.3x 23.6x
======== ======== ========
Adjusted leverage ratio(3).... 18.2x 18.8x 16.5x
======== ======== ========
Book value per share(4)....... $ 19.39 $ 17.54 $ 18.64
======== ======== ========
- --------
(1)Adjusted assets represent total assets less the sum of (i) assets that were
recorded under certain provisions of SFAS No. 140, (ii) the lesser of
securities purchased under agreements to resell or securities sold under
agreements to repurchase, (iii) certain securities borrowed transactions,
(iv) segregated customer cash balances and (v) goodwill.
(2)Leverage ratio equals total assets divided by tangible shareholders' equity
($21,045 million at May 31, 2002, $18,918 million at May 31, 2001 and
$20,488 million at November 30, 2001). For purposes of this calculation,
tangible shareholders' equity includes preferred and common equity and
Preferred Securities Subject to Mandatory Redemption, less goodwill.
(3)Adjusted leverage ratio equals adjusted assets divided by tangible
shareholders' equity.
(4)Book value per share equals common shareholders' equity divided by common
shares outstanding of 1,097 million at May 31, 2002, 1,110 million at May
31, 2001 and 1,093 million at November 30, 2001.
The Company's senior management establishes the overall funding and capital
policies of the Company, reviews the Company's performance relative to these
policies, monitors the availability of sources of financing, reviews the
foreign exchange risk of the Company and oversees the liquidity and interest
rate sensitivity of the Company's asset and liability position. The primary
goal of the Company's funding and liquidity activities is to ensure adequate
financing over a wide range of potential credit ratings and market
environments. For a description of the Company's funding and capital policies,
see "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources" included in the Form 10-K. The
Company also has a liquidity reserve policy that is designed to cover
volatility in funding needs. The liquidity reserve is held in the form of cash
and cash equivalents, and a target reserve is periodically assessed and
determined based on funding volatility and capacity.
The Company views 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 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 capital base to address the changing needs of its businesses. 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.
40
The Company funds its balance sheet on a global basis. The Company raises
funding for its Securities and Investment Management businesses through diverse
sources. These sources include the Company's capital, including equity and
long-term debt; repurchase agreements; U.S., Canadian, Euro, Japanese and
Australian commercial paper; letters of credit; unsecured bond borrowings;
securities lending; buy/sell agreements; municipal reinvestments; 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 funding sources utilized for the Company's Credit Services business
include the Company's capital, including equity and long-term debt;
asset-backed securitizations; deposits; Federal Funds; and short-term bank
notes. The Company sells consumer loans through asset securitizations using
several transaction structures, including an extendible asset-backed
certificate program.
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. generally accepted accounting principles
(see Notes 1 and 5 to the condensed consolidated financial statements). In
connection with its Discover Card securitization program, the Company transfers
credit card receivables, on a revolving basis, to the Discover Card Master
Trust I (the "Trust"), which issues asset-backed securities registered with the
Securities and Exchange Commission. 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 such feature
relates to the availability and adequacy of cash flows in the securitized pool
of receivables to meet contractual requirements ("economic early amortization").
Economic early amortization risk reflects the possibility of negative net
securitization cash flows and is driven primarily by the Trust's 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 would otherwise have been subsequently purchased by the Trust
from the Company would instead continue to be recognized on the Company's
condensed consolidated statements of financial condition since the cash flows
generated in the Trust 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.
The Company's bank subsidiaries solicit deposits from consumers, purchase
Federal Funds and issue short-term 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 directly to
cardmembers and savings deposits from individual securities clients. Brokered
deposits consist primarily of certificates of deposit issued by the Company's
bank subsidiaries. Other time deposits include certificates of deposit.
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, global and product diversification, risk
management policies, cash liquidity and capital structure. In addition, the
agencies that rate the Company's debt have focused on certain recent changes in
the market that may require financial services firms to assume more credit risk
in connection with their corporate lending activities and recent legal and
regulatory developments. A deterioration in any of the previously mentioned
41
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. 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
over-the-counter derivative transactions, including credit derivatives and
interest rate swaps.
As of June 30, 2002, the Company's credit ratings were as follows:
Commercial Paper Senior Debt
---------------- -----------
Dominion Bond Rating Service Limited.. R-1 (middle) AA (low)
Fitch Ratings(1)...................... F1+ AA-
Moody's Investors Service............. P-1 Aa3
Rating and Investment Information, Inc a-1+ AA
Standard & Poor's(2).................. A-1+ AA-
- --------
(1)In May 2002, Fitch Ratings lowered the Company's senior debt credit ratings
from "AA" with a negative outlook to "AA-" with a stable outlook.
(2)In July 2001, Standard & Poor's placed the Company's senior debt credit
ratings on negative outlook.
As the Company continues to expand globally and derives revenues in various
currencies, foreign currency management is a key element of the Company's
financial policies. The Company benefits from operating in several different
currencies because weakness in any particular currency often is offset by
strength in another currency. The Company closely monitors its exposure to
fluctuations in currencies and, where cost-justified, adopts strategies to
reduce the impact of these fluctuations on the Company's financial performance.
These strategies include engaging in various hedging activities to manage
income and cash flows denominated in foreign currencies and using foreign
currency borrowings, when appropriate, to finance investments outside the U.S.
During the six month period ended May 31, 2002, the Company issued senior
notes aggregating $10,018 million, including non-U.S. dollar currency notes
aggregating $1,597 million. 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 May 31, 2002 the aggregate
outstanding principal amount of the Company's Senior Indebtedness (as defined
in the Company's public debt shelf registration statements) was approximately
$92.7 billion (including Senior Indebtedness consisting of guaranteed
obligations of the indebtedness of subsidiaries). Between May 31, 2002 and June
30, 2002, the Company's long-term borrowings, net of repayments and
repurchases, decreased by approximately $744 million.
During the six month period ended May 31, 2002, the Company purchased $473
million of its common stock through open market purchases. Subsequent to May
31, 2002 and through June 30, 2002, the Company purchased an additional $74
million of its common stock through open market purchases.
In an effort to enhance its ongoing stock repurchase program, the Company
may sell put options on shares of its common stock to third parties. These put
options entitle the holder to sell shares of the Company's common stock to the
Company on certain dates at specified prices. As of May 31, 2002, put options
were outstanding on an aggregate of 3.0 million shares of the Company's common
stock. These put options have expiration dates that range from September 2002
through November 2002 with strike prices ranging from $39.76 to $40.10. The
Company may elect cash settlement of the put options instead of taking delivery
of the stock.
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 maintains a senior revolving credit agreement with a group of
banks to support general liquidity needs, including the issuance of commercial
paper (the "Morgan Stanley Facility"). Under the terms of the Morgan Stanley
Facility, the banks are committed to provide up to $5.5 billion. The Morgan
Stanley Facility contains restrictive covenants, which require, among other
things, that the Company maintain specified levels of
42
shareholders' equity. At May 31, 2002, the Company maintained a $7.8 billion
surplus shareholders' equity as compared with the Morgan Stanley Facility's
restrictive covenant requirement. The Company believes that the covenant
restrictions will neither impair its ability to obtain funding under the Morgan
Stanley Facility nor impair its ability to pay its current level of dividends.
At May 31, 2002, no borrowings were outstanding under the Morgan Stanley
Facility.
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 $1.875 billion.
The credit agreement contains restrictive covenants, which require, among other
things, that MS&Co. maintain specified levels of consolidated stockholder's
equity and Net Capital, each as defined in the MS&Co. Facility. At May 31,
2002, MS&Co. maintained a $2.3 billion surplus consolidated stockholder's
equity and a $3.2 billion surplus Net Capital. The Company believes that the
restrictive covenants will not impair its ability to secure loan arrangements,
letters of credit and other financial accommodations under the MS&Co. Facility.
At May 31, 2002, no borrowings were outstanding under the MS&Co. Facility.
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
$1.95 billion, available in six major currencies. The facility agreement
contains restrictive covenants which require, among other things, that MSIL
maintain specified levels of Shareholder's Equity and Financial Resources, each
as defined in the MSIL Facility. At May 31, 2002, MSIL maintained a $1.3
billion surplus Shareholder's Equity and a $1.5 billion surplus Financial
Resources. The Morgan Stanley Facility's restrictive covenants described above
apply to the Company as guarantor. The Company believes that the restrictive
covenants will not impair its ability to obtain funding under the MSIL
Facility. At May 31, 2002, no borrowings were outstanding under the MSIL
Facility.
Morgan Stanley Japan Limited ("MSJL"), the Company's Tokyo-based
broker-dealer subsidiary, maintains a committed revolving credit facility,
guaranteed by the Company, that provides funding to support general liquidity
needs, including support of MSJL's unsecured borrowings (the "MSJL Facility").
The Morgan Stanley Facility's restrictive covenants described above apply to
the Company as guarantor. Under the terms of the MSJL Facility, a syndicate of
banks is committed to provide up to 70 billion Japanese yen. The Company
believes that the restrictive covenants will not impair its ability to obtain
funding under the MSJL Facility. At May 31, 2002, no borrowings were
outstanding under the MSJL Facility.
Neither the Morgan Stanley Facility, the MS&Co. Facility, the MSIL Facility
nor the MSJL Facility require the Company to maintain specific credit ratings.
The Company anticipates that it will utilize any of these facilities for
short-term funding from time to time.
In December 2001, the Company redeemed all 1,725,000 outstanding shares of
its Series A Fixed/Adjustable Rate Cumulative Preferred Stock at a redemption
price of $200 per share. The Company also simultaneously redeemed all
corresponding Depositary Shares at a redemption price of $50 per Depositary
Share. Each Depositary Share represented 1/4 of a share of the Company's Series
A Fixed/Adjustable Rate Cumulative Preferred Stock.
43
Commitments and Less Liquid Assets
The Company's commitments associated with outstanding letters of credit,
private equity and other principal investment activities and financing
commitments as of May 31, 2002 are summarized below by period of expiration.
Since commitments associated with letters of credit and financing arrangements
may expire unused, the amounts shown do not necessarily reflect actual future
cash funding requirements:
Remaining
Fiscal Fiscal Fiscal
2002 2003-2004 2005-2006 Thereafter Total
--------- --------- --------- ---------- -------
(dollars in millions)
Letters of credit(1)......................................... $4,451 $ 256 $ -- $ -- $ 4,707
Private equity and other principal investments(1)............ 58 229 115 198 600
Financing commitments to investment grade counterparties(1).. 1,732 4,382 1,599 1,222 8,935
Financing commitments to non-investment grade
counterparties(1).......................................... 126 443 385 290 1,244
------ ------ ------ ------ -------
Total..................................................... $6,367 $5,310 $2,099 $1,710 $15,486
====== ====== ====== ====== =======
- --------
(1)See Note 10 to the condensed consolidated financial statements.
The table above does not include commitments to extend credit for consumer
loans of approximately $259 billion. Such commitments arise 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 do not necessarily represent future cash requirements, are periodically
reviewed based on account usage and customer creditworthiness. In addition, in
the ordinary course of business, the Company guarantees the unsecured 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 unsecured debt or trading obligations) are included in the Company's
condensed consolidated financial statements.
At May 31, 2002, the Company had commitments to enter into reverse
repurchase and repurchase agreements of approximately $29.0 billion and $41.9
billion, respectively.
At May 31, 2002, certain assets of the Company, such as real property,
equipment and leasehold improvements of $2.7 billion, aircraft assets of $4.9
billion and goodwill of $1.4 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 May 31, 2002, 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 $900 million, of which approximately $300 million represented the
Company's investments in its real estate funds.
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
44
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 is, and may continue to be, characterized
by periods of volatility and illiquidity. The Company has credit and other risk
policies and procedures to monitor total inventory positions and risk
concentrations for high-yield instruments that are administered in a manner
consistent with the Company's overall risk management policies and control
structure. The Company records high-yield instruments at fair value. Unrealized
gains and losses are recognized currently in the Company's condensed
consolidated statements of income. At May 31, 2002 and November 30, 2001, the
Company had high-yield instruments owned with a market value of approximately
$2.8 billion and $1.3 billion, respectively, and had high-yield instruments
sold, not yet purchased, with a market value of $1.3 billion and $0.5 billion,
respectively.
In connection with certain of its business activities, the Company provides,
on a selective basis, through certain of its subsidiaries (including Morgan
Stanley Bank), financing or financing commitments to companies in the form of
senior and subordinated debt, including bridge financing. The borrowers may be
rated investment grade or non-investment grade. These loans and funding
commitments typically are secured against the borrower's assets (in the case of
senior loans), have varying maturity dates, and are generally contingent upon
certain representations, warranties and contractual conditions applicable to
the borrower. As part of these activities, the Company may syndicate and trade
certain of these loans. At May 31, 2002 and November 30, 2001, the aggregate
value of investment grade loans and positions was $0.6 billion and $1.5
billion, respectively, and the aggregate value of non-investment grade loans
and positions was $1.9 billion and $1.4 billion, respectively. In connection
with these business activities (loans and positions and financing commitments),
the Company had hedges with a notional amount of $3.3 billion at May 31, 2002
and $1.4 billion at November 30, 2001. The Company expects that requests to
provide financing or financing commitments in connection with certain
investment banking activities will continue and may grow in the future.
In March 2002, the Company purchased an office facility with 725,000 square
feet of space in Westchester County, New York.
At May 31, 2002, financial instruments owned by the Company included
derivative products (generally in the form of futures, forwards, options,
swaps, including credit default swaps, caps, collars, floors, swap options and
similar instruments that derive their value from underlying interest rates,
foreign exchange rates, commodities, equity instruments, equity indices,
reference credits or other assets) that had an aggregate fair value of $30.1
billion. The fair value of all derivative products in a gain position
represents the Company's maximum exposure to derivatives related credit risk.
Derivative products may have both on- and off-balance sheet risk implications,
depending on the nature of the contract. However, in many cases derivatives
serve to reduce, rather than increase, the Company's exposure to losses from
market, credit and other risks. The risks associated with the Company's
derivative activities, including market and credit risks, are managed on an
integrated basis with associated cash instruments in a manner consistent with
the Company's overall risk management policies and procedures. The Company
manages its credit exposure to derivative products through various means, which
include reviewing counterparty financial soundness periodically; entering into
master netting agreements and collateral arrangements with counterparties in
appropriate circumstances; and limiting the duration of exposure.
45
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk
As of May 31, 2002, the Company's Aggregate Value-at-Risk ("VaR"), measured
at a 99% confidence level with a one-day time horizon, was $66 million.
Aggregate VaR increased from $42 million at November 30, 2001, as an increase
in equity price and interest rate VaR was partially offset by a higher
diversification benefit. Equity price VaR increased significantly, primarily as
a result of a concentrated single-name exposure that was substantially reduced
subsequent to quarter-end. For a summary of the Company's trading and related
market risk profile during the course of the quarter ended May 31, 2002, see
the average VaR for each of the Company's primary risk categories in the table
below.
The Company uses VaR as one of a range of risk management tools and notes
that VaR values should be interpreted in light of the method's strengths and
limitations. For a further discussion of the Company's risk management policies
and control structure, refer to the "Risk Management" section of the Form 10-K.
The table below presents the Company's VaR for each of the Company's primary
risk exposures and on an aggregate basis at May 31, 2002, February 28, 2002 and
November 30, 2001, incorporating substantially all financial instruments
generating market risk that are managed by the Company's institutional trading
businesses. This measure of VaR incorporates most of the Company's
trading-related market risks. Aggregate VaR also incorporates certain
non-trading positions, including (a) the funding liabilities related to
institutional trading positions and (b) public-company equity positions
recorded as principal investments by the Company. The incremental impact on VaR
of these non-trading positions was not material as of May 31, 2002,
February 28, 2002 and November 30, 2001, and, therefore, the table below does
not separately report trading and non-trading VaRs.
99%/One-Day VaR
------------------------------------------
At May 31, At February 28, At November 30,
Primary Market Risk Category 2002 2002 2001
---------------------------- ---------- --------------- ---------------
(dollars in millions, pre-tax)
Interest rate.................. $ 39 $29 $30
Equity price................... 50 17 23
Foreign exchange rate.......... 6 6 6
Commodity price................ 24 27 24
---- --- ---
Subtotal....................... 119 79 83
Less diversification benefit(1) 53 38 41
---- --- ---
Aggregate VaR.................. $ 66 $41 $42
==== === ===
- --------
(1)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.
In order to facilitate comparisons with other global financial services
firms, the Company notes that its Aggregate 95%/one-day VaR at May 31, 2002 was
$46 million.
46
The table below presents the high, low and average 99%/one-day Aggregate
trading VaR over the course of the quarter ended May 31, 2002 for substantially
all of the Company's institutional trading activities. Certain market risks
included in the quarter-end Aggregate VaR discussed above are excluded from
this measure (e.g., equity price risk in public-company equity positions
recorded as principal investments by the Company and certain funding
liabilities related to institutional trading positions).
Daily 99%/One-Day VaR
for the Quarter Ended
May 31, 2002
-------------------------
Primary Market Risk Category High Low Average
---------------------------- ---- --- -------
(dollars in millions, pre-tax)
Interest rate............ $44 $29 $34
Equity price............. 64 14 26
Foreign exchange rate.... 9 3 5
Commodity price.......... 31 23 27
Aggregate trading VaR.... 83 41 52
The histogram below presents the Company's daily 99%/one-day VaR for its
institutional trading activities during the quarter ended May 31, 2002:
Description of Histogram: The horizontal axis of the chart categorizes the
99%/one-day Value-at-Risk into numerical ranges. The vertical axis of the chart
indicates the number of trading days that Value-at-Risk fell into a given
numerical range. The histogram shows that distribution of daily 99%/one-day
Value-at-Risk during the quarter ended May 31, 2002 was:
Daily 99%/One-Day VaR Number of Days
(dollars in millions)
Less than 40 0
40 to 43 6
43 to 46 15
46 to 49 12
49 to 52 8
52 to 55 12
55 to 58 2
58 to 61 0
61 to 64 0
64 to 67 0
67 to 70 5
70 to 73 4
73 to 76 0
76 to 79 1
79 to 82 0
82 to 85 1
Greater than 85 0
47
The histogram below presents the distribution of daily net revenues during
the quarter ended May 31, 2002 for the Company's institutional trading
businesses (net of interest expense and including commissions and primary
revenue credited to the trading businesses):
Description of Histogram: The horizontal axis of the chart categorizes
daily net revenue of the institutional trading businesses into numerical ranges.
The vertical axis of the chart indicates the number of trading days that revenue
fell into a given numerical range. The histogram shows that distribution of
daily institutional trading revenue during the quarter ended May 31, 2002 was:
Daily Net Revenue of the Institutional
Securities Business
(dollars in millions) Number of Days
- -------------------------------------- --------------
Less than -10 0
-10 to -5 0
-5 to 0 2
0 to 5 3
5 to 10 3
10 to 15 7
15 to 20 10
20 to 25 8
25 to 30 7
30 to 35 8
35 to 40 7
40 to 45 3
45 to 50 2
50 to 55 1
55 to 60 3
60 to 65 1
65 to 70 0
70 to 75 0
75 to 80 0
80 to 85 0
85 to 90 0
Greater than 90 1
As of May 31, 2002, the level of interest rate risk exposure associated with
the Company's consumer lending activities, as measured by the reduction in
pre-tax income resulting from a hypothetical, immediate 100-basis-point
increase in interest rates, had not changed significantly from November 30,
2001.
Derivatives
With respect to certain derivative transactions, the Company requires
collateral, principally cash and U.S. government and agency securities, from
its counterparties to reduce default risk. The following table presents a
summary of counterparty credit ratings for the replacement cost of
over-the-counter derivatives in a gain position by maturity at May 31, 2002. In
addition, collateral received by the Company is presented by the credit rating
of the counterparties providing the collateral. The following table includes
credit exposure only from over-the-counter derivative transactions and does not
include other credit exposures, such as the Company's senior lending activities:
Years To Maturity
--------------------------------- Cross-Maturity Net-Exposure Net-Exposure
Credit Rating(1) Less than 1 1-3 3-5 Over 5 Netting(2) Pre-Collateral Post-Collateral
---------------- ----------- ------ ------ ------- -------------- -------------- ---------------
(dollars in millions)
AAA................. $ 764 $ 848 $1,324 $ 2,978 $(1,455) $ 4,459 $ 3,013
AA.................. 4,116 2,481 1,474 4,876 (2,639) 10,308 6,559
A................... 3,332 2,504 1,205 3,345 (2,202) 8,184 6,230
BBB................. 944 1,217 475 1,323 (913) 3,046 2,484
Non-investment grade 1,266 678 511 502 (240) 2,717 1,771
------- ------ ------ ------- ------- ------- -------
Total............ $10,422 $7,728 $4,989 $13,024 $(7,449) $28,714 $20,057
======= ====== ====== ======= ======= ======= =======
- --------
(1)Credit ratings are determined by external rating agencies or by equivalent
ratings used by the Company's Credit Risk Department.
(2)Represents 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 net within such
maturity category.
48
Part II OTHER INFORMATION
Item 1. Legal Proceedings
The following developments have occurred with respect to certain matters
previously reported in the Company's Annual Report on Form 10-K for the fiscal
year ended November 30, 2001 and in the Company's Quarterly Report on Form 10-Q
for the fiscal quarter ended February 28, 2002.
Electricity Trading Matters. Two additional class action complaints were
filed in California, and all of the California class actions were removed to
federal court. On May 22, May 29 and June 5, 2002, Morgan Stanley Capital Group
Inc., a subsidiary of the Company, responded to requests for information in
connection with the investigation by the Federal Energy Regulatory Commission
("FERC") into possible abuses of market power or market manipulation. On May
31, 2002, the FERC dismissed the complaint filed by the California Attorney
General against all sellers in the California power markets.
In re Merrill Lynch, et al. Securities Litigation. The United States
District Court for the District of New Jersey dismissed the case with prejudice
by stipulation and by order dated May 30, 2002.
IPO Allocation Matters. On May 24, 2002, defendants filed their joint
motion to dismiss the purported class action antitrust suits.
On April 19 and 20, 2002, plaintiffs filed the majority of their
consolidated amended complaints in the class action securities suits. The
underwriter defendants filed their joint motion to dismiss on July 1, 2002.
The Company has continued to receive and respond to subpoenas and requests
for documents and information from various governmental agencies in connection
with industry-wide investigations of IPO allocation practices, including the
Securities and Exchange Commission ("SEC") and the National Association of
Securities Dealers Regulation, Inc. ("NASDR"). The Company continues to
cooperate with these investigations.
In the Breakaway Solutions matter, defendants filed a notice of motion to
dismiss on May 28, 2002.
On May 2, 2002, a purported derivative action, captioned Brenner,
derivatively on behalf of Ask Jeeves v. Strauch, et al., was filed on behalf of
Ask Jeeves, Inc. ("Ask Jeeves") in California state court, against the Company,
Robertson Stephens, Inc., and various officers and directors of Ask Jeeves. The
complaint alleges that the underwriters underpriced the IPO securities of Ask
Jeeves and had a kickback agreement with institutional clients that received
allocations of Ask Jeeves IPO securities. The complaint alleges that defendants
breached both their fiduciary duty and their agency duty to Ask Jeeves and were
unjustly enriched. The complaint seeks consequential damages resulting from the
alleged lower amount of offering proceeds. On May 21, 2002, the Company
answered the complaint in state court and then removed the case to United
States District Court for the Northern District of California.
Research Matters. The Company has continued to receive and respond to
requests for documents and information from the New York State Attorney General
in connection with his investigation of the Company's research analyst
practices. In addition, the Company has received and is responding to subpoenas
and requests for documents and information in parallel industry-wide
investigations being conducted by other governmental and regulatory agencies,
including the SEC, NASDR, New York Stock Exchange and the United States
Attorney's Office for the Southern District of New York. The Company continues
to cooperate with these investigations.
On May 8, 2002, another purported class action was filed in the Supreme
Court of the State of New York alleging that research was biased. The complaint
makes a claim for breach of contract only. This case has been removed to the
United States District Court for the Southern District of New York, and a
motion to dismiss has been filed.
49
Mutual Fund Valuation Matters. In Abrams v. Van Kampen Funds Inc., et al.,
by decisions dated May 16 and May 29, 2002, the United States District Court
for the Northern District of Illinois granted in part and denied in part
defendants' motion to dismiss. On April 15, 2002, in Hicks v. Morgan Stanley &
Co. et al., defendants filed a motion to dismiss with the United States
District Court for the Southern District of New York.
Item 2. Changes in Securities and Use of Proceeds
(c) To enhance its ongoing stock repurchase program, the Company sold
European-style put options on an aggregate of 3.0 million shares of its common
stock during the quarter ended May 31, 2002. These put options have expiration
dates that range from September 2002 through November 2002 and entitle the
holders to sell common stock to the Company at prices ranging from $39.76 to
$40.10 per share. The sale of these put options, which were made as private
placements to third parties, generated proceeds to the Company of $6 million.
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of stockholders of the Company was held on March 19,
2002. Further details concerning matters submitted to a vote of stockholders
can be found in the Company's Quarterly Report on Form 10-Q for the fiscal
quarter ended February 28, 2002.
Item 6. Exhibits and Reports on Form 8-K
(a)Exhibits
An exhibit index has been filed as part of this Report on Page E-1.
(b)Reports on Form 8-K
Form 8-K dated March 26, 2002 reporting Item 5 and Item 7 in connection with
the announcement of the Company's financial results for the fiscal quarter
ended February 28, 2002.
Form 8-K dated March 27, 2002 reporting Item 5 and Item 7.
Form 8-K dated April 23, 2002 reporting Item 9.
50
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MORGAN STANLEY
(Registrant)
/s/ JOANNE PACE
By : ___________________
Joanne Pace, Controller and
Principal Accounting Officer
Date: July 11, 2002
51
EXHIBIT INDEX
MORGAN STANLEY
Quarter Ended May 31, 2002
Exhibit
No. Description
------- -----------
3.1 Amended and Restated Certificate of Incorporation, as amended to date.
3.2 Amended and Restated Bylaws.
11 Statement Re: Computation of Earnings Per Common Share (The
calculation of per share earnings is in Part I, Item 1, Note 9 to the
Condensed Consolidated Financial Statements (Earnings per Share) and
is omitted in accordance with Section (b)(11) of Item 601 of
Regulation S-K.)
12 Statement Re: Computation of Ratio of Earnings to Fixed Charges and
Computation of Earnings to Fixed Charges and Preferred Stock
Dividends.
15 Letter of awareness from Deloitte & Touche LLP, dated July 10, 2002,
concerning unaudited interim financial information.
E-1