================================================================================
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 August 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 September 30, 2002, there were 1,085,621,879 shares of the
Registrant's Common Stock, par value $.01 per share, outstanding.
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MORGAN STANLEY
INDEX TO QUARTERLY REPORT ON FORM 10-Q
Quarter Ended August 31, 2002
Page
----
Part I--Financial Information
Item 1. Financial Statements
Condensed Consolidated Statements of Financial Condition--August 31, 2002 (unaudited) and
November 30, 2001........................................................................... 1
Condensed Consolidated Statements of Income (unaudited)--Three and Nine Months Ended
August 31, 2002 and 2001.................................................................... 2
Condensed Consolidated Statements of Comprehensive Income (unaudited)--Three and Nine
Months Ended August 31, 2002 and 2001....................................................... 3
Condensed Consolidated Statements of Cash Flows (unaudited)--Nine Months Ended
August 31, 2002 and 2001.................................................................... 4
Notes to Condensed Consolidated Financial Statements (unaudited).............................. 5
Independent Accountants' Report............................................................... 23
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.... 24
Item 3. Quantitative and Qualitative Disclosures About Market Risk............................... 53
Item 4. Disclosure Controls and Procedures....................................................... 56
Part II--Other Information
Item 1. Legal Proceedings........................................................................ 56
Item 6. Exhibits and Reports on Form 8-K......................................................... 58
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WHERE YOU CAN FIND MORE INFORMATION
The Company files annual and quarterly reports, proxy statements and other
information with the Securities and Exchange Commission (the "SEC"). You may
read and copy any document we file at the SEC's public reference room at Room
1024, 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the SEC at
1-800-SEC-0330 for further information on the public reference room. The SEC
also maintains a website that contains reports, proxy statements and other
information that we electronically file. The address of the SEC's website is
http://www.sec.gov. In addition, the Company maintains its own website where
you may obtain our filings, including our annual reports on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K and proxy
statements (and any amendments thereto), free of charge, as soon as reasonably
practicable after we electronically file such documents with the SEC. The
information on the Company's website is not incorporated by reference in this
report. The address of the Company's website is http://www.morganstanley.com.
i
Item 1.
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in millions, except share data)
August 31, November 30,
2002 2001
----------- ------------
(unaudited)
ASSETS
Cash and cash equivalents......................... $ 27,965 $ 26,596
Cash and securities deposited with clearing
organizations or segregated under federal and
other regulations (including securities at fair
value of $29,608 at August 31, 2002 and $36,146
at November 30, 2001)............................ 40,302 46,326
Financial instruments owned (approximately $80
billion at August 31, 2002 and $74 billion at
November 30, 2001 were pledged to various
parties):
U.S. government and agency securities........... 30,881 25,696
Other sovereign government obligations.......... 27,796 22,039
Corporate and other debt........................ 56,178 47,607
Corporate equities.............................. 18,829 23,143
Derivative contracts............................ 39,533 32,078
Physical commodities............................ 547 285
Securities purchased under agreements to resell... 65,512 54,618
Securities provided as collateral................. 10,634 13,163
Securities borrowed............................... 131,496 120,758
Receivables:
Consumer loans (net of allowances of $927 at
August 31, 2002 and $847 at November 30, 2001) 21,898 20,108
Customers, net.................................. 18,626 22,188
Brokers, dealers and clearing organizations..... 6,046 6,462
Fees, interest and other........................ 5,071 5,283
Office facilities, at cost (less accumulated
depreciation and amortization of $2,732 at
August 31, 2002 and $2,124 at November 30, 2001). 2,323 2,579
Aircraft under operating leases (less accumulated
depreciation of $691 at August 31, 2002 and $479
at November 30, 2001)............................ 4,760 4,753
Goodwill.......................................... 1,447 1,438
Other assets...................................... 6,928 7,508
-------- --------
Total assets...................................... $516,772 $482,628
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Commercial paper and other short-term borrowings.. $ 38,773 $ 32,842
Deposits.......................................... 13,711 12,276
Financial instruments sold, not yet purchased:
U.S. government and agency securities........... 14,535 17,203
Other sovereign government obligations.......... 14,934 10,906
Corporate and other debt........................ 12,883 9,125
Corporate equities.............................. 14,393 13,046
Derivative contracts............................ 32,432 27,286
Physical commodities............................ 1,754 2,044
Securities sold under agreements to repurchase.... 125,516 122,695
Obligation to return securities received as
collateral....................................... 10,634 13,163
Securities loaned................................. 45,567 36,776
Payables:
Customers....................................... 91,724 93,719
Brokers, dealers and clearing organizations..... 3,351 4,331
Interest and dividends.......................... 5,879 2,761
Other liabilities and accrued expenses............ 12,867 12,795
Long-term borrowings.............................. 55,127 49,668
-------- --------
494,080 460,636
-------- --------
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, 1,093,052,009
and 1,093,006,744 shares outstanding at
August 31, 2002 and November 30, 2001,
respectively)................................. 12 12
Paid-in capital................................. 3,672 3,745
Retained earnings............................... 24,768 23,270
Employee stock trust............................ 2,895 3,086
Accumulated other comprehensive income (loss)... (225) (262)
-------- --------
Subtotal..................................... 31,122 30,196
Note receivable related to ESOP................. (29) (31)
Common stock held in treasury, at cost ($0.01
par value, 118,633,895 and 118,679,160 shares
at August 31, 2002 and November 30, 2001,
respectively)................................. (6,782) (6,935)
Common stock issued to employee trust........... (2,895) (2,514)
-------- --------
Total shareholders' equity................... 21,416 20,716
-------- --------
Total liabilities and shareholders' equity........ $516,772 $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 August 31, Nine Months Ended August 31,
------------------------------ ------------------------------
2002 2001 2002 2001
- - -------------- -------------- -------------- --------------
(unaudited) (unaudited)
Revenues:
Investment banking.... $ 482 $ 807 $ 1,838 $ 2,616
Principal
transactions:
Trading............ 457 1,079 2,266 4,846
Investments........ (64) (59) (47) (212)
Commissions........... 855 720 2,532 2,409
Fees:
Asset
management,
distribution
and
administration.... 971 1,054 3,041 3,237
Merchant and
cardmember........ 364 362 1,064 1,000
Servicing.......... 514 434 1,566 1,337
Interest and
dividends............ 4,373 5,825 12,079 20,011
Other................. 204 110 506 374
-------------- -------------- -------------- --------------
Total revenues..... 8,156 10,332 24,845 35,618
Interest expense...... 3,188 4,869 8,968 17,447
Provision for
consumer loan
losses............... 332 277 1,017 721
-------------- -------------- -------------- --------------
Net revenues....... 4,636 5,186 14,860 17,450
-------------- -------------- -------------- --------------
Non-interest
expenses:
Compensation and
benefits.......... 2,061 2,376 6,786 7,950
Occupancy and
equipment......... 198 224 604 666
Brokerage,
clearing and
exchange fees..... 208 176 563 520
Information
processing and
communications.... 341 363 1,000 1,089
Marketing and
business
development....... 291 280 804 987
Professional
services.......... 273 284 748 954
Other.............. 295 311 792 940
-------------- -------------- -------------- --------------
Total
non-interest
expenses....... 3,667 4,014 11,297 13,106
-------------- -------------- -------------- --------------
Income before
income taxes,
dividends on
preferred
securities subject
to mandatory
redemption,
extraordinary item
and cumulative
effect of
accounting change.... 969 1,172 3,563 4,344
Provision for
income taxes......... 337 423 1,242 1,576
Dividends on
preferred
securities subject
to
mandatory redemption. 21 14 65 28
-------------- -------------- -------------- --------------
Income before
extraordinary item
and cumulative
effect of
accounting change.... 611 735 2,256 2,740
Extraordinary item.... -- (30) -- (30)
Cumulative effect
of accounting
change............... -- -- -- (59)
-------------- -------------- -------------- --------------
Net income............ $ 611 $ 705 $ 2,256 $ 2,651
============== ============== ============== ==============
Preferred stock
dividend
requirements......... $ -- $ 9 $ -- $ 27
============== ============== ============== ==============
Earnings applicable
to common shares..... $ 611 $ 696 $ 2,256 $ 2,624
============== ============== ============== ==============
Earnings per common
share:
Basic before
extraordinary
item and
cumulative
effect of
accounting
change............ $ 0.57 $ 0.67 $ 2.08 $ 2.49
Extraordinary
item.............. -- (0.03) -- (0.03)
Cumulative
effect of
accounting
change............ -- -- -- (0.05)
-------------- -------------- -------------- --------------
Basic.............. $ 0.57 $ 0.64 $ 2.08 $ 2.41
============== ============== ============== ==============
Diluted before
extraordinary
item and
cumulative
effect of
accounting
change............ $ 0.55 $ 0.65 $ 2.03 $ 2.41
Extraordinary
item.............. -- (0.03) -- (0.03)
Cumulative
effect of
accounting
change............ -- -- -- (0.05)
-------------- -------------- -------------- --------------
Diluted............ $ 0.55 $ 0.62 $ 2.03 $ 2.33
============== ============== ============== ==============
Average common
shares outstanding:
Basic.............. 1,081,708,833 1,085,447,127 1,084,059,497 1,089,017,948
============== ============== ============== ==============
Diluted............ 1,105,494,894 1,119,301,107 1,111,980,428 1,126,540,440
============== ============== ============== ==============
See Notes to Condensed Consolidated Financial Statements.
2
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in millions)
Three Months Nine Months
Ended Ended
August 31, August 31,
---------- -------------
2002 2001 2002 2001
---- ---- ------ ------
(unaudited) (unaudited)
Net income.................................... $611 $705 $2,256 $2,651
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment.... 17 1 34 (50)
Cumulative effect of accounting change..... -- -- -- (13)
Net change in cash flow hedges............. (30) (27) 3 (74)
---- ---- ------ ------
Comprehensive income.......................... $598 $679 $2,293 $2,514
==== ==== ====== ======
See Notes to Condensed Consolidated Financial Statements.
3
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in millions)
Nine Months Ended
August 31,
------------------
2002 2001
-------- --------
(unaudited)
Cash flows from operating activities:
Net income................................................... $ 2,256 $ 2,651
Adjustments to reconcile net income to net cash
provided by (used for) operating activities:
Non-cash charges included in net income:
Gain on sale of building and sale of
self-directed online brokerage accounts........... (125) --
Cumulative effect of accounting change.............. -- 59
Asset impairment charge............................. 74 --
Other non-cash charges included in net income....... 1,695 1,389
Changes in assets and liabilities:
Cash and securities deposited with clearing
organizations or segregated under federal and
other regulations.................................... 6,024 1,573
Financial instruments owned, net of financial
instruments sold, not yet purchased.................. (11,048) (36,874)
Securities borrowed, net of securities loaned.......... (1,947) (19,481)
Receivables and other assets........................... 5,675 1,780
Payables and other liabilities......................... 249 5,230
-------- --------
Net cash provided by (used for) operating activities......... 2,853 (43,673)
-------- --------
Cash flows from investing activities:
Net (payments for) proceeds from:
Office facilities and aircraft under operating
leases............................................... (857) (1,347)
Purchase of Quilter Holdings Limited, net of
cash acquired........................................ -- (183)
Net principal disbursed on consumer loans.............. (6,064) (6,812)
Sale of self-directed online brokerage accounts........ 98 --
Sales of consumer loans................................ 3,259 7,638
-------- --------
Net cash used for investing activities....................... (3,564) (704)
-------- --------
Cash flows from financing activities:
Net proceeds from (payments for) short-term
borrowings.............................................. 5,931 (866)
Securities sold under agreements to repurchase, net
of securities purchased under agreements to resell...... (8,073) 43,233
Net proceeds from:
Deposits............................................... 1,435 966
Issuance of common stock............................... 145 174
Issuance of put options................................ 6 5
Issuance of long-term borrowings....................... 10,338 17,772
Issuance of Preferred Securities Subject to
Mandatory Redemption................................. -- 810
Payments for:
Repurchases of common stock............................ (671) (1,242)
Repayments of long-term borrowings..................... (5,934) (10,137)
Redemption of Capital Units............................ -- (4)
Redemption of Cumulative Preferred Stock............... (345) (200)
Cash dividends......................................... (752) (787)
-------- --------
Net cash provided by financing activities.................... 2,080 49,724
-------- --------
Net increase in cash and cash equivalents.................... 1,369 5,347
Cash and cash equivalents, at beginning of period............ 26,596 18,819
-------- --------
Cash and cash equivalents, at end of period.................. $ 27,965 $ 24,166
======== ========
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 business
segments--Institutional Securities, Individual Investor Group, Investment
Management and Credit Services. The Company's Institutional Securities business
includes securities underwriting and distribution; financial advisory services,
including advice on mergers and acquisitions, restructurings, real estate and
project finance; sales, trading, financing and market-making activities in
equity securities and related products and fixed income securities and related
products, including foreign exchange and commodities; principal investing,
including private equity activities; and aircraft financing activities. The
Company's Individual Investor Group business provides comprehensive financial
planning and investment advisory services designed to accommodate individual
investment goals and risk profiles. The Individual Investor Group provides its
clients with several investment and credit products and services, including
mutual funds, insurance products, financial planning, retirement planning,
personal trust and estate planning, credit management and account services. 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 changed its name 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
5
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 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 derivatives and the gains or losses on the hedged assets or liabilities
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
6
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
hedges, the changes in the fair value of the derivative are recorded in
accumulated other comprehensive income in shareholders' equity, 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 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 residential and
commercial mortgage loans, corporate bonds and loans, credit card loans and
other types of financial assets (see Notes 4 and 5). 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.
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
7
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
have indefinite lives will continue to be amortized over their useful lives and
reviewed for impairment. The 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
condensed 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 Nine Months Ended
August 31, August 31,
-------------------- ------------------
2002 2001 2002 2001
------ ------ ------ ------
(dollars in millions, except per share amounts)
Net Income
Income before extraordinary item and cumulative effect
of accounting change................................... $ 611 $ 735 $2,256 $2,740
Add: Goodwill amortization, net of tax................... -- 22 -- 60
----- ------ ------ ------
611 757 2,256 2,800
Extraordinary item....................................... -- (30) -- (30)
Cumulative effect of accounting change................... -- -- -- (59)
----- ------ ------ ------
Adjusted................................................. $ 611 $ 727 $2,256 $2,711
===== ====== ====== ======
Basic earnings per common share
Basic before extraordinary item and cumulative effect of
accounting change...................................... $0.57 $ 0.67 $ 2.08 $ 2.49
Add: Goodwill amortization, net of tax................... -- 0.02 -- 0.05
----- ------ ------ ------
0.57 0.69 2.08 2.54
Extraordinary item....................................... -- (0.03) -- (0.03)
Cumulative effect of accounting change................... -- -- -- (0.05)
----- ------ ------ ------
Adjusted................................................. $0.57 $ 0.66 $ 2.08 $ 2.46
===== ====== ====== ======
Diluted earnings per common share
Diluted before extraordinary item and cumulative effect
of accounting change................................... $0.55 $ 0.65 $ 2.03 $ 2.41
Add: Goodwill amortization, net of tax................... -- 0.02 -- 0.05
----- ------ ------ ------
0.55 0.67 2.03 2.46
Extraordinary item....................................... -- (0.03) -- (0.03)
Cumulative effect of accounting change................... -- -- -- (0.05)
----- ------ ------ ------
Adjusted................................................. $0.55 $ 0.64 $ 2.03 $ 2.38
===== ====== ====== ======
Changes in the carrying amount of the Company's goodwill for the nine month
period ended August 31, 2002, were as follows:
Individual
Institutional Investor Investment
Securities Group Management Total
------------- ---------- ---------- ------
(dollars in millions)
Balance as of November 30, 2001 $ 4 $467 $967 $1,438
Translation adjustments........ -- 9 -- 9
--- ---- ---- ------
Balance as of August 31, 2002.. $ 4 $476 $967 $1,447
=== ==== ==== ======
8
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
4. Securities Financing and Securitization 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 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
August 31, November 30,
2002 2001
---------- ------------
(dollars in millions)
Financial instruments owned:
U.S. government and agency securities $ 6,819 $ 9,310
Corporate and other debt............. 7,412 3,350
Corporate equities................... 2,030 2,850
------- -------
Total......................... $16,261 $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 August 31, 2002, the fair value of
securities received as collateral where the Company is permitted to sell or
repledge the securities was $345 billion, and the fair value of the portion
that has been sold or repledged was $314 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
9
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
In connection with its Institutional Securities business, the Company
engages in securitization activities related to commercial and residential
mortgage loans, corporate bonds and loans and other types of financial assets.
These assets are carried at fair value and any changes in fair value are
recognized in earnings until the time of securitization. The Company may act as
underwriter of the beneficial interests issued by the securitization vehicle.
Underwriting net revenues are recognized in connection with these transactions.
The Company may retain interests in the securitized financial assets as one or
more tranches of the securitization. These retained interests are included in
the condensed consolidated statements of financial condition at fair value. Any
changes in the fair value of such retained interests are recognized in the
condensed consolidated statements of income. Retained interests in securitized
financial assets associated with the Company's Institutional Securities
business were approximately $1.7 billion at August 31, 2002, the majority of
which were related to residential and commercial mortgage loan securitization
transactions.
The following table presents information on the Company's residential and
commercial mortgage loan securitization transactions. Key economic assumptions
and the sensitivity of the current fair value of the retained interests to
immediate 10% and 20% adverse changes in those assumptions at August 31, 2002
were as follows (dollars in millions):
Residential Commercial
Mortgage Mortgage
Loans Loans
----------- -----------
Retained interests (carrying amount/fair Retained interests (carrying amount/
value)................................ $1,140 fair value)....................... $395
Weighted average life (in months)....... 38 Weighted average life (in months)... 42
Credit losses (rate per annum).......... 0.2-4.0% Credit losses (rate per annum)...... 0.43-10.99%
Impact on fair value of 10% adverse Impact on fair value of 10%
change............................. $(8) adverse change................. $(2)
Impact on fair value of 20% adverse Impact on fair value of 20%
change............................. $(17) adverse change................. $(4)
Weighted average discount rate (rate per Weighted average discount rate (rate
annum)................................ 7.80% per annum)........................ 5.91%
Impact on fair value of 10% adverse Impact on fair value of 10%
change............................. $(13) adverse change................. $(5)
Impact on fair value of 20% adverse Impact on fair value of 20%
change............................. $(25) adverse change................. $(11)
Prepayment speed assumption............. 263-680PSA
Impact on fair value of 10% adverse
change............................. $(17)
Impact on fair value of 20% adverse
change............................. $(31)
The table above does not include the offsetting benefit of any financial
instruments that the Company may utilize to hedge risks inherent in its
retained interests. In addition, the sensitivity analysis 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
10
not be linear. Also, the effect of a variation in a particular assumption on
the fair value of the retained interests is calculated independent of changes
in any other assumption; in practice, changes in one factor may result in
changes in another, 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.
In connection with its Institutional Securities business, during the nine
month period ended August 31, 2002 the Company received $22 billion of proceeds
from new securitization transactions and $25 million of cash flows from
retained interests in securitization transactions.
5. Consumer Loans.
Consumer loans were as follows:
At At
August 31, November 30,
2002 2001
---------- ------------
(dollars in millions)
General purpose credit card, mortgage and consumer installment $22,825 $20,955
Less:
Allowance for consumer loan losses......................... 927 847
------- -------
Consumer loans, net........................................... $21,898 $20,108
======= =======
Activity in the allowance for consumer loan losses was as follows:
Three Months Nine Months
Ended Ended
August 31, August 31,
---------- ------------
2002 2001 2002 2001
---- ---- ------ ----
(dollars in millions)
Balance beginning of period........... $899 $787 $ 847 $783
Additions:
Provision for consumer loan losses. 332 277 1,017 721
Deductions:
Charge-offs........................ 333 301 1,012 793
Recoveries......................... (29) (29) (75) (81)
---- ---- ------ ----
Net charge-offs....................... 304 272 937 712
---- ---- ------ ----
Balance end of period................. $927 $792 $ 927 $792
==== ==== ====== ====
Interest accrued on general purpose credit card loans subsequently charged
off, recorded as a reduction of interest revenue, was $53 million and $163
million in the quarter and nine month period ended August 31, 2002, and $43
million and $124 million in the quarter and nine month period ended August 31,
2001.
At August 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 $472 million and $3,259 million in the quarter and nine month period ended
August 31, 2002 and $526 million and $7,638 million in the quarter and nine
month period ended August 31, 2001.
11
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 August
31, 2002, the Company had $9.1 billion of retained interests, including $6.9
billion of undivided seller's interest, in credit card asset securitizations.
The Company's undivided seller's interest ranks pari passu with 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 nine months ended August 31, 2002, the Company completed credit
card asset securitizations of $2.8 billion and recognized net securitization
gains of $16 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 $27.9 billion at August 31, 2002
and $29.2 billion 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 nine months ended August 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)... 14.00-16.50%
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
August 31,
2002
----------
Residual Interests (carrying amount/fair value) $ 226
Weighted average life (in months).............. 6.1
Payment rate (rate per month).................. 17.25%
Impact on fair value of 10% adverse change.. $ (16)
Impact on fair value of 20% adverse change.. $ (29)
Credit losses (rate per annum)................. 6.95%
Impact on fair value of 10% adverse change.. $ (75)
Impact on fair value of 20% adverse change.. $ (148)
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.
12
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The table below summarizes certain cash flows received from the
securitization master trust (dollars in billions):
Nine Months
Ended
August 31,
2002
-----------
Proceeds from new credit card asset securitizations............... $ 2.8
Proceeds from collections reinvested in previous credit card asset
securitizations................................................. $39.5
Contractual servicing fees received............................... $ 0.4
Cash flows received from retained interests....................... $ 1.4
The table below presents quantitative information about delinquencies, net
credit losses and components of managed general purpose credit card loans,
including securitized loans:
Nine Months Ended
At August 31, 2002 August 31, 2002
---------------------- ------------------
Loans Loans Average Net Credit
Outstanding Delinquent Loans Losses
----------- ---------- ------- ----------
(dollars in billions)
Managed general purpose credit card loans.......... $49.7 $2.8 $49.7 $2.3
Less: Securitized general purpose credit card loans 27.9
-----
Owned general purpose credit card loans............ $21.8
=====
6. Long-Term Borrowings.
Long-term borrowings at August 31, 2002 scheduled to mature within one year
aggregated $11,188 million.
During the nine month period ended August 31, 2002, the Company issued
senior notes aggregating $10,605 million, including non-U.S. dollar currency
notes aggregating $1,962 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, $1,159 million; 2004, $1,093 million; 2005, $156 million,
2006, $21 million, 2007, $2,776 million; and thereafter, $5,400 million. In the
nine month period ended August 31, 2002, $5,934 million of senior notes were
repaid.
The weighted average maturity of the Company's long-term borrowings, based
upon stated maturity dates, was approximately 4 years at August 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
----------------------- -----------------------
August 31, November 30, August 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
13
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 August 31, 2002 and November 30, 2001.
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.
14
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 $5,384 million at August 31, 2002, which exceeded the amount required
by $4,737 million. MSDWI's net capital totaled $1,524 million at August 31,
2002, which exceeded the amount required by $1,422 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, 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 August 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.
On May 17, 2002, the FDIC, in conjunction with other bank regulatory
agencies, issued guidance that requires FDIC-insured financial institutions to
treat accrued interest receivable related to credit card securitizations as a
residual interest, which requires holding higher regulatory capital beginning
December 31, 2002. The Company's FDIC-insured financial institutions have the
capacity to meet these additional capital requirements and intend to maintain
capital ratios in excess of the regulatory minimums after implementing this
revised guidance.
Certain other U.S. and non-U.S. subsidiaries are subject to various
securities, commodities and banking regulations, and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
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 14 million and 18 million shares of
its common stock through open market purchases during the nine month periods
ended August 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 August 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.
15
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 Nine Months
Ended Ended
August 31, August 31,
------------- -------------
2002 2001 2002 2001
------ ------ ------ ------
Basic EPS:
Income before extraordinary item and cumulative effect of accounting
change..................................................................... $ 611 $ 735 $2,256 $2,740
Extraordinary item.......................................................... -- (30) -- (30)
Cumulative effect of accounting change...................................... -- -- -- (59)
Preferred stock dividend requirements....................................... -- (9) -- (27)
------ ------ ------ ------
Net income available to common shareholders................................. $ 611 $ 696 $2,256 $2,624
====== ====== ====== ======
Weighted-average common shares outstanding.................................. 1,082 1,085 1,084 1,089
====== ====== ====== ======
Basic EPS before extraordinary item and cumulative effect of accounting
change..................................................................... $ 0.57 $ 0.67 $ 2.08 $ 2.49
Extraordinary item.......................................................... -- (0.03) -- (0.03)
Cumulative effect of accounting change...................................... -- -- -- (0.05)
------ ------ ------ ------
Basic EPS....................................................................... $ 0.57 $ 0.64 $ 2.08 $ 2.41
====== ====== ====== ======
Diluted EPS:
Income before extraordinary item and cumulative effect of accounting
change..................................................................... $ 611 $ 735 $2,256 $2,740
Extraordinary item.......................................................... -- (30) -- (30)
Cumulative effect of accounting change...................................... -- -- -- (59)
Preferred stock dividend requirements....................................... -- (9) -- (27)
------ ------ ------ ------
Net income available to common shareholders................................. $ 611 $ 696 $2,256 $2,624
====== ====== ====== ======
Weighted-average common shares outstanding.................................. 1,082 1,085 1,084 1,089
Effect of dilutive securities:
Stock options............................................................ 23 33 27 37
Convertible debt......................................................... 1 1 1 1
------ ------ ------ ------
Weighted-average common shares outstanding and common stock equivalents 1,106 1,119 1,112 1,127
====== ====== ====== ======
Diluted EPS before extraordinary item and cumulative effect of accounting
change..................................................................... $ 0.55 $ 0.65 $ 2.03 $ 2.41
Extraordinary item.......................................................... -- (0.03) -- (0.03)
Cumulative effect of accounting change...................................... -- -- -- (0.05)
------ ------ ------ ------
Diluted EPS..................................................................... $ 0.55 $ 0.62 $ 2.03 $ 2.33
====== ====== ====== ======
At August 31, 2002, there were approximately 68 and 65 million stock options
outstanding for the quarter and nine month periods ended August 31, 2002,
respectively, 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.
10. Commitments and Contingencies.
At August 31, 2002 and November 30, 2001, the Company had approximately $3.5
billion and $4.5 billion, respectively, of letters of credit outstanding to
satisfy various collateral requirements.
16
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company has commitments to fund certain fixed assets and other less
liquid investments, including at August 31, 2002, $588 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 August 31,
2002, the aggregate amount of such purchase commitments was $213 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 August 31, 2002, the Company provided commitments
associated with these activities to investment grade issuers aggregating $11.0
billion and commitments to non-investment grade issuers aggregating $1.4
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.
At August 31, 2002, the Company had commitments to enter into reverse
repurchase and repurchase agreements of approximately $34 billion and $44
billion, respectively.
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.
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
17
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 August
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 Other
Non- Non-
Investment Investment
AAA AA A BBB Grade Grade Total
------ ------- ------ ------ -------------- ---------- -------
(dollars in millions)
At August 31, 2002
Interest rate and currency swaps and options
(including caps, floors and swap options) and other
fixed income securities contracts.................. $5,049 $ 7,684 $6,407 $2,541 $3,755 $1,516 $26,952
Foreign exchange forward contracts and options...... 178 1,481 716 180 -- 813 3,368
Equity securities contracts (including equity swaps,
warrants and options).............................. 2,311 816 587 213 11 333 4,271
Commodity forwards, options and swaps............... 191 1,237 1,653 684 116 1,061 4,942
------ ------- ------ ------ ------ ------ -------
Total............................................ $7,729 $11,218 $9,363 $3,618 $3,882 $3,723 $39,533
====== ======= ====== ====== ====== ====== =======
Percent of total.................................... 20% 28% 24% 9% 10% 9% 100%
====== ======= ====== ====== ====== ====== =======
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%
====== ======= ====== ====== ====== ====== =======
18
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 Institutional 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 four business
segments--Institutional Securities, Individual Investor Group, Investment
Management and Credit Services, through which it provides a wide range of
financial products and services to its customers. Previously, the results of
the Company's institutional and individual securities activities were
aggregated into one reporting segment. Certain reclassifications have been made
to prior-period amounts to conform to the current year's presentation.
The Company's Institutional Securities business includes securities
underwriting and distribution; financial advisory services, including advice on
mergers and acquisitions, restructurings, real estate and project finance;
sales, trading, financing and market-making activities in equity securities and
related products and fixed income securities and related products, including
foreign exchange and commodities; principal investing, including private equity
activities; and aircraft financing activities. The Company's Individual
Investor Group business provides comprehensive financial planning and
investment advisory services designed to accommodate individual investment
goals and risk profiles. The Individual Investor Group provides its clients
with several investment and credit products and services, including mutual
funds, insurance products, financial planning, retirement planning, personal
trust and estate planning, credit management and account services. 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 have been allocated
to each business segment, generally in proportion to their respective revenues
or other relevant measures. Allocation decisions in global financial services
businesses are by their nature complex, subjective and involve a high degree of
judgment. Management is currently evaluating the segment allocation methodology
and the effect of any changes may be material to a particular segment.
Therefore, business segment results in the
19
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
future may reflect reallocations of revenues and expenses that result from such
changes. Reallocations of revenues or expenses among segments will have no
effect on the Company's overall results of operations. Selected financial
information for the Company's segments is presented in the table below:
Individual
Institutional Investor Investment Credit
Three Months Ended August 31, 2002 Securities Group Management Services Total
- ---------------------------------- ------------- ---------- ---------- -------- ------
(dollars in millions)
Net revenues excluding net interest................... $1,404 $ 955 $543 $549 $3,451
Net interest.......................................... 734 58 9 384 1,185
------ ------ ---- ---- ------
Net revenues.......................................... $2,138 $1,013 $552 $933 $4,636
====== ====== ==== ==== ======
Income before income taxes and dividends on preferred
securities subject to mandatory redemption.......... $ 413 $ 8 $229 $319 $ 969
Provision for income taxes............................ 132 3 93 109 337
Dividends on preferred securities subject to mandatory
redemption.......................................... 21 -- -- -- 21
------ ------ ---- ---- ------
Net income............................................ $ 260 $ 5 $136 $210 $ 611
====== ====== ==== ==== ======
Individual
Institutional Investor Investment Credit
Three Months Ended August 31, 2001(1) Securities Group Management Services Total
- ------------------------------------- ------------- ---------- ---------- -------- ------
(dollars in millions)
Net revenues excluding net interest................... $2,097 $ 988 $623 $522 $4,230
Net interest.......................................... 482 89 14 371 956
------ ------ ---- ---- ------
Net revenues.......................................... $2,579 $1,077 $637 $893 $5,186
====== ====== ==== ==== ======
Income before income taxes, dividends on preferred
securities subject to mandatory redemption and
extraordinary item.................................. $ 733 $ (95) $216 $318 $1,172
Provision for income taxes............................ 250 (37) 88 122 423
Dividends on preferred securities subject to mandatory
redemption.......................................... 14 -- -- -- 14
------ ------ ---- ---- ------
Income before extraordinary item...................... 469 (58) 128 196 735
Extraordinary item.................................... (30) -- -- -- (30)
------ ------ ---- ---- ------
Net income............................................ $ 439 $ (58) $128 $196 $ 705
====== ====== ==== ==== ======
Individual
Institutional Investor Investment Credit
Nine Months Ended August 31, 2002 Securities Group Management Services Total
- --------------------------------- ------------- ---------- ---------- -------- -------
(dollars in millions)
Net revenues excluding net interest................... $5,498 $2,894 $1,739 $1,618 $11,749
Net interest.......................................... 1,898 179 22 1,012 3,111
------ ------ ------ ------ -------
Net revenues.......................................... $7,396 $3,073 $1,761 $2,630 $14,860
====== ====== ====== ====== =======
Income before income taxes and dividends on preferred
securities subject to mandatory redemption.......... $1,946 $ 41 $ 690 $ 886 $ 3,563
Provision for income taxes............................ 641 17 271 313 1,242
Dividends on preferred securities subject to mandatory
redemption.......................................... 65 -- -- -- 65
------ ------ ------ ------ -------
Net income............................................ $1,240 $ 24 $ 419 $ 573 $ 2,256
====== ====== ====== ====== =======
20
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Individual
Institutional Investor Investment Credit
Nine Months Ended August 31, 2001(1) Securities Group Management Services Total
- ------------------------------------ ------------- ---------- ---------- -------- -------
(dollars in millions)
Net revenues excluding net interest................... $8,196 $3,157 $1,914 $1,619 $14,886
Net interest.......................................... 1,171 307 50 1,036 2,564
------ ------ ------ ------ -------
Net revenues.......................................... $9,367 $3,464 $1,964 $2,655 $17,450
====== ====== ====== ====== =======
Income before income taxes, dividends on preferred
securities subject to mandatory redemption,
extraordinary item and cumulative effect of
accounting change................................... $2,913 $ (84) $ 687 $ 828 $ 4,344
Provision for income taxes............................ 1,004 (26) 279 319 1,576
Dividends on preferred securities subject to mandatory
redemption.......................................... 28 -- -- -- 28
------ ------ ------ ------ -------
Income before extraordinary item and cumulative
effect of accounting change......................... 1,881 (58) 408 509 2,740
Extraordinary item.................................... (30) -- -- -- (30)
Cumulative effect of accounting change................ (46) -- -- (13) (59)
------ ------ ------ ------ -------
Net income............................................ $1,805 $ (58) $ 408 $ 496 $ 2,651
====== ====== ====== ====== =======
Individual
Institutional Investor Investment Credit
Total Assets(2) Securities Group Management Services Total
- --------------- ------------- ---------- ---------- -------- --------
(dollars in millions)
August 31, 2002...................................... $475,913 $8,681 $5,409 $26,769 $516,772
======== ====== ====== ======= ========
November 30, 2001.................................... $442,598 $9,823 $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 $7 million for the
quarter and $82 million for the nine month period ended August 31, 2002 and $56
million for the fiscal year ended November 30, 2001.
14. Asset Impairment.
The Company's aircraft financing business has continued to be adversely
affected by the slowdown in the commercial aircraft industry which began in
early 2001 and was exacerbated by the terrorist attacks of September 11, 2001
(see Note 13). In addition, the sustained reduction in passenger volume has
resulted in the
21
MORGAN STANLEY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
grounding of significant numbers of aircraft. Such conditions have contributed
significantly to the decline in lease rates for operating lessors, including
the Company's aircraft financing business. As a result of these conditions, and
in accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of," the Company incurred a
non-cash pre-tax charge of $74 million in the third quarter of fiscal 2002 to
reflect the impairment of certain aircraft. The impairment charge is reflected
in other expenses in the Company's condensed consolidated statements of income.
The results of the aircraft financing business are included in the Company's
Institutional Securities business segment (see Note 12).
In accordance with SFAS No. 121, the Company has compared the aggregate
undiscounted cash flows expected to be generated by each of its aircraft with
its carrying value. If an impairment was indicated under this approach, the
aircraft was written down to its estimated fair value, if lower. The Company
determines fair value by obtaining several independent appraisals of its
aircraft, which provide estimates of each aircraft's "base value". "Base value"
is estimated by the appraisers by presuming a transaction between an equally
willing and informed buyer and seller, neither under compulsion to buy or sell,
and with supply and demand for the aircraft in reasonable balance. The Company
believes that "base value" is the relevant measure of the aircraft's value as
it best reflects the fair value of the aircraft in accordance with SFAS No. 121.
In addition, the appraisals received by the Company provide estimates of
each aircraft's market value. "Market value" is estimated by the appraisers by
considering the state of the economy in which the aircraft is used, the status
of supply and demand for the particular aircraft type and the value of recent
transactions. "Market values" generally reflect the probable near-term value of
an aircraft without regard to the factors required to sustain an orderly
market. The Company believes that current industry-wide market values for
aircraft have decreased 20% to 30% from pre-September 11, 2001 market values.
15. Gain on Sale of Building.
During the nine month period ended August 31, 2002, the Company recorded a
pre-tax gain of $73 million related to the sale of a 1 million square-foot
office tower in New York City that had been under construction since 1999. The
gain is included within other revenues in the Company's condensed consolidated
statements of income. The Company allocated $53 million of the gain to its
Institutional Securities segment, $13 million of the gain to its Investment
Management segment and $7 million of the gain to its Individual Investor Group
segment. The allocation was based upon occupancy levels originally planned for
the building.
16. Asset Disposition.
In May 2002, the Company agreed to sell its self-directed online brokerage
accounts to Bank of Montreal's Harrisdirect. The transaction closed during the
third quarter of fiscal 2002. The Company recorded gross proceeds of
approximately $100 million (included within other revenues) and related costs
of approximately $50 million (included within other expenses) in the Individual
Investor Group segment.
22
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 August 31, 2002,
and the related condensed consolidated statements of income and comprehensive
income for the three-month and nine-month periods ended August 31, 2002 and
2001, and condensed consolidated statements of cash flows for the nine-month
periods ended August 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
October 14, 2002
23
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 business
segments--Institutional Securities, Individual Investor Group, Investment
Management and Credit Services. The Company's Institutional Securities business
includes securities underwriting and distribution; financial advisory services,
including advice on mergers and acquisitions, restructurings, real estate and
project finance; sales, trading, financing and market-making activities in
equity securities and related products and fixed income securities and related
products, including foreign exchange and commodities; principal investing,
including private equity activities; and aircraft financing activities. The
Company's Individual Investor Group business provides comprehensive financial
planning and investment advisory services designed to accommodate individual
investment goals and risk profiles. The Individual Investor Group provides its
clients with several investment and credit products and services, including
mutual funds, insurance products, financial planning, retirement planning,
personal trust and estate planning, credit management and account services. 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 changed its name 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; and investor sentiment and confidence in the financial markets. In
addition, there has been a heightened level of legislative, legal and
regulatory developments related to the financial services industry that may
affect future results of operations. Such factors also may have an impact on
the Company's ability to achieve its strategic objectives on a global basis,
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 Institutional Securities business, particularly its
involvement in primary and secondary markets for all types of financial
products, including derivatives, is subject to substantial positive and
negative fluctuations due to a variety of factors that 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.
- --------
* 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.
24
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. Such factors also
affect the level of individual investor participation in the financial markets,
which impacts the results of the Individual Investor Group. The level of global
market activity also could impact the flow of investment capital into or from
assets under management and supervision and the way in which such capital is
allocated among money market, equity, fixed income or other investment
alternatives, which could cause fluctuations to occur in the Company's
Investment Management business. In the Company's Credit Services business,
changes in economic variables, such as the number and size of personal
bankruptcy filings, the rate of unemployment and the level of consumer
confidence and consumer debt, may substantially affect consumer loan levels and
credit quality, which, in turn, could impact the results of Credit Services.
The Company's results of operations also may be materially affected by
competitive factors. Included among the principal competitive factors affecting
the Institutional Securities and Individual Investor Group businesses are the
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, competition has increased 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 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 Nine Month Period
ended August 31, 2002
The difficult conditions in the global financial markets that existed during
the first six months of fiscal 2002 worsened in the third quarter of fiscal
2002, which contributed to the decline in the Company's net revenues and net
income as compared to the quarter and nine month period ended August 31, 2001.
25
In the U.S., economic growth continued to be sluggish, the unemployment rate
remained at relatively high levels, and investors remained uncertain about the
strength and pace of the global economic recovery. In addition, investor
confidence weakened due to increased concerns regarding the quality of
corporate financial reporting, corporate governance, unethical or illegal
corporate practices and several significant corporate bankruptcies. The
Securities and Exchange Commission (the "SEC") responded by, among other
things, requiring chief executive officers and chief financial officers of
companies with large market capitalization to certify the accuracy of certain
prior financial reports and other SEC filings. In addition, the U.S. Congress
passed the Sarbanes-Oxley Act of 2002, which includes broad legislation
affecting public companies with provisions covering corporate governance and
management, new disclosure requirements, oversight of the accounting profession
and auditor independence. In light of the uncertainty regarding the timing and
sustainability of the nation's economic recovery and weaker performance in the
financial markets, the Federal Reserve Board left both the discount rate and
the overnight lending rate unchanged during the quarter.
In Europe, economic conditions were generally stable, although the rate of
economic growth was lower than previously anticipated. Leading indicators and
survey data also suggested weakness in the pace of future economic recovery.
While the prospects for price stability appeared favorable, the European
Central Bank (the "ECB") remained concerned about the weakness in domestic
demand within the region, as well as the difficult conditions existing in the
global financial markets. The recent appreciation of the euro relative to the
U.S. dollar may also have a negative impact on future economic growth in the
region. As a result, the ECB left the benchmark interest rate unchanged during
the quarter. In the U.K., the levels of demand, inflation and unemployment were
generally stable, and business survey data continued to suggest expectations of
an economic recovery. The Bank of England left the benchmark interest rate
unchanged during the quarter.
In Japan, economic conditions continued to be mixed. The level of economic
activity increased, primarily led by growth in the level of exports. However,
the prospects for continued recovery were still uncertain in light of the
difficult conditions existing throughout the global economy. Lingering concerns
over the banking sector, including the level of non-performing bank loans, the
slow pace of structural reforms and deflationary pressures also impacted the
prospects for future economic recovery. 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. However, their prospects for continued recovery will be
largely dependent on developments elsewhere in the world, particularly in the
U.S.
Results of the Company for the Quarter and Nine Month Period ended August 31,
2002
The Company's net income in the quarter and nine month period ended August
31, 2002 was $611 million and $2,256 million, respectively, a decrease of 13%
and 15% from the comparable periods of fiscal 2001. The Company's net income
for the quarter and nine month period ended August 31, 2001 included an
extraordinary loss of $30 million associated with the early extinguishment of
certain long-term borrowings. The Company's net income for the nine month
period ended August 31, 2001 also 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 extraordinary loss, the Company's net
income for the quarter ended August 31, 2002 was 17% below the comparable
period of fiscal 2001. Excluding the extraordinary loss and the cumulative
effect of the accounting change, the Company's net income for the nine month
period ended August 31, 2002 was 18% below the comparable period of fiscal 2001.
Diluted earnings per common share were $0.55 and $2.03 in the quarter and
nine month period ended August 31, 2002 as compared to $0.62 and $2.33 in the
quarter and nine month period ended August 31, 2001. Excluding the
extraordinary loss in the quarter ended August 31, 2001, the Company's diluted
earnings per share were $0.65. Excluding the extraordinary loss and the
cumulative effect of the accounting change in the nine month period ended
August 31, 2001, the Company's diluted earnings per share were $2.41. The
Company's
26
annualized return on common equity for the quarter and nine month period ended
August 31, 2002 was 11.4% and 14.3% as compared to 14.9% and 18.8% (excluding
the extraordinary loss and the cumulative effect of the accounting change) in
the comparable periods of fiscal 2001.
At August 31, 2002, the Company had approximately 58,000 employees
worldwide, a decrease of 7% from August 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.
Asset Disposition
In May 2002, the Company agreed to sell its self-directed online brokerage
accounts to Bank of Montreal's Harrisdirect. The transaction closed during the
third quarter of fiscal 2002. The Company recorded gross proceeds of
approximately $100 million (included within other revenues) and related costs
of approximately $50 million (included within other expenses) in the Individual
Investor Group segment.
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 business segments: Institutional
Securities, Individual Investor Group, 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.
Previously, the results of the Company's institutional and individual
securities activities were aggregated into one reporting segment. Allocation
decisions in global financial services businesses are by their nature complex,
subjective and involve a high degree of judgment. Management is currently
evaluating the segment allocation methodology and the effect of any changes may
be material to a particular segment. Therefore, business segment results in the
future may reflect reallocations of revenues and expenses that result from such
changes. Reallocations of revenues or expenses among segments will have no
effect on the Company's overall results of operations.
A substantial portion of the Company's compensation expense represents
performance-based bonuses, which is determined at the end of the Company's
fiscal year. The segment allocation of these bonuses reflects, among other
factors, the overall performance of the Company as well as the performance of
individual business units. The timing and magnitude of changes in the Company's
bonus accruals can have a significant effect on segment operating results in a
given period.
Accounting Developments
In August 2002, the Company, as a member of the Financial Services Forum,
announced that beginning in fiscal 2003 it will expense employee stock options
in accordance with SFAS No. 123, "Accounting for Stock-Based Compensation."
Under SFAS No. 123, compensation expense will be recognized based on the fair
value of stock options on the date of grant. The Company is in the process of
evaluating the impact of adopting the fair value based method of accounting for
stock-based employee compensation plans under SFAS No. 123.
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.
27
Institutional Securities
Statements of Income (dollars in millions)
Three Months Nine Months
Ended August 31, Ended August 31,
-------------- ---------------
2002 2001 2002 2001
------ ------ ------- -------
(unaudited) (unaudited)
Revenues:
Investment banking................................................ $ 413 $ 708 $ 1,623 $ 2,356
Principal transactions:
Trading....................................................... 328 903 1,834 4,233
Investments................................................... (13) (59) 1 (200)
Commissions....................................................... 556 414 1,608 1,376
Asset management, distribution and administration fees............ 42 35 112 113
Interest and dividends............................................ 3,630 4,980 9,974 17,337
Other............................................................. 78 96 320 318
------ ------ ------- -------
Total revenues................................................ 5,034 7,077 15,472 25,533
Interest expense.................................................. 2,896 4,498 8,076 16,166
------ ------ ------- -------
Net revenues.................................................. 2,138 2,579 7,396 9,367
------ ------ ------- -------
Non-interest expenses................................................ 1,725 1,846 5,450 6,454
------ ------ ------- -------
Income before income taxes, dividends on preferred securities subject
to mandatory redemption, extraordinary item and cumulative effect
of accounting change............................................... 413 733 1,946 2,913
Provision for income taxes........................................... 132 250 641 1,004
Dividends on preferred securities subject to mandatory redemption.... 21 14 65 28
------ ------ ------- -------
Income before extraordinary item and cumulative effect of accounting
change............................................................. 260 469 1,240 1,881
Extraordinary item................................................... -- (30) -- (30)
Cumulative effect of accounting change............................... -- -- -- (46)
------ ------ ------- -------
Net income........................................................ $ 260 $ 439 $ 1,240 $ 1,805
====== ====== ======= =======
Net revenues were $2,138 million and $7,396 million in the quarter and nine
month period ended August 31, 2002, a decrease of 17% and 21% from the
comparable periods of fiscal 2001. Net income for the quarter and nine month
period ended August 31, 2002 was $260 million and $1,240 million, a decrease of
41% and 31% from the comparable periods of fiscal 2001. Net income in the
quarter and nine month period ended August 31, 2001 included an extraordinary
loss of $30 million associated with the early extinguishment of certain
long-term borrowings. Net income in the nine month period ended August 31, 2001
also included a $46 million charge from the cumulative effect of an accounting
change associated with the Company's adoption of SFAS No. 133 on December 1,
2000. Excluding the extraordinary loss, net income for the quarter ended August
31, 2002 decreased 45% from the comparable period of fiscal 2001. Excluding the
extraordinary loss and the cumulative effect of the accounting change, net
income for the nine month period ended August 31, 2002 decreased 34% 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, which were partially offset by lower
principal investment losses. Net income in the quarter and nine month period
ended August 31, 2002 also reflected lower non-interest expenses, primarily due
to lower incentive-based compensation costs. Non-interest expenses in both the
quarter and nine month period ended August 31, 2002 included an asset
impairment charge of $74 million associated with the Company's aircraft
financing business. Net income for the nine month period ended August 31, 2002
included a pre-tax gain (included within other revenues) on the sale of an
office tower.
28
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 August 31, 2002 decreased 42% 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. The Company believes that the difficult economic and market
conditions that currently exist are likely to continue to have an adverse
impact on its investment banking activities in the foreseeable future.
Revenues from merger, acquisition and restructuring activities decreased 59%
to $149 million in the quarter ended August 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, particularly in the
technology, media, telecommunications and financial services sectors. The
global market for such transactions continued to be negatively affected 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 August 31, 2002 as
compared to the prior year period.
Underwriting revenues declined 24% to $264 million in the quarter ended
August 31, 2002 from the comparable period of fiscal 2001.
Equity underwriting revenues decreased in the quarter ended August 31, 2002
as compared to the prior year period, primarily due to a lower volume of equity
offerings, particularly in the technology and financial services sectors.
Fixed income underwriting revenues decreased in the quarter ended August 31,
2002 as compared to the prior year period, reflecting less favorable market
conditions, including higher volatility and widening credit spreads. These
conditions contributed to a lower volume of underwriting transactions for
structured fixed income products and investment grade and non-investment grade
corporate securities.
Investment banking revenues in the nine month period ended August 31, 2002
decreased 31% to $1,623 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 and loan 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 64% to $328 million in the quarter ended
August 31, 2002 from the comparable period of fiscal 2001. The decrease
reflected lower levels of fixed income trading revenues and losses from the
Company's corporate lending activities, principally mark to market losses on
loans.
Equity trading revenues increased slightly during the quarter ended August
31, 2002 from the comparable period of fiscal 2001, primarily reflecting higher
revenues from certain proprietary trading activities and from convertible
equity products. The increase in revenues from certain proprietary trading
activities and convertible equity products was primarily due to higher trading
volumes and higher levels of volatility in the equity markets. Equity trading
revenues were negatively affected by the Company's new pricing structure for
executing transactions on the NASDAQ (see "Commissions" herein).
29
Fixed income trading revenues decreased in the quarter ended August 31, 2002
from the comparable period of fiscal 2001, reflecting lower trading revenues
from government and investment grade fixed income securities and commodities,
partially offset by higher trading revenues from interest rate derivatives and
foreign exchange products. The decrease in government trading revenues was
primarily due to less favorable market conditions in comparison with the prior
year, reflecting 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 corporate bankruptcies, corporate reporting and accounting issues
and credit downgrades. Revenues from interest rate derivative products
increased due to higher levels of market volatility. Commodity trading revenues
decreased significantly as compared with the strong level of revenues recorded
during the quarter ended August 31, 2001. The decline was primarily
attributable to reduced levels of volatility and liquidity in the energy
markets, particularly in the electricity and natural gas sectors. Foreign
exchange trading revenues increased due to higher levels of market volatility,
as the U.S. dollar continued to depreciate against the yen and the euro during
the quarter.
In addition, principal transaction trading revenues in the quarter ended
August 31, 2002 included losses on loans associated with the Company's
corporate lending activities, which reflected the continued deterioration in
the credit markets.
Principal transaction net investment losses aggregating $13 million were
recorded in the quarter ended August 31, 2002 as compared to net losses of $59
million in the quarter ended August 31, 2001. Fiscal 2002's results primarily
included 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 57% in the nine month
period ended August 31, 2002 from the comparable period of fiscal 2001,
primarily reflecting a decline in equity and fixed income 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 interest rate derivative products. Commodity trading
revenues decreased significantly, primarily due to lower revenues from energy
products.
Principal transaction net investment gains aggregating $1 million were
recorded in the nine month period ended August 31, 2002, as compared to net
losses of $200 million in the nine month period ended August 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 options. Commission revenues increased
34% and 17% in the quarter and the nine month period ended August 31, 2002 from
the comparable periods of fiscal 2001. The increase in both the quarter and the
nine month period was due to higher 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. The increase in the quarter also reflected higher
commission revenues in Europe.
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, the results of such market-making activities were reported in
principal transaction trading revenues. As a result of the new pricing
structure, revenues earned from NASDAQ equity trading activities are now
included in commission revenues.
30
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,
customer activity in the Company's prime brokerage business 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 52% and 62% in the quarter and nine month period ended August 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. The increase in both
periods reflected 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.
Asset Management, Distribution and Administration Fees
Asset management, distribution and administration fees include revenues from
asset management services, primarily fees associated with the Company's private
equity and real estate investment activities.
Asset management, distribution and administration fees increased 20% in the
quarter and remained relatively unchanged in the nine month period ended August
31, 2002 from the comparable periods of fiscal 2001. The increase in the
quarter was primarily due to higher management fees from the Company's real
estate investment activities.
Other
Other revenues primarily consist of net rental and other revenues associated
with the Company's aircraft financing business. Other revenues decreased 19% in
the quarter and increased 1% in the nine month period ended August 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 nine month period reflected the inclusion of a gain (of which
$53 million was allocated to the Institutional Securities segment) related to
the Company's sale of an office tower in the first quarter of fiscal 2002. This
increase was 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.
Net revenues from the Company's aircraft financing business have declined in
fiscal 2002 as compared to the prior year, reflecting the slowdown in the
commercial aircraft industry in early 2001 that was exacerbated by the events
of September 11, 2001. In addition, the sustained reduction in passenger volume
has resulted in the grounding of significant numbers of aircraft. Such
conditions have contributed significantly to the decline in lease rates for
operating lessors, including the Company's aircraft financing business. The
Company currently expects these conditions to continue in the foreseeable
future.
Non-Interest Expenses
Non-interest expenses decreased 7% and 16% in the quarter and nine month
period ended August 31, 2002 from the comparable periods of fiscal 2001. In
both periods, the majority of the decrease was attributable to
31
lower compensation and benefits expense, which decreased 18% and 19% in the
quarter and nine month period, principally reflecting lower incentive-based
compensation due to lower levels of revenues and earnings. Brokerage, clearing
and exchange fees increased 22% and 6% in the quarter and nine month period due
to higher brokerage costs associated with global securities trading volume.
Professional services expense decreased 9% and 31% in the quarter and nine
month period reflecting lower consulting and temporary service costs. Other
expenses increased 115% and 9% in the quarter and nine month period primarily
due to an asset impairment charge associated with the Company's aircraft
financing business (see Note 14 to the condensed consolidated financial
statements). In addition, marketing and business development expenses decreased
14% in the nine month period reflecting lower travel and entertainment costs.
32
Individual Investor Group
Statements of Income (dollars in millions)
Three Months Nine Months
Ended August 31, Ended August 31,
-------------- --------------
2002 2001 2002 2001
------ ------ ------ ------
(unaudited) (unaudited)
Revenues:
Investment banking..................................... $ 61 $ 87 $ 190 $ 214
Principal transactions:
Trading............................................ 129 176 432 613
Investments........................................ (45) 1 (44) (11)
Commissions............................................ 288 294 890 1,000
Asset management, distribution and administration fees. 407 426 1,272 1,310
Interest and dividends................................. 88 155 281 617
Other.................................................. 115 4 154 31
------ ------ ------ ------
Total revenues..................................... 1,043 1,143 3,175 3,774
Interest expense....................................... 30 66 102 310
------ ------ ------ ------
Net revenues....................................... 1,013 1,077 3,073 3,464
------ ------ ------ ------
Non-interest expenses..................................... 1,005 1,172 3,032 3,548
------ ------ ------ ------
Income before income taxes................................ 8 (95) 41 (84)
Provision for income taxes................................ 3 (37) 17 (26)
------ ------ ------ ------
Net income............................................. $ 5 $ (58) $ 24 $ (58)
====== ====== ====== ======
Net revenues were $1,013 million and $3,073 million in the quarter and nine
month period ended August 31, 2002, a decrease of 6% and 11% from the
comparable periods of fiscal 2001. Net income for the quarter and nine month
period ended August 31, 2002 was $5 million and $24 million, as compared to net
losses of $58 million in the quarter and nine month period ended August 31,
2001. In both periods, the decreases in net revenues were primarily
attributable to lower investment banking, principal trading and net interest
revenues, principal investment losses and lower asset management, distribution
and administration fees. The decrease in net revenues for the nine month period
also reflected lower commission revenues. The increase in net income in both
periods was due to lower non-interest expenses, including lower compensation
costs and a credit of $59 million related to the resolution of a mutual fund
litigation matter.
In May 2002, the Company agreed to sell its self-directed online brokerage
accounts to Bank of Montreal's Harrisdirect. The transaction closed during the
third quarter of fiscal 2002. The Company recorded gross proceeds of
approximately $100 million (included within other revenues) and related costs
of approximately $50 million (included within non-interest expenses).
The Company believes that the difficult economic and market conditions that
currently exist, including weakened investor confidence and increased risk
aversion among individual investors, are likely to continue to have an adverse
impact on the results of its Individual Investor Group business.
Investment Banking
Investment banking revenues are derived from the Individual Investor Group's
distribution of equity and fixed income securities underwritten by the
Institutional Securities business. Investment banking revenues decreased 30%
and 11% in the quarter and nine month period from the comparable periods of
fiscal 2001 due to lower revenues from equity and fixed income underwriting
transactions as a result of the difficult conditions in the global financial
markets.
33
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. The Company maintains certain security
positions primarily to facilitate Individual Investor Group customer
transactions. Principal transaction trading revenues decreased 27% and 30% in
the quarter and nine month period ended August 31, 2002 from the comparable
periods of fiscal 2001. The decrease reflected lower levels of equity and fixed
income trading revenues.
Equity trading revenues decreased during the quarter ended August 31, 2002,
primarily due to less favorable market conditions. Equity trading revenues were
also negatively affected by the Company's new pricing structure for executing
transactions on the NASDAQ (see "Commissions" herein).
Fixed income trading revenues decreased in the quarter ended August 31, 2002
from the comparable period of fiscal 2001, reflecting less favorable market
conditions in government and corporate fixed income securities.
Principal transaction net investment losses aggregating $45 million were
recorded in the quarter ended August 31, 2002 as compared to net gains of $1
million in the quarter ended August 31, 2001. Principal transaction net
investment losses of $44 million were recorded in the nine month period ended
August 31, 2002, as compared to net losses of $11 million in the nine month
period ended August 31, 2001. Fiscal 2002's quarter and nine month results
primarily reflected the write-down of an equity investment related to the
Company's European individual securities business. Fiscal 2001's nine month
results primarily reflected unrealized losses in certain of the Company's
principal investments.
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 decreased 2% in the quarter
and 11% in the nine month period ended August 31, 2002 from the comparable
periods of fiscal 2001. The decrease in the quarter and nine month period was
due to lower levels of investor participation in the U.S. equity markets,
partially offset by the impact of a new commission-based pricing structure for
executing transactions on the NASDAQ.
In January 2002, the Company began implementing a commission-based pricing
structure for executing transactions on the NASDAQ. Prior to January 2002, the
Company operated its NASDAQ equity business through market-making activities,
which were primarily based on earning a spread between the bid and ask prices.
In prior periods, the results of such market-making activities were reported in
principal transaction trading revenues. As a result of the new pricing
structure, revenues earned from NASDAQ equity trading activities are now
included in commission revenues.
Net Interest
Interest and dividend revenues and interest expense are a function of the
level and mix of total assets and liabilities, including customer margin loans
and securities borrowed and securities loaned transactions. Net interest
revenues decreased 35% and 42% in the quarter and nine month period ended
August 31, 2002 from the comparable periods of fiscal 2001, primarily due to
lower net interest revenues from brokerage services provided to individual
customers, including a decrease in customer margin loans, partially offset by a
decline in interest expense due to a decrease in the Company's average cost of
borrowings.
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
34
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 fees declined 4% in the
quarter and 3% in the nine month period ended August 31, 2002 from the
comparable periods of fiscal 2001. The decrease in both periods was primarily
attributable to lower 12b-1 fees from promoting and distributing mutual funds,
reflecting a decrease in individual investors' mutual fund asset levels. The
decrease in the nine month period was partially offset by an increase in
revenues from the Company's ICS business.
Other
Other revenues primarily include account fees and other miscellaneous
service fees. Other revenues were $115 million in the quarter and $154 million
in the nine month period ended August 31, 2002 as compared to $4 million and
$31 million in the comparable periods of fiscal 2001. The increase in both
periods primarily reflected approximately $100 million of revenue received in
connection with the sale of the Company's self-directed online brokerage
accounts (see "Asset Disposition" herein). The increase in both periods was
also due to higher customer account fees. The increase in the nine month period
reflected the inclusion of a gain (of which $7 million was allocated to the
Individual Investor Group segment) related to the Company's sale of an office
tower in the first quarter of fiscal 2002.
Non-Interest Expenses
Non-interest expenses decreased 14% and 15% in the quarter and nine month
period ended August 31, 2002 from the comparable periods of fiscal 2001. In
both periods, the majority of the decrease was attributable to lower
compensation and benefits expense, which decreased 9% and 10% in the quarter
and nine month period, principally reflecting lower incentive-based
compensation due to lower levels of revenues and earnings as well as lower
employment levels. Occupancy and equipment expense decreased 12% in both the
quarter and nine month period reflecting lower rent expense resulting from the
utilization of alternate facilities after the loss of the World Trade Center
complex. Information processing and communication expenses decreased 16% and
20% in the quarter and nine month period due to lower data processing and
telecommunication costs. Professional services expense decreased 33% and 41% in
the quarter and nine month period reflecting lower consulting costs. Other
expenses decreased 45% and 38% in the quarter and nine month period due to the
benefit from the resolution of a mutual fund litigation matter and the
elimination of goodwill amortization due to the Company's adoption of SFAS No.
142, "Goodwill and Other Intangible Assets". These decreases were partially
offset by costs associated with the Company's sale of its self-directed online
brokerage accounts (see "Asset Disposition" herein).
35
Investment Management
Statements of Income (dollars in millions)
Three Months Nine Months
Ended August 31, Ended August 31,
--------------- --------------
2002 2001 2002 2001
---- ---- ------ ------
(unaudited) (unaudited)
Revenues:
Investment banking..................................... $ 8 $ 12 $ 25 $ 46
Principal transactions:
Investments........................................ (6) (1) (4) (1)
Commissions............................................ 11 12 34 33
Asset management, distribution and administration fees. 522 593 1,657 1,814
Interest and dividends................................. 9 16 23 57
Other.................................................. 8 7 27 22
---- ---- ------ ------
Total revenues..................................... 552 639 1,762 1,971
Interest expense....................................... -- 2 1 7
---- ---- ------ ------
Net revenues....................................... 552 637 1,761 1,964
---- ---- ------ ------
Non-interest expenses..................................... 323 421 1,071 1,277
---- ---- ------ ------
Income before income taxes................................ 229 216 690 687
Provision for income taxes................................ 93 88 271 279
---- ---- ------ ------
Net income............................................. $136 $128 $ 419 $ 408
==== ==== ====== ======
Net revenues were $552 million and $1,761 million in the quarter and nine
month period ended August 31, 2002, a decrease of 13% and 10% from the
comparable periods of fiscal 2001. Net income for the quarter and nine month
period ended August 31, 2002 was $136 million and $419 million, an increase of
6% and 3% from the comparable periods of fiscal 2001. In both periods, the
increases in net income primarily reflected a decline in non-interest expenses,
including the impact of a net pre-tax credit of $27 million associated with
certain legal matters, including the resolution of a mutual fund litigation
matter. The increase in net income in the nine month period also reflected a
pre-tax 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, net income was negatively impacted by lower asset management,
distribution and administration fees.
Investment Banking
Investment Management generates investment banking revenues from the
underwriting of Unit Investment Trust products. Investment banking revenues
decreased 33% and 46% in the quarter and nine month period ended August 31,
2002 from the comparable prior year periods, 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
Principal transaction revenues are generated from net gains and losses on
capital investments in certain of the Company's funds and other investments.
The Company recorded net principal investment losses of $6 million in the
quarter and $4 million in the nine month period ended August 31, 2002. In
fiscal 2001, the Company recorded net principal investment losses of $1 million
in both the quarter and nine month period ended August 31, 2001.
36
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 decreased 8% in the quarter and
increased 3% in the nine month period ended August 31, 2002 from the comparable
periods of fiscal 2001. The decrease in the quarter was due to lower sales
volumes of certain Van Kampen funds and insurance products. The increase in the
nine month period was due to a higher level of allocated commission revenues,
partially offset by the impact of lower sales volumes of certain Van Kampen
funds and insurance 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 36% and 56% in the quarter and nine month period
ended August 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 customer 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 August 31,
-----------------
2002 2001
---- ----
(dollars in billions)
Assets under management or supervision by distribution channel:
Retail...................................................... $252 $292
Institutional............................................... 172 179
---- ----
Total................................................... $424 $471
==== ====
Assets under management or supervision by asset class:
Equity...................................................... $175 $202
Fixed Income................................................ 127 138
Money Market................................................ 66 69
Other(1).................................................... 56 62
---- ----
Total(2)................................................ $424 $471
==== ====
- --------
(1)Includes alternative investment vehicles.
(2)Revenues and expenses associated with certain assets are included in the
Company's Individual Investor Group and Institutional Securities segments.
In the quarter and nine month period ended August 31, 2002, asset
management, distribution and administration fees decreased 12% and 9% from the
comparable periods of fiscal 2001. The decrease in revenues primarily reflected
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 reflected a less favorable asset mix due to a continued shift of
customer assets from equity products to fixed income and money market products,
which typically generate lower fees.
As of August 31, 2002, customer assets under management or supervision
decreased $47 billion from August 31, 2001. The decrease was attributable to
market depreciation, reflecting declines in the global financial markets,
coupled with net outflows of customer assets, as redemptions exceeded new sales
during the period from September 1, 2001 to August 31, 2002.
37
Non-Interest Expenses
Non-interest expenses decreased 23% and 16% in the quarter and nine month
period ended August 31, 2002 from the comparable period of fiscal 2001. In both
periods, the majority of the decrease was attributable to lower compensation
and benefits expense, which decreased 24% and 17% in the quarter and nine month
period, principally reflecting lower incentive-based compensation costs as well
as lower employment levels. Occupancy and equipment expense decreased 14% and
15% in the quarter and nine month period, reflecting lower rental expense due
to the utilization of alternate facilities after the loss of the World Trade
Center complex. Brokerage, clearing and exchange fees increased 17% and 12% in
the quarter and nine month period, primarily reflecting a higher level of
deferred commission amortization. Marketing and business development expense
decreased 32% and 23% in the quarter and nine month period, primarily related
to lower marketing and travel and entertainment costs. Other expenses decreased
148% and 86% in the quarter and nine month period, primarily reflecting the net
benefit from certain legal matters, including the resolution of a mutual fund
litigation matter. In both periods, the decrease in other expenses also
reflected a decline in discretionary spending on various operating costs and a
decline in goodwill amortization as a result of the Company's adoption of SFAS
No. 142.
38
Credit Services
Statements of Income (dollars in millions)
Three Months Nine Months
Ended August 31, Ended August 31,
---------------- ---------------
2002 2001 2002 2001
---- ---- ------ ------
(unaudited) (unaudited)
Fees:
Merchant and cardmember.................................... $364 $362 $1,064 $1,000
Servicing.................................................. 514 434 1,566 1,337
Other......................................................... 3 3 5 3
---- ---- ------ ------
Total non-interest revenues............................ 881 799 2,635 2,340
---- ---- ------ ------
Interest revenue.............................................. 646 674 1,801 2,000
Interest expense.............................................. 262 303 789 964
---- ---- ------ ------
Net interest income........................................ 384 371 1,012 1,036
Provision for consumer loan losses............................ 332 277 1,017 721
---- ---- ------ ------
Net credit income.......................................... 52 94 (5) 315
---- ---- ------ ------
Net revenues........................................... 933 893 2,630 2,655
---- ---- ------ ------
Non-interest expenses......................................... 614 575 1,744 1,827
---- ---- ------ ------
Income before income taxes and cumulative effect of accounting
change...................................................... 319 318 886 828
Provision for income taxes.................................... 109 122 313 319
---- ---- ------ ------
Income before cumulative effect of accounting change.......... 210 196 573 509
Cumulative effect of accounting change........................ -- -- -- (13)
---- ---- ------ ------
Net income................................................. $210 $196 $ 573 $ 496
==== ==== ====== ======
Net revenues were $933 million and $2,630 million in the quarter and nine
month period ended August 31, 2002, an increase of 4% and a decrease of 1% from
the comparable periods of fiscal 2001. Net income was $210 million and $573
million in the quarter and nine month period ended August 31, 2002, an increase
of 7% and 16% from the comparable periods of fiscal 2001. Net income for the
nine month period ended August 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 nine month period ended August 31,
2002 increased 13% from the comparable period of fiscal 2001. The increase in
net income for both periods was primarily attributable to higher servicing fees
and a lower income tax rate, partially offset by a higher provision for
consumer loan losses. The increase in net income for the nine month period also
reflected higher merchant and cardmember fees and lower non-interest expenses.
Non-Interest Revenues
Total non-interest revenues increased 10% and 13% in the quarter and nine
month period ended August 31, 2002 from the comparable periods of fiscal 2001.
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 and Discover Platinum
Card cardmembers 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 1% in the
quarter and 6% in
39
the nine month period ended August 31, 2002 from the comparable periods of
fiscal 2001. The increase in the quarter was due to higher merchant discount
revenue partially offset by lower late payment and cash advance fees. The
increase in the nine month period was due to higher merchant discount revenue
and late payment fees partially offset by lower cash advance fees. The increase
in merchant discount revenue in both periods was due to an increase in the
average merchant discount rate coupled with a higher level of sales volume. The
decrease in cash advance fees in both periods was due to lower cash advance
transaction volume. The decrease in late payment fees in the quarter was due to
lower fee assessments resulting from fewer delinquent accounts. The increase in
late payment fees in the nine month period resulted from the implementation of
a tiered fee and the elimination of certain payment features that previously
mitigated late charges.
Servicing fees are revenues derived from consumer loans that 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 did not complete
any new credit card asset securitization transactions during the third quarter
of fiscal 2002. The Company completed credit card asset securitization
transactions of $2.8 billion in the nine month period ended August 31, 2002.
During fiscal 2001, the Company completed credit card asset securitization
transactions of $0.5 billion in the quarter and $7.3 billion in the nine month
period ended August 31, 2001. The credit card asset securitization transactions
completed during the nine month period ended August 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 Nine Months
Ended August 31, Ended August 31,
--------------- ----------------
2002 2001 2002 2001
----- ------ ------- -------
(dollars in millions)
Merchant and cardmember fees...... $ 183 $ 177 $ 576 $ 547
Interest revenue.................. 995 1,067 3,065 3,233
Interest expense.................. (219) (354) (671) (1,221)
Provision for consumer loan losses (445) (456) (1,404) (1,222)
----- ------ ------- -------
Servicing fees.................... $ 514 $ 434 $ 1,566 $ 1,337
===== ====== ======= =======
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 18% and
17% in the quarter and nine month period ended August 31, 2002 from the
comparable periods of fiscal 2001. The increase in both periods was due to
higher levels of net interest cash flows primarily as a result of a lower cost
of funding. The increase in the nine month period was partially offset by
higher credit losses associated with a higher rate of charge-offs related to
the securitized portfolio. Net securitization gains and losses on general
purpose credit card loans are also included in servicing fees. In the absence
of any new securitizations in the quarter, the Company recorded $3 million of
net amortization in the quarter related to prior securitization transactions.
Net securitization gains of $16 million were recorded in the nine month period
ended August 31, 2002. Such amounts reflect a decrease of $6 million and $61
million from the comparable periods of fiscal 2001. Virtually all of the
decrease in the quarter and $33 million of the decrease in the nine month
period ended August 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 nine
month period ended August 31, 2001 by approximately $24 million. The
assumptions modified by the
40
Company in fiscal 2001 were the net interest rate spread and the net charge-off
rate. The assumed net interest rate spread increased, reflecting the projection
of a lower interest rate environment and the resulting lower interest expense
(i.e., cost of funding) on variable-rate securitizations, partially offset by
an estimated lower yield on credit card receivables attributable to estimated
lower interest rates and higher charge-offs of interest. The assumed net
charge-off rate increased, reflecting an increase in the projected charge-off
rate attributable to weakening economic conditions and its impact on the
Company's credit card portfolio. Additionally, net securitization gains were
lower by approximately $4 million in the nine month period ended August 31,
2002 due to a higher percentage of new securitization transactions 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 consumer loans and short-term investment assets and interest
expense incurred to finance those loans and assets. Assets, consisting
primarily of consumer loans, currently earn interest revenue at both fixed
rates and market-indexed variable rates. The Company incurs interest expense at
fixed and floating rates. Interest expense also includes the effects of any
interest rate contracts entered into by the Company as part of its interest
rate risk management program. This program is designed to reduce the volatility
of earnings resulting from changes in interest rates by having a financing
portfolio that reflects the existing repricing schedules of consumer loans as
well as the Company's right, with notice to cardmembers, to reprice certain
fixed rate consumer loans to a new interest rate in the future.
Net interest income increased 4% in the quarter and decreased 2% in the nine
month period ended August 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 a lower yield on average general purpose credit card loans.
The decrease in the nine 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 the nine month period was due to
higher levels of average securitized loans. The Company's increased focus on
credit quality has 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 5.41% and 6.09% for the quarters and 5.36% and 6.34% for the nine month
periods ended August 31, 2002 and 2001, respectively. The decline in the
average cost of borrowings reflected the Fed's aggressive easing of interest
rates during 2001.
41
The following tables present analyses of average balance sheets and interest
rates for the quarters and nine month periods ended August 31, 2002 and 2001
and changes in net interest income during those periods:
Average Balance Sheet Analysis
Three Months Ended August 31,
------------------------------------------------
2002 2001(3)
----------------------- -----------------------
Average Average
Balance Rate Interest Balance Rate Interest
------- ----- -------- ------- ----- --------
(dollars in millions)
ASSETS
Interest earning assets:
General purpose credit card loans..................... $20,476 11.86% $ 612 $20,407 12.15% $ 625
Other consumer loans.................................. 1,262 5.99 19 933 7.47 18
Investment securities................................. 57 1.49 -- 255 3.51 2
Other................................................. 2,378 2.47 15 2,539 4.65 29
------- ----- ------- -----
Total interest earning assets.................. 24,173 10.60 646 24,134 11.09 674
Allowance for loan losses............................. (902) (789)
Non-interest earning assets........................... 2,040 2,144
------- -------
Total assets................................... $25,311 $25,489
======= =======
LIABILITIES AND SHAREHOLDER'S EQUITY
Interest bearing liabilities:
Interest bearing deposits
Savings............................................ $ 974 1.54% $ 4 $ 1,377 3.53% $ 12
Brokered........................................... 10,390 5.87 154 9,040 6.60 151
Other time......................................... 1,789 4.88 22 3,082 5.92 46
------- ----- ------- -----
Total interest bearing deposits................ 13,153 5.41 180 13,499 6.13 209
Other borrowings...................................... 6,045 5.41 82 6,251 5.99 94
------- ----- ------- -----
Total interest bearing liabilities............. 19,198 5.41 262 19,750 6.09 303
Shareholder's equity/other liabilities................ 6,113 5,739
------- -------
Total liabilities and shareholder's equity..... $25,311 $25,489
======= =======
Net interest income................................... $ 384 $ 371
===== =====
Net interest margin(1)................................ 6.30% 6.10%
Interest rate spread(2)............................... 5.19% 5.00%
- --------
(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.
42
Average Balance Sheet Analysis
Nine Months Ended August 31,
------------------------------------------------
2002 2001(3)
----------------------- -----------------------
Average Average
Balance Rate Interest Balance Rate Interest
------- ----- -------- ------- ----- --------
(dollars in millions)
ASSETS
Interest earning assets:
General purpose credit card loans..................... $20,730 10.94% $1,702 $21,084 11.52% $1,824
Other consumer loans.................................. 1,165 6.05 53 799 8.07 48
Investment securities................................. 59 1.52 1 570 5.21 22
Other................................................. 2,473 2.48 45 2,406 5.86 106
------- ------ ------- ------
Total interest earning assets.................. 24,427 9.82 1,801 24,859 10.72 2,000
Allowance for loan losses............................. (877) (787)
Non-interest earning assets........................... 2,156 2,145
------- -------
Total assets................................... $25,706 $26,217
======= =======
LIABILITIES AND SHAREHOLDER'S EQUITY
Interest bearing liabilities:
Interest bearing deposits
Savings............................................ $ 1,051 1.59% $ 13 $ 1,622 4.70% $ 57
Brokered........................................... 9,527 6.10 436 8,950 6.68 449
Other time......................................... 2,141 5.18 83 3,034 6.10 139
------- ------ ------- ------
Total interest bearing deposits................ 12,719 5.57 532 13,606 6.31 645
Other borrowings...................................... 6,877 4.97 257 6,664 6.38 319
------- ------ ------- ------
Total interest bearing liabilities............. 19,596 5.36 789 20,270 6.34 964
Shareholder's equity/other liabilities................ 6,110 5,947
------- -------
Total liabilities and shareholder's equity..... $25,706 $26,217
======= =======
Net interest income................................... $1,012 $1,036
====== ======
Net interest margin(1)................................ 5.52% 5.55%
Interest rate spread(2)............................... 4.46% 4.38%
- --------
(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.
43
Rate/Volume Analysis
Three Months Ended Nine Months Ended
August 31, 2002 August 31, 2002
vs. 2001 vs. 2001
---------------------- ----------------------
Increase/(Decrease) Due Increase/(Decrease) Due
to Changes in: to Changes in:
---------------------- ----------------------
Volume Rate Total Volume Rate Total
------ ---- ----- ------ ----- -----
(dollars in millions)
INTEREST REVENUE
General purpose credit card loans.......... $ 2 $(15) $(13) $(31) $ (91) $(122)
Other consumer loans....................... 6 (5) 1 22 (17) 5
Investment securities...................... (2) -- (2) (20) (1) (21)
Other...................................... (2) (12) (14) 3 (64) (61)
---- -----
Total interest revenue.............. 1 (29) (28) (34) (165) (199)
---- -----
INTEREST EXPENSE
Interest bearing deposits:
Savings................................. (3) (5) (8) (20) (24) (44)
Brokered................................ 22 (19) 3 29 (42) (13)
Other time.............................. (19) (5) (24) (41) (15) (56)
---- -----
Total interest bearing deposits..... (5) (24) (29) (42) (71) (113)
Other borrowings........................... (3) (9) (12) 10 (72) (62)
---- -----
Total interest expense.............. (8) (33) (41) (32) (143) (175)
---- -----
Net interest income........................ $ 9 $ 4 $ 13 $ (2) $ (22) $ (24)
==== ==== ==== ==== ===== =====
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 August 31,
---------------------------------------------------
2002 2001(1)
------------------------- -------------------------
Avg. Bal. Rate Interest Avg. Bal. Rate Interest
--------- ----- -------- --------- ----- --------
(dollars in millions)
General purpose credit card loans............... $49,344 12.86% $1,600 $49,825 13.34% $1,676
Total interest earning assets................... 53,554 12.16 1,641 54,384 12.70 1,741
Total interest bearing liabilities.............. 48,578 3.93 481 50,000 5.21 657
General purpose credit card interest rate spread 8.93 8.13
Interest rate spread............................ 8.23 7.49
Net interest margin............................. 8.59 7.91
Nine Months Ended August 31,
---------------------------------------------------
2002 2001(1)
------------------------- -------------------------
Avg. Bal. Rate Interest Avg. Bal. Rate Interest
--------- ----- -------- --------- ----- --------
(dollars in millions)
General purpose credit card loans............... $49,701 12.71% $4,743 $49,588 13.45% $5,005
Total interest earning assets................... 53,972 12.01 4,866 54,192 12.86 5,233
Total interest bearing liabilities.............. 49,141 3.96 1,460 49,604 5.87 2,185
General purpose credit card interest rate spread 8.75 7.58
Interest rate spread............................ 8.05 6.99
Net interest margin............................. 8.41 7.49
- --------
(1) Certain prior-year information has been reclassified to conform to the
current year's presentation.
44
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 $927 million at
August 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 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 uncollectible, increased 20% in the quarter and 41% in the nine month
period ended August 31, 2002 from the comparable periods of fiscal 2001. The
increase in both periods was due to higher net charge-off rates. The increase
in the nine month period was partially offset by lower levels of average
general purpose credit card loans. In addition, to reflect the impact of the
continued difficult economic environment on its credit card portfolio and an
adverse trend in bankruptcy filings, the Company recorded a provision for
consumer loan loss expense that exceeded the amount of net consumer loans
charged off by $25 million and $75 million in the quarter and nine month period
ended August 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 nine month period ended August 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. Although the delinquency rate of the Company's managed credit card
portfolio in the greater than 90-day category improved modestly as compared to
the quarters ended May 31, 2002 and August 31, 2001, the rate of net
charge-offs may be higher in future periods if weak economic conditions
continue to persist.
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
45
general purpose credit card loan portfolio, interest rate movements and their
impact on consumer behavior, and the rate and magnitude of changes in the
Company's general purpose credit card loan portfolio, including the overall mix
of accounts, products and loan balances within the portfolio.
The following table presents owned and managed general purpose credit card
loans and delinquency and net charge-off rates:
Asset Quality
August 31, 2002 August 31, 2001 November 30, 2001
---------------- ---------------- ----------------
Owned Managed Owned Managed Owned Managed
------- ------- ------- ------- ------- -------
(dollars in millions)
General purpose credit card loans
at period-end..................... $21,840 $49,677 $20,194 $49,704 $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.................... 2.99% 3.23 % 3.33 % 3.70 % 3.43 % 3.83 %
90 to 179 days................... 2.39% 2.49 % 2.35% 2.61 % 2.74 % 3.02 %
Net charge-offs as a percentage of
average general purpose credit
card loans (year-to-date)......... 6.02% 6.27 % 4.49 % 5.19 % 4.76 % 5.36 %
Non-Interest Expenses
Non-interest expenses increased 7% in the quarter and decreased 5% in the
nine month period ended August 31, 2002 from the comparable periods of fiscal
2001. Compensation and benefits expense increased 11% in the quarter,
principally reflecting an increase in compensation accruals and personnel
benefits. Marketing and business development expenses increased 16% in the
quarter due to higher advertising costs, which reflected the timing of
advertising campaigns. The Company currently expects marketing and business
development expense to increase in the fourth quarter as compared to the third
quarter of fiscal 2002. Professional services expense increased 22% in the
quarter, attributable to higher consulting expenses associated with
international operations and higher domestic collection and legal fees. Other
expenses decreased 12% in the quarter related to lower inquiry fees associated
with fewer new account applications and lower costs associated with cardmember
fraud. The decrease in non-interest expenses in the nine month period primarily
reflected lower marketing and business development expenses, which decreased
22% due to lower advertising, telemarketing and direct mailing costs,
principally reflecting the timing of advertising campaigns.
Liquidity and Capital Resources
The Company's total assets increased to $516.8 billion at August 31, 2002
from $482.6 billion at November 30, 2001, primarily attributable to increases
in financial instruments owned, including corporate and other debt, derivative
contracts, 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
46
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
---------------------------
August 31, November
2002 30, 2001
---------- --------
(dollars in millions, except
ratio and per share data)
Total assets........................................... $516,772 $482,628
======== ==========
Adjusted assets(1)..................................... $361,517 $338,957
======== ==========
Leverage ratio(2)...................................... 24.4x 23.6x
======== ==========
Adjusted leverage ratio(3)............................. 17.1x 16.5x
======== ==========
Book value per share(4)................................ $ 19.59 $ 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) the lesser of securities borrowed or
securities loaned, (iv) segregated customer cash balances and (v) goodwill.
(2) Leverage ratio equals total assets divided by tangible shareholders' equity
($21,179 million at August 31, 2002 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 1,093 million at August 31, 2002 and 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. 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. In addition,
the Company attempts to maintain total equity, on a consolidated basis, at
least equal to the sum of its operating subsidiaries' equity. The Company
returns internally generated equity capital that is in excess of the needs of
its businesses to its shareholders through common stock repurchases and
dividends.
The Company funds its balance sheet on a global basis. The Company raises
funding for its Institutional Securities, Individual Investor Group 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
47
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 that are registered
with the Securities and Exchange Commission or privately placed. This structure
includes certain features designed to protect the investors that could result
in earlier-than-expected amortization of the transactions, potentially
resulting in the need for the Company to obtain alternative funding
arrangements. The primary feature relates to the availability and adequacy of
cash flows in the securitized pool of receivables to meet contractual
requirements ("economic early amortization").
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 Investor Group 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
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
48
term counterparty performance is critical, such as over-the-counter derivative
transactions, including credit derivatives and interest rate swaps.
In connection with certain over-the-counter trading agreements associated
with the Institutional Securities business, the Company would be required to
provide additional collateral to certain counterparties in the event of a
downgrade by either Standard & Poor's or Moody's Investors Service. At August
31, 2002, the amount of additional collateral that would be required in the
event of a one notch downgrade was approximately $400 million.
As of September 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......................... F1+ AA-
Moody's Investors Service............. P-1 Aa3
Rating and Investment Information, Inc a-1+ AA
Standard & Poor's(1).................. A-1+ AA-
- --------
(1)In August 2002, Standard & Poor's placed the Company's commercial paper and
senior debt credit ratings on CreditWatch with negative implications.
As the Company operates 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 nine month period ended August 31, 2002, the Company issued
senior notes aggregating $10,605 million, including non-U.S. dollar currency
notes aggregating $1,962 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 August 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 $91.0 billion (including Senior Indebtedness consisting of
guaranteed obligations of the indebtedness of subsidiaries). Between August 31,
2002 and September 30, 2002, the Company's long-term borrowings, net of
repayments and repurchases, decreased by approximately $112 million.
During the nine month period ended August 31, 2002, the Company purchased
$671 million of its common stock through open market purchases. Subsequent to
August 31, 2002 and through September 30, 2002, the Company purchased an
additional $121 million of its common stock through a combination of open
market purchases and settlement of put options.
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 August 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.
49
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 shareholders' equity. At
August 31, 2002, the Company maintained a $7.9 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 August 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 August 31,
2002, MS&Co. maintained a $2.4 billion surplus consolidated stockholder's
equity and a $3.5 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 August 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 August 31, 2002, MSIL maintained a $1.3
billion surplus Shareholder's Equity and a $1.9 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 August 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 August 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.
50
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 August 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)............................. $2,186 $1,346 $ -- $ -- $ 3,532
Private equity and other principal investments(1) 50 237 98 203 588
Financing commitments to investment grade
counterparties(1).............................. 289 6,510 962 3,280 11,041
Financing commitments to non-investment grade
counterparties(1).............................. 123 290 257 754 1,424
------ ------ ------ ------ -------
Total..................................... $2,648 $8,383 $1,317 $4,237 $16,585
====== ====== ====== ====== =======
- --------
(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 August 31, 2002, the Company had commitments to enter into reverse
repurchase and repurchase agreements of approximately $34 billion and $44
billion, respectively.
At August 31, 2002, certain assets of the Company, such as real property,
equipment and leasehold improvements of $2.3 billion, aircraft assets of $4.8
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 August 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 $800 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 are not included because reporting
gross market value exposures would not accurately reflect the risks associated
51
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 manages its
aggregate and single-issuer net exposure through the use of derivatives and
other financial instruments. The Company records high-yield instruments at fair
value. Unrealized gains and losses are recognized currently in the Company's
condensed consolidated statements of income. At August 31, 2002 and November
30, 2001, the Company had high-yield instruments owned with a market value of
approximately $3.1 billion and $1.3 billion, respectively, and had high-yield
instruments sold, not yet purchased, with a market value of $0.9 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 subject to
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 August 31, 2002 and November 30, 2001, the aggregate
value of investment grade loans and positions was $0.3 billion and $1.5
billion, respectively, and the aggregate value of non-investment grade loans
and positions was $1.3 billion and $1.4 billion, respectively. In connection
with these business activities (which includes the loans and positions
discussed above and the financing commitments included in the table on page
51), the Company had hedges with a notional amount of $5.0 billion at August
31, 2002 and $1.4 billion at November 30, 2001. Requests to provide financing
or financing commitments in connection with certain investment banking
activities will continue and may grow in the future.
At August 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 $39.5
billion. The fair value of all derivative products in a gain position at August
31, 2002 represents the Company's maximum current 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.
52
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk
As of August 31, 2002, Aggregate Value-at-Risk ("VaR"), incorporating
substantially all financial instruments generating market risk that are
primarily managed by the Company's institutional trading businesses, measured
at a 99% confidence level with a one-day time horizon, was $56 million.
Aggregate VaR decreased from $66 million at May 31, 2002, as a decrease in
equity price VaR was partially offset by an increase in interest rate VaR. The
decrease in equity price VaR resulted primarily from the reduction of a
concentrated single-name exposure that existed at May 31, 2002. The increase in
interest rate VaR is due primarily to improvements in the modeling of
credit-sensitive products. Absent such improvements, at August 31, 2002
interest rate VaR would have been $43 million and Aggregate VaR would have been
$51 million. These modeling improvements reflect the Company's continuing
efforts to enhance its risk-measurement processes, including an improvement to
the VaR methodology applied to certain mortgage and asset-backed security and
loan products. For a summary of the Company's trading and related market risk
profile during the course of the quarter ended August 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 VaR for each of the Company's primary risk
exposures and on an aggregate basis at August 31, 2002, May 31, 2002 and
November 30, 2001. This measure of VaR incorporates substantially all 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 August 31, 2002, May 31,
2002 and November 30, 2001, and, therefore, the table below does not separately
report trading and non-trading VaRs.
99%/One-Day VaR
----------------------------------------
At August 31, At May 31, At November 30,
Primary Market Risk Category 2002 2002 2001
---------------------------- ------------- ---------- ---------------
(dollars in millions, pre-tax)
Interest rate.................. $51 $ 39 $30
Equity price................... 16 50 23
Foreign exchange rate.......... 5 6 6
Commodity price................ 25 24 24
--- ---- ---
Subtotal....................... 97 119 83
Less diversification benefit(1) 41 53 41
--- ---- ---
Aggregate VaR.................. $56 $ 66 $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, Aggregate 95%/one-day VaR at August 31, 2002 was $40 million.
53
The table below presents the high, low and average 99%/one-day Aggregate
trading VaR over the course of the quarter ended August 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
August 31, 2002
-------------------------
Primary Market Risk Category High Low Average
---------------------------- ---- --- -------
(dollars in millions, pre-tax)
Interest rate............ $52 $39 $45
Equity price............. 49 14 22
Foreign exchange rate.... 11 5 7
Commodity price.......... 25 19 22
Aggregate trading VaR.... 72 45 54
The histogram below presents the Company's daily 99%/one-day VaR for its
institutional trading activities during the quarter ended August 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 August 31, 2002 was:
Daily 99%/One-Day VaR
(dollars in millions) Number of Days
- --------------------- --------------
less than 40 0
40 to 43 0
43 to 46 2
46 to 49 16
49 to 52 16
52 to 55 12
55 to 58 5
58 to 61 4
61 to 64 4
64 to 67 3
67 to 70 0
70 to 73 2
73 to 76 0
76 to 79 0
79 to 82 0
82 to 85 0
greater than 85 0
54
The histogram below presents the distribution of daily net revenues during
the quarter ended August 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 August 31, 2002
was:
Daily Net Revenue of the Institutional
Trading Business
(dollars in millions) Number of Days
- -------------------------------------- --------------
less than -15 0
-15 to -10 1
-10 to -5 2
-5 to 0 0
0 to 5 2
5 to 10 6
10 to 15 6
15 to 20 8
20 to 25 6
25 to 30 13
30 to 35 4
35 to 40 5
40 to 45 1
45 to 50 4
50 to 55 2
55 to 60 0
60 to 65 3
65 to 70 1
70 to 75 1
75 to 80 0
80 to 85 0
85 to 90 0
greater than 90 0
As of August 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 August 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
-----------------------------
Less Cross-Maturity Net-Exposure Net-Exposure
Credit Rating(1) than 1 1-3 3-5 Over 5 Netting(2) Pre-Collateral Post-Collateral
---------------- ------- ------ ------ ------- -------------- -------------- ---------------
(dollars in millions)
AAA................................ $ 642 $ 796 $2,035 $ 4,142 $ (2,295) $ 5,320 $ 3,267
AA................................. 4,078 2,216 2,211 6,535 (3,822) 11,218 7,892
A.................................. 4,038 3,433 1,481 3,790 (3,379) 9,363 5,878
BBB................................ 1,250 896 631 1,830 (989) 3,618 3,093
Non-investment grade............... 2,473 1,495 1,065 3,749 (1,177) 7,605 3,723
------- ------ ------ ------- -------- ------- -------
Total....................... $12,481 $8,836 $7,423 $20,046 $(11,662) $37,124 $23,853
======= ====== ====== ======= ======== ======= =======
- --------
(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.
55
Item 4. Controls and Procedures
Based on their evaluation, as of a date within 90 days of the filing of this
Form 10-Q, the Company's Chief Executive Officer and Chief Financial Officer
have concluded the Company's disclosure controls and procedures (as defined in
Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934) are
effective. There have been no significant changes in internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
Part II OTHER INFORMATION
Item 1. Legal Proceedings
(a) The following matters have been commenced against the Company.
In re Turkcell Iletisim Hizmetleri, A.S. Securities Litigation. In November
2000, a class action was filed in the U.S. District Court for the Southern
District of New York ("SDNY") against Turkcell Iletisim Hizmetleri A.S., a
Turkish telecommunications company ("Turkcell"), certain officers of Turkcell,
and six underwriters of Turkcell's initial public offering ("IPO"), including
the Company. Turkcell offered 96 million American Depositary Shares ("ADSs") to
the public in its July 11, 2000 IPO, at a price of $17.60 per ADS. The
complaint was subsequently consolidated with several other class action
complaints. Plaintiffs filed a consolidated and amended complaint on March 29,
2001, which purports to cover a class of purchasers of Turkcell ADSs between
the IPO and September 21, 2000. The complaint alleges that the registration
statement and prospectus contained materially false and misleading information
(and/or omitted facts necessary to make statements not misleading) concerning
Turkcell's operating income and the rate at which Turkcell was losing
customers. The complaint asserts a claim under Section 11 of the Securities Act
of 1933 against all defendants and seeks unspecified compensatory damages,
costs, expenses and attorneys' fees. On November 1, 2001, the court granted
defendants' motion to dismiss claims concerning Turkcell's operating income,
but denied the motion with respect to claims relating to the rate at which
Turkcell was losing customers. On August 22, 2002, the court granted
plaintiffs' motion for class certification.
Official Committee of Unsecured Creditors of Sunbeam Corporation v. Morgan
Stanley & Co. Inc., et al. In July 2001, the Official Committee of Unsecured
Creditors of Sunbeam filed an adversary proceeding on behalf of the estate of
Sunbeam in the Bankruptcy Court of the SDNY against the Company, one of its
affiliates, and two other financial institutions. The complaint alleges that
the Company acted with gross negligence and aided and abetted fraud and breach
of fiduciary duty in connection with advice given to Sunbeam's board of
directors concerning Sunbeam's acquisition of three companies in 1998 and the
offering of subordinated debt to finance the acquisitions. The complaint also
asserts causes of action for equitable subordination and fraudulent transfer
against all the defendants and one for setoff against the Company and its
affiliate. The complaint seeks compensatory and punitive damages. An amended
complaint was filed on September 6, 2001. All defendants moved to dismiss the
amended complaint on October 1, 2001, which motions are pending. On September
6, 2002, Sunbeam filed the Debtor's Second Amended Disclosure Statement and
Plan of Reorganization, which would provide for the dismissal with prejudice of
the adversary proceeding if the Plan were approved by the Court. On October 4,
2002, the Court held a hearing on the adequacy of the Disclosure Statement, and
allowed Sunbeam to distribute the Disclosure Statement to the creditors,
subject to some changes to the description of the adversary proceeding. The
Court also set a date for a hearing on Plan confirmation in late November 2002.
EEOC Matter. On September 10, 2001, the U.S. Equal Employment Opportunity
Commission (the "EEOC") filed suit against the Company in the SDNY alleging
that since 1995 the Company engaged in a pattern or practice of discrimination
against Allison Schieffelin, a former employee, and other females who have held
the positions of associate, vice-president, executive director or managing
director in the Company's Institutional Equity Division in pay, promotion and
other terms, conditions and privileges of employment and seeking compensatory
and punitive damages. The EEOC also alleges that the Company retaliated against
Schieffelin. On
56
the same date, Schieffelin filed a motion to intervene in the EEOC action,
along with a complaint alleging that she had been discriminated against because
of her sex on the same basis. Schieffelin also alleged that she had been
retaliated against. On October 15, 2001, the court granted Schieffelin's motion
to intervene. On September 4, 2002, the court entered an order permitting the
EEOC to amend its complaint to include all Institutional Equity Division female
exempt non-officers eligible to be promoted to vice president, including
associates and professionals.
(b) 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 Reports on Form
10-Q for the fiscal quarters ended February 28, 2002 and May 31, 2002.
Term Trust Matters. On July 29, 2002, the National Adjudicatory Council of
the National Association of Securities Dealers Regulation, Inc. affirmed the
hearing panel's dismissal of all charges against Morgan Stanley DW Inc. and
both individual respondents.
Electricity Trading Matters. With respect to the purported class actions in
California, Morgan Stanley Capital Group, Inc. ("MSCG") filed motions to
dismiss or stay on July 11, 2002.
On October 1, 2002, MSCG received a subpoena from the Commodities Futures
Trading Commission ("CFTC") in connection with that agency's ongoing
investigation of certain trading by energy and power marketing firms. MSCG is
cooperating with the CFTC in responding to the subpoena.
IPO Allocation Matters. In the Ask Jeeves matter, on July 24, 2002,
plaintiffs filed a motion to transfer the case to the SDNY to be coordinated
with the class action securities suits, captioned In re Initial Public Offering
Securities Litigation. Defendants opposed that motion, and on August 21, 2002,
underwriter defendants filed a motion for judgment on the pleadings.
On October 9, 2002, the U.S. Securities and Exchange Commission (which is
conducting a joint inquiry with the New York Stock Exchange and the National
Association of Securities Dealers) issued a request to the Company for
information relating to IPO allocations to executives of companies for which
the Company provided investment banking services.
The Company continues to cooperate with various governmental and regulatory
agencies conducting industry-wide investigations of IPO allocation practices.
Research Matters. The Company continues to cooperate with various
governmental and regulatory agencies conducting industry-wide investigations of
research analyst independence.
In addition, beginning on August 30, 2002, several purported class action
complaints against the Company, other financial services firms, and some
individual research analysts, including one of the Company's analysts, have
been filed in the SDNY. These actions are on behalf of purchasers of common
stock of various companies. They allege that the purported classes were
defrauded by defendants' failure to disclose that defendants issued positive
stock recommendations to obtain investment banking business and by their
concealment of significant conflicts of interest. They also allege violations
of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5
thereunder and seek compensatory damages.
Several purported class action complaints also were filed in the SDNY,
beginning July 31, 2002, against the Company, the Morgan Stanley Technology
Fund (the "Technology Fund"), Morgan Stanley Investment Management, Inc. and
certain other subsidiaries of the Company alleging securities fraud violations
in connection with the underwriting and management of the Technology Fund and
seeking unspecified damages for their losses on investments in the Technology
Fund. Plaintiffs' allege in these cases that Company analysts issued overly
optimistic stock recommendations to obtain investment banking business and that
the desire to obtain investment banking business influenced decisions made by
the Fund manager.
IPO Fee Litigation. In In re Issuer Plaintiff Initial Public Offering Fee
Antitrust Litigation, the Court denied defendants motion to dismiss the
consolidated class action complaint on September 25, 2002.
Mutual Fund Valuation Matters. In Abrams v. Van Kampen Funds Inc., et al.,
the United States District Court for the Northern District of Illinois, by
order dated August 26, 2002, granted the lead plaintiff's motion for class
certification.
57
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 June 11, 2002 reporting Item 5 and Item 7.
Form 8-K dated June 19, 2002 reporting Item 5 and Item 7 in connection
with the announcement of the Company's financial results for the fiscal
quarter ended May 31, 2002.
Form 8-K dated July 16, 2002 reporting Item 9.
Form 8-K dated August 13, 2002 reporting Item 7 and Item 9.
Form 8-K dated August 15, 2002 reporting Item 5.
58
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
MORGAN STANLEY
(Registrant)
By: /S/ JOANNE PACE
-----------------------------
Joanne Pace, Controller and
Principal Accounting Officer
Date: October 15, 2002
59
Certification
I, Philip J. Purcell, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Morgan Stanley;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons performing
the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: October 15, 2002
/S/ PHILIP J. PURCELL
Philip J. Purcell
Chairman of the Board and Chief Executive Officer
60
Certification
I, Stephen S. Crawford, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Morgan Stanley;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons performing
the equivalent function):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: October 15, 2002
/S/ STEPHEN S. CRAWFORD
Stephen S. Crawford
Executive Vice President and Chief Financial Officer
61
EXHIBIT INDEX
MORGAN STANLEY
Quarter Ended August 31, 2002
Exhibit
No. Description
- ------- -----------
4 Second Supplemental Senior Indenture dated as of October 8, 2002 between Morgan Stanley and
JPMorgan Chase Bank, as trustee.
10.1 Directors' Equity Capital Accumulation Plan, amended and restated effective as of
September 16, 2002.
10.2 Amendment to Morgan Stanley & Co. Incorporated Excess Benefit Plan, effective as of
September 1, 2002.
10.3 Amendment to Supplemental Executive Retirement Plan, effective as of September 1, 2002.
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 October 14, 2002, concerning unaudited
interim financial information.
99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
E-1