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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

[x]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2004

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 1-8529

LEGG MASON, INC.

(Exact name of registrant as specified in its charter)

  Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   X        No _____  

  Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes   X        No _____  

  Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

105,923,323 shares of common stock and 2,815,722 exchangeable shares as of the close of business on February 2, 2005. The exchangeable shares, which were issued by Legg Mason Canada Holdings in connection with the acquisition of Legg Mason Canada Inc., are exchangeable at any time into common stock on a one-for-one basis and entitle holders to dividend, voting and other rights equivalent to common stock.

PART I.  

FINANCIAL INFORMATION

Item 1.  

Financial Statements

LEGG MASON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

 (In thousands, except per share amounts)

(Unaudited)

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LEGG MASON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS

(continued)

(In thousands, except per share amounts)

(Unaudited)

See Notes to Consolidated Financial Statements

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LEGG MASON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

See Notes to Consolidated Financial Statements

4

LEGG MASON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in thousands)

(Unaudited)

See Notes to Consolidated Financial Statements

5

LEGG MASON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

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LEGG MASON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(continued)

(Dollars in thousands)

(Unaudited)

SUPPLEMENTARY DISCLOSURE:

Non-cash activity:

In connection with the sale of the mortgage banking and servicing business of Legg Mason Real Estate Services during the nine months ended December 31, 2003, Legg Mason received a $6,900 non-interest bearing note due September 30, 2007, with a net present value of $5,100.

See Notes to Consolidated Financial Statements

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LEGG MASON, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share amounts, unless otherwise noted)

December 31, 2004

(Unaudited)

1. Interim Basis of Reporting

The accompanying unaudited interim consolidated financial statements of Legg Mason, Inc. and its subsidiaries (collectively "Legg Mason") have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information.  The interim consolidated financial statements have been prepared using the interim basis of reporting and, as such, reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the results for the periods presented.  The nature of our business is such that the results of any interim period are not necessarily indicative of the results for a full year.

The information contained in the interim consolidated financial statements should be read in conjunction with our latest Annual Report on Form 10-K filed with the Securities and Exchange Commission. Where appropriate, the prior year's financial statements have been reclassified to conform to the current year’s presentation.  Unless otherwise noted, all per share amounts include both common shares of Legg Mason and shares issued in connection with the acquisition of Legg Mason Canada Inc., which are exchangeable into common shares of Legg Mason on a one-for-one basis at any time.

The preparation of interim consolidated financial statements requires management to make assumptions and estimates that affect the amounts reported in the interim consolidated financial statements and accompanying notes.  Actual amounts could differ from those estimates and the differences could have a material impact on the interim consolidated financial statements.

Terms such as "we," "us," "our," and "company" refer to Legg Mason.

2. Significant Accounting Policies

Special Purpose Entities

In the normal course of our business activities, we are the general partner, and in some cases a limited partner, in investment partnerships and are the investment manager and/or managing member in limited liability companies and offshore investment vehicles.  These entities are primarily vehicles to facilitate investments by our customers in many types of investment strategies including real estate, equity and fixed income portfolios.  Our exposure to risk in these entities is generally limited to any equity investment we have made and any earned but uncollected management fees.  Uncollected fees from these entities were not material at December 31, 2004.

The following lists Variable Interest Entities ("VIEs") in which we believe we have a variable interest but are not the primary beneficiary and, therefore, these VIEs are not subject to consolidation by us:

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(1) Excludes one offshore investment vehicle and three limited liability companies in which one of our asset management subsidiaries has approximately $17.5 million invested by its long-term incentive plan.  We do not have a direct variable interest since we do not earn any fees on these assets.

During April 2004, we provided a $1,200 subordinated loan to an unaffiliated entity, which became the sole equity investor in a VIE.  The VIE simultaneously issued $31,583 of debt instruments to third-party investors.  As a result of our loan to the sole equity investor in the VIE, we considered ourselves the primary beneficiary of the VIE under Financial Accounting Standards Board (“FASB”) Interpretation Number (“FIN”) 46, “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51.”  Accordingly, we were required to consolidate this entity as of, and for the six months ended, September 30, 2004.  In October 2004, the subordinated loan was repaid and, as a result, we are no longer required to consolidate this VIE.

Our Statement of Financial Condition at December 31, 2004 includes $15,700 of assets attributable to consolidated VIEs, which primarily includes $5,970 in cash and cash equivalents and $9,625 in trading assets, and $15,700 of liabilities attributable to consolidated VIEs, which primarily includes $9,732 in minority interest included with other liabilities and $5,857 in trading liabilities.  Our assets, exclusive of the assets of consolidated VIEs, are not subject to the claims of the creditors of these consolidated VIEs and likewise the assets of the consolidated VIEs are not available to our creditors.  

Stock Based Compensation

During fiscal 2004, we adopted the fair value method of accounting for stock-based compensation on a prospective basis for all stock options granted and stock purchase plan transactions after April 1, 2003, using the Black-Scholes option pricing model. Under the prospective method allowed under Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure,” compensation expense is recognized based on the fair value of stock options granted after April 1, 2003 over the applicable vesting period. No compensation expense was recognized for stock options granted prior to April 1, 2003. Therefore, the expense related to stock-based employee compensation included in the determination of net income for the three and nine months ended December 31, 2004 is less than that which would have been included if the fai r value method had been applied to all awards.

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The following table reflects pro forma results utilizing the retrospective method as if compensation expense associated with all option grants (regardless of grant date) and the stock purchase plan were recognized over the vesting period:

The weighted average fair value of options granted during the nine months ended December 31, 2004 and 2003 using the Black-Scholes option pricing model was $22.53 and $19.85 per share, respectively.   The following weighted average assumptions were used in the model for grants during the periods:

Restricted Cash

Included in cash and cash equivalents at December 31, 2004 is $20,578, which represents cash in an escrow account in connection with our appeal of a civil copyright lawsuit.  This cash is considered restricted and is not available to Legg Mason for general corporate use.

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Recent Accounting Developments

The FASB has issued the following pronouncements since March 31, 2004.

In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment", which requires all share-based payment transactions to be valued using the fair value method.  SFAS 123R eliminates the ability to account for share-based compensation using the intrinsic value method under Accounting Principles Board Opinion (“APB”) 25.  SFAS 123R is effective for all interim periods beginning after June 15, 2005.  Retroactive application of the provisions of SFAS 123R to the beginning of the fiscal year that includes the effective date is permitted, but not required. See table in Stock Based Compensation for the potential impact on Legg Mason’s Consolidated Financial Statements under the retrospective method.  

In December 2004, the FASB issued FASB Staff Position FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004."  The American Jobs Creation Act, which was signed into law on October 22, 2004, provides for a one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. taxpayers.  Historically, Legg Mason has reinvested cumulative undistributed earnings of its non-U.S. subsidiaries and accordingly, deferred U.S. federal income taxes on such undistributed earnings were not recorded.  Legg Mason is currently evaluating the income tax effects of the foreign earnings repatriation provision within the Act and cannot reasonably estimate the income tax effects, if any, at this time.

The Emerging Issues Task Force (“EITF”) reached a consensus regarding Issue 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share.”  The guidance in this EITF requires contingently convertible instruments, if dilutive, to be included retroactively in diluted earnings per share computations from the date of issuance of the instruments. The effective date of this EITF is for reporting periods ending after December 15, 2004. As a result of the adoption of this EITF, our contingently convertible senior notes are now included in our diluted earnings per share computation for the full nine months ended December 31, 2003, which has resulted in a reduction in diluted earnings per share of $0.05 for that period.

The EITF reached a consensus on Topic No. D-108, "Use of the Residual Method to Value Acquired Assets Other Than Goodwill." Companies who have applied the residual method to the valuation of intangible assets for purposes of impairment testing should perform an impairment test applying this guidance by no later than the beginning of their first fiscal year beginning after December 15, 2004. Impairments of intangible assets recognized upon application of a direct value method by entities previously applying the residual method should be reported as a cumulative effect of a change in accounting principle.  These requirements should be applied to business combinations completed after September 29, 2004.  The adoption of EITF D-108 did not impact Legg Mason's Consolidated Financial Statements.

The EITF reached a consensus on Issue 04-10, “Determining Whether to Aggregate Operating Segments That Do Not Meet the Quantitative Thresholds.”  This EITF requires that individual operating segments that do not meet the quantitative thresholds set forth in SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information,” for separate reporting may be aggregated only if the segments meet certain requirements.  These requirements are applicable for fiscal years ending after October 13, 2004.  The adoption of EITF 04-10 did not impact Legg Mason's identified segments.

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The EITF reached a consensus on Issue 03-16, “Accounting for Investments in Limited Liability Companies.”  This EITF requires that an investment in a Limited Liability Company (“LLC”) that maintains a “specific ownership account” for each investor – similar to a partnership capital account structure – should be viewed as similar to an investment in a limited partnership for purposes of determining whether a non-controlling investment in an LLC should be accounted for using the cost method or the equity method.  These requirements are applicable for reporting periods beginning after June 15, 2004.  The adoption of EITF 03-16 did not materially impact Legg Mason's Consolidated Financial Statements.

3. Acquisition of Scudder Private Investment Counsel Offices

On November 12, 2004, Legg Mason Investment Counsel, LLC, a wholly owned subsidiary of Legg Mason, agreed to acquire from Deutsche Investment Management Americas the New York City, Philadelphia, Cincinnati and Chicago offices of Scudder Private Investment Counsel (the “Acquired Offices”). The acquisition of these offices fits Legg Mason’s strategic objective to grow its asset management business.  The transaction closed on December 31, 2004.  Under the terms of the agreement, Legg Mason purchased the Acquired Offices for cash of $55,000.  The transaction includes a contingent payment based on the revenues of the Acquired Offices on the first anniversary of closing, with the aggregate purchase price to be no more than $81,300.  The Acquired Offices had $5.4 billion of assets under management at December 31, 2004.  The allocation of the purchase price resu lted in $17,833 of Goodwill and $35,900 of Amortizable Asset Management Contracts.  We engaged the services of a third party to perform an independent valuation of the assets acquired and the liabilities assumed to assist us in reporting the results of the acquisition.  The fair value of the asset management contracts of $35,900 will be amortized over an estimated life of 12 years.  

4. Trading Assets, at Fair Value

At December 31, 2004, Legg Mason had pledged securities owned of $528 as collateral to counterparties for securities loaned transactions, which can be sold or repledged by the counterparties.

5. Intangible Assets and Goodwill

The following table reflects the components of intangible assets as of:

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Estimated amortization expense for each of the next five fiscal years is as follows:

During the quarter ended December 31, 2004, Legg Mason acquired the four offices of Scudder Private Investment Counsel as described in Note 3.  The increase in the cost of amortizable asset management contracts primarily reflects the value of the contracts acquired of $35,900.

During the quarter ended June 30, 2004, we determined that, as a result of both Private Capital Management, L.P. ("PCM") and Royce & Associates, LLC ("Royce") meeting certain revenue levels as specified in the acquisition agreements, a contingent acquisition payment of $400,000 was due to the prior owners of PCM and a contingent acquisition payment of $100,000 was due to the prior owners of Royce.  During the quarter ended September 30, 2004, payments totaling $400,000 were made from available cash to the prior owners of PCM.  During the quarter ended December 31, 2004, payments totaling $100,000 were made from available cash to the prior owners of Royce.  

The carrying value of goodwill of $991,600 at December 31, 2004 is primarily attributable to the Asset Management reporting segment.  The increase in the carrying value of goodwill since March 31, 2004 primarily reflects $500,000 for additional purchase consideration described above, $17,833 related to the acquisition of the four offices of Scudder Private Investment Counsel, and $2,500 related to a contingent acquisition payment for the business of Rothschild Asset Management (Singapore) Limited.  The goodwill related to the additional purchase consideration and the acquisition of the four offices is deductible for tax purposes.

6. Common Stock

On July 20, 2004 Legg Mason declared a three-for-two stock split, paid as a dividend on September 24, 2004 to stockholders of record on September 8, 2004.  Accordingly, all share and per share information has been retroactively restated to reflect the stock split, except for the common stock and additional paid-in capital presented in the Consolidated Statement of Financial Condition.

On December 15, 2004, Legg Mason sold 4.6 million shares of common stock (including shares sold under an option to cover over-allotments) at $70.30 per share less underwriting fees for net proceeds of approximately $311,000.

7. Long-Term Debt

In April 2004, Western Asset Management Company, a subsidiary of Legg Mason, entered into a $20,000 term loan agreement with a commercial bank to finance tenant improvements on real property at the subsidiary’s new headquarters.  The loan bears interest at 4.19% and is collateralized by the property and equipment of the subsidiary, with a maturity date of October 2010.  The subsidiary is required to maintain a compensating balance over the life of the loan beginning with $5,000 at the funding date and decreasing to zero at a predetermined rate.  This compensating balance is not legally restricted; however, failure to maintain the appropriate balance will result in additional bank charges and possible acceleration of the maturity if such charges are not paid.  The loan also provides for restrictive covenants at the subsidiary relating to the maintenance of specified fin ancial performance ratios such as tangible net worth and debt service coverage.  At December 31, 2004, we were in compliance with all covenants related to this and all facilities.

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In April 2004, we entered into a transaction with a VIE that issued $31,583 in long-term debt to finance the construction of a building which we were required to consolidate under FIN 46.  As discussed in Note 2, as of December 31, 2004, we were no longer required to consolidate this VIE.

As of December 31, 2004, the aggregate maturities of long-term debt (current accreted value of $819,982), based on the contractual terms, are as follows:

8. Commitments and Contingencies

We lease office facilities and equipment under non-cancelable operating leases and also have multi-year agreements for data processing and other services. These leases and service agreements expire on varying dates through 2020. Certain leases provide for renewal options and contain escalation clauses providing for increased rentals based upon maintenance, utility and tax increases.

As of December 31, 2004, the minimum annual aggregate rentals are as follows:

We have been the subject of customer complaints and have also been named as a defendant in various legal actions arising primarily from securities brokerage, asset management and investment banking activities, including certain class actions, which primarily allege violations of securities laws and seek unspecified damages, which could be substantial. We are also involved in governmental and self-regulatory agency inquiries, investigations and proceedings. In accordance with SFAS No. 5 “Accounting for Contingencies,” we have established provisions for estimated losses from pending complaints, legal actions, investigations and proceedings. While the ultimate resolution of these actions cannot be currently determined, in the opinion of management, after consultation with legal counsel, we have no reason to believe that the resolution of these actions will have a material adverse effect on our financial condition. However, the results of operations could be materially affected during any period if liabilities in that period differ sufficiently from our estimates.  In addition, the ultimate costs of litigation-related charges can vary significantly from period to period, depending on factors such as market conditions, the size and volume of customer complaints and claims, including class action suits and recoveries from indemnification, contribution or insurance reimbursement.

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Starting in September 2003, Legg Mason has responded to inquiries from the Securities and Exchange Commission (the “SEC”) relating to its industry-wide mutual fund probes. Legg Mason Wood Walker (“LMWW”) has been cooperating with two separate investigations undertaken by the SEC staff  (the “Staff”) that arose out of those inquiries. One investigation is ongoing, and Legg Mason is not currently able to predict the outcome of that investigation, or to predict what effect, if any, that investigation will have on Legg Mason’s business or results of operations. With respect to the Staff’s other investigation, LMWW commenced negotiations with the Staff to resolve all aspects of that investigation and recorded a $1,200 charge in the September quarter.  While no settlement with the SEC has been reached and no assurance can be given that this matter wi ll be settled consistent with the amount reserved, Legg Mason does not expect that a settlement of that investigation will be material to Legg Mason’s business or results of operations.

The Financial Services Authority (the “FSA”) in the United Kingdom conducted an investigation into a number of fund management and brokerage firms, including Legg Mason Investments (Europe) Limited (“LMI”), involved in the split capital investment trust business in the United Kingdom.  On December 24, 2004, without admitting any wrongdoing, a number of firms, including LMI, entered into a settlement agreement with the FSA to resolve the FSA’s investigation.  Under the settlement agreement, LMI contributed to a fund that will be available for distribution to eligible investors in split capital trust investment vehicles.  LMI’s contribution to the settlement did not materially impact Legg Mason’s results of operations or financial condition.

9. Earnings Per Share

Basic earnings per share ("EPS") is calculated by dividing net earnings by the weighted average number of common shares outstanding. Diluted EPS is similar to basic EPS, but adjusts for the effect of potential common shares.

As a result of the adoption of EITF 04-08, diluted earnings per share for nine months ended December 31, 2003 have been restated to include, as of April 1, 2003, 6.6 million shares issuable upon conversion of our zero-coupon contingent convertible senior notes.  Previously our senior notes were included in the calculation of diluted earnings per share beginning in the quarter ended December 31, 2003 because the senior notes became convertible during that quarter.    

The following table presents the computations of basic and diluted EPS:

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10. Net Capital Requirements

Our broker-dealer subsidiaries are subject to the Securities and Exchange Commission’s Uniform Net Capital Rule.  The rule provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would fall below specified levels.  As of December 31, 2004, the broker-dealer subsidiaries had aggregate net capital, as defined, of $383,682, which exceeded required net capital by $357,314.  During October 2004, Legg Mason Wood Walker, Incorporated, our primary broker-dealer subsidiary, paid a $100,000 dividend from its available cash to its parent company, Legg Mason, Inc.  

11. Business Segment Information

We currently operate through the following business segments: Asset Management, Private Client and Capital Markets. The business segment classifications are based upon factors such as the services provided and distribution channels utilized. Certain services that we offer are provided to clients through more than one of our business segments. Therefore, the revenue categories are allocated to multiple segments. We allocate certain common income and expense items among our business segments based upon various methodologies and factors. These methodologies are by their nature subjective and are reviewed periodically by management. Business segment results in the future may reflect reallocations of revenues and expenses that result from changes in methodologies, but any reallocations will have no effect on our consolidated results of operations.

Asset Management provides investment advisory services to institutional and individual clients and to company-sponsored investment funds. The primary sources of revenue in Asset Management are investment advisory, distribution and administrative fees, which typically are calculated as a percentage of the assets in the account and vary based upon factors such as the type of underlying investment product, the amount of assets under management and the type of services that are provided. In addition, performance fees may be earned on certain investment advisory contracts for exceeding performance benchmarks. Distribution fees earned on company-sponsored investment funds are reported in Asset Management when the fund is sold through direct marketing channels and in the Private Client segment when the fund is sold through its branch distribution network. Revenues from Asset Management tend to be mor e stable than those from Private Client and Capital Markets because they are less affected by changes in securities market conditions.

Private Client distributes a wide range of financial products through its branch distribution network, including equity and fixed income securities, proprietary and non-affiliated mutual funds and annuities. The primary sources of net revenues for Private Client are commissions and principal credits earned on equity and fixed income transactions in customer brokerage accounts, distribution fees earned from mutual funds, fee-based account fees and net interest from customers’ margin loan and credit account balances. Sales credits associated with underwritten offerings initiated in the Capital Markets segment are reported in Private Client when sold through its branch distribution network.

Capital Markets consists of our equity and fixed income institutional sales and trading and corporate and public finance investment banking. The primary sources of revenue for equity and fixed income institutional sales and trading include commissions and principal credits on transactions in both corporate and municipal products. We maintain proprietary fixed income and equity securities inventory primarily to facilitate customer transactions and recognize trading profits and losses from proprietary trading activities. Investment banking revenues include underwriting fees and advisory fees from private placements and mergers and acquisitions. Sales credits associated with underwritten offerings are reported in Capital Markets when sold through institutional distribution channels. The results of this business segment also include realized and unrealized gains and losses on investments acquired in connection with merchant and investment banking activities.

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In September 2003, we sold the mortgage banking and servicing operation of Legg Mason Real Estate Services, Inc. ("LMRES"), which had been previously reported in Other. Other also included certain unallocated corporate revenues and expenses. Consolidated results have been restated to reflect the historical results of the sold business as discontinued operations and the remaining operations of LMRES in Capital Markets. The corporate revenues and expenses that are not allocated to the business segments are now reported separately as Corporate.  The Corporate net revenues include $2,000 resulting from the deconsolidation of a variable interest entity in the quarter ended December 31, 2004 as described in Note 2.  The Corporate loss from continuing operations for the nine months ended December 31, 2003 includes a single litigation award charge of $17,500.

Business segment financial results are as follows:

We analyze our assets on a consolidated basis and therefore do not provide this information by segment.

We principally operate in the United States of America, the United Kingdom and Canada. Revenues and expenses for geographic purposes are generally allocated based on the location of the office providing the service.

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Results by geographic region are as follows:

12. Discontinued Operations

On September 30, 2003, Legg Mason sold certain assets and liabilities comprising the commercial mortgage banking and mortgage servicing operations of its wholly owned subsidiary, LMRES.  LMRES continues to operate its real estate investment group, which is now included in the Capital Markets segment.  Legg Mason recorded a gain, net of transaction costs, of $10,861 ($6,481, net of income tax).  This gain is reflected as Gain on Sale of Discontinued Operations on the Consolidated Statement of Earnings for the nine months ended December 31, 2003.  The sale of certain assets of LMRES was a result of Legg Mason’s long-term strategic objective to focus on Legg Mason's core businesses.  Results of prior periods have been restated to reflect the results of the sold business as discontinued operations.  The net assets, pre-tax earnings and cash flows from the operati ons of LMRES that were sold were not material to Legg Mason's consolidated operations.

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

Legg Mason, Inc., a holding company, and its subsidiaries (collectively "Legg Mason") are principally engaged in providing asset management, securities brokerage, investment banking and related financial services to individuals, institutions, corporations and municipalities. We currently operate through three business segments: Asset Management, Private Client and Capital Markets.

Our profitability may vary significantly from period to period as a result of a variety of factors, including the amount of assets under management, the volume of trading in securities, the volatility and general level of securities prices and interest rates, the level of customer margin and credit account balances and the demand for investment banking services. Accordingly, sustained periods of unfavorable market conditions may adversely affect our profitability. For a further discussion of factors that may affect our results of operations, refer to Item 1 – "Business – Factors Affecting the Company and the Financial Services Industry" in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004.

Terms such as "we," "us," "our," and "company" refer to Legg Mason.

Business Environment

The challenging equity markets in which we operated during the first six months of fiscal 2005 improved during the third fiscal quarter.  Equity markets rose following the U.S. presidential election and as oil prices eased from record highs.  The Dow Jones Industrial Average, the Nasdaq Composite Index and the S&P 500 were up 7%, 15% and 9%, respectively, for the quarter ended December 31, 2004, and were up 4%, 9% and 8%, respectively, for the nine months ended December 31, 2004.  However, this rebound was tempered in January as the indexes were down in the first several weeks of trading.  Fixed income trading activity remained modest, as evidenced by a fairly narrow trading range, and as a result of economic indicators, which continue to send mixed signals about the health of the economy and its impact on inflation and interest rates.  < /B>The federal funds rate was raised by 0.25% on both November 10, 2004 and December 14, 2004.