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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended May 31, 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 1-11758

 

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

Executive Offices)

  (Zip Code)

 

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  ¨

 

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes  x    No  ¨

 

As of June 30, 2004, there were 1,098,427,102 shares of the Registrant’s Common Stock, par value $.01 per share, outstanding.

 


 


Table of Contents

MORGAN STANLEY

 

INDEX TO QUARTERLY REPORT ON FORM 10-Q

Quarter Ended May 31, 2004

 

     Page

Part I—Financial Information

    

Item 1.

     Financial Statements (unaudited)     
      

Condensed Consolidated Statements of Financial Condition—May 31, 2004 and November 30, 2003

   1
      

Condensed Consolidated Statements of Income—Three and Six Months Ended May 31, 2004 and 2003

   3
      

Condensed Consolidated Statements of Comprehensive Income—Three and Six Months Ended May 31, 2004 and 2003

   4
      

Condensed Consolidated Statements of Cash Flows—Six Months Ended May 31, 2004 and 2003

   5
      

Notes to Condensed Consolidated Financial Statements

   6
      

Report of Independent Registered Public Accounting Firm

   32

Item 2.

    

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

   33

Item 3.

    

Quantitative and Qualitative Disclosures About Market Risk

   64

Item 4.

    

Controls and Procedures

   69

Part II—Other Information

    

Item 1.

     Legal Proceedings    70

Item 2.

     Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities    73

Item 4.

     Submission of Matters to a Vote of Security Holders    73

Item 6.

     Exhibits and Reports on Form 8-K    74

 

AVAILABLE INFORMATION

 

The Company files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 450 Fifth Street, NW, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including the Company) file electronically with the SEC. The SEC’s internet site is www.sec.gov. The Company’s internet site is www.morganstanley.com. The Company makes available free of charge through its internet site, via a link to the SEC’s internet site at www.sec.gov, its annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The Company also makes available, through its internet site, via a link to the SEC’s internet site, statements of beneficial ownership of the Company’s equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act. The Company makes available on www.morganstanley.com its most recent annual report on Form 10-K, its quarterly reports on Form 10-Q for the current fiscal year, its most recent proxy statement and its most recent summary annual report to shareholders, although in some cases these documents are not available on our site as soon as they are available on the SEC’s site. You will need to have on your computer the Adobe Acrobat Reader software to view these documents, which are in PDF format. If you do not have Adobe Acrobat Reader, a link to Adobe’s internet site, from which you can download the software, is provided. In addition, the Company posts on www.morganstanley.com its Certificate of Incorporation, Bylaws, Charters for its Audit Committee, Compensation Committee and Nominating and Governance Committee as well as its Corporate Governance Policies, its Policy Regarding Shareholder Communication with the Board of Directors, its Policy Regarding Director Candidates Recommended by Shareholders and its Code of Ethics and Business Conduct for its directors, officers and employees. You can request a copy of these documents, excluding exhibits, at no cost, by writing or telephoning us at 1585 Broadway, New York, NY 10036, Attention: Investor Relations (212-761-4000). The information on the Company’s website is not incorporated by reference into this report.

 

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Table of Contents

Item 1.

 

MORGAN STANLEY

 

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(dollars in millions, except share data)

 

     May 31,
2004


   November 30,
2003


     (unaudited)

Assets

             

Cash and cash equivalents

   $ 32,070    $ 29,692

Cash and securities deposited with clearing organizations or segregated under federal and other regulations (including securities at fair value of $30,179 at May 31, 2004 and $18,957 at November 30, 2003)

     41,782      28,526

Financial instruments owned (approximately $120 billion at May 31, 2004 and $73 billion at November 30, 2003 were pledged to various parties):

             

U.S. government and agency securities

     39,839      24,133

Other sovereign government obligations

     23,305      21,592

Corporate and other debt

     82,679      80,594

Corporate equities

     31,123      29,984

Derivative contracts

     49,320      44,652

Physical commodities

     685      671

Securities purchased under agreements to resell

     96,042      78,205

Securities received as collateral

     33,091      27,278

Securities borrowed

     202,412      153,813

Receivables:

             

Consumer loans (net of allowances of $956 at May 31, 2004 and $1,002 at November 30, 2003)

     17,489      19,382

Customers, net

     45,931      37,321

Brokers, dealers and clearing organizations

     10,124      5,563

Fees, interest and other

     6,469      4,349

Office facilities, at cost (less accumulated depreciation of $2,702 at May 31, 2004 and $2,506 at November 30, 2003)

     2,470      2,433

Aircraft under operating leases (less accumulated depreciation of $1,155 at May 31, 2004 and $1,041 at November 30, 2003)

     4,140      4,407

Goodwill

     1,531      1,514

Other assets

     8,999      8,734
    

  

Total assets

   $ 729,501    $ 602,843
    

  

 

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MORGAN STANLEY

 

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION—(Continued)

(dollars in millions, except share data)

 

     May 31,
2004


    November 30,
2003


 
     (unaudited)  

Liabilities and Shareholders’ Equity

                

Commercial paper and other short-term borrowings

   $ 34,769     $ 28,386  

Deposits

     11,294       12,839  

Financial instruments sold, not yet purchased:

                

U.S. government and agency securities

     21,083       17,072  

Other sovereign government obligations

     21,833       17,505  

Corporate and other debt

     9,112       10,141  

Corporate equities

     33,681       25,615  

Derivative contracts

     41,615       36,242  

Physical commodities

     3,116       4,873  

Securities sold under agreements to repurchase

     190,605       147,618  

Obligation to return securities received as collateral

     33,091       27,278  

Securities loaned

     80,689       64,375  

Payables:

                

Customers

     118,863       96,794  

Brokers, dealers and clearing organizations

     5,111       5,706  

Interest and dividends

     3,651       2,138  

Other liabilities and accrued expenses

     14,174       12,918  

Long-term borrowings

     79,746       65,600  
    


 


       702,433       575,100  
    


 


Capital Units

     66       66  
    


 


Preferred securities subject to mandatory redemption

     —         2,810  
    


 


Commitments and contingencies

                

Shareholders’ equity:

                

Common stock, $0.01 par value;

                

Shares authorized: 3,500,000,000 at May 31, 2004 and November 30, 2003;

Shares issued: 1,211,703,552 at May 31, 2004 and 1,211,699,552 at November 30, 2003;

Shares outstanding: 1,098,127,106 at May 31, 2004 and 1,084,696,446 at November 30, 2003

     12       12  

Paid-in capital

     3,972       4,028  

Retained earnings

     29,938       28,038  

Employee stock trust

     2,915       3,008  

Accumulated other comprehensive income (loss)

     (82 )     (156 )
    


 


Subtotal

     36,755       34,930  

Note receivable related to ESOP

     (3 )     (4 )

Common stock held in treasury, at cost, $0.01 par value;

                

113,576,446 shares at May 31, 2004 and 127,003,106 shares at November 30, 2003

     (6,104 )     (6,766 )

Common stock issued to employee trust

     (2,915 )     (2,420 )

Unearned stock-based compensation

     (731 )     (873 )
    


 


Total shareholders’ equity

     27,002       24,867  
    


 


Total liabilities and shareholders’ equity

   $ 729,501     $ 602,843  
    


 


 

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

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

 

     Three Months Ended May 31,

   Six Months Ended May 31,

     2004

   2003

   2004

   2003

     (unaudited)    (unaudited)

Revenues:

                           

Investment banking

   $ 983    $ 536    $ 1,812    $ 1,125

Principal transactions:

                           

Trading

     2,064      1,670      3,896      3,382

Investments

     191      59      220      37

Commissions

     877      709      1,778      1,382

Fees:

                           

Asset management, distribution and administration

     1,113      881      2,185      1,777

Merchant and cardmember

     306      338      643      702

Servicing

     485      503      1,057      1,070

Interest and dividends

     3,663      3,449      7,445      7,238

Other

     120      113      243      199
    

  

  

  

Total revenues

     9,802      8,258      19,279      16,912

Interest expense

     2,951      2,904      5,925      5,748

Provision for consumer loan losses

     200      309      462      645
    

  

  

  

Net revenues

     6,651      5,045      12,892      10,519
    

  

  

  

Non-interest expenses:

                           

Compensation and benefits

     2,923      2,274      5,635      4,823

Occupancy and equipment

     206      195      406      391

Brokerage, clearing and exchange fees

     237      202      461      393

Information processing and communications

     318      315      638      630

Marketing and business development

     263      251      517      514

Professional services

     356      259      674      484

Other

     546      634      843      943
    

  

  

  

Total non-interest expenses

     4,849      4,130      9,174      8,178
    

  

  

  

Income before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption

     1,802      915      3,718      2,341

Losses from unconsolidated investees

     81      36      174      70

Provision for income taxes

     498      240      1,050      705

Dividends on preferred securities subject to mandatory redemption

     —        40      45      62
    

  

  

  

Net income

   $ 1,223    $ 599    $ 2,449    $ 1,504
    

  

  

  

Earnings per common share:

                           

Basic

   $ 1.13    $ 0.56    $ 2.27    $ 1.40
    

  

  

  

Diluted

   $ 1.10    $ 0.55    $ 2.21    $ 1.37
    

  

  

  

Average common shares outstanding:

                           

Basic

     1,082,211,511      1,077,386,468      1,080,776,922      1,077,413,715
    

  

  

  

Diluted

     1,110,357,415      1,097,478,351      1,108,270,257      1,097,824,226
    

  

  

  

 

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in millions)

 

    

Three Months

Ended

May 31,


   

Six Months

Ended

May 31,


 
     2004

    2003

    2004

   2003

 
     (unaudited)     (unaudited)  

Net income

   $ 1,223     $ 599     $ 2,449    $ 1,504  

Other comprehensive income (loss), net of tax:

                               

Foreign currency translation adjustment

     (7 )     17       36      39  

Net change in cash flow hedges

     24       (18 )     38      (59 )
    


 


 

  


Comprehensive income

   $ 1,240     $ 598     $ 2,523    $ 1,484  
    


 


 

  


 

 

 

See Notes to Condensed Consolidated Financial Statements.

 

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MORGAN STANLEY

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in millions)

 

     Six Months Ended May 31,

 
     2004

    2003

 
     (unaudited)  

CASH FLOWS FROM OPERATING ACTIVITIES

                

Net income

   $ 2,449     $ 1,504  

Adjustments to reconcile net income to net cash used for operating activities:

                

Non-cash charges (credits) included in net income:

                

Aircraft-related charges

     109       323  

Compensation payable in common stock and options

     111       (39 )

Depreciation and amortization

     302       358  

Provision for consumer loan losses

     462       645  

Changes in assets and liabilities:

                

Cash and securities deposited with clearing organizations or segregated under federal and other regulations

     (13,256 )     3,312  

Financial instruments owned, net of financial instruments sold, not yet purchased

     (10,436 )     9,511  

Securities borrowed, net of securities loaned

     (32,285 )     (11,076 )

Receivables and other assets

     (15,196 )     (12,662 )

Payables and other liabilities

     24,283       4,302  
    


 


Net cash used for operating activities

     (43,457 )     (3,822 )
    


 


CASH FLOWS FROM INVESTING ACTIVITIES

                

Net (payments for) proceeds from:

                

Office facilities and aircraft under operating leases

     (186 )     (382 )

Net principal disbursed on consumer loans

     (3,004 )     (4,981 )

Sales of consumer loans

     4,435       8,731  
    


 


Net cash provided by investing activities

     1,245       3,368  
    


 


CASH FLOWS FROM FINANCING ACTIVITIES

                

Net proceeds from (payments for):

                

Short-term borrowings

     6,383       (10,307 )

Securities sold under agreements to repurchase, net of securities purchased under agreements to resell and certain derivatives financing activities

     27,962       911  

Deposits

     (1,545 )     4  

Net proceeds from:

                

Issuance of common stock

     195       133  

Issuance of long-term borrowings

     21,059       16,372  

Issuance of Preferred securities subject to mandatory redemption

     —         1,500  

Payments for:

                

Repayments of long-term borrowings

     (8,729 )     (8,465 )

Repurchases of common stock

     (187 )     (350 )

Cash dividends

     (548 )     (498 )
    


 


Net cash provided by (used for) financing activities

     44,590       (700 )
    


 


Net increase (decrease) in cash and cash equivalents

     2,378       (1,154 )

Cash and cash equivalents, at beginning of period

     29,692       29,212  
    


 


Cash and cash equivalents, at end of period

   $ 32,070     $ 28,058  
    


 


 

See Notes to Condensed Consolidated Financial Statements.

 

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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 real estate investment vehicles; and aircraft financing activities. The Company’s Individual Investor Group business provides comprehensive financial planning, investment advisory and brokerage services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s financial advisors and investment representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s private equity activities also are included within the Investment Management business segment. The Company’s Credit Services business offers Discover®-branded cards and other consumer finance products and services and includes the operation of Discover Business Services, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

 

Basis of Financial Information.    The 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 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.

 

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. The Company’s policy is to consolidate all entities in which it owns more than 50% of the outstanding voting stock unless it does not control the entity. In accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), as revised, the Company also consolidates any variable interest entities for which it is the primary beneficiary (see Note 12). For investments in companies in which the Company has significant influence over operating and financial decisions (generally defined as owning a voting or economic interest of 20% to 50%), the Company applies the equity method of accounting. In those cases where the Company’s investment is less than 20% and significant influence does not exist, such investments are carried at cost.

 

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

 

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

 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended November 30, 2003 (the “Form 10-K”) as supplemented by the first quarter fiscal 2004 Quarterly Report on Form 10-Q. 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 Used for Trading and Investment.    Financial instruments owned and Financial instruments sold, not yet purchased, which include cash and derivative products, are recorded at fair value in the condensed consolidated statements of financial condition, and gains and losses are reflected in principal trading revenues in the condensed consolidated statements of income. Loans and lending commitments associated with the Company’s lending activities also are recorded at fair value. Fair value is the amount at which financial instruments could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.

 

The price transparency of the particular product will determine the degree of judgment involved in determining the fair value of the Company’s financial instruments. Price transparency is affected by a wide variety of factors, including, for example, the type of product, whether it is a new product and not yet established in the marketplace, and the characteristics particular to the transaction. Products for which actively quoted prices or pricing parameters are available or for which fair value is derived from actively quoted prices or pricing parameters will generally have a higher degree of price transparency. By contrast, products that are thinly traded or not quoted will generally have reduced to no price transparency.

 

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

 

The fair value of over-the-counter (“OTC”) derivative contracts is derived primarily using pricing models, which may require multiple market input parameters. Where appropriate, valuation adjustments are made to account for credit quality and market liquidity. These adjustments are applied on a consistent basis and are based upon observable market data where available. In the absence of observable market prices or parameters in an active market, observable prices or parameters of other comparable current market transactions, or other observable data supporting a fair value based on a pricing model at the inception of a contract, fair value is based on the transaction price. The Company also uses pricing models to manage the risks introduced by OTC derivatives. Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be modeled using a series of techniques, including closed form analytic formulae, such as the Black-Scholes option pricing model, simulation models or a combination thereof, applied consistently. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. Pricing models take into account the contract terms, including the maturity, as well as market parameters such as interest rates, volatility and the creditworthiness of the counterparty.

 

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

 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

expense. 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 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, which approximate fair value. The carrying value of such equity securities is adjusted when changes in the underlying fair values are readily ascertainable, generally as evidenced by observable 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 fair value is less than the carrying value. The Company’s partnership interests, including general partnership and limited partnership interests in real estate funds, are included within Other assets in the Company’s condensed consolidated statements of financial condition and are recorded at fair value based upon changes in the fair value of the underlying partnership’s net assets.

 

Financial Instruments Used for Asset and Liability Management.    The Company enters into various derivative financial instruments for non-trading purposes. These instruments are included within Financial instruments owned—derivative contracts or Financial instruments sold, not yet purchased—derivative contracts within the condensed consolidated statements of financial condition and 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 liabilities. 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, including fixed rate borrowings that fund consumer loans. The Company’s designated cash flow hedges consist primarily of hedges of floating rate borrowings in connection with its aircraft financing business. In general, interest rate exposure in this business arises to the extent that the interest obligations associated with debt used to finance the Company’s aircraft portfolio do not correlate with the aircraft rental payments received by the Company. The Company’s objective is to manage the exposure created by its floating interest rate obligations given that future lease rates on new leases may not be repriced at levels that fully reflect changes in market interest rates. The Company utilizes interest rate swaps to minimize the risk created by its longer-term floating rate interest obligations and measures that risk by reference to the duration of those obligations and the expected sensitivity of future lease rates to future market interest rates.

 

For qualifying fair value hedges, the changes in the fair value of the derivative and the gain or loss on the hedged asset or liability relating to the risk being hedged are recorded currently in earnings. These amounts are recorded in interest expense and provide offset of one another. For qualifying cash flow hedges, the changes in the fair value of the derivative are recorded in Accumulated other comprehensive income (loss) in shareholders’ equity, net of tax effects, and amounts in Accumulated other comprehensive income (loss) 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

 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

these contracts is deferred and reported within Accumulated other comprehensive income (loss) in shareholders’ equity, net of tax effects, with the related unrealized amounts due from or to counterparties included in Financial instruments owned or Financial instruments sold, not yet purchased. The interest elements (forward points) on these foreign exchange forward contracts are recorded in earnings.

 

Securitization Activities.    The Company engages in securitization activities related to commercial and residential mortgage loans, corporate bonds and loans, U.S. agency collateralized mortgage obligations, municipal bonds, credit card loans and other types of financial assets (see Notes 3 and 4). The Company may retain interests in the securitized financial assets as one or more tranches of the securitization, undivided seller’s interests, accrued interest and fees (“accrued interest receivable”) on securitized credit card receivables, 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, observable market prices are used if available. However, observable 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.

 

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

 

In accordance with SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” the Company modified its classification within the condensed consolidated statement of cash flows of the activity associated with certain derivative financial instruments. The activity related to derivative financial instruments entered into or modified after June 30, 2003 and that have been determined to contain a financing element at inception where the Company is deemed the borrower is now included within “Cash flows from financing activities.” Prior to July 1, 2003, the activity associated with such derivative financial instruments is included within “Cash flows from operating activities.”

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

2.    Goodwill.

 

During the first quarter of fiscal 2004, the Company completed the annual 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.

 

Changes in the carrying amount of the Company’s goodwill for the six month period ended May 31, 2004 were as follows:

 

     Institutional
Securities


   Individual
Investor
Group


   Investment
Management


   Total

     (dollars in millions)

Balance as of November 30, 2003

   $ 8    $ 539    $ 967    $ 1,514

Translation adjustments

     —        17      —        17
    

  

  

  

Balance as of May 31, 2004

   $ 8    $ 556    $ 967    $ 1,531
    

  

  

  

 

3.    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. The Company’s policy is 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
May 31,
2004


   At
November 30,
2003


     (dollars in millions)

Financial instruments owned:

             

U.S. government and agency securities

   $ 11,199    $ 5,717

Other sovereign government obligations

     144      164

Corporate and other debt

     16,848      12,089

Corporate equities

     6,357      3,477
    

  

Total

   $ 34,548    $ 21,447
    

  

 

The Company enters into reverse repurchase agreements, repurchase agreements, securities borrowed 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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

these agreements and transactions, the Company either receives or provides collateral, including U.S. government and agency securities, other sovereign government obligations, corporate and other debt, and corporate equities. The Company receives collateral in the form of securities in connection with reverse repurchase agreements, securities borrowed transactions and customer margin loans. In many cases, the Company is permitted to sell or repledge these securities held as collateral and use the securities to secure repurchase agreements, to enter into securities lending transactions or for delivery to counterparties to cover short positions. At May 31, 2004 and November 30, 2003, the fair value of securities received as collateral where the Company is permitted to sell or repledge the securities was $670 billion and $511 billion, respectively, and the fair value of the portion that has been sold or repledged was $611 billion and $462 billion, respectively.

 

The Company manages credit exposure arising from reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions by, in appropriate circumstances, entering into master netting agreements and collateral arrangements with counterparties that provide the Company, in the event of a customer default, the right to liquidate collateral and the right to offset a counterparty’s rights and obligations. The Company also monitors the fair value of the underlying securities as compared with the related receivable or payable, including accrued interest, and, as necessary, requests additional collateral to ensure such transactions are adequately collateralized. Where deemed appropriate, the Company’s agreements with third parties specify its rights to request additional collateral. Customer receivables generated from margin lending activity are collateralized by customer-owned securities held by the Company. For these transactions, adherence to the Company’s collateral policies significantly limits 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, U.S. agency collateralized mortgage obligations, corporate bonds and loans, municipal bonds and other types of financial assets. These assets are carried at fair value, and any changes in fair value are recognized in the condensed consolidated statements of income. The Company may act as underwriter of the beneficial interests issued by securitization vehicles. 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 $3.5 billion at May 31, 2004, the majority of which were related to residential mortgage loan, U.S. agency collateralized mortgage obligation and commercial mortgage loan securitization transactions. Net gains at the time of securitization during the six month period ended May 31, 2004 were not material. The assumptions that the Company used to determine the fair value of its retained interests at the time of securitization related to those transactions that occurred during the six month period ended May 31, 2004 were not materially different from the assumptions included in the table below. Additionally, as indicated in the table below, the Company’s exposure to credit losses related to these retained interests was not material to the Company’s results of operations.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table presents information on the Company’s residential mortgage loan, U.S. agency collateralized mortgage obligation 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 May 31, 2004 were as follows (dollars in millions):

 

     Residential
Mortgage
Loans


    U.S. Agency
Collateralized
Mortgage
Obligations


    Commercial
Mortgage
Loans


 

Retained interests (carrying amount/fair value)

   $ 1,594     $ 1,206     $ 396  

Weighted average life (in months)

     44       111       81  

Credit losses (rate per annum)

     0.05-34.46 %     —         0.24-12.91 %

Impact on fair value of 10% adverse change

   $ (37 )     —       $ (1 )

Impact on fair value of 20% adverse change

   $ (72 )     —       $ (2 )

Weighted average discount rate (rate per annum)

     9.40 %     7.39 %     6.01 %

Impact on fair value of 10% adverse change

   $ (25 )   $ (48 )   $ (11 )

Impact on fair value of 20% adverse change

   $ (49 )   $ (92 )   $ (22 )

Prepayment speed assumption

     318-2100 PSA     130-347 PSA     —    

Impact on fair value of 10% adverse change

   $ (12 )   $ (11 )     —    

Impact on fair value of 20% adverse change

   $ (9 )   $ (24 )     —    

 

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 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 six month periods ended May 31, 2004 and 2003, the Company received $32 billion and $34 billion, respectively, of proceeds from new securitization transactions and cash flows from retained interests in securitization transactions of $2.2 billion and $2.4 billion, respectively.

 

4.    Consumer Loans.

 

Consumer loans were as follows:

 

    

At

May 31,
2004


   At
November 30,
2003


     (dollars in millions)

General purpose credit card, mortgage and consumer installment

   $ 18,445    $ 20,384

Less:

             

Allowance for consumer loan losses

     956      1,002
    

  

Consumer loans, net

   $ 17,489    $ 19,382
    

  

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Activity in the allowance for consumer loan losses was as follows:

 

    

Three Months

Ended

May 31,


   

Six Months

Ended

May 31,


 
     2004

    2003

    2004

    2003

 
     (dollars in millions)  

Balance at beginning of period

   $ 1,004     $ 950     $ 1,002     $ 928  

Additions:

                                

Provision for consumer loan losses

     200       309       462       645  

Deductions:

                                

Charge-offs

     280       312       571       648  

Recoveries

     (32 )     (28 )     (63 )     (50 )
    


 


 


 


Net charge-offs

     248       284       508       598  
    


 


 


 


Balance at end of period

   $ 956     $ 975     $ 956     $ 975  
    


 


 


 


 

Interest accrued on general purpose credit card loans subsequently charged off, net of recoveries, recorded as a reduction of interest revenue, was $64 million and $123 million in the quarter and six month period ended May 31, 2004 and $68 million and $135 million in the quarter and six month period ended May 31, 2003. Cardmember fees accrued on general purpose credit card loans subsequently charged off, net of recoveries, recorded as a reduction to merchant and cardmember fee revenue, was $38 million and $78 million in the quarter and six month period ended May 31, 2004 and $45 million and $90 million in the quarter and six month period ended May 31, 2003.

 

At May 31, 2004, the Company had commitments to extend credit for consumer loans of approximately $260 billion. Such commitments arise primarily from agreements with customers for unused lines of credit on certain credit cards, provided there is no violation of conditions established in the related agreement. These commitments, substantially all of which the Company can terminate at any time and which do not necessarily represent future cash requirements, are periodically reviewed based on account usage and customer creditworthiness.

 

The Company received net proceeds from consumer loan sales of $1,239 million and $4,435 million in the quarter and six month period ended May 31, 2004 and $2,812 million and $8,731 million in the quarter and six month period ended May 31, 2003.

 

Credit Card Securitization Activities.    The Company’s retained interests in credit card asset securitizations include undivided seller’s interests, accrued interest receivable on securitized credit card receivables, cash collateral accounts, servicing rights and rights to any excess cash flows (“Residual Interests”) remaining after payments to investors in the securitization trusts of their contractual rate of return and reimbursement of credit losses. The undivided seller’s interests less an applicable allowance for loan losses is recorded in Consumer loans. The Company’s undivided seller’s interests rank pari passu with investors’ interests in the securitization trusts, and the remaining retained interests are subordinate to investors’ interests. Accrued interest receivable and cash collateral accounts are recorded in Other assets at amounts that approximate fair value. The Company receives annual servicing fees of 2% of the investor principal balance outstanding. The Company does not recognize servicing assets or servicing liabilities for servicing rights since the servicing contracts provide only adequate compensation (as defined in SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”) to the Company for performing the servicing. Residual Interests are recorded in Other assets and classified as trading and reflected at fair value with changes in fair value recorded currently in earnings. At May 31, 2004, the Company had $9.8 billion of retained interests, including $6.7 billion

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

of undivided seller’s interests, in credit card asset securitizations. The retained interests are subject to credit, payment and interest rate risks on the transferred credit card assets. The investors and the securitization trusts have no recourse to the Company’s other assets for failure of cardmembers to pay when due.

 

During the six month periods ended May 31, 2004 and 2003, the Company completed credit card asset securitizations of $1.9 billion and $5.7 billion, respectively, and recognized net securitization gains of $7 million and $46 million, respectively, as servicing fees in the Company’s condensed consolidated statements of income. The uncollected balances of securitized general purpose credit card loans were $29.3 billion at May 31, 2004 and $29.4 billion at November 30, 2003.

 

Key economic assumptions used in measuring the Residual Interests at the date of securitization resulting from credit card asset securitizations completed during the six month periods ended May 31, 2004 and May 31, 2003 were as follows:

 

     Six Months
Ended
May 31,


 
     2004

    2003

 

Weighted average life (in months)

   6.1     5.7-7.1  

Payment rate (rate per month)

   18.00 %   14.89-18.00 %

Credit losses (rate per annum)

   6.90 %   3.86-6.90 %

Discount rate (rate per annum)

   14.00 %   14.00 %

 

Key economic assumptions and the sensitivity of the current fair value of the Residual Interests to immediate 10% and 20% adverse changes in those assumptions were as follows (dollars in millions):

 

    

At

May 31,

2004


 

Residual Interests (carrying amount/fair value)

   $ 264  

Weighted average life (in months)

     5.7  

Weighted average payment rate (rate per month)

     18.25 %

Impact on fair value of 10% adverse change

   $ (18 )

Impact on fair value of 20% adverse change

   $ (33 )

Weighted average credit losses (rate per annum)

     6.58 %

Impact on fair value of 10% adverse change

   $ (72 )

Impact on fair value of 20% adverse change

   $ (143 )

Weighted average discount rate (rate per annum)

     12.00 %

Impact on fair value of 10% adverse change

   $ (2 )

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.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The table below summarizes certain cash flows received from the securitization master trusts (dollars in billions):

 

    

Six Months Ended

May 31,


     2004

   2003

Proceeds from new credit card asset securitizations

   $ 1.9    $ 5.7

Proceeds from collections reinvested in previous credit card asset securitizations

   $ 31.7    $ 29.3

Contractual servicing fees received

   $ 0.3    $ 0.3

Cash flows received from retained interests

   $ 0.9    $ 0.9

 

The table below presents quantitative information about delinquencies, net principal credit losses and components of managed general purpose credit card loans, including securitized loans (dollars in billions):

 

     At May 31, 2004

   Six Months Ended
May 31, 2004


     Loans
Outstanding


   Loans
Delinquent


   Average
Loans


   Net
Principal
Credit
Losses


Managed general purpose credit card loans

   $ 46.8    $ 2.3    $ 47.8    $ 1.5

Less: Securitized general purpose credit card loans

     29.3                     
    

                    

Owned general purpose credit card loans

   $ 17.5                     
    

                    

 

5.    Long-Term Borrowings.

 

Long-term borrowings at May 31, 2004 scheduled to mature within one year aggregated $6,687 million.

 

During the six month period ended May 31, 2004, the Company issued senior notes aggregating $21,104 million, including non-U.S. dollar currency notes aggregating $3,664 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: 2005, $349 million; 2006, $28 million; 2007, $3,031 million; 2008, $2,392 million; and thereafter, $15,304 million. In the six month period ended May 31, 2004, $8,729 million of senior notes were repaid.

 

The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 6 years at May 31, 2004.

 

The Company issues U.S. dollar index/equity linked borrowings, including various structured instruments whose payments and redemption values are linked to the performance of a specific index (e.g., Standard & Poor’s 500), a basket of stocks or a specific equity security. The Company accounts for such structured borrowings as having an embedded derivative. To minimize the exposure resulting from movements in the underlying equity position or index, the Company enters into various equity swap contracts and purchased options that effectively convert the borrowing costs into floating rates based upon LIBOR. The equity swaps and purchased options are derivatives and are accounted for at fair value in accordance with SFAS No. 133, with changes in fair value included in Principal transaction trading revenue. Principal transaction trading revenues in the six month periods ended May 31, 2004 and May 31, 2003 include changes in the fair value of embedded derivatives in the Company’s structured borrowings. Prior to the second quarter of fiscal 2004, such amounts were included in interest expense. Prior period information has been reclassified to conform to the current period’s presentation. In the quarter ended February 29, 2004, principal transaction trading revenues included $515 million that was previously recorded as a decrease to interest expense. In the quarter and six month period ended May 31, 2003, principal transaction trading revenues included $87 million and $243 million that were previously recorded as increases to interest expense. These reclassifications are recorded within the Company’s Institutional Securities business segment and had no impact on net revenues.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

6.    Capital Units, Capital Securities and Junior Subordinated Deferrable Interest Debentures.

 

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 of the Company’s Cumulative Preferred Stock. The aggregate amount of Capital Units outstanding was $66 million at both May 31, 2004 and November 30, 2003.

 

Prior to February 29, 2004, Preferred Securities Subject to Mandatory Redemption (also referred to as “Capital Securities” herein) represented preferred minority interests in certain of the Company’s subsidiaries. Accordingly, dividends paid on Preferred Securities Subject to Mandatory Redemption were 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.

 

In December 2003, the FASB issued certain revisions to FIN 46 to clarify and expand on the accounting guidance for variable interest entities. In accordance with this revised guidance, the Company deconsolidated all of its statutory trusts that had issued Capital Securities as of February 29, 2004. As a result, the junior subordinated deferrable interest debentures issued by the Company to the statutory trusts are included within Long-term borrowings, and the common securities issued by the statutory trusts and owned by the Company are recorded in Other assets. In addition, the Capital Securities issued by the statutory trusts are no longer included in the Company’s condensed consolidated statement of financial condition. Subsequent to February 29, 2004, dividends on the junior subordinated deferrable interest debentures have been recorded within interest expense. The impact of the deconsolidation of the statutory trusts did not have a material effect on the Company’s condensed consolidated financial position or results of operations. See Note 12 to the consolidated financial statements for the fiscal year ended November 30, 2003 included in the Form 10-K.

 

7.    Common Stock and Shareholders’ Equity.

 

Regulatory Requirements.    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 SEC, the NYSE and the Commodity Futures Trading Commission. MS&Co. and MSDWI have consistently operated in excess of these requirements. MS&Co.’s net capital totaled $2,857 million at May 31, 2004, which exceeded the amount required by $1,998 million. MSDWI’s net capital totaled $1,185 million at May 31, 2004, which exceeded the amount required by $1,057 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 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 May 31, 2004, the leverage ratio, Tier 1 risk-weighted capital ratio and total risk-weighted capital ratio of each of the Company’s FDIC-insured financial institutions exceeded these regulatory minimums.

 

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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

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.

 

Regulatory Developments.    The SEC approved a rule on April 28, 2004 in response to industry requests to establish a voluntary framework for comprehensive, group-wide risk management procedures and consolidated supervision of certain financial services holding companies by the SEC. The framework is designed to minimize the duplicative regulatory burdens on U.S. securities firms resulting from the European Union (“EU”) Directive (2002/87/EC) concerning the supplementary supervision of financial conglomerates active in the EU. The rule also would allow MS&Co., one of the Company’s U.S. broker-dealers, to use an alternative method, based on mathematical models, to calculate net capital charges for market and derivatives-related credit risk. Under this rule, the SEC has the authority to regulate the holding company and any unregulated affiliate of a registered broker-dealer, including subjecting the holding company to capital requirements generally consistent with the standards of the Basel Committee on Banking Supervision (“Basel II”). The Company currently expects to apply to the SEC later this year for permission to operate under the rule.

 

The Company continues to work with its regulators to understand and assess the impact of the rule and Basel II capital standards. Many important elements of the new regulations are still being finalized. The Company cannot fully predict the impact that these changes will have on its businesses; however, compliance with consolidated supervision and the imposition of revised capital standards are likely to impose additional costs and affect decisions with respect to raising and using capital.

 

Treasury Shares.    During the six month periods ended May 31, 2004 and 2003, the Company purchased approximately $187 million and $350 million of its common stock, respectively, under its publicly announced repurchase programs through open market purchases at an average cost of $54.04 and $39.12 per share, respectively.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

8.    Earnings per Share.

 

Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the assumed conversion of all dilutive securities. The following table presents the calculation of basic and diluted EPS (in millions, except for per share data):

 

    

Three Months

Ended

May 31,


  

Six Months

Ended

May 31,


     2004

   2003

   2004

   2003

Basic EPS

                           

Net income applicable to common shareholders

   $ 1,223    $ 599    $ 2,449    $ 1,504
    

  

  

  

Weighted average common shares outstanding

     1,082      1,077      1,081      1,077
    

  

  

  

Basic EPS

   $ 1.13    $ 0.56    $ 2.27    $ 1.40
    

  

  

  

Diluted EPS

                           

Net income applicable to common shareholders

   $ 1,223    $ 599    $ 2,449    $ 1,504
    

  

  

  

Weighted average common shares outstanding

     1,082      1,077      1,081      1,077

Effect of dilutive securities

     28      20      27      21
    

  

  

  

Weighted average common shares outstanding and common stock equivalents

     1,110      1,097      1,108      1,098
    

  

  

  

Diluted EPS

   $ 1.10    $ 0.55    $ 2.21    $ 1.37
    

  

  

  

 

At May 31, 2004 and 2003, there were approximately 91 million and 84 million dilutive securities (including stock options and restricted stock units) outstanding, respectively, that were considered antidilutive and therefore were excluded from the computation of diluted EPS.

 

9.    Commitments and Contingencies.

 

Letters of Credit.    At May 31, 2004 and November 30, 2003, the Company had approximately $9.1 billion and $7.7 billion, respectively, of letters of credit outstanding to satisfy various collateral requirements.

 

Securities Activities.    In connection with certain of its Institutional Securities business activities, the Company provides to selected clients through subsidiaries (including Morgan Stanley Bank), loans or lending commitments, including bridge financing. The borrowers may be rated investment grade or non-investment grade. These loans and commitments have varying terms, may be senior or subordinated, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated or traded by the Company. At May 31, 2004 and November 30, 2003, the aggregate value of investment grade loans and positions was $1.1 billion and $1.0 billion, respectively, and the aggregate value of non-investment grade loans and positions was $1.8 billion and $0.7 billion, respectively. At May 31, 2004 and November 30, 2003, the Company’s aggregate investment grade lending commitments were $16.5 billion and $14.2 billion, respectively, and its aggregate non-investment grade lending commitments were $2.2 billion and $1.9 billion, respectively. In connection with these business activities (which include the loans and positions and lending commitments), the Company had hedges (primarily credit default swaps) with a notional amount of $7.3 billion at May 31, 2004 and $5.5 billion at November 30, 2003.

 

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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.

 

The Company has commitments to fund other less liquid investments, including at May 31, 2004, $225 million in connection with its principal investment and private equity activities. Additionally, the Company has provided and will continue to provide financing, including margin lending and other extensions of credit to clients that may subject the Company to increased credit and liquidity risks.

 

At May 31, 2004, the Company had commitments to enter into reverse repurchase and repurchase agreements of approximately $45 billion and $33 billion, respectively.

 

Legal.    In the normal course of business, the Company has been named, from time to time, as a defendant in various legal actions, including arbitrations, class actions and other litigation, arising in connection with its activities as a global diversified financial services institution. Certain of the legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. The Company also is involved, from time to time, in investigations and proceedings by governmental and self-regulatory agencies, certain of which may result in adverse judgments, fines or penalties. The number of these investigations and proceedings has increased in recent years with regard to many firms, including the Company. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or otherwise in financial distress.

 

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 the eventual loss or range of loss related to such matters. The Company is contesting liability and/or the amount of damages in each pending matter and believes, based on current knowledge and after consultation with counsel, that the outcome of each matter 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 future period, depending on, among other things, the level of the Company’s income for such period.

 

10.    Derivative Contracts.

 

In the normal course of business, the Company enters into a variety of derivative contracts related to financial instruments and commodities. The Company uses these instruments for trading and investment purposes, as well as for asset and liability management (see Note 1). 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—Critical Accounting Policies—Fair Value” and Note 11 to the consolidated financial statements for the fiscal year ended November 30, 2003, included in the Form 10-K.

 

The fair value (carrying amount) of derivative instruments represents the amount at which the derivative could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale, and is further described in Note 1. 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

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

settlements exceeding fair value amounts recognized in the condensed consolidated statements of financial condition. The amounts in the following table represent unrealized gains and losses on exchange traded and OTC options and other contracts (including interest rate, foreign exchange, and other forward contracts and swaps) for derivatives for trading and investment and for asset and liability management, net of offsetting positions in situations where netting is appropriate. The asset amounts are not reported net of collateral, which the Company obtains with respect to certain of these transactions to reduce its exposure to credit losses.

 

Credit risk with respect to derivative instruments arises from the failure of a counterparty to perform according to the terms of the contract. The Company’s exposure to credit risk at any point in time is represented by the fair value of the contracts reported as assets. The Company monitors the creditworthiness of counterparties to these transactions on an ongoing basis and requests additional collateral when deemed necessary. The Company believes the ultimate settlement of the transactions outstanding at May 31, 2004 will not have a material effect on the Company’s financial condition.

 

The Company’s derivatives (both listed and OTC) at May 31, 2004 and November 30, 2003 are summarized in the table below, showing the fair value of the related assets and liabilities by product:

 

     At May 31, 2004

   At November 30, 2003

     Assets

   Liabilities

   Assets

   Liabilities

     (dollars in millions)

Interest rate and currency swaps and options, credit derivatives and other fixed income securities contracts

   $ 27,613    $ 19,146    $ 27,280    $ 18,950

Foreign exchange forward contracts and options

     4,950      5,199      5,964      5,561

Equity securities contracts (including equity swaps, warrants and options)

     5,316      7,752      4,503      5,781

Commodity forwards, options and swaps

     11,441      9,518      6,905      5,950
    

  

  

  

Total

   $ 49,320    $ 41,615    $ 44,652    $ 36,242
    

  

  

  

 

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.

 

11.    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 provides a wide range of financial products and services to its customers in each of its business segments: Institutional Securities, Individual Investor Group, Investment Management and Credit Services. Certain reclassifications have been made to prior-period amounts to conform to the current year’s presentation (see Note 5).

 

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 real

 

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estate investment vehicles; and aircraft financing activities. The Company’s Individual Investor Group business provides comprehensive financial planning, investment advisory and brokerage services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s financial advisors and investment representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s private equity activities also are included within the Investment Management business segment. The Company’s Credit Services business offers Discover-branded cards and other consumer finance products and services and includes the operation of Discover Business Services, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

 

Revenues and expenses directly associated with each respective segment are included in determining their operating results. Other revenues and expenses that are not directly attributable to a particular segment are allocated based upon the Company’s allocation methodologies, generally based on each segment’s respective revenues or other relevant measures.

 

As a result of treating certain intersegment transactions as transactions with external parties, the Company includes an “Intersegment Eliminations” category to reconcile the segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations represents, among other things, the effect of timing differences associated with the revenue and expense recognition of commissions paid by Investment Management to Individual Investor Group associated with sales of certain products and the related compensation costs paid to Individual Investor Group’s financial advisors.

 

Selected financial information for the Company’s segments is presented below:

 

Three Months Ended May 31, 2004


   Institutional
Securities


   Individual
Investor
Group


   Investment
Management


   Credit
Services


   Intersegment
Eliminations


    Total

     (dollars in millions)

Net revenues excluding net interest

   $ 3,568    $ 1,149    $ 690    $ 607    $ (75 )   $ 5,939

Net interest

     380      60      —        272      —         712
    

  

  

  

  


 

Net revenues

   $ 3,948    $ 1,209    $ 690    $ 879    $ (75 )   $ 6,651
    

  

  

  

  


 

Income before losses from unconsolidated investees and income taxes

   $ 1,134    $ 132    $ 209    $ 298    $ 29     $ 1,802

Losses from unconsolidated investees

     81      —        —        —        —         81
    

  

  

  

  


 

Income before taxes

   $ 1,053    $ 132    $ 209    $ 298    $ 29     $ 1,721
    

  

  

  

  


 

 

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Three Months Ended May 31, 2003(1)


   Institutional
Securities


   Individual
Investor
Group


   Investment
Management


    Credit
Services


   Intersegment
Eliminations


    Total

     (dollars in millions)

Net revenues excluding net interest

   $ 2,529    $ 949    $ 562     $ 538    $ (78 )   $ 4,500

Net interest

     150      53      (4 )     346      —         545
    

  

  


 

  


 

Net revenues

   $ 2,679    $ 1,002    $ 558     $ 884    $ (78 )   $ 5,045
    

  

  


 

  


 

Income before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption

   $ 400    $ 62    $ 122     $ 302    $ 29     $ 915

Losses from unconsolidated investees

     36      —        —         —        —         36

Dividends on preferred securities subject to mandatory redemption

     40      —        —         —        —         40
    

  

  


 

  


 

Income before taxes

   $ 324    $ 62    $ 122     $ 302    $ 29     $ 839
    

  

  


 

  


 

 

Six Months Ended May 31, 2004(1)


   Institutional
Securities


   Individual
Investor
Group


   Investment
Management


   Credit
Services


   Intersegment
Eliminations


    Total

     (dollars in millions)

Net revenues excluding net interest

   $ 6,630    $ 2,300    $ 1,332    $ 1,259    $ (149 )   $ 11,372

Net interest

     822      120      —        578      —         1,520
    

  

  

  

  


 

Net revenues

   $ 7,452    $ 2,420    $ 1,332    $ 1,837    $ (149 )   $ 12,892
    

  

  

  

  


 

Income before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption

   $ 2,320    $ 298    $ 379    $ 663    $ 58     $ 3,718

Losses from unconsolidated investees

     174      —        —        —        —         174

Dividends on preferred securities subject to mandatory redemption

     45      —        —        —        —         45
    

  

  

  

  


 

Income before taxes

   $ 2,101    $ 298    $ 379    $ 663    $ 58     $ 3,499
    

  

  

  

  


 

 

Six Months Ended May 31, 2003(1)


  Institutional
Securities


   Individual
Investor
Group


   Investment
Management


    Credit
Services


   Intersegment
Eliminations


    Total

    (dollars in millions)

Net revenues excluding net interest

  $ 5,078    $ 1,883    $ 1,086     $ 1,129    $ (147 )   $ 9,029

Net interest

    736      104      (3 )     653      —         1,490
   

  

  


 

  


 

Net revenues

  $ 5,814    $ 1,987    $ 1,083     $ 1,782    $ (147 )   $ 10,519
   

  

  


 

  


 

Income before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption

  $ 1,342    $ 123    $ 222     $ 592    $ 62     $ 2,341

Losses from unconsolidated investees

    70      —        —         —        —         70

Dividends on preferred securities subject to mandatory redemption

    62      —        —         —        —         62
   

  

  


 

  


 

Income before taxes

  $ 1,210    $ 123    $ 222     $ 592    $ 62     $ 2,209
   

  

  


 

  


 

 

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Total Assets


   Institutional
Securities


   Individual
Investor
Group


   Investment
Management


   Credit
Services


   Intersegment
Eliminations


    Total

     (dollars in millions)

At May 31, 2004

   $ 685,072    $ 17,339    $ 4,081    $ 23,241    $ (232 )   $ 729,501
    

  

  

  

  


 

At November 30, 2003(1)

   $ 557,501    $ 16,665    $ 3,778    $ 25,185    $ (286 )   $ 602,843
    

  

  

  

  


 


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

 

12.    Variable Interest Entities.

 

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

 

The Company is involved with various entities in the normal course of business that may be deemed to be VIEs and may hold interests therein, including debt securities, interest-only strip investments and derivative instruments, that may be considered variable interests. Transactions associated with these entities include asset- and mortgage-backed securitizations and structured financings (including collateralized debt, bond or loan obligations and credit-linked notes). The Company engages in these transactions principally to facilitate client needs and as a means of selling financial assets. The Company consolidates entities in which it has a controlling financial interest in accordance with accounting principles generally accepted in the U.S. For those entities deemed to be qualifying special purpose entities (as defined in SFAS No. 140), which includes the credit card asset securitization master trusts (see Note 4), the Company does not consolidate the entity.

 

On February 1, 2003, the Company adopted FIN 46 for VIEs created after January 31, 2003 and for VIEs in which the Company obtains an interest after January 31, 2003. In October 2003, the FASB deferred the effective date of FIN 46 for arrangements with VIEs existing prior to February 1, 2003 to fiscal periods ending after December 15, 2003. In December 2003, the FASB issued a revision of FIN 46 (“FIN 46R”) to address certain technical corrections and implementation issues that have arisen. As of February 29, 2004, the Company adopted FIN 46 or FIN 46R for all of its variable interests. For these variable interests, the Company consolidated those VIEs (including financial asset-backed securitization, mortgage-backed securitization, collateral debt obligation, credit-linked note, structured note, municipal bond trust, equity-linked note and exchangeable trust entities) in which the Company was the primary beneficiary. In limited instances, the Company deconsolidated VIEs for which it was not the primary beneficiary as a result of the adoption of FIN 46R. This is further discussed in Note 6 with respect to statutory trusts that had issued Capital Securities. As of May 31, 2004, the Company adopted FIN 46R for those variable interests that were previously accounted for under FIN 46. The effect of adopting FIN 46 and FIN 46R as of February 29, 2004 and May 31, 2004 did not have a material effect on the Company’s condensed consolidated results of operations or condensed consolidated financial position.

 

Institutional Securities.    At May 31, 2004, in connection with its Institutional Securities business, the aggregate size of VIEs, including financial asset-backed securitization, mortgage-backed securitization, collateralized debt obligation, credit-linked note, structured note, municipal bond trust, equity-linked note and exchangeable trust entities, for which the Company was the primary beneficiary of the entities was approximately $3.3 billion,

 

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which is the carrying amount of the consolidated assets recorded as Financial instruments owned that are collateral for the entities’ obligations. The nature and purpose of these entities that the Company consolidated were to issue a series of notes to investors that provide the investors a return based on the holdings of the entities. These transactions were executed to facilitate client investment objectives. The structured note, equity-linked note, certain credit-linked note, certain mortgage-backed securitization, certain financial asset-backed securitization and municipal bond transactions also were executed as a means of selling financial assets. The Company holds either the entire class or a majority of the class of subordinated notes or entered into a derivative instrument with the VIE and as a result bears the majority of the expected losses or receives a majority of the expected residual returns of the entities. The Company consolidates these entities, in accordance with its consolidation accounting policy, and as a result eliminates all intercompany transactions, including derivatives and other intercompany transactions such as fees received to underwrite the notes or to structure the transactions. The Company accounts for the assets held by the entities as Financial instruments owned and the liabilities of the entities as financings. For those liabilities that include an embedded derivative, the Company has bifurcated such derivative in accordance with SFAS No. 133, as amended by SFAS No. 149. The beneficial interests of these consolidated entities are payable solely from the cash flows of the assets held by the VIE.

 

At May 31, 2004, also in connection with its Institutional Securities business, the aggregate size of the entities for which the Company holds significant variable interests, which consist of subordinated and other classes of beneficial interests, limited partnership investments and secondary guarantees, was approximately $12.9 billion. The Company’s variable interests associated with these entities, primarily credit-linked note, loan and bond issuing, financial asset-backed securitization and tax credit limited liability entities, including investments in affordable housing tax credit funds and underlying synthetic fuel production plants, were approximately $7.1 billion consisting primarily of senior beneficial interests, which represent the Company’s maximum exposure to loss at May 31, 2004. The Company may hedge the risks inherent in its variable interest holdings, thereby reducing its exposure to loss. The Company’s maximum exposure to loss does not include the offsetting benefit of any financial instruments that the Company utilizes to hedge these risks.

 

Investment Management.    At May 31, 2004, in connection with its Investment Management business, where the Company is the asset manager for collateralized bond and loan obligation entities, the Company was neither the primary beneficiary of nor held any significant variable interests in such VIEs due to the modification of the treatment of fees paid to a decision maker under FIN 46R. FIN 46 included a requirement that expected residual returns include the total amount of fees on a gross basis paid to decision makers instead of including only the variability in such fees as is the guidance in FIN 46R.

 

The Company purchases and sells interests in entities that may be deemed to be VIEs in the ordinary course of its business. As a result of these activities, it is possible that such entities may be consolidated and deconsolidated at various points in time. Therefore, the Company’s variable interests included above may not be held by the Company at the end of future quarterly reporting periods.

 

13.    Guarantees.

 

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

 

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the guaranteed party based on another entity’s failure to perform under an agreement as well as indirect guarantees of the indebtedness of others.

 

Derivative Contracts.    Under FIN 45, certain derivative contracts meet the accounting definition of a guarantee, including certain written options, contingent forward contracts and credit default swaps. Although the Company’s derivative arrangements do not specifically identify whether the derivative counterparty retains the underlying asset, liability or equity security, the Company has disclosed information regarding all derivative contracts that could meet the FIN 45 definition of a guarantee. The maximum potential payout for certain derivative contracts, such as written interest rate caps and written foreign currency options, cannot be estimated as increases in interest or foreign exchange rates in the future could possibly be unlimited. Therefore, in order to provide information regarding the maximum potential amount of future payments that the Company could be required to make under certain derivative contracts, the notional amount of the contracts has been disclosed.

 

The Company records all derivative contracts at fair value. For this reason, the Company does not monitor its risk exposure to such derivative contracts based on derivative notional amounts; rather the Company manages its risk exposure on a fair value basis. Aggregate market risk limits have been established, and market risk measures are routinely monitored against these limits. The Company also manages its exposure to these derivative contracts through a variety of risk mitigation strategies, including, but not limited to, entering into offsetting economic hedge positions. The Company believes that the notional amounts of the derivative contracts generally overstate its exposure.

 

Financial Guarantees to Third Parties.    In connection with its corporate lending business and other corporate activities, the Company provides standby letters of credit and other financial guarantees to counterparties. Such arrangements represent obligations to make payments to third parties if the counterparty fails to fulfill its obligation under a borrowing arrangement or other contractual obligation.

 

Liquidity Guarantees.    The Company has entered into liquidity facilities with special purpose entities (“SPE”) and other counterparties, whereby the Company is required to make certain payments if losses or defaults occur. The Company often may have recourse to the underlying assets held by the SPEs in the event payments are required under such liquidity facilities.

 

Market Value Guarantees.    Market value guarantees are issued to guarantee return of principal invested to fund investors associated with certain European equity funds and to guarantee timely payment of a specified return to investors in certain affordable housing tax credit funds. The guarantees associated with certain European equity funds are designed to provide for any shortfall between the market value of the underlying fund assets and invested principal and a stipulated return amount. The guarantees provided to investors in certain affordable housing tax credit funds are designed to return an investor’s contribution to a fund and the investor’s share of tax losses and tax credits expected to be generated by a fund.

 

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The table below summarizes certain information regarding these guarantees at May 31, 2004:

 

     Maximum Potential Payout/Notional

         
     Years to Maturity

         

Type of Guarantee


   Less than 1

   1-3

   3-5

   Over 5

   Total

   Carrying
Amount


   Collateral/
Recourse


     (dollars in millions)

Derivative contracts

   $ 397,385    $ 207,747    $ 227,658    $ 162,624    $ 995,414    $ 16,891    $ 110

Standby letters of credit and other financial guarantees

     361      315      44      23      743      5      115

Market value guarantees

     11      16      236      382      645      36      48

Liquidity facilities

     526      890      —        177      1,593      —        —  

 

Indemnities.    In the normal course of its business, the Company provides standard indemnities to counterparties for taxes, including U.S. and foreign withholding taxes, on interest and other payments made on derivatives, securities and stock lending transactions, certain annuity products and other financial arrangements. These indemnity payments could be required based on a change in the tax laws or change in interpretation of applicable tax rulings. Certain contracts contain provisions that enable the Company to terminate the agreement upon the occurrence of such events. The maximum potential amount of future payments that the Company could be required to make under these indemnifications cannot be estimated. The Company has not recorded any contingent liability in the condensed consolidated financial statements for these indemnifications and believes that the occurrence of any events that would trigger payments under these contracts is remote.

 

Exchange/Clearinghouse Member Guarantees.    The Company is a member of various U.S. and non-U.S. exchanges and clearinghouses that trade and clear securities and/or futures contracts. Associated with its membership, the Company may be required to pay a proportionate share of the financial obligations of another member who may default on its obligations to the exchange or the clearinghouse. While the rules governing different exchange or clearinghouse memberships vary, in general the Company’s guarantee obligations would arise only if the exchange or clearinghouse had previously exhausted its resources. In addition, any such guarantee obligation would be apportioned among the other non-defaulting members of the exchange or clearinghouse. Any potential contingent liability under these membership agreements cannot be estimated. The Company has not recorded any contingent liability in the condensed consolidated financial statements for these agreements and believes that any potential requirement to make payments under these agreements is remote.

 

General Partner Guarantees.    As a general partner in certain private equity and real estate partnerships, the Company receives distributions from the partnerships according to the provisions of the partnership agreements. The Company may, from time to time, be required to return all or a portion of such distributions to the limited partners in the event the limited partners do not achieve a certain return as specified in various partnership agreements, subject to certain limitations. The maximum potential amount of future payments that the Company could be required to make under these and other similar provisions at May 31, 2004 was $224 million. As of May 31, 2004, the Company’s liability for distributions that the Company has determined it is probable it will be required to refund based on the applicable refund criteria specified in the various partnership agreements was $89 million.

 

Securitized Asset Guarantees.    As part of the Company’s Institutional Securities and Credit Services securitization activities, the Company provides representations and warranties that certain securitized assets conform to specified guidelines. The Company may be required to repurchase such assets or indemnify the purchaser against losses if the assets do not meet certain conforming guidelines. Due diligence is performed by the Company to ensure that asset guideline qualifications are met, and to the extent the Company has acquired such assets to be securitized from other parties, the Company seeks to obtain its own representations and

 

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warranties regarding the assets. The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of all assets subject to such securitization activities. The Company does not monitor the total value of assets historically transferred to securitization vehicles. Therefore, the Company is unable to develop an estimate of the maximum payout under these guarantees. However, the Company believes that it is unlikely it will have to make material payments under the arrangement, and no liabilities related to these arrangements have been recorded. Also, in connection with originations of residential mortgage loans under the Company’s FlexSource® program, the Company may permit borrowers to pledge marketable securities as collateral instead of requiring cash down payments for the purchase of the underlying residential property. Upon sale of the residential mortgage loans, the Company may provide a surety bond that reimburses the purchasers for shortfalls in the borrowers’ securities accounts up to certain limits if the collateral maintained in the securities accounts (along with the associated real estate collateral) is insufficient to cover losses that purchasers experience as a result of defaults by borrowers on the underlying residential mortgage loans. The Company requires the borrowers to meet daily collateral calls to ensure the marketable securities pledged in lieu of a cash down payment are sufficient. At May 31, 2004, the maximum potential amount of future payments the Company may be required to make under its surety bond was $199 million. The Company has not recorded any contingent liability in the condensed consolidated financial statements for these representations and warranties and reimbursement agreements and believes that the probability of any payments under these arrangements is remote.

 

Merchant Chargeback Guarantees.    In connection with its Credit Services business, the Company owns and operates merchant processing services in the U.S. related to its general purpose credit cards. As a merchant processor in the U.S. and an issuer of credit cards in the U.K., the Company is contingently liable for processed credit card sales transactions in the event of a dispute between the cardmember and a merchant. If a dispute is resolved in the cardmember’s favor, the Company will credit or refund the amount to the cardmember and charge back the transaction to the merchant. If the Company is unable to collect the amount from the merchant, the Company will bear the loss for the amount credited or refunded to the cardmember. In most instances, a payment requirement by the Company is unlikely to arise because most products or services are delivered when purchased, and credits are issued by merchants on returned items in a timely fashion. However, where the product or service is not provided until some later date following the purchase, the likelihood of payment by the Company increases. For example, the Company processes cardmember transactions for airline ticket purchases. In the event an airline ceases operations, the Company could be contingently liable to its cardmembers for refunds of the ticket purchase prices. The maximum potential amount of future payments related to these contingent liabilities is estimated to be the total cardmember sales transaction volume to date that could qualify as a valid disputed transaction under the Company’s merchant processing network and cardmember agreements; however, the Company believes that this amount is not representative of the Company’s actual potential loss exposure based on the Company’s historical experience. This amount cannot be quantified as the Company cannot determine whether current or cumulative transaction volumes may include or result in disputed transactions.

 

During the quarter and six month period ended May 31, 2004, the Company incurred losses related to merchant chargebacks of $1 million and $2 million, respectively, and processed aggregate credit card transaction volume of $24.4 billion and $48.5 billion, respectively. The amount of the liability related to the Company’s credit cardmember merchant guarantee was not material at May 31, 2004. The Company mitigates this risk by withholding settlement from merchants or obtaining escrow deposits from certain merchants that are considered higher risk due to various factors such as time delays in the delivery of products or services. At May 31, 2004, the Company had settlement withholdings and escrow deposits of $40 million.

 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Other.    The Company may, from time to time, in its role as investment banking advisor, be required to provide guarantees in connection with certain European merger and acquisition transactions. If required by the regulating authorities, the Company provides a guarantee that the acquirer in the merger and acquisition transaction has or will have sufficient funds to complete the transaction and would then be required to make the acquisition payments in the event the acquirer’s funds are insufficient at the completion date of the transaction. These arrangements generally cover the time frame from the transaction offer date to its closing date and therefore are generally short-term in nature. The maximum potential amount of future payments that the Company could be required to make cannot be estimated. The likelihood of any payment by the Company under these arrangements is remote given the level of the Company’s due diligence associated with its role as investment banking advisor. There were no such arrangements outstanding at May 31, 2004.

 

14.    Investments in Unconsolidated Investees.

 

The Company invests in unconsolidated investees that own synthetic fuel production plants. The Company accounts for these investments under the equity method of accounting. The Company’s share of the operating losses generated by these investments is recorded within Losses from unconsolidated investees, and the tax credits and the tax benefits associated with these operating losses are recorded within the Company’s Provision for income taxes. The synthetic fuel produced qualifies for tax credits based on Section 29 of the Internal Revenue Code. Under Section 29, tax credits are not available for synthetic fuel produced after 2007. The Company recorded Losses from unconsolidated investees of $81 million and $174 million in the quarter and six month period ended May 31, 2004, respectively, and $36 million and $70 million in the quarter and six month period ended May 31, 2003, respectively. These losses were more than offset by tax credits of $78 million and $182 million in the quarter and six month period ended May 31, 2004, respectively, and $41 million and $88 million in the quarter and six month period ended May 31, 2003, respectively, and tax benefits on the losses of $39 million and $70 million in the quarter and six month period ended May 31, 2004, respectively, and $14 million and $28 million in the quarter and six month period ended May 31, 2003, respectively.

 

One of the Company’s unconsolidated investees (“the LLC”) has informed the Company that the Internal Revenue Service (“IRS”) field auditors intend to challenge the placed-in-service date of several synthetic fuel facilities owned by the LLC. One of the conditions to qualify for tax credits under Section 29 of the Internal Revenue Code is that the production facility must have been placed-in-service before July 1, 1998.

 

The Company understands that the LLC intends to contest the IRS proposed position vigorously. If the IRS succeeds in disallowing any or all of the tax credits related to these facilities, it could have an adverse effect on the Company’s tax liability or results of operations. The Company has recognized cumulative tax credits of approximately $80 million associated with the LLC’s synthetic fuel facilities.

 

15.    Employee Benefit Plans.

 

The Company maintains various pension and benefit plans to eligible employees (see Note 15 to the consolidated financial statements for the fiscal year ended November 30, 2003 included in the Form 10-K).

 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The components of the Company’s net periodic benefit expense were as follows:

 

    

Three Months

Ended

May 31,


   

Six Months

Ended

May 31,


 
     2004

    2003

    2004

    2003

 
     (dollars in millions)  

Service cost, benefits earned during the period

   $ 28     $ 29     $ 56     $ 58  

Interest cost on projected benefit obligation

     33       31       66       62  

Expected return on plan assets

     (32 )     (29 )     (64 )     (58 )

Net amortization and other

     6       7       12       14  
    


 


 


 


Net periodic benefit expense

   $ 35     $ 38     $ 70     $ 76  
    


 


 


 


 

16.    Aircraft Impairment.

 

Fiscal 2004 Activity.

 

In accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company’s aircraft are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value of an aircraft may not be recoverable. During the second quarter of fiscal 2004 the Company evaluated various financing strategies for its aircraft financing business. As part of this evaluation and to determine the potential debt ratings associated with the financing strategies, the Company commissioned appraisals of the aircraft portfolio from three independent aircraft appraisal firms.

 

Although the operating environment for the Company’s aircraft leasing business has been more favorable since the last impairment date (May 31, 2003), with fewer aircraft on the ground and more lease activity, the appraisals indicated a decrease in the aircraft portfolio average market value of 12% from the last impairment date. In accordance with SFAS No. 144, the Company considered the decline in appraisal values a significant decrease in the market price of its aircraft portfolio and thus a trigger event to test for impairment in the carrying value of its aircraft.

 

In accordance with SFAS No. 144, the Company tested each of its aircraft for impairment by comparing each aircraft’s projected undiscounted cash flows to its respective carrying value. For those aircraft for which impairment was indicated (because the projected undiscounted cash flows were less than the carrying value), the Company adjusted the carrying value of each aircraft to its fair value, if lower than the carrying value. To determine each aircraft’s fair value, the Company used the market value appraisals provided by independent appraisers (BK Associates, Inc., Morten Beyer & Agnew, Inc. and Airclaims Limited). As a result of this review, the Company recorded a non-cash pre-tax asset impairment charge of $109 million in the second quarter of fiscal 2004 based on the average of the market value appraisals provided by the three independent appraisers. The impairment charge was primarily concentrated in two particular types of aircraft, the MD-83 and A300-600R, which contributed approximately $85 million of the total $109 million charge. The decrease in the projected undiscounted cash flows and the significant decline in the appraisal values for these aircraft reflects, among other things, a very small operator base and therefore limited opportunities to lease such aircraft. The impairment charge is included within Other expenses in the condensed consolidated statement of income. The results of the aircraft financing business are included in the Institutional Securities business segment.

 

The current market environment continues to be characterized by limited sales activity. If the Company liquidated its entire fleet ($4.1 billion carrying value at May 31, 2004) at this time, which is not currently contemplated, the Company believes that, based upon the range of values provided by independent appraisers,

 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

the Company would realize a value for its entire fleet that is substantially lower than the carrying value of the fleet. The current portfolio appraisal market values, based on the above three appraisals, range from a high of $3.77 billion to a low of $2.78 billion with an average of $3.12 billion. The Company has not recorded an impairment charge of this magnitude because there was no indication of impairment for the majority of the individual aircraft as their projected undiscounted cash flows exceeded their respective carrying values.

 

Fiscal 2003 Activity.

 

Prior to fiscal 2003, the Company had used “base value” estimates provided by independent appraisers to estimate the fair value of its impaired aircraft. Accordingly, during the first quarter of fiscal 2003, the Company recorded a non-cash pre-tax charge of $36 million to adjust the carrying value of previously impaired aircraft to “market value.” The charge is reflected in Other expenses in the condensed consolidated statement of income during the first quarter of fiscal 2003.

 

In accordance with SFAS No. 144, the Company reviewed the carrying value of its aircraft portfolio for impairment during the second quarter of fiscal 2003 given the difficult conditions existing in the commercial aircraft industry at the time, including the adverse impact of the military conflict in Iraq, the outbreak of Severe Acute Respiratory Syndrome and the bankruptcy of several airlines.

 

In the second quarter of fiscal 2003, the Company tested each of its aircraft for impairment by comparing each aircraft’s projected undiscounted cash flows to its respective carrying value. For each aircraft for which impairment was indicated, the Company adjusted the carrying value of each aircraft to its fair value, if lower than carrying value. To determine each aircraft’s fair value, the Company used market value estimates provided by independent appraisers (BK Associates, Inc., Morten Beyer & Agnew, Inc. and Airclaims Limited). As a result of this review, the Company recorded a non-cash pre-tax asset impairment charge of $287 million based on the average market value provided by independent appraisers in the second quarter of fiscal 2003.

 

The Company had followed a valuation methodology designed to align the changes in projected undiscounted cash flows for impaired aircraft with the change in carrying value of such aircraft. Under this methodology, the Company calculated the $36 million impairment charge in the first quarter of fiscal 2003 using the highest portfolio valuation provided by the appraisers and calculated the $287 million impairment charge recorded in the second quarter of fiscal 2003 based on the average of the three appraisal values. The Company has determined that future impairment charges will be based upon the average market appraisal values from independent appraisers. If the average market appraisal values had been used to measure impairment in each of the prior quarters in which impairment was recognized, pre-tax income would have differed as follows:

 

     Change in
Pre-tax Income
Increase
(Decrease)


 
     (dollars in
millions)
 

Quarter ended:

        

November 30, 2001

   $ (70.9 )

February 28, 2002

     1.0  

May 31, 2002

     1.5  

August 31, 2002

     (71.9 )

November 30, 2002

     2.7  

February 28, 2003

     38.3  

May 31, 2003

     97.0  
    


Aggregate difference

   $ (2.3 )
    


 

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MORGAN STANLEY

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

17.    Subsequent Event

 

On June 3, 2004, the Company completed the acquisition of Barra, Inc. (“Barra”) following approval of the previously announced merger agreement by Barra’s shareholders. Barra is a global leader in delivering risk management systems and services to managers of portfolio and firm-wide investment risk. In the next few months, Barra’s operations will be combined with Morgan Stanley Capital International Inc., a majority-owned subsidiary of the Company and a component of the Institutional Securities business segment. The acquisition price was $41.00 per share in cash, or an aggregate consideration of approximately $800 million.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

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 (“Morgan Stanley”) as of May 31, 2004, and the related condensed consolidated statements of income and comprehensive income for the three-month and six-month periods ended May 31, 2004 and 2003, and condensed consolidated statements of cash flows for the six-month periods ended May 31, 2004 and 2003. These interim financial statements are the responsibility of the management of Morgan Stanley.

 

We conducted our reviews in accordance with standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), 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 reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim 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 standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition of Morgan Stanley and subsidiaries as of November 30, 2003, 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, 2003; and, in our report dated February 23, 2004, (which report contains an explanatory paragraph relating to the adoption of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123,” in 2003), we 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, 2003 is fairly stated, in all material respects, in relation to the consolidated statement of financial condition from which it has been derived.

 

/S/    DELOITTE & TOUCHE LLP

 

New York, New York

July 12, 2004

 

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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 real estate investment vehicles; and aircraft financing activities. The Company’s Individual Investor Group business provides comprehensive financial planning, investment advisory and brokerage services designed to accommodate individual investment goals and risk profiles. The Company’s Investment Management business provides global asset management products and services for individual and institutional investors through three principal distribution channels: a proprietary channel consisting of the Company’s financial advisors and investment representatives; a non-proprietary channel consisting of third-party broker-dealers, banks, financial planners and other intermediaries; and the Company’s institutional channel. The Company’s private equity activities also are included within the Investment Management business segment. The Company’s Credit Services business offers Discover®-branded cards and other consumer finance products and services and includes the operation of Discover Business Services, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

 

The Company’s results of operations may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect the Company’s future results, please see “Forward-Looking Statements” immediately preceding Part I, Item 1, “Competition” and “Regulation” in Part I, Item 1 and “Certain Factors Affecting Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended November 30, 2003 (the “Form 10-K”).

 

The Company’s results of operations for the three and six month periods ended May 31, 2004 and 2003 are discussed below.

 

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Results of Operations.

 

Executive Summary.

 

Financial Information.

 

    

Three Months

Ended May 31,


   

Six Months

Ended May 31,


 
     2004

    2003(1)

    2004

    2003(1)

 

Net revenues (dollars in millions):

                                

Institutional Securities

   $ 3,948     $ 2,679     $ 7,452     $ 5,814  

Individual Investor Group

     1,209       1,002       2,420       1,987  

Investment Management

     690       558       1,332       1,083  

Credit Services

     879       884       1,837       1,782  

Intersegment Eliminations

     (75 )     (78 )     (149 )     (147 )
    


 


 


 


Consolidated net revenues

   $ 6,651     $ 5,045     $ 12,892     $ 10,519  
    


 


 


 


Income before taxes(2) (dollars in millions):

                                

Institutional Securities

   $ 1,134     $ 400     $ 2,320     $ 1,342  

Individual Investor Group

     132       62       298       123  

Investment Management

     209       122       379       222  

Credit Services

     298       302       663       592  

Intersegment Eliminations

     29       29       58       62  
    


 


 


 


Consolidated income before taxes

   $ 1,802     $ 915     $ 3,718     $ 2,341  
    


 


 


 


Consolidated net income (dollars in millions)

   $ 1,223     $ 599     $ 2,449     $ 1,504  
    


 


 


 


Basic earnings per common share

   $ 1.13     $ 0.56     $ 2.27     $ 1.40  
    


 


 


 


Diluted earnings per common share

   $ 1.10     $ 0.55     $ 2.21     $ 1.37  
    


 


 


 


Statistical Data.                                 

Return on average common equity

     18.4 %     10.6 %     18.8 %     13.4 %

Effective income tax rate

     28.9 %     28.6 %     30.0 %     31.9 %

Consolidated Assets Under Management or Supervision

    (dollars in billions):

                                

Equity

   $ 226     $ 174     $ 226     $ 174  

Fixed Income

     128       127       128       127  

Money Market

     70       65       70       65  

Other(3)

     76       55       76       55  
    


 


 


 


Total(4)

   $ 500     $ 421     $ 500     $ 421  
    


 


 


 


Worldwide employees

     51,580       53,507       51,580       53,507  

 

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Statistical Data—(Continued).

 

    

Three Months

Ended May 31,


   

Six Months

Ended May 31,


 
     2004

    2003(1)

    2004

    2003(1)

 

Institutional Securities:

                                

Mergers and acquisitions completed transactions(5):

                                

Rank

     2       4       2       2  

Market Share

     37.5 %     21.3 %     31.4 %     21.8 %

Mergers and acquisitions announced transactions(5):

                                

Rank

     3       10       3       9  

Market Share

     22.8 %     7.9 %     27.8 %     11.3 %

Global equity and equity-linked issues(5):

                                

Rank

     1       1       1       2  

Market Share

     13.2 %     13.9 %     13.7 %     13.5 %

Global fixed income issues(5):

                                

Rank

     2       5       3       2  

Market Share

     7.7 %     6.8 %     7.2 %     6.9 %

Individual Investor Group:

                                

Global financial advisors

     10,722       11,644       10,722       11,644  

Total client assets (dollars in billions)

   $ 579     $ 532     $ 579     $ 532  

Fee-based assets as a percentage of total client assets

     25 %     21 %     25 %     21 %

Investment Management:

                                

Assets under management or supervision (dollars in billions)

   $ 384     $ 336     $ 384     $ 336  

Percent of fund assets in top half of Lipper rankings(6)

     68 %     51 %     68 %     51 %

Credit Services (dollars in millions, unless otherwise noted)(7):

                                

Period-end credit card loans—Owned

   $ 17,506     $ 18,465     $ 17,506     $ 18,465  

Period-end credit card loans—Managed

   $ 46,828     $ 50,880     $ 46,828     $ 50,880  

Average credit card loans—Owned

   $ 16,202     $ 19,120     $ 17,036     $ 20,695  

Average credit card loans—Managed

   $ 46,929     $ 51,174     $ 47,793     $ 51,979  

Net principal charge-off rate—Owned

     6.02 %     5.92 %     5.91 %     5.73 %

Net principal charge-off rate—Managed

     6.48 %     6.50 %     6.40 %     6.34 %

Transaction volume (dollars in billions)

   $ 24.4     $ 24.0     $ 48.5     $ 50.0  

(1) Certain prior-period information has been reclassified to conform to the current year’s presentation.
(2) Represents income before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption.
(3) Amounts include alternative investment vehicles.
(4) Revenues and expenses associated with these assets are included in the Company’s Investment Management, Individual Investor Group and Institutional Securities segments.
(5) Source: Thomson Financial—The data for the three months ended May 31 is for the periods from March 1 to May 31, 2004 and March 1 to May 31, 2003, respectively. The data for the six months ended May 31 is for the periods from January 1 to May 31, 2004 and January 1 to May 31, 2003, respectively, as Thomson Financial presents this data on a calendar year basis.
(6) Source: Lipper, one-year performance as of May 31, 2004 and 2003, respectively.
(7) Managed data include owned and securitized credit card loans. For an explanation of managed data and a reconciliation of credit card loan and asset quality data, see “Credit Services—Managed General Purpose Credit Card Loan Data” herein.

 

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Second Quarter 2004 Performance.

 

Company Results.    The Company recorded net income of $1,223 million in the quarter ended May 31, 2004, a 104% increase from last year’s second quarter, and diluted earnings per share of $1.10, a 100% increase from last year’s second quarter. The current quarter’s results included a $109 million pre-tax asset impairment charge related to the Company’s aircraft financing business, which reduced net income by $65 million, diluted earnings per share by $0.06 and the annualized return on average common equity by 1.0%. The prior year quarter’s results included a $287 million pre-tax aircraft impairment charge which reduced net income by $172 million and diluted earnings per share by $0.16 and the annualized return on average common equity by 3.1%. Net revenues (total revenues less interest expense and the provision for loan losses) rose 32% from last year’s second quarter to $6.7 billion and the return on average common equity was 18.4% as compared with 10.6% in the second quarter of fiscal 2003.

 

Total non-interest expenses were $4.8 billion in the second quarter of fiscal 2004, an increase of 17% from the prior year. The increase primarily reflects higher costs due to increased business activity, including higher compensation and benefits expense. Higher costs associated with legal and regulatory matters also contributed to the increase in non-interest expenses.

 

Losses from unconsolidated investees were $81 million in the quarter ended May 31, 2004 as compared with $36 million in the prior year. These losses were more than offset by tax credits of $78 million in the quarter ended May 31, 2004 and $41 million in the quarter ended May 31, 2003 and tax benefits on the losses of $39 million in the quarter ended May 31, 2004 and $14 million in the quarter ended May 31, 2003. See Note 14 to the condensed consolidated financial statements for developments regarding one of the Company’s unconsolidated investees.

 

The Company’s effective tax rate was 29% for the quarter ended May 31, 2004 as compared with 31% for the quarter ended February 29, 2004 (which brings the effective tax rate for the six months ended May 31, 2004 to 30%). The decrease primarily reflected additional domestic tax credits.

 

For the six months ended May 31, 2004, net income was $2,449 million, a 63% increase over $1,504 million a year ago. Diluted earnings per share were $2.21, up 61% from a year ago. Net revenues in the six month period rose 23% from a year ago to $12.9 billion and non-interest expenses increased 12% to $9.2 billion. The annualized return on average common equity was 18.8% as compared with 13.4% in the prior year period.

 

Institutional Securities.    The Company’s Institutional Securities business recorded income before taxes of $1,134 million in the second quarter of fiscal 2004, an increase of 184% over last year’s second quarter. Net revenues increased 47% to $3.9 billion, driven by record revenues in the Company’s fixed income business and strong results in both its equities and investment banking businesses.

 

In investment banking, total underwriting revenues rose 77% to $567 million from last year’s second quarter. Equity underwriting revenues more than doubled, reflecting the Company’s participation in significantly higher levels of industry-wide equity underwriting activity. Fixed income underwriting revenues rose 51%, as the Company’s market share of global fixed income issuances expanded from 7% a year ago to 8% in the current quarter according to Thomson Financial. Advisory revenues were $324 million, a 130% increase from last year’s second quarter, reflecting a significant improvement in the Company’s market share in completed merger, acquisition and restructuring transactions. According to Thomson Financial, for the calendar year-to-date, the Company ranked first in global equity and equity-linked issuances with a 14% market share, third in announced global merger, acquisition and restructuring transactions with a 28% market share and third in global fixed income issuances with a 7% market share.

 

Fixed income sales and trading net revenues were $1.8 billion, a 43% increase from the second quarter of fiscal 2003. Revenues for interest rate and currency products were at record levels while commodities recorded its second best quarter ever. Equity sales and trading net revenues increased 29% from last year to $1.1 billion, reflecting higher revenues in the Company’s derivative products and cash businesses. Higher revenues in the Company’s prime brokerage business also contributed to the increase in equity sales and trading revenues.

 

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Principal transaction investment revenues were $136 million, compared with $44 million in last year’s second quarter. The quarter’s revenues were primarily associated with the Company’s real estate and principal investment activities, as well as a gain on the sale of its interest in TradeWeb.

 

Non-interest expenses rose 23% from last year’s second quarter to $2.8 billion on increased compensation accruals related to higher revenues and increased brokerage and clearing and professional services costs driven by higher levels of business activity. These increases were partially offset by a lower aircraft impairment charge in the current quarter as compared with last year’s second quarter.

 

Individual Investor Group.    The Individual Investor Group reported pre-tax income of $132 million, more than double the $62 million reported in the second quarter of fiscal 2003. Net revenues rose 21% from a year ago to $1.2 billion. Asset management, distribution and administration fees increased 38% on higher asset levels, and commissions rose 18% on increased individual investor activity in equity products. Non-interest expenses were up 15% to $1.1 billion, driven by higher compensation expenses and sub-advisory fees related to higher net revenues, and higher costs associated with legal and regulatory matters. Total client assets were $579 billion, a 9% increase from last year’s second quarter. Client assets in fee-based accounts rose 28% to $145 billion over the past twelve months and increased as a percentage of total client assets to 25% from 21% over the same period. At quarter-end, the number of global financial advisors was 10,722, a decrease of 922 over the past year.

 

Investment Management.    Investment Management pre-tax income rose 71% from last year’s second quarter to $209 million. Net revenues rose 24%, reflecting an increase in average assets under management and a more favorable asset mix due to improved equity markets. In addition, principal investment revenues increased to $59 million from $14 million in the prior year, reflecting higher net investment gains in Private Equity. Non-interest expenses increased 10% to $481 million, primarily reflecting higher compensation expense and higher sub-advisory fees. Assets under management within Investment Management were $384 billion, up $48 billion over the second quarter of last year. The increase over the past year resulted from both market appreciation and positive net flows. At quarter-end, the percent of the Company’s fund assets performing in the top half of the Lipper rankings was 68% over one year, 65% over three years and 77% over five years.

 

Credit Services.    Credit Services recorded pre-tax income of $298 million compared with $302 million in last year’s second quarter. A lower provision for loan losses, reflecting improved credit quality, was offset by lower net interest income and a decline in merchant and cardmember fees. Managed credit card loans of $46.8 billion at quarter end were 8% lower than a year ago, mainly due to a decline in balance transfer volume and an increase in payment rates. The managed credit card net charge-off rate for the second quarter was 6.48%, 2 basis points lower than a year ago. The decrease in the charge-off rate from a year ago was due to a decline in net charge-off dollars, partially offset by a $4.2 billion decline in average credit card managed loans. The managed over-30-day delinquency rate was 4.88%, a decrease of 133 basis points from the second quarter of fiscal 2003 and the lowest level since the second quarter of fiscal 1995. The managed over-90-day delinquency rate was 2.40%, 61 basis points lower than a year ago and the lowest level since the fourth quarter of fiscal 2000. A record number of new merchant outlets were enrolled during the quarter.

 

Business Outlook.

 

Entering the second half of fiscal 2004, business and market trends are mixed. Global economic growth continues to be generally strong, particularly in the U.S. However, investors are concerned about the pace of economic growth, as well as increasing inflationary pressures, higher oil prices, and high levels of geopolitical risk. These factors may negatively impact the operating results of the Institutional Securities, Individual Investor Group and Investment Management segments. In addition, they may also exacerbate the lower level of business activity in Institutional Securities and the Individual Investor Group that typically occurs during the summer months.

 

With respect to the Credit Services business, growth in loan balances and credit quality will continue to be a focus. In addition, Credit Services’ marketing expenses are typically higher in the latter half of the fiscal year.

 

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Global Market and Economic Conditions in the Quarter and Six Month Period Ended May 31, 2004.

 

In the U.S., the strong rate of economic expansion that began during the second half of 2003 has continued into fiscal 2004. U.S. economic performance continued to benefit from accommodative fiscal and monetary policies, supported by productivity gains. Corporate earnings were generally strong, and consumer confidence rose as the U.S. labor market strengthened due to job creation and a decline in unemployment. Major equity market indices declined during the second quarter partly due to the expectation that inflationary pressures will lead the Federal Reserve Board (the “Fed”) to tighten monetary policy. In addition, concern over higher oil prices, the continued turmoil in Iraq and global geopolitical tension depressed market sentiment and activity. Subsequent to quarter-end, on June 30, 2004, the Fed raised both the overnight lending rate and the discount rate by 0.25%.

 

In Europe, the economic recovery continued, albeit more slowly than in the U.S. and Asia. This was partly due to weak domestic demand. The U.K. experienced strong consumer confidence and a tightening labor market. During the six month period ended May 31, 2004, the Bank of England raised the benchmark interest rate by 0.50% to 4.25% due to growing concerns over inflation. In June 2004, the benchmark interest rate was raised by an additional 0.25%.

 

In Japan, the economy continued to exhibit signs of recovery primarily driven by higher investment spending and exports. During 2004, favorable economic data and the improvement in global economic activity increased expectations that Japan’s recovery would continue. Economies elsewhere in Asia also improved.

 

Subsequent Event.

 

On June 3, 2004, the Company completed the acquisition of Barra, Inc. (“Barra”) following approval of the previously announced merger agreement by Barra’s shareholders. Barra is a global leader in delivering risk management systems and services to managers of portfolio and firm-wide investment risk. In the next few months, Barra’s operations will be combined with Morgan Stanley Capital International Inc., a majority-owned subsidiary of the Company and a component of the Institutional Securities business segment. The acquisition price was $41.00 per share in cash, or an aggregate consideration of approximately $800 million.

 

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. Certain revenues and expenses have been allocated to each business segment, generally in proportion to their respective revenues or other relevant measures.

 

As a result of treating certain intersegment transactions as transactions with external parties, the Company includes an “Intersegment Eliminations” category to reconcile the segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations represents, among other things, the effect of timing differences associated with the revenue and expense recognition of commissions paid by Investment Management to Individual Investor Group associated with sales of certain products and the related compensation costs paid to Individual Investor Group’s financial advisors. Income before taxes in Intersegment Eliminations was $29 million in the quarters ended May 31, 2004 and 2003, and $58 million and $62 million in the six month periods ended May 31, 2004 and 2003, respectively.

 

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

 

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INSTITUTIONAL SECURITIES

 

INCOME STATEMENT INFORMATION

(dollars in millions)

 

     Three Months
Ended May 31,


  

Six Months

Ended May 31,


     2004

   2003

   2004

   2003

Revenues:

                           

Investment banking

   $ 891    $ 461    $ 1,630    $ 962

Principal transactions:

                           

Trading

     1,923      1,503      3,614      3,061

Investments

     136      44      152      34

Commissions

     527      423      1,032      838

Asset management, distribution and administration fees

     32      22      66      45

Interest and dividends

     3,151      2,831      6,376      6,025

Other

     59      76      136      138
    

  

  

  

Total revenues

     6,719      5,360      13,006      11,103

Interest expense

     2,771      2,681      5,554      5,289
    

  

  

  

Net revenues

     3,948      2,679      7,452      5,814
    

  

  

  

Non-interest expenses

     2,814      2,279      5,132      4,472
    

  

  

  

Income before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption

     1,134      400      2,320      1,342

Losses from unconsolidated investees

     81      36      174      70

Dividends on preferred securities subject to mandatory redemption

     —        40      45      62
    

  

  

  

Income before taxes

   $ 1,053    $ 324    $ 2,101    $ 1,210
    

  

  

  

 

Institutional Securities recorded net revenues of $3,948 million and $7,452 million in the quarter and six month period ended May 31, 2004, increases of 47% and 28%, respectively, from the comparable periods of fiscal 2003. Income before taxes for the quarter and six month period ended May 31, 2004 was $1,053 million and $2,101 million, increases of $729 million and $891 million, respectively, from the comparable periods of fiscal 2003. The increase in net revenues in both periods reflected higher revenues from investment banking and sales and trading activities. The increase in income before taxes in both periods primarily reflected higher net revenues, partially offset by higher non-interest expenses, including higher compensation and benefits expense.

 

Investment Banking.    Investment banking revenues increased 93% in the quarter ended May 31, 2004 primarily reflecting higher revenues from merger, acquisition and restructuring activities and from equity and fixed income underwriting transactions. The level of investment banking revenues recorded during the quarter was the highest since the fourth quarter of fiscal 2000.

 

Revenues from merger, acquisition and restructuring activities were $324 million in the quarter ended May 31, 2004, an increase of 130% from the comparable period of fiscal 2003. The increase reflected higher merger, acquisition and restructuring transaction activity across several sectors, particularly in financial services, healthcare, media and telecommunications and technology. Market share of completed transactions also increased significantly as compared with the prior year period.

 

Underwriting revenues were $567 million, an increase of 77% from the comparable period of fiscal 2003.

 

Equity underwriting revenues were $314 million, an increase of 107% from the comparable prior year period. The increase reflected higher industry-wide new issuance activity as compared with weak volume in the second

 

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quarter of fiscal 2003. The increases in the volume of global equity offerings in the quarter ended May 31, 2004 included several sectors, such as financial services, basic materials, healthcare and media and telecommunications.

 

Fixed income underwriting revenues were $253 million, an increase of 51%, reflecting higher revenues from global high yield issuances.

 

The backlog of merger, acquisition and restructuring transactions and equity and fixed income underwriting transactions increased at May 31, 2004 as compared with the prior year, generally reflecting improved global market and economic conditions. The backlog of merger, acquisition and restructuring and equity underwriting transactions decreased from the end of the first quarter of fiscal 2004, while the backlog of fixed income underwriting transactions increased.

 

Investment banking revenues in the six month period ended May 31, 2004 increased 69% from the comparable period of fiscal 2003. The increase reflected stronger performance in all investment banking businesses.

 

Sales and Trading Revenues.    Sales and trading revenues are composed of principal transaction trading revenues, commissions and net interest revenues. In assessing the profitability of its sales and trading activities, the Company views principal trading, commissions and net interest revenues in the aggregate. In addition, decisions relating to principal transactions in securities are based on an overall review of aggregate revenues and costs associated with each transaction or series of transactions. This review includes 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.

 

Principal transaction trading revenues in the six month periods ended May 31, 2004 and May 31, 2003 include changes in the fair value of embedded derivatives in the Company’s structured borrowings. Prior to the second quarter of fiscal 2004, such amounts were included in interest expense (see Note 5 to the condensed consolidated financial statements). Prior period information has been reclassified to conform to the current period’s presentation. In the quarter ended February 29, 2004, principal transaction trading revenues included $515 million that was previously recorded as a decrease to interest expense. In the quarter and six month period ended May 31, 2003, principal transaction trading revenues included $87 million and $243 million that were previously recorded as increases to interest expense. These reclassifications had no impact on net revenues.

 

Sales and trading revenues include the following:

 

     Three Months
Ended May 31,


  

Six Months

Ended May 31,


     2004

   2003

   2004

   2003

     (dollars in millions)

Equities

   $ 1,113    $ 865    $ 2,218    $ 1,842

Fixed income(1)

   $ 1,828      1,282    $ 3,479      2,917

(1) Amounts include interest rate and currency products, credit products and commodities.

 

Total sales and trading revenues increased 36% in the quarter ended May 31, 2004 from the comparable period of fiscal 2003, reflecting higher revenues from both equity and fixed income products.

 

Equity sales and trading revenues increased 29% in the quarter ended May 31, 2004. The increase was driven by higher revenues in the derivative products and cash businesses. Derivatives products benefited from increased customer trading activity while the increase in the cash business was driven by higher market volumes. Higher revenues in the prime brokerage businesses also contributed to the increase.

 

Fixed income sales and trading revenues increased 43% in the quarter ended May 31, 2004 to a record level. Revenues from commodities products increased approximately 195% and reflected higher revenues from

 

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electricity and oil products as tight supply and rising demand drove prices and volatilities higher. Interest rate and currency product revenues increased approximately 55% and benefited from favorable trading conditions and increased customer flow activity. The increase was primarily attributable to foreign exchange and derivative products. Credit products revenues decreased approximately 10%, reflecting lower revenues from high yield and securitized products, partially offset by an increase in investment grade products.

 

Total sales and trading revenues increased 18% in the six month period ended May 31, 2004 from the comparable period of fiscal 2003, primarily reflecting higher equity and fixed income sales and trading revenues. Equity sales and trading revenues increased 20% in the six month period ended May 31, 2004, driven by higher revenues in the prime brokerage, cash and derivatives businesses. The prime brokerage business experienced significant increases in customer balances that contributed to higher revenues. The cash business benefited from higher market volumes, increased levels of cash inflows to equity mutual funds and an overall more positive market environment as compared with fiscal 2003. The derivatives business revenues were higher as a result of continued increases in customer trading activity. The increase in fixed income sales and trading revenues was primarily due to higher revenues from interest rate and currency products and credit products. Higher revenues from interest rate and currency products were driven by favorable trading conditions in the derivatives and foreign exchange markets. Credit product revenues, including securitized products and high yield fixed income securities, benefited from increased securitization flows and strong customer volumes.

 

In addition to the equity and fixed income sales and trading revenues discussed above, sales and trading revenues include the net interest expense associated with the Company’s aircraft financing activities, as well as corporate lending activities. In the quarter and six month period ended May 31, 2004, sales and trading revenues associated with corporate lending activities increased by approximately $30 million and $75 million due to growth in the loan portfolio and improved conditions in the credit markets.

 

Principal Transactions—Investments.    Principal transaction net investment revenue increased $92 million and $118 million in the quarter and six month period ended May 31, 2004. Both periods’ results included a gain on the sale of an investment in TradeWeb, an electronic trading platform. Gains associated with real estate and principal investment activities also contributed to the increases from the prior year periods.

 

Asset Management, Distribution and Administration Fees.    Asset management, distribution and administration fees increased 45% and 47% in the quarter and six month period ended May 31, 2004 due to higher fees associated with real estate investment and advisory activities, primarily due to the acquisition of a majority of the U.S. real estate equity investment management business of Lend Lease Corporation in November 2003.

 

Other.    Other revenues decreased 22% and 1% in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003. The decreases were primarily attributable to lower miscellaneous revenue items and lower revenues from the aircraft financing business.

 

Net revenues from the Company’s aircraft financing business continued to be adversely affected by the slowdown in the commercial aircraft industry that began in 2001. In fiscal 2002 and fiscal 2003, declining aircraft passenger volume, overcapacity of aircraft and financial difficulties experienced by major airlines contributed significantly to a decline in lease rates for operating lessors, including the Company’s aircraft financing business. These conditions improved somewhat toward the end of fiscal 2003 and in the first half of fiscal 2004. At May 31, 2004, the number of the Company’s aircraft that were off-lease or not committed to a lease transaction had decreased significantly from the prior year.

 

Non-Interest Expenses.    Non-interest expenses increased 23% and 15% in the quarter and the six month period ended May 31, 2004. Compensation and benefits expense increased 42% and 22% in the quarter and six month period, primarily due to higher incentive-based compensation accruals, reflecting higher net revenues. Excluding compensation and benefits expense, non-interest expenses remained virtually unchanged in the quarter and

 

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increased 3% in the six month period. Brokerage, clearing and exchange fees increased 21% and 22% in the quarter and six month period, primarily reflecting increased trading activity. Professional services expense increased 34% for both the quarter and six month period, primarily due to higher consulting and employee recruitment costs. Other expenses decreased 23% and 24% in the quarter and the six month period, primarily reflecting a lower aircraft impairment charge. The quarter and six month period ended May 31, 2004 included an aircraft impairment charge of $109 million as compared with $287 million in the comparable periods of 2003. The six month period of fiscal 2003 also included a $36 million charge to adjust the carrying value of previously impaired aircraft to market value (see Note 16 to the condensed consolidated financial statements). The decrease in other expenses from the second quarter of fiscal 2003 was partially offset by legal accruals of approximately $110 million related to the Parmalat Matter and IPO Allocation Matters (see “Legal Proceedings” in Part I, Item 3 of the Form 10-K and Part II, Item 1 of this Report and the Company’s Quarterly Report on Form 10-Q for the quarter ended February 29, 2004).

 

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INDIVIDUAL INVESTOR GROUP

 

INCOME STATEMENT INFORMATION

(dollars in millions)

 

     Three Months
Ended May 31,


  

Six Months

Ended May 31,


     2004

    2003

   2004

   2003

           

Revenues:

             

Investment banking

   $ 82     $ 66    $ 159    $ 146

Principal transactions:

                            

Trading

     141       167      282      321

Investments

     (4 )     1      —        7

Commissions

     367       310      784      590

Asset management, distribution and administration fees

     511       370      983      756

Interest and dividends

     95       92      188      181

Other

     52       35      92      63
    


 

  

  

Total revenues

     1,244       1,041      2,488      2,064

Interest expense

     35       39      68      77
    


 

  

  

Net revenues

     1,209       1,002      2,420      1,987
    


 

  

  

Non-interest expenses

     1,077       940      2,122      1,864
    


 

  

  

Income before taxes

   $ 132     $ 62    $ 298    $ 123
    


 

  

  

 

Individual Investor Group net revenues were $1,209 million and $2,420 million in the quarter and six month period ended May 31, 2004, an increase of 21% and 22% from the comparable periods of fiscal 2003. Individual Investor Group income before taxes was $132 million and $298 million in the quarter and six month period ended May 31, 2004 as compared with $62 million and $123 million in the comparable periods of fiscal 2003. The increase in net revenues in both periods was primarily attributable to higher commission revenues and asset management, distribution and administration fees. The increase in income before taxes in both periods was primarily due to higher net revenues, partially offset by higher non-interest expenses, including higher compensation and benefits expense.

 

The results for the Individual Investor Group in the quarter and six month period ended May 31, 2004 benefited from higher individual investor participation in the U.S. equity markets and positive inflows into equity mutual funds. Client assets were $579 billion at May 31, 2004.

 

Investment Banking.    Investment banking revenues increased 24% and 9% in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003. The increase in both periods was primarily due to higher revenues from the underwriting of Unit Investment Trust products. Equity underwriting revenues decreased in the six month period ended May 31, 2004.

 

Principal Transactions.    Principal transaction trading revenues decreased 16% and 12% in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003. The decrease in both periods reflected lower revenues from fixed income products, including corporate and municipal fixed income securities. The decrease in the six month period also reflected lower revenues from government fixed income securities, as individual investors’ preferences shifted toward equity products.

 

Commissions.    Commission revenues increased 18% and 33% in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003 due to higher customer trading volumes as individual investor participation in the U.S. equity markets increased.

 

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Net Interest.     Net interest revenues increased 13% and 15% in the quarter and six month periods ended May 31, 2004 from the comparable periods of fiscal 2003. The increase in both periods was primarily due to higher net interest revenues from brokerage services provided to individual customers as a result of an increase in the level of customer margin loans. In addition, there was 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 increased 38% and 30% in the quarter and six month periods ended May 31, 2004 from the comparable periods of fiscal 2003. An increase in client asset balances as compared with the prior periods resulted in higher fees from investors electing fee-based pricing arrangements, including separately managed and Morgan Stanley ChoiceSM accounts. The increase in client asset balances was primarily due to market appreciation, reflecting improvement in the global financial markets. Client assets in fee-based accounts rose 28% to $145 billion during the period from June 1, 2003 to May 31, 2004 and increased as a percentage of total client assets to 25% from 21%.

 

Other.    Other revenues increased 49% and 46% in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003. The increase in both periods was primarily due to higher revenues from customer service and account fees.

 

Non-Interest Expenses.    Non-interest expenses increased 15% and 14% in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003. The increase in both periods was primarily attributable to higher compensation and benefits expense, which increased 12% and 11% in the quarter and six month period, principally reflecting higher incentive-based compensation accruals due to higher levels of net revenues. This increase was partially offset by reduced costs reflecting lower employment levels. Excluding compensation and benefits expense, non-interest expenses increased 20% in both the quarter and six month period. Professional services expense increased 69% and 59% in the quarter and six month period largely due to higher sub-advisory fees related to the Investment Consulting Services business, as well as higher consulting and legal fees. Other expenses increased 48% and 59% in the quarter and six month period, primarily resulting from higher accruals associated with legal and regulatory matters.

 

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INVESTMENT MANAGEMENT

 

INCOME STATEMENT INFORMATION

(dollars in millions)

 

    

Three Months

Ended May 31,


  

Six Months

Ended May 31,


 
     2004

   2003

   2004

   2003

 

Revenues:

                             

Investment banking

   $ 10    $ 9    $ 23    $ 17  

Principal transactions:

                             

Investments

     59      14      68      (4 )

Commissions

     8      3      16      7  

Asset management, distribution and administration fees

     607      528      1,210      1,051  

Interest and dividends

     1      —        3      2  

Other

     6      8      15      15  
    

  

  

  


Total revenues

     691      562      1,335      1,088  

Interest expense

     1      4      3      5  
    

  

  

  


Net revenues

     690      558      1,332      1,083  
    

  

  

  


Non-interest expenses

     481      436      953      861  
    

  

  

  


Income before taxes

   $ 209    $ 122    $ 379    $ 222  
    

  

  

  


 

Investment Management net revenues were $690 million and $1,332 million for the quarter and six month period ended May 31, 2004, an increase of 24% and 23% from the comparable periods of fiscal 2003. Investment Management income before taxes was $209 million and $379 million for the quarter and six month period ended May 31, 2004, an increase of 71% from the comparable periods of fiscal 2003. The increase in net revenues in both periods primarily reflected higher fee-based revenues due to an increase in average assets under management or supervision and a more favorable average asset mix. The increase in average assets under management was primarily attributable to market appreciation, reflecting improved conditions in the global financial markets as compared with the prior year. Higher net gains in the Company’s private equity portfolio also contributed to the increase in net revenues in both periods. The increase in income before taxes in both periods was primarily due to higher net revenues, partially offset by an increase in non-interest expenses, including higher compensation and benefits expense.

 

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

 

Investment Banking.    Investment banking revenues increased 11% and 35% in the quarter and six month period ended May 31, 2004, reflecting a higher volume of Unit Investment Trust sales.

 

Principal Transactions—Investments.    Principal transaction net investment gains aggregating $59 million and $68 million were recognized in the quarter and six month period ended May 31, 2004 as compared with net gains of $14 million and net losses of $4 million in the quarter and six month period ended May 31, 2003, respectively. Results in the quarter and six month period ended May 31, 2004 were primarily related to higher net gains on certain investments (including Ping An Insurance (Group) Company of China, Ltd.) in the Company’s private equity portfolio as compared with the prior year periods.

 

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Commissions.    Commission revenues increased in the quarter and six month period ended May 31, 2004 reflecting higher sales volume of certain fund products.

 

Asset Management, Distribution and Administration Fees.    Investment Management’s period end and average customer assets under management or supervision were as follows:

 

    

At

May 31,

2004


  

At

May 31,

2003


  

Average For the Three

Months Ended


  

Average For the Six

Months Ended


          

May 31,

2004


  

May 31,

2003


  

May 31,

2004


  

May 31,

2003


     (dollars in billions)

Assets under management or supervision by distribution channel:

                                         

Retail

   $ 195    $ 185    $ 197    $ 180    $ 199    $ 181

Institutional

     189      151      187      146      179      147
    

  

  

  

  

  

Total

   $ 384    $ 336    $ 384    $ 326    $ 378    $ 328
    

  

  

  

  

  

Assets under management or supervision by asset class:

                                         

Equity

   $ 182    $ 142    $ 183    $ 130    $ 180    $ 131

Fixed income

     114      116      116      116      114      118

Money market

     66      62      64      64      63      64

Other(1)

     22      16      21      16      21      15
    

  

  

  

  

  

Total

   $ 384    $ 336    $ 384    $ 326    $ 378    $ 328
    

  

  

  

  

  


(1) Amounts include alternative investment vehicles.

 

Asset management, distribution and administration fees increased 15% in both the quarter and six month period, reflecting higher fund management and administration fees commensurate with an 18% and 15% increase in average assets under management or supervision and a more favorable average asset mix, as market appreciation resulted in a shift toward equity products.

 

As of May 31, 2004, customer assets under management or supervision increased $48 billion from May 31, 2003. The increase was primarily due to market appreciation, reflecting improvement in the global equity markets. Net flows into institutional products were positive for the second consecutive quarter, led by the launch of the Morgan Stanley Institutional Liquidity Funds and sales of fixed income and alternative investment products.

 

Non-Interest Expenses.    Non-interest expenses increased 10% and 11% in the quarter and six month period ended May 31, 2004. Compensation and benefits expense increased 26% and 28% in the quarter and six month period, principally reflecting higher incentive-based compensation accruals due to higher net revenues. Excluding compensation and benefits expense, non-interest expenses increased 2% and 3% in the quarter and six month period ended May 31, 2004. Professional services expenses increased 63% and 66% in the quarter and six month period, primarily reflecting an increase in sub-advisory, consulting and legal fees. Marketing and business development expenses decreased 25% in the six month period, primarily due to lower promotional costs. Brokerage, clearing and exchange fees decreased 6% and 5% in the quarter and six month period, reflecting lower amortization expense associated with certain open-ended funds. The decrease in amortization expense reflected a lower level of deferred costs in recent periods due to a decrease in sales of certain open-end funds.

 

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CREDIT SERVICES

 

INCOME STATEMENT INFORMATION

(dollars in millions)

 

    

Three Months

Ended May 31,


  

Six Months

Ended May 31,


     2004

   2003

   2004

   2003

Fees:

                           

Merchant and cardmember

   $ 306    $ 338    $ 643    $ 702

Servicing

     485      503      1,057      1,070

Other

     16      6      21      2
    

  

  

  

Total non-interest revenues

     807      847      1,721      1,774
    

  

  

  

Interest revenue

     435      543      915      1,089

Interest expense

     163      197      337      436
    

  

  

  

Net interest income

     272      346      578      653

Provision for consumer loan losses

     200      309      462      645
    

  

  

  

Net credit income

     72      37      116      8
    

  

  

  

Net revenues

     879      884      1,837      1,782
    

  

  

  

Non-interest expenses

     581      582      1,174      1,190
    

  

  

  

Income before taxes

   $ 298    $ 302    $ 663    $ 592
    

  

  

  

 

Credit Services net revenues were $879 million and $1,837 million in the quarter and six month period ended May 31, 2004, a decrease of 1% and an increase of 3% from the comparable periods of fiscal 2003. Income before income taxes was $298 million and $663 million in the quarter and six month period ended May 31, 2004, a decrease of 1% and an increase of 12% from the comparable periods of fiscal 2003. The decrease in net revenues in the quarter was primarily due to lower net interest income and non-interest revenues, partially offset by a lower provision for consumer loan losses. The increase in net revenues in the six month period was primarily attributable to a lower provision for consumer loan losses, partially offset by lower net interest income and non-interest revenues. The increase in income before taxes in the six month period reflected higher net revenues and lower non-interest expenses.

 

Merchant and Cardmember Fees.    Merchant and cardmember fees decreased 9% and 8% in the quarter and six month period. The decrease was due to lower late payment and overlimit fees and higher cardmember rewards, partially offset by higher balance transfer fees and merchant discount revenues. The decline in late payment and overlimit fees reflected fewer late fee occurrences and a decline in overlimit accounts, partially offset by lower charge-offs. The increase in cardmember rewards reflects increased sales volume and the impact of promotional programs. Balance transfer fees increased as a result of the Company’s increased focus on improving balance transfer profitability. The increase in merchant discount revenue was due to a modest increase in sales volume.

 

In response to industry-wide regulatory guidance, the Company is in the process of revising its overlimit fee assessment policies. The Company will continue to review the criteria under which cardmembers who exceed their credit limit are charged a fee; this process is expected to result in lower cardmember fee revenue in future periods.

 

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Servicing Fees.

 

The table below presents the components of servicing fees:

 

    

Three Months

Ended May 31,


   

Six Months

Ended May 31,


 
     2004

    2003

    2004

    2003

 
    

(dollars in millions)

 

Merchant and cardmember fees

   $ 161     $ 185     $ 343     $ 369  

Interest revenue

     1,015       1,049       2,059       2,083  

Other revenue

     —         30       30       87  

Interest expense

     (174 )     (213 )     (350 )     (415 )

Provision for consumer loan losses

     (517 )     (548 )     (1,025 )     (1,054 )
    


 


 


 


Servicing fees

   $ 485     $ 503     $ 1,057     $ 1,070  
    


 


 


 


 

Servicing fees decreased 4% in the quarter ended May 31, 2004 reflecting lower other revenue and cardmember fees partially offset by a lower provision for consumer loan losses. The decrease in the other revenue component of servicing fees reflected net losses from general purpose credit card securitizations, which were attributable to net gain amortization of prior securitizations, along with lower net gains from mortgage securitizations and whole loan sales. The decrease in net general purpose credit card securitization gains primarily reflected the absence of securitization transactions in the fiscal 2004 quarter. Cardmember fees were lower due to lower late payment and overlimit fees, partially offset by higher balance transfer fees. The decrease in the provision for consumer loan losses was attributable to a lower level of average securitized general purpose credit card loans and a lower rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio.

 

Servicing fees decreased 1% in the six month period ended May 31, 2004 reflecting lower other revenue and cardmember fees, partially offset by higher net interest cash flows and a lower provision for consumer loan losses. The decrease in the Other revenue component of servicing fees was attributable to lower levels of general purpose credit card and mortgage loan securitization transactions in the six month period ended May 31, 2004 as compared with the six month period in fiscal 2003. The increase in net interest cash flows was driven primarily by a lower interest rate environment, including the favorable impact of maturing fixed rate securitizations and higher levels of lower cost floating rate securitizations. Cardmember fees were lower due to lower late payment and overlimit fees, partially offset by higher balance transfer fees. The decrease in the provision for consumer loan losses was attributable to a lower level of average securitized general purpose credit card loans and a lower rate of net principal charge-offs related to the securitized general purpose credit card loan portfolio.

 

The Company did not complete any general purpose credit card asset securitization transactions during the second quarter of fiscal 2004 as compared with $1.5 billion in the second quarter of fiscal 2003. The Company completed general purpose credit card asset securitizations of $1.9 billion in the six month period ended May 31, 2004 and $5.7 billion in the comparable period of fiscal 2003. The credit card asset securitization transactions completed in the six month period ended May 31, 2004 have expected maturities ranging from approximately five to seven years from the date of issuance. The Company did not complete any mortgage loan securitization transactions in the fiscal 2004 periods, while $0.6 billion and $0.8 billion were completed during the second quarter and six month period of fiscal 2003. The Company also received net proceeds from mortgage whole loan sales of $1.2 billion and $2.5 billion in the quarter and six month period ended May 31, 2004 and $0.7 billion and $2.2 billion in the quarter and six month period ended May 31, 2003.

 

Net Interest Income.    Net interest income decreased 21% and 11% in the quarter and six month period ended May 31, 2004, as a decline in interest revenue was partially offset by lower interest expense. In the quarter, the decline in interest revenue was primarily due to a decrease in average general purpose credit card loans along with a lower yield. The lower yield on general purpose credit card loans in the quarter was primarily due to a

 

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decline in revolving balances partially offset by repricing of higher risk cardmembers. In the six month period, the decline in interest revenue was due to a decrease in average general purpose credit card loans, partially offset by a higher yield. The decrease in the average general purpose credit card loans in both periods was primarily due to a lower level of balance transfer volume and higher payment rates. The higher yield on general purpose credit card loans in the six month period was primarily due to higher rates charged to higher risk cardmembers and a decline in the percentage of loan balances subject to promotional rates. The decrease in interest expense in the quarter was primarily due to a lower level of average interest bearing liabilities. The decrease in interest expense in the six month period was primarily due to a lower level of average interest bearing liabilities and a decrease in the Company’s average cost of borrowings. The Company’s average cost of borrowings was 4.15% and 4.42% for the six month periods ended May 31, 2004 and 2003, respectively. The decline in the average cost of borrowings reflected the favorable impact of replacing certain maturing fixed rate debt with lower cost financing.

 

The following tables present analyses of Credit Services average balance sheets and interest rates for the quarters and six month periods ended May 31, 2004 and 2003 and changes in net interest income during those periods:

 

Average Balance Sheet Analysis.

 

     Three Months Ended May 31,

 
     2004

    2003

 
    

Average

Balance


    Rate

    Interest

   

Average

Balance


    Rate

    Interest

 
     (dollars in millions)  

ASSETS

                                            

Interest earning assets:

                                            

General purpose credit card loans

   $ 16,202     9.93 %   $ 405     $ 19,120     10.57 %   $ 510  

Other consumer loans

     1,343     5.16       18       1,454     5.55       20  

Investment securities

     111     0.67       —         65     0.98       —    

Other

     2,679     1.84       12       2,785     1.95       13  
    


       


 


       


Total interest earning assets

     20,335     8.50       435       23,424     9.21       543  

Allowance for loan losses

     (999 )                   (954 )              

Non-interest earning assets

     2,442                     2,451                
    


               


             

Total assets

   $ 21,778                   $ 24,921                
    


               


             

LIABILITIES AND SHAREHOLDER’S EQUITY

                                            

Interest bearing liabilities:

                                            

Interest bearing deposits

                                            

Savings

   $ 699     0.83 %   $ 1     $ 816     1.04 %   $ 2  

Brokered

     8,922     5.08       114       10,847     5.28       144  

Other time

     1,386     4.29       15       1,609     4.51       19  
    


       


 


       


Total interest bearing deposits

     11,007     4.71       130       13,272     4.92       165  

Other borrowings

     4,232     3.07       33       4,936     2.58       32  
    


       


 


       


Total interest bearing liabilities

     15,239     4.26       163       18,208     4.29       197  

Shareholder’s equity/other liabilities

     6,539                     6,713                
    


               


             

Total liabilities and shareholder’s equity

   $ 21,778                   $ 24,921                
    


               


             

Net interest income

                 $ 272                   $ 346  
                  


               


Net interest margin(1)

                   5.31 %                   5.87 %

Interest rate spread(2)

           4.24 %                   4.92 %        

(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.

 

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Average Balance Sheet Analysis.

 

     Six Months Ended May 31,

 
     2004

    2003

 
     Average
Balance


    Rate

    Interest

    Average
Balance


    Rate

    Interest

 
     (dollars in millions)  

ASSETS

                                            

Interest earning assets:

                                            

General purpose credit card loans

   $ 17,036     10.03 %   $ 855     $ 20,695     9.87 %   $ 1,019  

Other consumer loans

     1,347     5.22       35       1,601     5.49       44  

Investment securities

     107     0.72       —         64     1.01       —    

Other

     2,680     1.82       25       2,712     1.96       26  
    


       


 


       


Total interest earning assets

     21,170     8.64       915       25,072     8.71       1,089  

Allowance for loan losses

     (997 )                   (944 )              

Non-interest earning assets

     2,458                     2,431                
    


               


             

Total assets

   $ 22,631                   $ 26,559                
    


               


             

LIABILITIES AND SHAREHOLDER’S EQUITY

                                            

Interest bearing liabilities:

                                            

Interest bearing deposits

                                            

Savings

   $ 719     0.84 %   $ 3     $ 842     1.02 %   $ 4  

Brokered

     9,251     5.10       236       10,731     5.40       289  

Other time

     1,673     3.80       32       1,644     4.59       38  
    


       


 


       


Total interest bearing deposits

     11,643     4.65       271       13,217     5.02       331  

Other borrowings

     4,598     2.87       66       6,565     3.22       105  
    


       


 


       


Total interest bearing liabilities

     16,241     4.15       337       19,782     4.42       436  

Shareholder’s equity/other liabilities

     6,390                     6,777                
    


               


             

Total liabilities and shareholder’s equity

   $ 22,631                   $ 26,559                
    


               


             

Net interest income

                 $ 578                   $ 653  
                  


               


Net interest margin(1)

                   5.46 %                   5.23 %

Interest rate spread(2)

           4.49 %                   4.29 %        

(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.

 

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Rate/Volume Analysis.

 

     Three Months Ended
May 31, 2004 vs. 2003


     Six Months Ended
May 31, 2004 vs. 2003


 
     Increase/(Decrease) due to
Changes in:


     Increase/(Decrease) due to
Changes in:


 

Increase/(Decrease) due to Changes in:


   Volume

     Rate

     Total

     Volume

     Rate

     Total

 
     (dollars in millions)  

Interest Revenue

                                                     

General purpose credit card loans

   $ (78 )    $ (27 )    $ (105 )    $ (180 )    $ 16      $ (164 )

Other consumer loans

     (1 )      (1 )      (2 )      (7 )      (2 )      (9 )

Other

     —          (1 )      (1 )      —          (1 )      (1 )
                      


                    


Total interest revenue

     (71 )      (37 )      (108 )      (170 )      (4 )      (174 )
                      


                    


Interest Expense

                                                     

Interest bearing deposits:

                                                     

Savings

     —          (1 )      (1 )      —          (1 )      (1 )

Brokered

     (25 )      (5 )      (30 )      (40 )      (13 )      (53 )

Other time

     (3 )      (1 )      (4 )      1        (7 )      (6 )
                      


                    


Total interest bearing deposits

     (28 )      (7 )      (35 )      (39 )      (21 )      (60 )

Other borrowings

     (4 )      5        1        (31 )      (8 )      (39 )
                      


                    


Total interest expense

     (32 )      (2 )      (34 )      (78 )      (21 )      (99 )
                      


                    


Net interest income

   $ (39 )    $ (35 )    $ (74 )    $ (92 )    $ 17      $ (75 )
    


  


  


  


  


  


 

In response to industry-wide regulatory guidance, the Company continues to review the minimum payment requirements on its general purpose credit card loans. A change in the minimum payment requirements may impact future levels of general purpose credit card loans and related interest and fee revenues and charge-offs.

 

Provision for Consumer Loan Losses.    The provision for consumer loan losses decreased 35% and 28% in the quarter and six month period ended May 31, 2004 primarily due to lower net principal charge-offs. In both the quarter and six month periods of fiscal 2004, the decline in net principal charge-offs was primarily due to improvement in credit quality. In addition, the six month period of fiscal 2004 also reflected lower bankruptcy charge-offs driven by a decline in U.S. personal bankruptcy filings. Despite the decline in net principal charge-off dollars, the net principal charge-off rates increased in the owned portfolio as compared with the comparable periods of fiscal 2003, reflecting the lower level of general purpose credit card loans. The Company reduced the allowance for consumer loan losses by $47 million and $48 million in the quarter and six month period ended May 31, 2004, respectively. This reduction was due to the improvement in credit quality, including lower delinquency rates and dollars. In contrast, the Company recorded a provision for consumer loan losses that exceeded the amount of net consumer loans charged off by approximately $23 million and $45 million in the quarter and six month period ended May 31, 2003, respectively, which reflected unfavorable trends in cardmember delinquencies and higher levels of personal bankruptcy filings.

 

Delinquencies.    Delinquency rates in both the over 30- and over 90-day categories were lower in both the owned and managed portfolios at May 31, 2004 as compared with May 31, 2003, reflecting improvements in portfolio credit quality, including the favorable impact of improving U.S. economic conditions on the portfolio. The managed over-30-day delinquency rate was the lowest level since the second quarter of fiscal 1995 and the managed over-90-day delinquency rate was the lowest level since the fourth quarter of fiscal 2000.

 

Non-Interest Expenses.    Non-interest expenses were relatively unchanged in the quarter and six month period ended May 31, 2004 from the comparable periods of fiscal 2003. Compensation and benefits expense decreased 1% and 4% in the quarter and six month period, reflecting a decrease in personnel costs due to lower employment levels due, in part, to workforce reductions conducted during the fourth quarter of fiscal 2003.

 

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Excluding compensation and benefits expense, non-interest expenses were relatively unchanged in the quarter and six month period. Other expense decreased 6% in the quarter primarily reflecting a decrease in certain operating expenses, including lower costs associated with cardmember fraud and merchant bankruptcies. Information and communications expense increased 6% in the quarter primarily due to higher data processing costs. In the six month period, marketing and business development expense decreased 5% due to lower direct mail costs and other marketing expenses. Other expense decreased 5% in the six month period primarily due to lower postage costs. Professional services expense increased 14% in the six month period reflecting increased costs associated with enhanced credit and collection strategies.

 

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

 

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

 

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

 

     Three Months Ended

 
     May 31, 2004

    May 31, 2003

 
     Average
Balance


   Interest
Yield


    Interest
Rate
Spread


    Average
Balance


   Interest
Yield


    Interest
Rate
Spread


 

General Purpose Credit Card Loans:

                                      

Owned

   $ 16,202    9.93 %   5.67 %   $ 19,120    10.57 %   6.28 %

Securitized

     30,727    12.91 %   10.77 %     32,054    12.81 %   10.23 %
    

              

            

Managed

   $ 46,929    11.88 %   9.06 %   $ 51,174    11.97 %   8.78 %
    

              

            

 

     Six Months Ended

 
     May 31, 2004

    May 31, 2003

 
     Average
Balance


   Interest
Yield


    Interest
Rate
Spread


    Average
Balance


   Interest
Yield


    Interest
Rate
Spread


 

General Purpose Credit Card Loans:

                                      

Owned

   $ 17,036    10.03 %   5.88 %   $ 20,695    9.87 %   5.45 %

Securitized

     30,757    13.15 %   10.98 %     31,284    13.20 %   10.59 %
    

              

            

Managed

   $ 47,793    12.04 %   9.21 %   $ 51,979    11.87 %   8.56 %
    

              

            

 

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

 

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

 

     Three Months Ended

 
     May 31, 2004

    May 31, 2003

 
          Delinquency
Rates


         Delinquency
Rates


 
     Period
End
Loans


   Over
30
Days


    Over
90
Days


    Period
End
Loans


   Over
30
Days


    Over
90
Days


 

General Purpose Credit Card Loans:

                                      

Owned

   $ 17,506    4.37 %   2.15 %   $ 18,465    5.27 %   2.56 %

Securitized

     29,322    5.18 %   2.55 %     32,415    6.74 %   3.27 %
    

              

            

Managed

   $ 46,828    4.88 %   2.40 %   $ 50,880    6.21 %   3.01 %
    

              

            

 

     Three Months Ended

    Six Months Ended

 
    

May 31,

2004


   

May 31,

2003


   

May 31,

2004


   

May 31,

2003


 

Net Principal Charge-offs

                        

Owned

   6.02 %   5.92 %   5.91 %   5.73 %

Securitized

   6.73 %   6.84 %   6.67 %   6.74 %

Managed

   6.48 %   6.50 %   6.40 %   6.34 %

Net Total Charge-offs (inclusive of interest and fees)