FORM 10-Q

10-Q 1 d10q.htm FORM 10-Q FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended August 31, 2004

¨	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 September 30, 2004, there were 1,094,573,359 shares of the Registrant’s Common Stock, par value $.01 per share, outstanding.

MORGAN STANLEY

INDEX TO QUARTERLY REPORT ON FORM 10-Q

Quarter Ended August 31, 2004


		Page
Part I—Financial Information
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Statements of Financial Condition—August 31, 2004 and November 30, 2003	1
	Condensed Consolidated Statements of Income—Three and Nine Months Ended August 31, 2004 and 2003	3
	Condensed Consolidated Statements of Comprehensive Income—Three and Nine Months Ended August 31, 2004 and 2003	4
	Condensed Consolidated Statements of Cash Flows—Nine Months Ended August 31, 2004 and 2003	5
	Notes to Condensed Consolidated Financial Statements	6
	Report of Independent Registered Public Accounting Firm	34
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	35
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	68
Item 4.	Controls and Procedures	73

Part II—Other Information
Item 1.	Legal Proceedings	74
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	76
Item 6.	Exhibits and Reports on Form 8-K	77

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.


		i

Item 1.

MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(dollars in millions, except share data)


	August 31, 2004		November 30, 2003
	(unaudited)
Assets
Cash and cash equivalents	$	46,243	$	29,692
Cash and securities deposited with clearing organizations or segregated under federal and other regulations (including securities at fair value of $35,640 at August 31, 2004 and $18,957 at November 30, 2003)		45,595		28,526
Financial instruments owned (approximately $104 billion at August 31, 2004 and $73 billion at November 30, 2003 were pledged to various parties):
U.S. government and agency securities		56,040		24,133
Other sovereign government obligations		26,260		21,592
Corporate and other debt		77,048		80,594
Corporate equities		26,407		29,984
Derivative contracts		49,633		44,652
Physical commodities		932		671
Securities purchased under agreements to resell		92,816		78,205
Securities received as collateral		33,251		27,278
Securities borrowed		202,863		153,813
Receivables:
Consumer loans (net of allowances of $954 at August 31, 2004 and $1,002 at November 30, 2003)		18,738		19,382
Customers, net		40,081		37,321
Brokers, dealers and clearing organizations		6,649		5,563
Fees, interest and other		4,799		4,349
Office facilities, at cost (less accumulated depreciation of $2,791 at August 31, 2004 and $2,506 at November 30, 2003)		2,530		2,433
Aircraft under operating leases (less accumulated depreciation of $1,156 at August 31, 2004 and $1,041 at November 30, 2003)		4,028		4,407
Goodwill and intangible assets		2,191		1,523
Other assets		8,929		8,725

Total assets	$	745,033	$	602,843


		1

MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION—(Continued)

(dollars in millions, except share data)


	August 31, 2004			November 30, 2003
	(unaudited)
Liabilities and Shareholders’ Equity
Commercial paper and other short-term borrowings	$	30,417		$	28,386
Deposits		12,392			12,839
Financial instruments sold, not yet purchased:
U.S. government and agency securities		26,139			17,072
Other sovereign government obligations		21,891			17,505
Corporate and other debt		11,869			10,141
Corporate equities		30,651			25,615
Derivative contracts		39,425			36,242
Physical commodities		2,643			4,873
Securities sold under agreements to repurchase		195,739			147,618
Obligation to return securities received as collateral		33,251			27,278
Securities loaned		84,079			64,375
Payables:
Customers		119,438			96,794
Brokers, dealers and clearing organizations		6,748			5,706
Interest and dividends		3,091			2,138
Other liabilities and accrued expenses		13,771			12,918
Long-term borrowings		86,003			65,600

		717,547			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 August 31, 2004 and November 30, 2003; Shares issued: 1,211,701,552 at August 31, 2004 and 1,211,699,552 at November 30, 2003; Shares outstanding: 1,096,707,183 at August 31, 2004 and 1,084,696,446 at November 30, 2003		12			12
Paid-in capital		3,865			4,028
Retained earnings		30,500			28,038
Employee stock trust		2,839			3,008
Accumulated other comprehensive income (loss)		(140	)		(156	)

Subtotal		37,076			34,930
Note receivable related to ESOP		(3	)		(4	)
Common stock held in treasury, at cost, $0.01 par value;
114,994,369 shares at August 31, 2004 and 127,003,106 shares at November 30, 2003		(6,155	)		(6,766	)
Common stock issued to employee trust		(2,839	)		(2,420	)
Unearned stock-based compensation		(659	)		(873	)

Total shareholders’ equity		27,420			24,867

Total liabilities and shareholders’ equity	$	745,033		$	602,843

See Notes to Condensed Consolidated Financial Statements.


		2

MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

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


	Three Months Ended August 31,						Nine Months Ended August 31,
	2004			2003			2004			2003
	(unaudited)						(unaudited)
					(As Restated, See Note 19)
Revenues:
Investment banking	$	783		$	608		$	2,595		$	1,733
Principal transactions:
Trading		695			1,818			4,591			5,200
Investments		125			38			345			75
Commissions		768			775			2,546			2,157
Fees:
Asset management, distribution and administration		1,088			956			3,273			2,733
Merchant and cardmember		349			340			992			1,042
Servicing		459			462			1,516			1,532
Interest and dividends		5,410			3,821			12,855			11,059
Other		177			108			416			305

Total revenues		9,854			8,926			29,129			25,836
Interest expense		4,189			3,367			10,111			9,111
Provision for consumer loan losses		240			310			702			955

Net revenues		5,425			5,249			18,316			15,770

Non-interest expenses:
Compensation and benefits		2,347			2,287			7,982			6,763
Occupancy and equipment		228			191			634			582
Brokerage, clearing and exchange fees		231			212			692			605
Information processing and communications		326			315			964			945
Marketing and business development		279			197			796			711
Professional services		400			283			1,074			767
Other		332			236			1,176			1,143

Total non-interest expenses		4,143			3,721			13,318			11,516

Income from continuing operations before losses from unconsolidated investees, income taxes and dividends on preferred securities subject to mandatory redemption		1,282			1,528			4,998			4,254
Losses from unconsolidated investees		77			105			251			175
Provision for income taxes		343			342			1,392			1,175
Dividends on preferred securities subject to mandatory redemption		—			47			45			109

Income from continuing operations		862			1,034			3,310			2,795

Discontinued operations:
Loss/(gain) from discontinued operations (including loss on disposal of $42 million in fiscal 2004)		42			(2	)		40			36
Income tax (benefit)/provision		(17	)		1			(16	)		(14	)

Loss/(gain) on discontinued operations		25			(1	)		24			22

Net income	$	837		$	1,035		$	3,286		$	2,773

Basic earnings per common share:
Income from continuing operations	$	0.80		$	0.96		$	3.06		$	2.59
Loss from discontinued operations		(0.02	)		—			(0.02	)		(0.02	)

Basic earnings per common share	$	0.78		$	0.96		$	3.04		$	2.57

Diluted earnings per common share:
Income from continuing operations	$	0.78		$	0.94		$	2.99		$	2.54
Loss from discontinued operations		(0.02	)		—			(0.02	)		(0.02	)

Diluted earnings per common share	$	0.76		$	0.94		$	2.97		$	2.52

Average common shares outstanding:
Basic		1,081,448,663			1,077,680,996			1,081,160,252			1,077,140,296

Diluted		1,105,546,130			1,100,593,303			1,107,494,887			1,098,234,894

See Notes to Condensed Consolidated Financial Statements.


		3

MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in millions)


	Three Months Ended August 31,						Nine Months Ended August 31,
	2004			2003			2004			2003
	(unaudited)						(unaudited)
					(As Restated, See Note 19)
Net income	$	837		$	1,035		$	3,286		$	2,773
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustment		(6	)		(14	)		30			25
Net change in cash flow hedges		(52	)		46			(14	)		(13	)

Comprehensive income	$	779		$	1,067		$	3,302		$	2,785

See Notes to Condensed Consolidated Financial Statements.


		4

MORGAN STANLEY

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in millions)


	Nine Months Ended August 31,
	2004			2003
	(unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3,286		$	2,773
Loss on discontinued operations		24			22

Income from continuing operations		3,310			2,795
Adjustments to reconcile net income to net cash used for operating activities:
Non-cash charges (credits) included in net income:
Aircraft-related charges		107			288
Compensation payable in common stock and options		201			(49	)
Depreciation and amortization		463			558
Provision for consumer loan losses		702			955
Changes in assets and liabilities:
Cash and securities deposited with clearing organizations or segregated under federal and other regulations		(17,069	)		5,296
Financial instruments owned, net of financial instruments sold, not yet purchased		(16,624	)		11,995
Securities borrowed, net of securities loaned		(29,346	)		(17,701	)
Receivables and other assets		(4,036	)		(14,689	)
Payables and other liabilities		25,434			8,483

Net cash used for operating activities		(36,858	)		(2,069	)

CASH FLOWS FROM INVESTING ACTIVITIES
Net (payments for) proceeds from:
Office facilities and aircraft under operating leases		(293	)		(524	)
Purchase of Barra, Inc., net of cash acquired		(758	)		—
Net principal disbursed on consumer loans		(5,233	)		(6,361	)
Sales of consumer loans		5,175			9,972

Net cash (used for) provided by investing activities		(1,109	)		3,087

CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from (payments for):
Short-term borrowings		2,031			(22,007	)
Securities sold under agreements to repurchase, net of securities purchased under agreements to resell and certain derivatives financing activities		36,006			8,203
Deposits		(447	)		(445	)
Net proceeds from:
Issuance of common stock		240			172
Issuance of long-term borrowings		28,688			18,182
Issuance of Preferred securities subject to mandatory redemption		—			2,000
Payments for:
Repayments of long-term borrowings		(10,734	)		(10,566	)
Repurchases of common stock		(444	)		(350	)
Redemption of Preferred securities subject to mandatory redemption		—			(400	)
Cash dividends		(822	)		(747	)

Net cash provided by (used for) financing activities		54,518			(5,958	)

Net increase (decrease) in cash and cash equivalents		16,551			(4,940	)
Cash and cash equivalents, at beginning of period		29,692			29,212

Cash and cash equivalents, at end of period	$	46,243		$	24,272

See Notes to Condensed Consolidated Financial Statements.


		5

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 Network, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services business segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

Basis of Financial Information. The 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.

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/A for the fiscal


		6

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

year ended November 30, 2003 (the “Form 10-K/A”) as supplemented by the first and second quarter fiscal 2004 Quarterly Reports on Form 10-Q/A. 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.

Discontinued Operations. Revenues and expenses associated with certain aircraft designated as “held for sale” have been classified as discontinued operations for all periods presented in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” See Note 17 for additional discussion of discontinued operations.

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

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

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

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

LOGO

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 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 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 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.

LOGO

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 condensed consolidated statements of income was not material for all periods presented.

The Company also utilizes foreign exchange forward contracts to manage the currency exposure relating to its net monetary investments in non-U.S. dollar functional currency operations. The gain or loss from revaluing these contracts is deferred and reported within Accumulated other comprehensive income (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 and Intangible Assets.

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 condensed consolidated financial condition or results of operations.

Changes in the carrying amount of the goodwill for the nine month period ended August 31, 2004 were as follows:


	Institutional Securities		Individual Investor Group		Investment Management		Total
	(dollars in millions)
Balance as of November 30, 2003(1)	$	6	$	542	$	966	$	1,514
Translation adjustments		—		13		—		13
Goodwill acquired during the year		314		—		—		314

Balance as of August 31, 2004	$	320	$	555	$	966	$	1,841

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

Acquired intangible assets as of August 31, 2004 were as follow:


	Gross Carrying Amount		Accumulated Amortization
	(dollars in millions)
Amortizable intangible assets:
Trademarks	$	102	$	1
Technology-related		222		6
Customer relationships		26		1
Other		9		1

Total amortizable intangible assets	$	359	$	9

The estimated amortization expense is approximately $40 million per year over the next five fiscal years.

For additional information on goodwill and intangible assets acquired in connection with the acquisition of Barra, Inc., see Note 18.

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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 August 31, 2004		At November 30, 2003
	(dollars in millions)
Financial instruments owned:
U.S. government and agency securities	$	14,728	$	5,717
Other sovereign government obligations		148		164
Corporate and other debt		17,523		12,089
Corporate equities		5,475		3,477

Total	$	37,874	$	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 these agreements and transactions, the Company either receives or provides collateral, including U.S. government and agency securities, other sovereign government obligations, corporate and other debt, and corporate equities. The Company receives collateral in the form of securities in connection with reverse repurchase agreements, securities borrowed transactions and customer margin loans. In many cases, the Company is permitted to sell or repledge these securities held as collateral and use the securities to secure repurchase agreements, to enter into securities lending transactions or for delivery to counterparties to cover short positions. At August 31, 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 $653 billion and $511 billion, respectively, and the fair value of the portion that has been sold or repledged was $596 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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 $3.9 billion at August 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 quarter and nine month period ended August 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 quarter and nine month period ended August 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 results of operations.

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 August 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)	$	1,885		$	1,401		$	435
Weighted average life (in months)		33			75			83
Credit losses (rate per annum)		0.05-45.90	%		—			0.27-12.89	%
Impact on fair value of 10% adverse change	$	(59	)		—		$	(1	)
Impact on fair value of 20% adverse change	$	(115	)		—		$	(1	)
Weighted average discount rate (rate per annum)		9.21	%		6.27	%		6.13	%
Impact on fair value of 10% adverse change	$	(27	)	$	(35	)	$	(13	)
Impact on fair value of 20% adverse change	$	(52	)	$	(69	)	$	(25	)
Prepayment speed assumption(1)		270-1375	PSA		156-816	PSA		—
Impact on fair value of 10% adverse change	$	(27	)	$	(12	)		—
Impact on fair value of 20% adverse change	$	(27	)	$	(22	)		—

(1)	Commercial mortgage loans typically contain provisions that either prohibit or economically penalize the borrower from prepaying the loan for a specified period of time.

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 both the nine month periods ended August 31, 2004 and 2003, the Company received $55 billion of proceeds from new securitization transactions and cash flows from retained interests in securitization transactions of $4.2 billion and $3.6 billion, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

4. Consumer Loans.

Consumer loans were as follows:


	At August 31, 2004		At November 30, 2003
	(dollars in millions)
General purpose credit card, mortgage and consumer installment	$	19,692	$	20,384
Less:
Allowance for consumer loan losses		954		1,002

Consumer loans, net	$	18,738	$	19,382

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


	Three Months Ended August 31,						Nine Months Ended August 31,
	2004			2003			2004			2003
	(dollars in millions)
Balance at beginning of period	$	956		$	975		$	1,002		$	928
Additions:
Provision for consumer loan losses		240			310			702			955
Deductions:
Charge-offs		276			328			847			976
Recoveries		(34	)		(31	)		(97	)		(81	)

Net charge-offs		242			297			750			895

Balance at end of period	$	954		$	988		$	954		$	988

Interest accrued on general purpose credit card loans subsequently charged off, net of recoveries, recorded as a reduction of interest revenue, was $49 million and $172 million in the quarter and nine month period ended August 31, 2004 and $67 million and $202 million in the quarter and nine month period ended August 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 $30 million and $108 million in the quarter and nine month period ended August 31, 2004 and $43 million and $133 million in the quarter and nine month period ended August 31, 2003.

At August 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 $740 million and $5,175 million in the quarter and nine month period ended August 31, 2004 and $1,241 million and $9,972 million in the quarter and nine month period ended August 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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 August 31, 2004, the Company had $10.7 billion of retained interests, including $7.7 billion 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 nine month periods ended August 31, 2004 and 2003, the Company completed credit card asset securitizations of $1.9 billion and $5.7 billion, respectively, and recognized net securitization losses of $7 million and net securitization gains of $37 million, respectively, as servicing fees in the condensed consolidated statements of income. The uncollected balances of securitized general purpose credit card loans were $28.6 billion at August 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 nine month periods ended August 31, 2004 and August 31, 2003 were as follows:


	Nine Months Ended August 31,
	2004		2003
Weighted average life (in months)	6.1		5.6-7.1
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 August 31, 2004
Residual Interests (carrying amount/fair value)	$	250
Weighted average life (in months)		5.4
Weighted average payment rate (rate per month)		18.35	%
Impact on fair value of 10% adverse change	$	(16	)
Impact on fair value of 20% adverse change	$	(30	)
Weighted average credit losses (rate per annum)		6.44	%
Impact on fair value of 10% adverse change	$	(66	)
Impact on fair value of 20% adverse change	$	(131	)
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	$	(4	)

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The sensitivity analysis in the table above is hypothetical and should be used with caution. Changes in fair value based on a 10% or 20% variation in an assumption generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the Residual Interests is calculated independent of changes in any other assumption; in practice, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower payments and increased credit losses), which might magnify or counteract the sensitivities. In addition, the sensitivity analysis does not consider any corrective action that the Company may take to mitigate the impact of any adverse changes in the key assumptions.

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


	Nine Months Ended August 31,
	2004		2003
Proceeds from new credit card asset securitizations	$	1.9	$	5.7
Proceeds from collections reinvested in previous credit card asset securitizations	$	47.1	$	45.8
Contractual servicing fees received	$	0.5	$	0.5
Cash flows received from retained interests	$	1.3	$	1.3

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 August 31, 2004				Nine Months Ended August 31, 2004
	Loans Outstanding		Loans Delinquent		Average Loans		Net Principal Credit Losses
Managed general purpose credit card loans	$	47.1	$	2.3	$	47.5	$	2.2
Less: Securitized general purpose credit card loans		28.6

Owned general purpose credit card loans	$	18.5

5. Long-Term Borrowings.

Long-term borrowings at August 31, 2004 scheduled to mature within one year aggregated $12,252 million.

During the nine month period ended August 31, 2004, the Company issued senior notes aggregating $28,764 million, including non-U.S. dollar currency notes aggregating $4,599 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, $515 million; 2006, $173 million; 2007, $4,819 million; 2008, $2,388 million; and thereafter, $20,869 million. In the nine month period ended August 31, 2004, $10,734 million of senior notes were repaid.

The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.5 years at August 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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 nine month periods ended August 31, 2004 and August 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 and nine month period ended August 31, 2003, principal transaction trading revenues included $287 million and $44 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.

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 August 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 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 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 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/A.

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 $3,552 million at August 31, 2004, which exceeded the amount required by $2,817 million. MSDWI’s net capital totaled $1,203 million at August 31, 2004, which exceeded the amount required by $1,077 million. MSIL, a London-based broker-dealer subsidiary, is subject to

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the capital requirements of the Financial Services Authority, and MSJL, a Tokyo-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Agency. 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 August 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 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 (the “CSE 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 CSE Rule also would allow MS&Co., one of the Company’s U.S. broker-dealers, to use an alternative method, based on mathematical models, to calculate net capital charges for market and derivatives-related credit risk. Under the CSE Rule, the SEC will regulate the holding company and any unregulated affiliate of a registered broker-dealer, including subjecting the holding company to capital requirements generally consistent with the standards of the Basel Committee on Banking Supervision (“Basel II”). 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 CSE 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 may affect decisions with respect to raising and using capital.

Treasury Shares. During the nine month periods ended August 31, 2004 and 2003, the Company purchased approximately $444 million and $350 million of its common stock, respectively, under its publicly announced repurchase programs through open market purchases at an average cost of $51.26 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 August 31,						Nine Months Ended August 31,
	2004			2003			2004			2003
Basic EPS:
Income from continuing operations	$	862		$	1,034		$	3,310		$	2,795
Loss/(gain) on discontinued operations		25			(1	)		24			22

Net income applicable to common shareholders	$	837		$	1,035		$	3,286		$	2,773

Weighted average common shares outstanding		1,081			1,078			1,081			1,077

Basic earnings per common share:
Income from continuing operations	$	0.80		$	0.96		$	3.06		$	2.59
Loss from discontinued operations		(0.02	)		—			(0.02	)		(0.02	)

Basic EPS	$	0.78		$	0.96		$	3.04		$	2.57

Diluted EPS:
Income from continuing operations	$	862		$	1,034		$	3,310		$	2,795
Loss/(gain) on discontinued operations		25			(1	)		24			22

Net income applicable to common shareholders	$	837		$	1,035		$	3,286		$	2,773

Weighted average common shares outstanding		1,081			1,078			1,081			1,077
Effect of dilutive securities		25			23			26			21

Weighted average common shares outstanding and common stock equivalents		1,106			1,101			1,107			1,098

Diluted earnings per common share:
Income from continuing operations	$	0.78		$	0.94		$	2.99		$	2.54
Loss from discontinued operations		(0.02	)		—			(0.02	)		(0.02	)

Diluted EPS	$	0.76		$	0.94		$	2.97		$	2.52

The following securities were considered antidilutive and therefore were excluded from the computation of diluted EPS.


	Three Months Ended August 31,		Nine Months Ended August 31,
	2004	2003	2004	2003
	(in millions)
Number of antidilutive securities (including stock options and restricted stock units) outstanding at end of period	117	63	108	63

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

9. Commitments and Contingencies.

Letters of Credit. At August 31, 2004 and November 30, 2003, the Company had approximately $9.6 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 August 31, 2004 and November 30, 2003, the aggregate value of investment grade loans and positions was $0.8 billion and $1.0 billion, respectively, and the aggregate value of non-investment grade loans and positions was $1.0 billion and $0.7 billion, respectively. At August 31, 2004 and November 30, 2003, the Company’s aggregate investment grade lending commitments were $18.3 billion and $14.2 billion, respectively, and its aggregate non-investment grade lending commitments were $2.7 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 $9.5 billion at August 31, 2004 and $5.5 billion at November 30, 2003.

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 August 31, 2004, $194 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 August 31, 2004, the Company had commitments to enter into reverse repurchase and repurchase agreements of approximately $40 billion and $35 billion, respectively.

Legal. In addition to the matters described in the Company’s Annual Report on Form 10-K/A for the fiscal year ended November 30, 2003 and in the Company’s Quarterly Reports on Form 10-Q/A for fiscal 2004, 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. In some cases, the issuers that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.

The Company is also involved, from time to time, in other investigations and proceedings by governmental and self-regulatory agencies (both formal and informal) regarding the Company’s business, including, among other matters, accounting and operational matters, certain of which may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. The number of these investigations and proceedings has increased in recent years with regard to many firms in the financial services industry, including the Company.

The Company contests liability and/or the amount of damages in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

indeterminant damages or where investigations and proceedings are in the early stages, the Company cannot predict with certainty the loss or range of loss related to such matters, how such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, fine, penalty or other relief might be. Subject to the foregoing, the Company believes, based on current knowledge and after consultation with counsel, that the outcome of each such pending matter will not have a material adverse effect on the condensed consolidated financial condition of the Company, although the outcome could be material to the Company’s or a business segment’s operating results for a particular future period, depending on, among other things, the level of the Company’s or a business segment’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 Note 11 to the consolidated financial statements for the fiscal year ended November 30, 2003, included in the Form 10-K/A.

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 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 August 31, 2004 will not have a material effect on the Company’s financial condition.

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company’s derivatives (both listed and OTC) at August 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 August 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	$	30,354	$	20,124	$	27,280	$	18,950
Foreign exchange forward contracts and options		3,605		3,471		5,964		5,561
Equity securities contracts (including equity swaps, warrants and options)		5,364		7,543		4,503		5,781
Commodity forwards, options and swaps		10,310		8,287		6,905		5,950

Total	$	49,633	$	39,425	$	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 Notes 5 and 17).

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 Network, a network of merchant and cash access locations primarily in the U.S. Morgan Stanley-branded credit cards and personal loan products that are offered in the U.K. are also included in the Credit Services business segment. The Company provides its products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals.

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.

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 August 31, 2004	Institutional Securities		Individual Investor Group		Investment Management		Credit Services		Intersegment Eliminations			Total
	(dollars in millions)
Net revenues excluding net interest	$	1,949	$	1,065	$	691	$	563	$	(64	)	$	4,204
Net interest		827		59		1		334		—			1,221

Net revenues	$	2,776	$	1,124	$	692	$	897	$	(64	)	$	5,425

Income from continuing operations before losses from unconsolidated investees, income taxes and discontinued operations	$	682	$	22	$	217	$	330	$	31		$	1,282
Losses from unconsolidated investees		77		—		—		—		—			77

Income before taxes and discontinued operations(1)	$	605	$	22	$	217	$	330	$	31		$	1,205


Three Months Ended August 31, 2003(2)	Institutional Securities		Individual Investor Group		Investment Management			Credit Services		Intersegment Eliminations			Total
	(dollars in millions)
Net revenues excluding net interest	$	2,716	$	1,046	$	600		$	510	$	(77	)	$	4,795
Net interest		76		56		(2	)		324		—			454

Net revenues	$	2,792	$	1,102	$	598		$	834	$	(77	)	$	5,249

Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations	$	925	$	143	$	142		$	287	$	31		$	1,528
Losses from unconsolidated investees		105		—		—			—		—			105
Dividends on preferred securities subject to mandatory redemption		47		—		—			—		—			47

Income before taxes and discontinued operations(1)	$	773	$	143	$	142		$	287	$	31		$	1,376

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MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


Nine Months Ended August 31, 2004(2)	Institutional Securities		Individual Investor Group		Investment Management			Credit Services		Intersegment Eliminations			Total
	(dollars in millions)
Net revenues excluding net interest	$	8,575	$	3,365	$	2,023		$	1,822	$	(213	)	$	15,572
Net interest		1,652		179		1			912		—			2,744

Net revenues	$	10,227	$	3,544	$	2,024		$	2,734	$	(213	)	$	18,316

Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations	$	3,000	$	320	$	596		$	993	$	89		$	4,998
Losses from unconsolidated investees		251		—		—			—		—			251
Dividends on preferred securities subject to mandatory redemption		45		—		—			—		—			45

Income before taxes and discontinued operations(1)	$	2,704	$	320	$	596		$	993	$	89		$	4,702


Nine Months Ended August 31, 2003(2)	Institutional Securities		Individual Investor Group		Investment Management			Credit Services		Intersegment Eliminations			Total
	(dollars in millions)
Net revenues excluding net interest	$	7,792	$	2,929	$	1,686		$	1,639	$	(224	)	$	13,822
Net interest		816		160		(5	)		977		—			1,948

Net revenues	$	8,608	$	3,089	$	1,681		$	2,616	$	(224	)	$	15,770

Income from continuing operations before losses from unconsolidated investees, income taxes, dividends on preferred securities subject to mandatory redemption and discontinued operations	$	2,581	$	311	$	385		$	884	$	93		$	4,254
Losses from unconsolidated investees		175		—		—			—		—			175
Dividends on preferred securities subject to mandatory redemption		109		—		—			—		—			109

Income before taxes and discontinued operations(1)	$	2,297	$	311	$	385		$	884	$	93		$	3,970


Total Assets	Institutional Securities		Individual Investor Group		Investment Management		Credit Services		Intersegment Eliminations			Total
	(dollars in millions)
At August 31, 2004	$	699,954	$	17,051	$	4,287	$	23,945	$	(204	)	$	745,033