UNITED STATES 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 September 30, 2010
OR
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
Commission File Number 1-11758
(Exact Name of Registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation or organization)
New York, NY 10036
(Address of principal executiveoffices, including zip code)
(I.R.S. Employer Identification No.)
(Registrant’s telephone number,including area code)
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of October 31, 2010, there were 1,512,877,397 shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding.
QUARTERLY REPORT ON FORM 10-Q
For the quarter ended September 30, 2010
Part I—Financial Information
Item 1.
Financial Statements (unaudited)
Condensed Consolidated Statements of Financial Condition—September 30, 2010 and December 31, 2009
Condensed Consolidated Statements of Income—Three and Nine Months Ended September 30, 2010 and 2009
Condensed Consolidated Statements of Comprehensive Income—Three and Nine Months Ended September 30, 2010 and 2009
Condensed Consolidated Statements of Cash Flows—Nine Months Ended September 30, 2010 and 2009
Condensed Consolidated Statements of Changes in Total Equity—Nine Months Ended September 30, 2010 and 2009
Note 1. Introduction and Basis of Presentation
Note 2. Summary of Significant Accounting Policies
Note 3. Morgan Stanley Smith Barney Holdings LLC
Note 4. Fair Value Disclosures
Note 5. Securities Available for Sale
Note 6. Collateralized Transactions
Note 7. Variable Interest Entities and Securitization Activities
Note 8. Goodwill and Net Intangible Assets
Note 9. Long-Term Borrowings
Note 10. Derivative Instruments and Hedging Activities
Note 11. Commitments, Guarantees and Contingencies
Note 12. Regulatory Requirements
Note 13. Total Equity
Note 14. Earnings per Common Share
Note 15. Interest Income and Interest Expense
Note 16. Employee Benefit Plans
Note 17. Income Taxes
Note 18. Segment and Geographic Information
Note 19. Japan Securities Joint Venture
Note 20. Discontinued Operations
Note 21. Other Revenues
Note 22. Subsequent Events
Report of Independent Registered Public Accounting Firm
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
Executive Summary
Business Segments
Other Matters
Critical Accounting Policies
Liquidity and Capital Resources
Item 3.
Item 4.
Part II—Other Information
Item 1A.
Item 6.
AVAILABLE INFORMATION
Morgan Stanley 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 100 F Street, NE, Washington, DC 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 Morgan Stanley) file electronically with the SEC. Morgan Stanley’s electronic SEC filings are available to the public at the SEC’s internet site, www.sec.gov.
Morgan Stanley’s internet site is www.morganstanley.com. You can access Morgan Stanley’s Investor Relations webpage at www.morganstanley.com/about/ir. Morgan Stanley makes available free of charge, on or through its Investor Relations webpage, its proxy statements, 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. Morgan Stanley also makes available, through its Investor Relations webpage, via a link to the SEC’s internet site, statements of beneficial ownership of Morgan Stanley’s equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.
Morgan Stanley has a Corporate Governance webpage. You can access information about Morgan Stanley’s corporate governance atwww.morganstanley.com/about/company/governance. Morgan Stanley posts the following on its Corporate Governance webpage:
Amended and Restated Certificate of Incorporation;
Amended and Restated Bylaws;
Charters for its Audit Committee; Internal Audit Subcommittee; Compensation, Management Development and Succession Committee; Nominating and Governance Committee; and Risk Committee;
Corporate Governance Policies;
Policy Regarding Communication with the Board of Directors;
Policy Regarding Director Candidates Recommended by Shareholders;
Policy Regarding Corporate Political Contributions;
Policy Regarding Shareholder Rights Plan;
Code of Ethics and Business Conduct;
Code of Conduct; and
Integrity Hotline information.
Morgan Stanley’s Code of Ethics and Business Conduct applies to all directors, officers and employees, including its Chief Executive Officer, Chief Financial Officer and Finance Director and Controller. Morgan Stanley will post any amendments to the Code of Ethics and Business Conduct and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange LLC (“NYSE”) on its internet site. You can request a copy of these documents, excluding exhibits, at no cost, by contacting Investor Relations, 1585 Broadway, New York, NY 10036 (212-761-4000). The information on Morgan Stanley’s internet site is not incorporated by reference into this report.
Part I—Financial Information.
MORGAN STANLEY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in millions, except share data)
(unaudited)
Assets
Cash and due from banks ($245 at September 30, 2010 related to consolidated variable interest entities generally not available to the Company)
Interest bearing deposits with banks
Cash deposited with clearing organizations or segregated under federal and other regulations or requirements
Financial instruments owned, at fair value (approximately $147 billion and $101 billion were pledged to various parties at September 30, 2010 and December 31, 2009, respectively):
U.S. government and agency securities
Other sovereign government obligations
Corporate and other debt ($3,917 at September 30, 2010 related to consolidated variable interest entities, generally not available to the Company)
Corporate equities
Derivative and other contracts
Investments ($1,656 at September 30, 2010 related to consolidated variable interest entities, generally not available to the Company)
Physical commodities
Total financial instruments owned, at fair value
Securities available for sale
Securities received as collateral, at fair value
Federal funds sold and securities purchased under agreements to resell
Securities borrowed
Receivables:
Customers
Brokers, dealers and clearing organizations
Fees, interest and other
Loans
Other investments
Premises, equipment and software costs (net of accumulated depreciation of $4,322 and $3,734 at September 30, 2010 and December 31, 2009, respectively) ($485 at September 30, 2010 related to consolidated variable entities, generally not available to the Company)
Goodwill
Intangible assets (net of accumulated amortization of $542 and $275 at September 30, 2010 and December 31, 2009, respectively) (includes $139 and $137 at fair value at September 30, 2010 and December 31, 2009, respectively)
Other assets
Total assets
See Notes to Condensed Consolidated Financial Statements.
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION—(CONTINUED)
Liabilities and Equity
Commercial paper and other short-term borrowings (includes $2,220 and $791 at fair value at September 30, 2010 and December 31, 2009, respectively)
Deposits (includes $4,214 and $4,967 at fair value at September 30, 2010 and December 31, 2009, respectively)
Financial instruments sold, not yet purchased, at fair value:
Corporate and other debt
Total financial instruments sold, not yet purchased, at fair value
Obligation to return securities received as collateral, at fair value
Securities sold under agreements to repurchase (includes $266 at fair value at September 30, 2010)
Securities loaned
Other secured financings (includes $8,481 and $8,102 at fair value at September 30, 2010 and December 31, 2009, respectively) ($2,970 at September 30, 2010 related to consolidated variable interest entities and are non-recourse to the Company)
Payables:
Interest and dividends
Other liabilities and accrued expenses
Long-term borrowings (includes $40,809 and $37,610 at fair value at September 30, 2010 and December 31, 2009, respectively)
Commitments and contingencies
Equity
Morgan Stanley shareholders’ equity:
Preferred stock
Common stock, $0.01 par value;
Shares authorized: 3,500,000,000 at September 30, 2010 and December 31, 2009;
Shares issued: 1,603,913,074 at September 30, 2010 and 1,487,850,163 at December 31, 2009;
Shares outstanding: 1,512,989,777 at September 30, 2010 and 1,360,595,214 at December 31, 2009
Paid-in capital
Retained earnings
Employee stock trust
Accumulated other comprehensive loss
Common stock held in treasury, at cost, $0.01 par value; 90,923,297 shares at September 30, 2010 and 127,254,949 shares at December 31, 2009
Common stock issued to employee trust
Total Morgan Stanley shareholders’ equity
Noncontrolling interests
Total equity
Total liabilities and equity
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(dollars in millions, except share and per share data)
Revenues:
Investment banking
Principal transactions:
Trading
Investments
Commissions
Asset management, distribution and administration fees
Other
Total non-interest revenues
Interest income
Interest expense
Net interest
Net revenues
Non-interest expenses:
Compensation and benefits
Occupancy and equipment
Brokerage, clearing and exchange fees
Information processing and communications
Marketing and business development
Professional services
Total non-interest expenses
Income from continuing operations before income taxes
Provision for (benefit from) income taxes
Income from continuing operations
Discontinued operations:
Gain (loss) from discontinued operations
Net gain (loss) from discontinued operations
Net income
Net income (loss) applicable to noncontrolling interests
Net income applicable to Morgan Stanley
Earnings (loss) applicable to Morgan Stanley common shareholders
Amounts applicable to Morgan Stanley:
Earnings (loss) per basic common share:
Income (loss) from continuing operations
Earnings (loss) per basic common share
Earnings (loss) per diluted common share:
Earnings (loss) per diluted common share
Average common shares outstanding:
Basic
Diluted
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(dollars in millions)
Other comprehensive income, net of tax:
Foreign currency translation adjustments(1)
Amortization of cash flow hedges(2)
Net unrealized gain on securities available for sale (3)
Pension and postretirement related adjustments(4)
Comprehensive income
Other comprehensive income applicable to noncontrolling interests
Comprehensive income applicable to Morgan Stanley
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net income to net cash provided by (used for) operating activities:
Compensation payable in common stock and options
Depreciation and amortization
Gain on business dispositions
Gain on repurchase of long-term debt
Insurance reimbursement
Loss on assets held for sale
Impairment charges and other-than-temporary impairment charges
Changes in assets and liabilities:
Financial instruments owned, net of financial instruments sold, not yet purchased
Receivables, loans and other assets
Payables and other liabilities
Securities sold under agreements to repurchase
Net cash provided by (used for) operating activities
CASH FLOWS FROM INVESTING ACTIVITIES
Net (payments for) proceeds from:
Premises, equipment and software costs
Business acquisitions, net of cash acquired
Business dispositions, net of cash disposed
MUFG transaction
Purchases of securities available for sale
Redemption of securities available for sale
Net cash used for investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from (payments for):
Short-term borrowings
Dividends received from Noncontrolling interests
Derivatives financing activities
Other secured financings
Deposits
Excess tax benefits associated with stock-based awards
Net proceeds from:
Morgan Stanley public offerings of common stock
Issuance of common stock
Issuance of long-term borrowings
Payments for:
Long-term borrowings
Series D Preferred Stock and warrant
Redemption of junior subordinated debentures related to CIC
Repurchases of common stock for employee tax withholding
Cash dividends
Net cash (used for) provided by financing activities
Effect of exchange rate changes on cash and cash equivalents
Cash and cash equivalents related to variable interest entities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, at beginning of period
Cash and cash equivalents, at end of period
Cash and cash equivalents include:
Cash and due from banks
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash payments for interest were $4,066 million and $5,679 million for the nine months ended September 30, 2010 and 2009, respectively.
Cash payments for income taxes were $378 million and $785 million for the nine months ended September 30, 2010 and 2009, respectively.
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN TOTAL EQUITY
Nine Months Ended September 30, 2010
BALANCE AT DECEMBER 31, 2009
Dividends
Shares issued under employee plans and related tax effects
Repurchases of common stock
Net change in cash flow hedges
Pension and postretirement adjustments
Foreign currency translation adjustments
Gain on MUFG transaction
Change in net unrealized gains on securities available for sale
Redemption of CIC equity units and issuance of common stock
Increases in noncontrolling interest related to MUFG transaction
Increases in noncontrolling interest for issuances of shares by a subsidiary of the Company
Increases in noncontrolling interest for the sale of a subsidiary’s shares by the Company
Increase in noncontrolling interests related to the consolidation of certain real estate partnerships sponsored by the Company
Decrease in noncontrolling interests related to dividends of noncontrolling interests
Other increases in noncontrolling interests
BALANCE AT SEPTEMBER 30, 2010
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN TOTAL EQUITY—(Continued)
Nine Months Ended September 30, 2009
BALANCE AT DECEMBER 31, 2008
Net income (loss)
Preferred stock extinguished and exchanged for common stock
Series D preferred stock and warrant
Gain on MSSB transaction
Increases in noncontrolling interests related to MSSB transaction
Increases in noncontrolling interests related to the consolidation of two real estate funds sponsored by the
Company
Decreases in noncontrolling interests related to disposition of a subsidiary
BALANCE AT SEPTEMBER 30, 2009
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The Company. Morgan Stanley, a financial holding company, is a global financial services firm that maintains significant market positions in each of its business segments—Institutional Securities, Global Wealth Management Group and Asset Management. Unless the context otherwise requires, the terms “Morgan Stanley” and the “Company” mean Morgan Stanley and its consolidated subsidiaries.
A summary of the activities of each of the Company’s business segments is as follows:
Institutional Securities includes capital raising; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; corporate lending; sales, trading, financing and market-making activities in equity and fixed income securities and related products, including foreign exchange and commodities; and investment activities.
Global Wealth Management Group, which includes the Company’s 51% interest in Morgan Stanley Smith Barney Holdings LLC (“MSSB”) (see Note 3), provides brokerage and investment advisory services to individual investors and small-to-medium sized businesses and institutions covering various investment alternatives; financial and wealth planning services; annuity and other insurance products; credit and other lending products; cash management services; retirement services; and trust and fiduciary services.
Asset Management provides global asset management products and services in equity, fixed income, alternative investments, which includes hedge funds and funds of funds, and merchant banking, which includes real estate, private equity and infrastructure, to institutional and retail clients through proprietary and third-party distribution channels (see “Discontinued Operations—Retail Asset Management Business” herein). Asset Management also engages in investment activities.
Discontinued Operations.
Retail Asset Management Business. On June 1, 2010, the Company completed the sale of substantially all of its retail asset management business (“Retail Asset Management”), including Van Kampen Investments, Inc., to Invesco Ltd. (“Invesco”). The Company received $800 million in cash and approximately 30.9 million shares of Invesco stock upon sale, resulting in a cumulative after-tax gain of $673 million, of which $514 million was recorded in the quarter ended June 30, 2010. The remaining gain of $159 million, representing tax basis benefits, was recorded primarily in the quarter ended December 31, 2009. The results of Retail Asset Management are reported as discontinued operations within the Asset Management business segment for all periods presented through the date of sale.
The Company recorded the 30.9 million shares as securities available for sale (see Note 5 for further information).
Revel Entertainment Group, LLC. On March 31, 2010, the Board of Directors authorized a plan of disposal by sale for Revel Entertainment Group, LLC (“Revel”), a development stage enterprise and subsidiary of the Company that is primarily associated with a development property in Atlantic City, New Jersey. Total assets of Revel included in the Company’s condensed consolidated statement of financial condition at September 30, 2010 approximated $40 million, which represented its fair value, net of estimated costs to sell. The results of Revel are reported as discontinued operations for all periods presented within the Institutional Securities business segment. The quarter and nine months ended September 30, 2010 includes losses of approximately $229 million and approximately $1.2 billion, respectively, in connection with write-downs and related costs of such planned disposition.
CityMortgage Bank. In the third quarter of 2010, the Company completed the disposal of CityMortgage Bank (“CMB”), a Moscow-based mortgage bank. The results of CMB are reported as discontinued operations for all periods presented within the Institutional Securities business segment.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Other. In the third quarter of 2010, the Company completed a disposal of a real estate property within the Asset Management business segment. The results of operations are reported as discontinued operations for all periods presented.
MSCI Inc. In May 2009, the Company divested all of its remaining ownership interest in MSCI Inc. (“MSCI”). The results of MSCI are reported as discontinued operations through the date of sale within the Institutional Securities business segment.
Crescent. Discontinued operations for the three and nine months ended September 30, 2009 included operating results related to Crescent Real Estate Equities Limited Partnership (“Crescent”), a former real estate subsidiary of the Company. The Company completed the disposition of Crescent in the fourth quarter of 2009, whereby the Company transferred its ownership interest in Crescent to Crescent’s primary creditor in exchange for full release of liability on the related loans. The results of Crescent are reported as discontinued operations within the Asset Management business segment.
Discover. On June 30, 2007, the Company completed the spin-off of its business segment Discover Financial Services (“DFS”) to its shareholders. On February 11, 2010, DFS paid the Company $775 million in complete satisfaction of its obligations to the Company regarding the sharing of proceeds from the lawsuit against Visa and MasterCard. The payment was recorded as a gain in discontinued operations for the nine months ended September 30, 2010.
See Note 20 for additional information on discontinued operations.
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, the valuation of goodwill, compensation, the outcome of litigation and tax matters and other matters that affect the condensed consolidated financial statements and related disclosures. The Company believes that the estimates utilized in the preparation of the condensed consolidated financial statements are prudent and reasonable. Actual results could differ materially from these estimates.
Certain reclassifications have been made to prior period amounts to conform to the current period’s presentation.
Material intercompany balances and transactions have been eliminated.
The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 (the “Form 10-K”). The condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for the fair presentation of the results for the interim period. The results of operations for interim periods are not necessarily indicative of results for the entire year.
Consolidation. 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, including certain variable interest entities (“VIEs”) (see Note 7). The Company adopted accounting guidance for noncontrolling interests on January 1, 2009. Accordingly, for consolidated subsidiaries that are less than wholly owned, the third-party holdings of equity interests are referred to as noncontrolling interests. The portion of net income attributable to noncontrolling interests for such subsidiaries is presented as Net income (loss) applicable to noncontrolling interests on the condensed consolidated statements of income, and the portion of the
shareholders’ equity of such subsidiaries is presented as Noncontrolling interests in the condensed consolidated statements of financial condition and condensed consolidated statements of changes in total equity.
For entities where (1) the total equity investment at risk is sufficient to enable the entity to finance its activities without additional support and (2) the equity holders bear the economic residual risks and returns of the entity and have the power to direct the activities of the entity that most significantly affect its economic performance, the Company consolidates those entities it controls either through a majority voting interest or otherwise. For entities that do not meet these criteria, commonly known as VIEs, the Company consolidates those entities where the Company has the power to make the decisions that most significantly affect the economic performance of the VIE and has the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE, except for certain VIEs that are money market funds, investment companies or are entities qualifying for accounting purposes as investment companies. Generally, the Company consolidates those entities when it absorbs a majority of the expected losses or a majority of the expected residual returns, or both, of the entities.
Notwithstanding the above, under accounting guidance prior to January 1, 2010, certain securitization vehicles, commonly known as qualifying special purpose entities (“QSPEs”), were not consolidated by the Company if they met certain criteria regarding the types of assets and derivatives they could hold and the range of discretion they could exercise in connection with the assets they held. These entities are now subject to the consolidation requirements for VIEs.
For investments in entities in which the Company does not have a controlling financial interest but has significant influence over operating and financial decisions, the Company generally applies the equity method of accounting with net gains and losses recorded within Other revenues. Where the Company has elected to measure certain eligible investments at fair value in accordance with the fair value option, net gains and losses are recorded within Principal transactions—Investments (see Note 4).
Equity and partnership interests held by entities qualifying for accounting purposes as investment companies are carried at fair value.
The Company’s significant regulated U.S. and international subsidiaries include Morgan Stanley & Co. Incorporated (“MS&Co.”), Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. International plc (“MSIP”), Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”), Morgan Stanley Bank, N.A. and Morgan Stanley Investment Advisors Inc.
Income Statement Presentation. The Company, through its subsidiaries and affiliates, provides a wide variety of products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. In connection with the delivery of the various products and services to clients, the Company manages its revenues and related expenses in the aggregate. As such, when assessing the performance of its businesses, the Company considers its principal trading, investment banking, commissions, and interest income, along with the associated interest expense, as one integrated activity for each of the Company’s separate businesses.
Effective January 1, 2010, the Company reclassified dividend income associated with trading and investing activities to Principal transactions—Trading or Principal transactions—Investments depending upon the business activity. Previously, these amounts were included in Interest and dividends on the condensed consolidated statements of income. These reclassifications were made in connection with the Company’s conversion to a financial holding company. Prior periods have been adjusted to conform to the current presentation.
Revenue Recognition.
Investment Banking. Underwriting revenues and advisory fees from mergers, acquisitions and restructuring transactions are recorded when services for the transactions are determined to be substantially completed, generally as set forth under the terms of the engagement. Transaction-related expenses, primarily consisting of legal, travel and other costs directly associated with the transaction, are deferred and recognized in the same period as the related investment banking transaction revenue. Underwriting revenues are presented net of related expenses. Non-reimbursed expenses associated with advisory transactions are recorded within Non-interest expenses.
Commissions. The Company generates commissions from executing and clearing customer transactions on stock, options and futures markets. Commission revenues are recognized in the accounts on trade date.
Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees are recognized over the relevant contract period. Sales commissions paid by the Company in connection with the sale of certain classes of shares of its open-end mutual fund products are accounted for as deferred commission assets. The Company periodically tests the deferred commission assets for recoverability based on cash flows expected to be received in future periods. In certain management fee arrangements, the Company is entitled to receive performance-based fees (also referred to as incentive fees) when the return on assets under management exceeds certain benchmark returns or other performance targets. In such arrangements, performance fee revenue is accrued (or reversed) quarterly based on measuring account/fund performance to date versus the performance benchmark stated in the investment management agreement. Performance-based fees are recorded within Principal transactions—investments or Asset management, distribution and administration fees depending on the nature of the arrangement. The amount of performance-based fee revenue at risk of reversing if fund performance falls below stated investment management agreement benchmarks was approximately $172 million at September 30, 2010 and approximately $122 million at December 31, 2009.
Principal Transactions. See “Financial Instruments and Fair Value” below for principal transactions revenue recognition discussions.
Financial Instruments and Fair Value.
A significant portion of the Company’s financial instruments is carried at fair value with changes in fair value recognized in earnings each period. A description of the Company’s policies regarding fair value measurement and its application to these financial instruments follows.
Financial Instruments Measured at Fair Value. All of the instruments within Financial instruments owned and Financial instruments sold, not yet purchased, are measured at fair value, either through the fair value option election (discussed below) or as required by other accounting guidance. These financial instruments primarily represent the Company’s trading and investment activities and include both cash and derivative products. In addition, certain debt and equity securities classified as Securities available for sale are measured at fair value in accordance with accounting guidance for certain investments in debt and equity securities. Furthermore, Securities received as collateral and Obligation to return securities received as collateral are measured at fair value as required by other accounting guidance. Additionally, certain Commercial paper and other short-term borrowings (primarily structured notes), certain Deposits, Other secured financings, certain Securities sold under agreements to repurchase and certain Long-term borrowings (primarily structured notes and certain junior subordinated debentures) are measured at fair value through the fair value option election.
Gains and losses on all of these instruments carried at fair value are reflected in Principal transactions—Trading revenues, Principal transactions—Investment revenues or Investment banking revenues in the condensed consolidated statements of income, except for Securities available for sale (see “Securities Available for Sale” section herein and Note 5) and derivatives accounted for as hedges (see “Hedge Accounting” section herein and Note 10). Interest income and expense are recorded within the condensed consolidated statements of income depending on the nature of the instrument and related market conventions. When interest is included as a component of the instruments’ fair value, interest is included within Principal transactions—Trading revenues or Principal transactions—Investment revenues. Otherwise, it is included within Interest income or Interest expense. Dividend income is recorded in Principal transactions—Trading or Principal transactions—Investment revenues depending on the business activity. The fair value of over-the-counter (“OTC”) financial instruments, including derivative contracts related to financial instruments and commodities, is presented in the accompanying condensed consolidated statements of financial condition on a net-by-counterparty basis, when appropriate. Additionally, the Company nets fair value of cash collateral paid or received against fair value amounts recognized for net derivative positions executed with the same counterparty under the same master netting arrangement.
Fair Value Option. The fair value option permits the irrevocable fair value option election on an instrument-by-instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument. The Company applies the fair value option for eligible instruments, including certain loans and lending commitments, certain equity method investments, certain securities sold under agreements to repurchase, certain structured notes, certain junior subordinated debentures, certain time deposits and certain other secured financings.
Fair Value Measurement—Definition and Hierarchy. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.
In determining fair value, the Company uses various valuation approaches and establishes a hierarchy for inputs used in measuring fair value that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s assumptions about the assumptions other market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the observability of inputs as follows:
Level 1—Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not applied to Level 1 instruments. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
Level 2—Valuations based on one or more quoted prices in markets that are not active or for which all significant inputs are observable, either directly or indirectly.
Level 3—Valuations based on inputs that are unobservable and significant to the overall fair value measurement.
The availability of observable inputs can vary from product to product and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new and not yet established in the marketplace, the liquidity of markets and other characteristics particular to the transaction. To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination
of fair value requires more judgment. Accordingly, the degree of judgment exercised by the Company in determining fair value is greatest for instruments categorized in Level 3.
The Company considers prices and inputs that are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3 (see Note 4). In addition, a downturn in market conditions could lead to further declines in the valuation of many instruments.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement falls in its entirety is determined based on the lowest level input that is significant to the fair value measurement in its entirety.
Valuation Techniques. Many cash and OTC derivative contracts have bid and ask prices that can be observed in the marketplace. Bid prices reflect the highest price that a party is willing to pay for an asset. Ask prices represent the lowest price that a party is willing to accept for an asset. For financial instruments whose inputs are based on bid-ask prices, the Company does not require that the fair value estimate always be a predetermined point in the bid-ask range. The Company’s policy is to allow for mid-market pricing and adjusting to the point within the bid-ask range that meets the Company’s best estimate of fair value. For offsetting positions in the same financial instrument, the same price within the bid-ask spread is used to measure both the long and short positions.
Fair value for many cash and OTC derivative contracts is derived using pricing models. Pricing models take into account the contract terms (including maturity) as well as multiple inputs, including, where applicable, commodity prices, equity prices, interest rate yield curves, credit curves, correlation, creditworthiness of the counterparty, option volatility and currency rates. Where appropriate, valuation adjustments are made to account for various factors such as liquidity risk (bid-ask adjustments), credit quality and model uncertainty. Adjustments for liquidity risk adjust model derived mid-market levels of Level 2 and Level 3 financial instruments for the bid-mid or mid-ask spread required to properly reflect the exit price of a risk position. Bid-mid and mid-ask spreads are marked to levels observed in trade activity, broker quotes or other external third-party data. Where these spreads are unobservable for the particular position in question, spreads are derived from observable levels of similar positions. The Company applies credit-related valuation adjustments to its short-term and long-term borrowings (including structured notes and junior subordinated debentures) for which the fair value option was elected and to OTC derivatives. The Company considers the impact of changes in its own credit spreads based upon observations of the Company’s secondary bond market spreads when measuring fair value for short-term and long-term borrowings. For OTC derivatives, the impact of changes in both the Company’s and the counterparty’s credit standing is considered when measuring fair value. In determining the expected exposure, the Company simulates the distribution of the future exposure to a counterparty, then applies market-based default probabilities to the future exposure, leveraging external third-party credit default swap (“CDS”) spread data. Where CDS spread data is unavailable for a specific counterparty, bond market spreads, CDS spread data based on the counterparty’s credit rating or CDS spread data that references a comparable counterparty may be utilized. The Company also considers collateral held and legally enforceable master netting agreements that mitigate the Company’s exposure to each counterparty. Adjustments for model uncertainty are taken for positions whose underlying models are reliant on significant inputs that are neither directly nor indirectly observable, hence requiring reliance on established theoretical concepts in their derivation. These adjustments are derived by making assessments of the possible degree of variability using statistical approaches and market-based information where possible. The Company generally subjects all valuations and models to a review process initially and on a periodic basis thereafter.
Fair value is a market-based measure considered from the perspective of a market participant rather than an entity-specific measure. Therefore, even when market assumptions are not readily available, the Company’s own assumptions are set to reflect those that the Company believes market participants would use in pricing the asset or liability at the measurement date.
See Note 4 for a description of valuation techniques applied to the major categories of financial instruments measured at fair value.
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis. Certain of the Company’s assets are measured at fair value on a non-recurring basis. The Company incurs losses or gains for any adjustments of these assets to fair value. A downturn in market conditions could result in impairment charges in future periods.
For assets and liabilities measured at fair value on a non-recurring basis, fair value is determined by using various valuation approaches. The same hierarchy as described above, which maximizes the use of observable inputs and minimizes the use of unobservable inputs by generally requiring that the observable inputs be used when available, is used in measuring fair value for these items.
For further information on financial assets and liabilities that are measured at fair value on a recurring and non-recurring basis, see Note 4.
Hedge Accounting.
The Company applies hedge accounting using various derivative financial instruments and non-U.S. dollar-denominated debt to hedge interest rate and foreign exchange risk arising from assets and liabilities not held at fair value as part of asset/liability and currency management. These derivative financial instruments are included within Financial instruments owned—Derivative and other contracts or Financial instruments sold, not yet purchased—Derivative and other contracts in the condensed consolidated statements of financial condition.
The Company’s hedges are designated and qualify for accounting purposes as one of the following types of hedges: hedges of changes in fair value of assets and liabilities due to the risk being hedged (fair value hedges), and hedges of net investments in foreign operations whose functional currency is different from the reporting currency of the parent company (net investment hedges).
For further information on derivative instruments and hedging activities, see Note 10.
Condensed Consolidated Statements of Cash Flows.
For purposes of the condensed consolidated statements of cash flows, cash and cash equivalents consist of Cash and due from banks and Interest bearing deposits with banks, which are highly liquid investments with original maturities of three months or less and readily convertible to known amounts of cash. The Company’s significant non-cash activities include assets acquired of approximately $0.4 billion and assumed liabilities of approximately $0.1 billion in connection with a business acquisition and approximately $0.6 billion of equity securities received in connection with the sale of Retail Asset Management in the nine months ended September 30, 2010. The Company’s significant non-cash activities include assets acquired of $11.0 billion and assumed liabilities of $3.2 billion, in connection with business acquisitions in the nine months ended September 30, 2009. During the nine months ended September 30, 2009, the Company consolidated two real estate funds sponsored by the Company with assets of $600 million, liabilities of $18 million and Noncontrolling interests of $582 million.
Repurchase and Securities Lending Transactions.
Securities borrowed or purchased under agreements to resell and securities loaned or sold under agreements to repurchase are treated as collateralized financings. Securities purchased under agreements to resell (“reverse repurchase agreements”) and Securities sold under agreements to repurchase (“repurchase agreements”) are carried on the condensed consolidated statements of financial condition at the amounts at which the securities will be subsequently sold or repurchased, plus accrued interest, except for certain repurchase agreements for which the Company has elected the fair value option (See Note 4). Where appropriate, transactions with the same counterparty are reported on a net basis. Securities borrowed and securities loaned are recorded at the amount of cash collateral advanced or received.
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 and other types of financial assets (see Note 7). Such transfers of financial assets are generally accounted for as sales when the Company has relinquished control over the transferred assets and does not consolidate the transferee. The gain or loss on sale of such financial assets depends, in part, on the previous carrying amount of the assets involved in the transfer (generally at fair value) and the sum of the proceeds and the fair value of the retained interests at the date of sale. Transfers that are not accounted for as sales are treated as secured financings (“failed sales”).
Earnings per Common Share.
Basic earnings per common share (“EPS”) is computed by dividing income available to Morgan Stanley common shareholders by the weighted average number of common shares outstanding for the period. Income available to Morgan Stanley common shareholders represents net income applicable to Morgan Stanley reduced by preferred stock dividends and allocations of earnings to participating securities. Common shares outstanding include common stock and vested restricted stock unit awards where recipients have satisfied either the explicit vesting terms or retirement eligibility requirements. Diluted EPS reflects the assumed conversion of all dilutive securities.
Effective October 13, 2008, as a result of an adjustment to Equity Units sold to a wholly owned subsidiary of China Investment Corporation Ltd. (“CIC”), the Company began calculating EPS in accordance with the accounting guidance for determining EPS for participating securities. The accounting guidance for participating securities and the two-class method of calculating EPS addresses the computation of EPS by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company along with common shareholders according to a predetermined formula. The two-class method requires the Company to present EPS as if all of the earnings for the period are distributed to Morgan Stanley common shareholders and any participating securities, regardless of whether any actual dividends or distributions are made. The amount allocated to the participating securities is based upon the contractual terms of their respective contract and is reflected as a reduction to “Net income applicable to Morgan Stanley common shareholders” for the Company’s basic and diluted EPS calculations (see Note 14). The two-class method does not impact the Company’s actual net income applicable to Morgan Stanley or other financial results. Unless contractually required by the terms of the participating securities, no losses are allocated to participating securities for purposes of the EPS calculation under the two-class method.
In December 2007, the Company sold Equity Units that included contracts to purchase Company common stock to a wholly owned subsidiary of CIC (the “CIC Entity”) for approximately $5,579 million. On July 1, 2010, Moody’s Investor Services announced that it was lowering the equity credit assigned to such Equity Units. The
terms of the Equity Units permitted the Company to redeem the junior subordinated debentures underlying the Equity Units upon the occurrence and continuation of such a change in equity credit (a “Rating Agency Event”). In response to this Rating Agency Event, the Company redeemed the junior subordinated debentures in August 2010 and the redemption proceeds were subsequently used by the CIC Entity to settle its obligation under the purchase contracts. The settlement of the purchase contracts and delivery of 116,062,911 shares of Company common stock to the CIC Entity occurred in August 2010.
Under current accounting guidance, unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method described above. Share-based payment awards that pay dividend equivalents subject to vesting are not deemed participating securities and are included in diluted shares outstanding (if dilutive) under the treasury stock method.
Goodwill and Intangible Assets.
Goodwill and indefinite-lived intangible assets are not amortized and are reviewed annually (or more frequently when certain events or circumstances exist) for impairment. Other intangible assets are amortized over their estimated useful lives and reviewed for impairment.
Deferred Compensation Arrangements.
Deferred Compensation Plans. The Company maintains various deferred compensation plans for the benefit of certain employees that provide a return to the participating employees based upon the performance of various referenced investments. The Company often invests directly, as a principal, in such referenced investments related to its obligations to perform under the deferred compensation plans. Changes in value of such investments made by the Company are recorded primarily in Principal transactions—Investments. Expenses associated with the related deferred compensation plans are recorded in Compensation and benefits.
Employee Loans.
At September 30, 2010 and December 31, 2009, the Company had $5.9 billion and $3.5 billion, respectively, of loans outstanding primarily to certain MSSB employees that are included in Receivables—Fees, interest and other on the condensed consolidated statements of financial condition. These loans are full-recourse, require periodic payments and have repayment terms ranging from 4 to 12 years.
Securities Available for Sale (“AFS”).
During the quarter ended March 31, 2010, the Company established a portfolio of debt securities that are classified as securities available for sale. During the quarter ended June 30, 2010, the Company classified certain marketable equity securities received in connection with the Company’s sale of Retail Asset Management as AFS securities (see Note 1). AFS securities are reported at fair value in the condensed consolidated statement of financial condition with unrealized gains and losses reported in Accumulated other comprehensive income (loss), net of tax. Interest and dividend income, including amortization of premiums and accretion of discounts, is included in Interest income in the condensed consolidated statement of income. Realized gains and losses on AFS securities are reported in earnings (see Note 5). The Company utilizes the “first-in, first-out” method as the basis for determining the cost of AFS securities.
Other-than-temporary impairment. AFS securities in unrealized loss positions resulting from the current fair value of a security being less than amortized cost, are analyzed as part of the Company’s ongoing assessment of other-than-temporary impairment (“OTTI”).
For AFS debt securities, the Company incurs a loss in the condensed consolidated statement of income for the OTTI if the Company has the intent to sell the security or it is more likely than not the Company will be required to sell the security before recovery of its amortized cost basis as of the reporting date. For those debt securities the Company does not expect to sell or expect to be required to sell, the Company must evaluate whether it expects to recover the entire amortized cost basis of the debt security. In the event of a credit loss, only the amount of impairment associated with the credit loss is recognized in income. Unrealized losses relating to factors other than credit are recorded in Accumulated other comprehensive income (loss), net of tax.
For AFS equity securities, the Company considers various factors including the intent and ability to hold the equity security for a period of time sufficient for recovery to amortized cost in evaluating whether an OTTI exists. When the Company lacks that intent and ability, the equity security is considered other-than-temporarily impaired and the security will be written down to fair value, with the full difference between fair value and amortized cost recognized in earnings.
Accounting Developments.
Transfers of Financial Assets and Extinguishments of Liabilities and Consolidation of Variable Interest Entities. In June 2009, the Financial Accounting Standards Board (the “FASB”) issued accounting guidance, which changed the way entities account for securitizations and special-purpose entities. The accounting guidance amended the accounting for transfers of financial assets and requires additional disclosures about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. It eliminated the concept of a QSPE and changed the requirements for derecognizing financial assets.
The accounting guidance also amended the accounting for consolidation and changed how a reporting entity determines when a VIE that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate a VIE is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. In February 2010, the FASB finalized a deferral of these accounting changes, effective January 1, 2010, for certain interests in money market funds, investment companies or in entities qualifying for accounting purposes as investment companies (the “Deferral”). The Company will continue to analyze consolidation under other existing authoritative guidance for entities subject to the Deferral. The adoption of the accounting guidance on January 1, 2010 did not have a material impact on the Company’s condensed consolidated statement of financial condition.
Scope Exception Related to Embedded Credit Derivatives. In March 2010, the FASB issued accounting guidance that changes the accounting for credit derivatives embedded in beneficial interests in securitized financial assets. The new guidance eliminates the scope exception for embedded credit derivatives, unless they are created solely by subordination of one financial instrument to another. Bifurcation and separate recognition may be required for certain beneficial interests that are currently not accounted for at fair value through earnings. The adoption of this accounting guidance on July 1, 2010 did not have a material impact on the Company’s condensed consolidated financial statements.
Smith Barney. On May 31, 2009, the Company and Citigroup Inc. (“Citi”) consummated the combination of the Company’s Global Wealth Management Group and the businesses of Citi’s Smith Barney in the U.S., Quilter Holdings Ltd in the U.K., and Smith Barney Australia (collectively, “Smith Barney”). In addition to the Company’s contribution of respective businesses to MSSB, the Company paid Citi $2,755 million in cash. The
combined businesses operate as Morgan Stanley Smith Barney. Pursuant to the terms of the amended contribution agreement, dated at May 29, 2009, certain businesses of Smith Barney and Morgan Stanley will be contributed to MSSB subsequent to May 31, 2009 (the “delayed contribution businesses”). Morgan Stanley and Citi will each own their delayed contribution businesses until they are transferred to MSSB and gains and losses from such businesses will be allocated to the Company’s and Citi’s respective share of MSSB’s gains and losses. The Company owns 51% and Citi owns 49% of MSSB.
At May 31, 2009, the Company included MSSB in its condensed consolidated financial statements. The results of MSSB are included within the Global Wealth Management Group business segment. See Note 3 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K for further information on Smith Barney.
Citi Managed Futures. Citi contributed its managed futures business and certain related proprietary trading positions to MSSB on July 31, 2009 (“Citi Managed Futures”). The Company paid Citi approximately $300 million in cash in connection with this transfer. At July 31, 2009, Citi Managed Futures was wholly-owned and consolidated by MSSB, of which the Company owns 51% and Citi owns 49%.
See Note 3 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K for further information on Citi Managed Futures.
Pro forma condensed combined financial information
The following unaudited pro forma condensed combined financial information presents the results of operations of the Company as they may have appeared if the closing of MSSB and Citi Managed Futures had been completed on January 1, 2009 (dollars in millions, except share data).
Loss from discontinued operations
Benefit from income taxes
Loss on discontinued operations
Net income applicable to noncontrolling interests
Net loss from discontinued operations
The unaudited pro forma condensed combined financial information is presented for illustrative purposes only and does not indicate the actual financial results of the Company had the closing of Smith Barney and Citi Managed Futures been completed on January 1, 2009, nor is it indicative of the results of operations in future periods. Included in the unaudited pro forma combined financial information for the quarter and nine months ended September 30, 2009 were pro forma adjustments to reflect the results of operations of Smith Barney and Citi Managed Futures as well as the impact of amortizing certain purchase accounting adjustments such as amortizable intangible assets. The pro forma condensed financial information does not indicate the impact of possible business model changes nor does it consider any potential impacts of market conditions, expense efficiencies or other factors.
Fair Value Measurements.
A description of the valuation techniques applied to the Company’s major categories of assets and liabilities measured at fair value on a recurring basis follows.
Financial Instruments Owned and Financial Instruments Sold, Not Yet Purchased
U.S. Government and Agency Securities
U.S. Treasury Securities. U.S. treasury securities are valued using quoted market prices. Valuation adjustments are not applied. Accordingly, U.S. treasury securities are generally categorized in Level 1 of the fair value hierarchy.
U.S. Agency Securities. U.S. agency securities are comprised of three main categories consisting of agency-issued debt, agency mortgage pass-through securities and collateralized mortgage obligations. Non-callable agency-issued debt securities are generally valued using quoted market prices. Callable agency-issued debt securities are valued by benchmarking model-derived prices to quoted market prices and trade data for identical or comparable securities. The fair value of agency mortgage pass-through securities is model-driven based on spreads of the comparable To-be-announced (“TBA”) security. Collateralized mortgage obligations are valued using indices, quoted market prices and trade data for identical or comparable securities. Actively traded non-callable agency-issued debt securities are generally categorized in Level 1 of the fair value hierarchy. Callable agency-issued debt securities, agency mortgage pass-through securities and collateralized mortgage obligations are generally categorized in Level 2 of the fair value hierarchy.
Other Sovereign Government Obligations
Foreign sovereign government obligations are valued using quoted prices in active markets when available. To the extent quoted prices are not available, fair value is determined based on a valuation model that has as inputs interest rate yield curves, cross-currency basis index spreads, and country credit spreads for structures similar to the bond in terms of issuer, maturity and seniority. These bonds are generally categorized in Level 1 or Level 2 of the fair value hierarchy.
Corporate and Other Debt
State and Municipal Securities. The fair value of state and municipal securities is determined using recently executed transactions, market price quotations and pricing models that factor in, where applicable, interest rates, bond or credit default swap spreads and volatility. These bonds are generally categorized in Level 2 of the fair value hierarchy.
Residential Mortgage-Backed Securities (“RMBS”), Commercial Mortgage-Backed Securities (“CMBS”), and other Asset-Backed Securities (“ABS”). RMBS, CMBS and other ABS may be valued based on price or spread data obtained from observed transactions or independent external parties such as vendors or brokers. When position-specific external price data are not observable, the fair value determination may require benchmarking to similar instruments and/or analyzing expected credit losses, default and recovery rates. In evaluating the fair value of each security, the Company considers security collateral-specific attributes including payment priority, credit enhancement levels, type of collateral, delinquency rates and loss severity among other factors. In addition, for RMBS borrowers, FICO scores and the level of documentation for the loan are also considered. Market standard models, such as Intex, Trepp or others, may be deployed to model the specific collateral composition and cash flow structure of
each deal. Key inputs to these models are market spreads, forecasted credit losses, default and prepayment rates for each asset category. Valuation levels of RMBS and CMBS indices are also used as an additional data point for benchmarking purposes or to price outright index positions.
RMBS, CMBS and other ABS are categorized in Level 3 of the fair value hierarchy if external prices or significant spread inputs are unobservable or if the comparability assessment involves significant subjectivity related to property type differences, cash flows, performance and other inputs; otherwise, they are categorized in Level 2 of the fair value hierarchy.
Corporate Bonds. The fair value of corporate bonds is determined using recently executed transactions, market price quotations (where observable), bond spreads or credit default swap spreads obtained from independent external parties such as vendors and brokers adjusted for any basis difference between cash and derivative instruments. The spread data used are for the same maturity as the bond. If the spread data do not reference the issuer, then data that reference a comparable issuer are used. When observable price quotations are not available, fair value is determined based on cash flow models with yield curves, bond or single name credit default swap spreads and recovery rates as significant inputs. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy; in instances where prices, spreads or any of the other aforementioned key inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.
Collateralized Debt Obligations (“CDOs”). The Company holds cash CDOs that typically reference a tranche of an underlying synthetic portfolio of single name credit default swaps. The collateral is usually ABS or other corporate bonds. Credit correlation, a primary input used to determine the fair value of a cash CDO, is usually unobservable and derived using a benchmarking technique. The other model inputs such as credit spreads, including collateral spreads, and interest rates are typically observable. CDOs are categorized in Level 2 of the fair value hierarchy when the credit correlation input is insignificant. In instances where the credit correlation input is deemed to be significant, these instruments are categorized in Level 3 of the fair value hierarchy.
Corporate Loans and Lending Commitments. The fair value of corporate loans is determined using recently executed transactions, market price quotations (where observable), implied yields from comparable debt, and market observable credit default swap spread levels obtained from independent external parties such as vendors and brokers adjusted for any basis difference between cash and derivative instruments, along with proprietary valuation models and default recovery analysis where such transactions and quotations are unobservable. The fair value of contingent corporate lending commitments is determined by using executed transactions on comparable loans and the anticipated market price based on pricing indications from syndicate banks and customers. The valuation of these commitments also takes into account certain fee income. Corporate loans and lending commitments are generally categorized in Level 2 of the fair value hierarchy; in instances where prices or significant spread inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.
Mortgage Loans. Mortgage loans are valued using observable prices based on transactional data for identical or comparable instruments, when available. Where observable prices are not available, the Company estimates fair value based on benchmarking to prices and rates observed in the primary market for similar loan or borrower types, or based on the present value of expected future cash flows using its best estimates of the key assumptions, including forecasted credit losses, prepayment rates, forward yield curves and discount rates commensurate with the risks involved or a methodology that utilizes the capital structure and credit spreads of recent comparable securitization transactions. Mortgage loans valued based on observable transactional data for identical or comparable instruments are categorized in Level 2 of the fair value hierarchy. Where observable prices are not available, due to the subjectivity involved in
comparability assessment related to mortgage loan vintage, geographical concentration, prepayment speed and projected loss assumptions, mortgage loans are classified in Level 3 of the fair value hierarchy.
Auction Rate Securities (“ARS”). The Company primarily holds investments in Student Loan Auction Rate Securities (“SLARS”) and Municipal Auction Rate Securities (“MARS”) with interest rates that are reset through periodic auctions. SLARS are ABS backed by pools of student loans. MARS are municipal bonds often wrapped by municipal bond insurance. ARS were historically traded and valued as floating rate notes, priced at par due to the auction mechanism. Beginning in fiscal 2008, uncertainties in the credit markets have resulted in auctions failing for certain types of ARS. Once the auctions failed, ARS could no longer be valued using observations of auction market prices. Accordingly, the fair value of ARS is determined using independent external market data where available and an internally developed methodology to discount for the lack of liquidity and non-performance risk.
Inputs that impact the valuation of SLARS are independent external market data, the underlying collateral types, level of seniority in the capital structure, amount of leverage in each structure, credit rating and liquidity considerations. Inputs that impact the valuation of MARS are independent external market data when available, the maximum rate, quality of underlying issuers/insurers and evidence of issuer calls. ARS are generally categorized in Level 2 of the fair value hierarchy as the valuation technique relies on observable external data. The majority of SLARS are generally categorized in Level 2 of the fair value hierarchy.
Corporate Equities.
Exchange-Traded Equity Securities. Exchange-traded equity securities are generally valued based on quoted prices from the exchange. To the extent these securities are actively traded, valuation adjustments are not applied and they are categorized in Level 1 of the fair value hierarchy; otherwise, they are categorized in Level 2 or Level 3 of the fair value hierarchy.
Derivative and Other Contracts.
Listed Derivative Contracts. Listed derivatives that are actively traded are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Listed derivatives that are not actively traded are valued using the same approaches as those applied to OTC derivatives; they are generally categorized in Level 2 of the fair value hierarchy.
OTC Derivative Contracts. OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, equity prices or commodity prices.
Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be either observed or modeled using a series of techniques, and model inputs from comparable benchmarks, including closed-form analytic formulas, such as the Black-Scholes option-pricing model, and simulation models or a combination thereof. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swaps, certain option contracts and certain credit default swaps. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. A substantial majority of OTC derivative products valued by the Company using pricing models fall into this category and are categorized in Level 2 of the fair value hierarchy.
Other derivative products, including complex products that have become illiquid, require more judgment in the implementation of the valuation technique applied due to the complexity of the valuation assumptions and the reduced observability of inputs. This includes derivative interests in certain mortgage-related CDO securities, certain types of ABS credit default swaps, basket credit default swaps, and CDO-squared positions (a CDO-squared position is a special purpose vehicle that issues interests, or tranches, that are backed by tranches issued by other CDOs) where direct trading activity or quotes are unobservable. These instruments involve significant unobservable inputs and are categorized in Level 3 of the fair value hierarchy.
Derivative interests in complex mortgage-related CDOs and ABS credit default swaps, for which observability of external price data is extremely limited, are valued based on an evaluation of the market and model input parameters sourced from similar positions as indicated by primary and secondary market activity. Each position is evaluated independently taking into consideration the underlying collateral performance and pricing, behavior of the tranche under various cumulative loss and prepayment scenarios, deal structures (e.g., non-amortizing reference obligations, call features, etc.) and liquidity. While these factors may be supported by historical and actual external observations, the determination of their value as it relates to specific positions nevertheless requires significant judgment.
For basket credit default swaps and CDO-squared positions, the correlation input between reference credits is unobservable for each specific swap or position and is benchmarked to standardized proxy baskets for which correlation data are available. The other model inputs such as credit spread, interest rates and recovery rates are observable. In instances where the correlation input is deemed to be significant, these instruments are categorized in Level 3 of the fair value hierarchy; otherwise, these instruments are categorized in Level 2 of the fair value hierarchy.
The Company trades various derivative structures with commodity underlyings. Depending on the type of structure, the model inputs generally include interest rate yield curves, commodity underlier price curves, implied volatility of the underlying commodities and, in some cases, the implied correlation between these inputs. The fair value of these products is determined using executed trades and broker and consensus data to provide values for the aforementioned inputs. Where these inputs are unobservable, relationships to observable commodities and data points, based on historic and/or implied observations, are employed as a technique to estimate the model input values. Commodity derivatives are generally categorized in Level 2 of the fair value hierarchy; in instances where significant inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.
Investments.
The Company’s investments include investments in private equity funds, real estate funds, hedge funds and direct equity investments. Direct equity investments are presented in the fair value hierarchy table as Principal investments and Other. Initially, the transaction price is generally considered by the Company as the exit price and is the Company’s best estimate of fair value.
After initial recognition, in determining the fair value of internally and externally managed funds, the Company considers the net asset value of the fund provided by the fund manager to be the best estimate of fair value. For non-exchange traded investments either held directly or held within internally managed funds, fair value after initial recognition is based on an assessment of each underlying investment, considering rounds of financing and third-party transactions, discounted cash flow analyses and market-based information, including comparable company transactions, trading multiples and changes in market outlook, among other factors. Exchange-traded direct equity investments are generally valued based on quoted prices from the exchange.
Exchange-traded direct equity investments that are actively traded are categorized in Level 1 of the fair value hierarchy. Non-exchange traded direct equity investments and investments in private equity and real estate funds are generally categorized in Level 3 of the fair value hierarchy. Investments in hedge funds that are redeemable at the measurement date or in the near future are categorized in Level 2 of the fair value hierarchy; otherwise they are categorized in Level 3 of the fair value hierarchy.
Physical Commodities.
The Company trades various physical commodities, including crude oil and refined products, natural gas, base and precious metals and agricultural products. Fair value for physical commodities is determined using observable inputs, including broker quotations and published indices. Physical commodities are categorized in Level 2 of the fair value hierarchy.
Securities Available for Sale.
Securities available for sale are comprised of U.S. government and agency securities and equity securities, including U.S. Treasury securities, agency-issued debt, agency mortgage pass-through securities and equity securities. Actively traded U.S. Treasury securities, non-callable agency-issued debt securities and equity securities are generally categorized in Level 1 of the fair value hierarchy. Callable agency-issued debt securities, agency mortgage pass-through securities are generally categorized in Level 2 of the fair value hierarchy. For further information on securities available for sale, see Note 5.
Commercial Paper and Other Short-term Borrowings/Long-Term Borrowings.
Structured Notes. The Company issues structured notes that have coupon or repayment terms linked to the performance of debt or equity securities, indices, currencies or commodities. Fair value of structured notes is determined using valuation models for the derivative and debt portions of the notes. These models incorporate observable inputs referencing identical or comparable securities, including prices that the notes are linked to, interest rate yield curves, option volatility, and currency, commodity or equity rates. Independent, external and traded prices for the notes are also considered. The impact of the Company’s own credit spreads is also included based on the Company’s observed secondary bond market spreads. Most structured notes are categorized in Level 2 of the fair value hierarchy.
Deposits.
Time Deposits. The fair value of certificates of deposit is determined using third-party quotations. These deposits are generally categorized in Level 2 of the fair value hierarchy.
Securities sold under agreements to repurchase.
The fair value of a repurchase agreement is computed using a standard cash-flow discounting methodology. The inputs to the valuation include contractual cash flows and collateral funding spreads, which are estimated using various benchmarks, interest rate yield curves and option volatilities. Due to the significance of the unobservable inputs, repurchase agreements are categorized in Level 3 of the fair value hierarchy.
The following fair value hierarchy tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis at September 30, 2010 and December 31, 2009. See Note 2 for a discussion of the Company’s policies regarding the fair value hierarchy.
Assets and Liabilities Measured at Fair Value on a Recurring Basis at September 30, 2010
Financial instruments owned:
U.S. government and agency securities:
U.S. Treasury securities
U.S. agency securities
Total U.S. government and agency securities
Corporate and other debt:
State and municipal securities
Residential mortgage-backed securities
Commercial mortgage-backed securities
Asset-backed securities
Corporate bonds
Collateralized debt obligations
Loans and lending commitments
Other debt
Total corporate and other debt
Corporate equities(1)
Derivative and other contracts:
Interest rate contracts
Credit contracts
Foreign exchange contracts
Equity contracts
Commodity contracts
Netting(2)
Total derivative and other contracts
Investments(3)
Private equity funds
Real estate funds
Hedge funds
Principal investments
Total investments
Total financial instruments owned
Securities available for sale:
Debt securities:
Equity securities(4)
Total securities available for sale
Securities received as collateral
Intangible assets(5)
Liabilities
Commercial paper and other short-term borrowings
Financial instruments sold, not yet purchased:
Unfunded lending commitments
Total financial instruments sold, not yet purchased
Obligation to return securities received as collateral
Transfers Between Level 1 and Level 2 During the Quarter Ended September 30, 2010.
Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the quarter ended September 30, 2010, the Company reclassified approximately $1.6 billion of derivative assets and approximately $1.6 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on exchange-quoted prices.
Transfers Between Level 1 and Level 2 During the Nine Months Ended September 30, 2010.
Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the nine months ended September 30, 2010, the Company reclassified approximately $2.2 billion of derivative assets and approximately $2.3 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on exchange-quoted prices.
Financial instruments owned—Corporate equities. During the nine months ended September 30, 2010, the Company reclassified approximately $1.2 billion of certain Corporate equities from Level 2 to Level 1 as transactions in these securities occurred with sufficient frequency and volume to constitute an active market.
Assets and Liabilities Measured at Fair Value on a Recurring Basis at December 31, 2009
Derivative and other contracts(2)
Intangible assets(3)
The following tables present additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter and nine months ended September 30, 2010 and for the quarter and nine months ended September 30, 2009, respectively. Level 3 instruments may be hedged with instruments classified in Level 1 and Level 2. As a result, the realized and unrealized gains (losses) for assets and liabilities within the Level 3 category presented in the tables below do not reflect the related realized and unrealized gains (losses) on hedging instruments that have been classified by the Company in the Level 1 and/or Level 2 categories.
Additionally, both observable and unobservable inputs may be used to determine the fair value of positions that the Company has classified within the Level 3 category. As a result, the unrealized gains (losses) during the period for assets and liabilities within the Level 3 category presented in the tables below may include changes in fair value during the period that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.
For assets and liabilities that were transferred into Level 3 during the period, gains (losses) are presented as if the assets or liabilities had been transferred into Level 3 at the beginning of the period; similarly, for assets and liabilities that were transferred out of Level 3 during the period, gains (losses) are presented as if the assets or liabilities had been transferred out at the beginning of the period.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Three Months Ended September 30, 2010
Net derivative and other contracts:
Total net derivative and other contracts(3)
Investments:
Intangible assets
Financial instruments owned—Corporate and other debt. During the quarter ended September 30, 2010, the Company reclassified approximately $3.9 billion of certain Corporate and other debt, primarily loans and hybrid contracts, from Level 3 to Level 2. The Company reclassified these loans and hybrid contracts as external prices and/or spread inputs became observable and certain unobservable inputs were deemed insignificant to the overall measurement.
The Company also reclassified approximately $0.9 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to certain corporate loans and were generally due to a reduction in market price quotations for these or comparable instruments, or a lack of available broker quotes, such that unobservable inputs had to be utilized for the fair value measurement of these instruments.
Other Secured Financings. During the quarter ended September 30, 2010, the Company reclassified approximately $1.0 billion of Other Secured Financings from Level 3 to Level 2. The reclassifications were due to an increase in available broker quotes and/or consensus pricing such that significant inputs for the fair value measurement were observable.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Nine Months Ended September 30, 2010
Financial instruments owned—Corporate and other debt. During the nine months ended September 30, 2010, the Company reclassified approximately $3.5 billion of certain Corporate and other debt, primarily loans and hybrid contracts, from Level 3 to Level 2. The Company reclassified these loans and hybrid contracts as external prices and/or spread inputs became observable and certain unobservable inputs were deemed insignificant to the overall measurement.
The Company also reclassified approximately $1.0 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to certain corporate loans and were generally due to a reduction in market price quotations for these or comparable instruments, or a lack of available broker quotes, such that unobservable inputs had to be utilized for the fair value measurement of these instruments.
Financial instruments owned—Net derivative and other contracts. The net losses in Net derivative and other contracts were primarily driven by tightening of credit spreads on underlying reference entities of single name and basket credit default swaps.
During the nine months ended September 30, 2010, the Company reclassified approximately $1.1 billion of certain Net derivative contracts from Level 3 to Level 2. These reclassifications were related to certain tranched bespoke credit basket default swaps and single name credit default swaps for which certain unobservable inputs were deemed insignificant.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Three Months Ended September 30, 2009
Net derivative and other contracts(3)
Financial instruments owned—Corporate and other debt. The net gains in Corporate and other debt were primarily driven by mark-to-market gains on corporate loans, CDOs and certain other debt, partially offset by losses in commercial mortgage-backed securities.
During the quarter ended September 30, 2009, the Company reclassified approximately $3.3 billion of certain Corporate and other debt from Level 3 to Level 2. The reclassifications were primarily related to corporate loans, state and municipal securities, asset-backed securities and commercial mortgage-backed securities. The reclassifications were primarily due to an increase in market price quotations for these or comparable instruments, or available broker quotes, such that observable inputs were utilized for the fair value measurement of these instruments. Corporate loans were reclassified as more liquidity entered the market and price transparency increased for certain corporate loans due to refinancing activities. Separately, certain SLARS were reclassified from Level 3 to Level 2 as there was increased activity in the SLARS market and restructuring activity of the underlying trusts.
Long-term borrowings. During the quarter ended September 30, 2009, the Company reclassified approximately $1.3 billion of certain Long-term borrowings from Level 2 to Level 3. The reclassifications primarily related to structured notes for which certain significant inputs became unobservable and deemed significant.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Nine Months Ended September 30, 2009
Financial instruments owned—Corporate and other debt. During the nine months ended September 30, 2009, the net losses in Corporate and other debt were primarily driven by certain corporate loans and certain commercial mortgage-backed securities, partially offset by gains in certain other debt.
During the nine months ended September 30, 2009, the Company reclassified approximately $1.6 billion of certain Corporate and other debt from Level 3 to Level 2. The reclassifications were primarily related to certain other debt, state and municipal securities and commercial mortgage-backed securities. As the unobservable inputs became insignificant in the overall valuation, the fair value of these instruments became highly correlated with similar instruments in an observable market. The reclassifications were partly offset by the reclassification of certain corporate loans and lending commitments from Level 2 to Level 3. The reclassifications were due to a reduction in market price quotations for these or comparable instruments, or a lack of available broker quotes, such that unobservable inputs had to be utilized for the fair value measurement of these instruments. The key unobservable inputs include assumptions to establish comparability to bonds, loans or swaps with observable price/spread levels.
Financial instruments owned—Net derivative and other contracts. During the nine months ended September 30, 2009, the net losses in Net derivative and other contracts were primarily driven by tightening of credit spreads on underlying reference entities of single name and basket credit default swaps.
During the nine months ended September 30, 2009, the Company reclassified approximately $8.8 billion of certain Derivatives and other contracts from Level 3 to Level 2. These reclassifications of certain Derivatives and other contracts were related to single name mortgage-related credit default swaps and credit default swaps on certain classes of CDOs. The primary reason for the reclassifications is that, due to market deterioration, the values associated with the unobservable inputs, such as correlation, for these derivative contracts were no longer deemed significant to the fair value measurement. In addition, certain corporate tranche-indexed credit default swaps were reclassified due to increased availability of transaction data, broker quotes and/or consensus pricing.
Financial instruments owned—Investments. During the nine months ended September 30, 2009, the net losses from investments were primarily related to investments associated with the Company’s real estate products.
Financial instruments sold, not yet purchased—Corporate and other debt. During the nine months ended September 30, 2009, the Company reclassified approximately $1.1 billion of certain Corporate and other debt from Level 3 to Level 2. These reclassifications primarily related to contracts referencing commercial mortgage-backed securities, subprime CDOs and other subprime ABS securities. Their fair value was highly correlated with similar instruments in an observable market and, due to market deterioration, the values associated with the unobservable inputs were no longer deemed significant to the fair value measurement.
During the nine months ended September 30, 2009, the sales of Corporate and other debt were primarily related to contracts referencing commercial mortgage-backed securities, subprime CDOs and other subprime ABS securities.
Long-term borrowings. During the quarter ended September 30, 2009, the Company reclassified approximately $1.3 billion of certain Long-term borrowings from Level 2 to Level 3. The reclassifications primarily related to structured notes for which certain significant inputs became unobservable.
Fair Value of Investments that Calculate Net Asset Value.
The following table presents information about the Company’s investments in private equity funds, real estate funds and hedge funds measured at fair value based on net asset value at September 30, 2010 and December 31, 2009, respectively.
Hedge funds(1):
Long-short equity hedge funds
Fixed income/credit-related hedge funds
Event-driven hedge funds
Multi-strategy hedge funds
Total
Private Equity Funds. Amount includes several private equity funds that pursue multiple strategies including leveraged buyouts, venture capital, infrastructure growth capital, distressed investments, and mezzanine capital. In addition, the funds may be structured with a focus on specific domestic or foreign geographic regions. These investments are generally not redeemable with the funds. Instead, the nature of the investments in this category is that distributions are received through the liquidation of the underlying assets of the fund. At September 30, 2010, it is estimated that 7% of the fair value of the funds will be liquidated in the next five years, another 43% of the fair value of the funds will be liquidated between five to ten years and the remaining 50% of the fair value of the funds have a remaining life of greater than ten years.
Real Estate Funds. Amount includes several real estate funds that invest in real estate assets such as commercial office buildings, retail properties, multi-family residential properties, developments, or hotels. In addition, the funds may be structured with a focus on specific geographic domestic or foreign regions. These investments are generally not redeemable with the funds. Distributions from each fund will be received as the underlying investments of the funds are liquidated. At September 30, 2010, it is estimated that 20% of the fair value of the funds will be liquidated within the next five years, another 33% of the fair value of the funds will be liquidated between five to ten years and the remaining 47% of the fair value of the funds have a remaining life of greater than ten years.
Hedge Funds. Investments in hedge funds may be subject to initial period lock-up restrictions or gates. A hedge fund lock-up provision is a provision which provides that, during a certain initial period, an investor may not
make a withdrawal from the fund. The purpose of a gate is to restrict the level of redemptions that an investor in a particular hedge fund can demand on any redemption date.
Long-short Equity Hedge Funds. Amount includes investments in hedge funds that invest, long or short, in equities. Equity value and growth hedge funds purchase stocks perceived to be undervalued and sell stocks perceived to be overvalued. Investments representing approximately 38% of the fair value of the investments in this category cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for 100% of investments subject to lock-up restrictions ranged from one to three years at September 30, 2010. Investments representing approximately 32% of the fair value of the investments in long-short equity hedge funds cannot be redeemed currently because an exit restriction has been imposed by the hedge fund manager. The restriction period for 100% of investments subject to an exit restriction is expected to be less than a year at September 30, 2010.
Fixed Income/Credit-Related Hedge Funds. Amount includes investments in hedge funds that employ long-short, distressed or relative value strategies in order to benefit from investments in undervalued or over-valued securities that are primarily debt or credit related. At September 30, 2010, investments representing approximately 26% of the fair value of the investments in fixed income/credit-related hedge funds cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for these investments was three years or less at September 30, 2010.
Event-Driven Hedge Funds. Amount includes investments in hedge funds that invest in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. This may involve the simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the target company. At September 30, 2010, investments representing approximately 69% of the value of the investments in this category cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for these investments was two years or less at September 30, 2010.
Multi-strategy Hedge Funds. Amount includes investments in hedge funds that pursue multiple strategies to realize short and long-term gains. Management of the hedge funds has the ability to overweight or underweight different strategies to best capitalize on current investment opportunities. At September 30, 2010, investments representing approximately 24% of the fair value of the investments in this category cannot be redeemed currently because the investments include certain initial period lock-up restrictions. The remaining restriction period for 71% of investments subject to lock-ups was two years or less at September 30, 2010. The remaining restriction period for the other 29% of investments subject to lock-up restrictions was estimated to be greater than three years at September 30, 2010.
Fair Value Option.
The Company elected the fair value option for certain eligible instruments that are risk managed on a fair value basis. The following tables present net gains (losses) due to changes in fair value for items measured at fair value pursuant to the fair value option election for the quarters and nine months ended September 30, 2010 and 2009.
Three months ended September 30, 2010
Three months ended September 30, 2009
In addition to the amounts in the above table, as discussed in Note 2, all of the instruments within Financial instruments owned or Financial instruments sold, not yet purchased are measured at fair value, either through the election of the fair value option, or as required by other accounting guidance.
The following tables present information on the Company’s short-term and long-term borrowings (including structured notes and junior subordinated debentures), loans, unfunded lending and Securities sold under agreements to repurchase commitments for which the fair value option was elected:
Fair Value Option—Gains (Losses) Due to Changes in Instrument Specific Credit Spreads
Short-term and long-term borrowings(1)
Loans(2)
Unfunded lending commitments(3)
Amount by Which Contractual Principal Amount Exceeds Fair Value
Loans 90 or more days past due in non-accrual status or both(2)(3)
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis.
Certain assets were measured at fair value on a non-recurring basis and are not included in the tables above. These assets may include loans, equity method investments, premises and equipment, intangible assets and real estate investments.
The following tables present, by caption on the condensed consolidated statement of financial condition, the fair value hierarchy for those assets measured at fair value on a non-recurring basis for which the Company recognized a non-recurring fair value adjustment for the quarters and nine months ended September 30, 2010 and 2009, respectively.
Three and Nine Months Ended September 30, 2010.
Loans(3)
Other investments(4)
In addition to the losses included in the table above, the Company incurred a loss of approximately $1.2 billion in connection with the planned disposition of Revel for the nine months ended September 30, 2010 which was included in discontinued operations. The loss related to Premises, equipment and software costs and was included in discontinued operations (see Note 1). The fair value of Revel, net of estimated costs to sell, included in Premises, equipment and software costs was approximately $40 million at September 30, 2010 and was classified in Level 3. Fair value was determined using discounted cash flow models.
There were no liabilities measured at fair value on a non-recurring basis during the quarter and nine months ended September 30, 2010.
Three and Nine Months Ended September 30, 2009.
Other investments(3)
Premises, equipment and software costs(3)
In addition to the losses included in the table above, losses of approximately $466 million (of which $45 million related to Other investments, $11 million related to Intangible assets and $410 million related to Other assets) were included in discontinued operations related to Crescent for the nine months ended September 30, 2009 (see Note 1). The carrying value of Crescent assets at September 30, 2009 was $476 million (of which $12 million related to Other investments, $3 million related to Intangible assets and $461 million related to Other assets) all of which were classified in Level 3. Fair values were generally determined using discounted cash flow models or third-party appraisals and valuations.
There were no liabilities measured at fair value on a non-recurring basis during the quarter and nine months ended September 30, 2009.
Financial Instruments Not Measured at Fair Value.
Some of the Company’s financial instruments are not measured at fair value on a recurring basis but nevertheless are recorded at amounts that approximate fair value due to their liquid or short-term nature. Such financial assets
and financial liabilities include: Cash and due from banks, Interest bearing deposits with banks, Cash deposited with clearing organizations or segregated under federal and other regulations or requirements, Federal funds sold and Securities purchased under agreements to resell, Securities borrowed, certain Securities sold under agreements to repurchase, Securities loaned, Receivables—Customers, Receivables—Brokers, dealers and clearing organizations, Payables—Customers, Payables—Brokers, dealers and clearing organizations, certain Commercial paper and other short-term borrowings, and certain Deposits.
The Company’s long-term borrowings are recorded at amortized amounts unless elected under the fair value option or designated as a hedged item in a fair value hedge. For long-term borrowings not measured at fair value, the fair value of the Company’s long-term borrowings was estimated using either quoted market prices or discounted cash flow analyses based on the Company’s current borrowing rates for similar types of borrowing arrangements. At September 30, 2010, the carrying value of the Company’s long-term borrowings not measured at fair value was approximately $3.0 billion higher than fair value. At December 31, 2009, the carrying value of the Company’s long-term borrowings not measured at fair value was approximately $1.4 billion higher than fair value.
The following table presents information about the Company’s AFS securities at September 30, 2010:
Debt securities available for sale:
Equity securities available for sale(1)
The table below presents the fair value of investments in debt securities available for sale that have been in an unrealized loss position for less than 12 months or for 12 months or longer at September 30, 2010:
There were no equity securities available for sale in an unrealized loss position at September 30, 2010. For debt securities, the loss relates to agency mortgage-backed securities. The Company does not intend to sell these securities or expect to be required to sell these securities prior to recovery of the amortized cost basis. In addition, the Company does not expect these securities to experience a credit loss given the explicit and implicit guarantee provided by the U.S. government. The Company believes that the debt securities with an unrealized loss in Accumulated other comprehensive income were not other-than-temporarily impaired at September 30, 2010.
The following table presents the amortized cost and fair value of debt securities available for sale by contractual maturity dates at September 30, 2010:
Due within 1 year
After 1 year but through 5 years
After 10 years
The Company pledges its financial instruments owned to collateralize repurchase agreements and other securities financings. Pledged financial instruments that can be sold or repledged by the secured party are identified as Financial instruments owned (pledged to various parties) in the condensed consolidated statements of financial condition. The carrying value and classification of financial instruments 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:
The Company enters into reverse repurchase agreements, repurchase agreements, securities borrowed and securities loaned transactions to, among other things, acquire securities to cover short positions and settle other securities obligations, to accommodate customers’ needs and to finance the Company’s inventory positions. The Company’s policy is generally to take possession of Securities purchased under agreements to resell. 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 and derivative 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 and derivative transactions or for delivery to counterparties to cover short positions. At September 30, 2010 and December 31, 2009, the fair value of financial instruments received as collateral where the Company is permitted to sell or repledge the securities was $583 billion and $429 billion, respectively, and the fair value of the portion that had been sold or repledged was $435 billion and $311 billion, respectively.
The Company additionally receives securities as collateral in connection with certain securities for securities transactions in which the Company is the lender. In instances where the Company is permitted to sell or repledge
these securities, the Company reports the fair value of the collateral received and the related obligation to return the collateral in the condensed consolidated statements of financial condition. At September 30, 2010 and December 31, 2009, $17,062 million and $13,656 million, respectively, were reported as Securities received as collateral and an Obligation to return securities received as collateral in the condensed consolidated statements of financial condition. Collateral received in connection with these transactions that was subsequently repledged was approximately $16 billion and $13 billion at September 30, 2010 and December 31, 2009, 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.
At September 30, 2010 and December 31, 2009, cash and securities deposited with clearing organizations or segregated under federal and other regulations or requirements were as follows:
Securities(1)
Other secured financings include the liabilities related to transfers of financial assets that are accounted for as financings rather than sales, consolidated VIEs where the Company is deemed to be the primary beneficiary, and certain equity-linked notes and borrowings. These liabilities are generally payable from the cash flows of the related assets accounted for as Financial instruments owned (see Note 7).
The Company is involved with various special purpose entities (“SPEs”) in the normal course of business. In most cases, these entities are deemed to be VIEs.
The Company applies accounting guidance for consolidation of VIEs 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. Entities that previously met the criteria as QSPEs that were not subject to consolidation prior to January 1, 2010 became
subject to the consolidation requirements for VIEs on that date. Excluding entities subject to the Deferral (as defined in Note 2), effective January 1, 2010, the primary beneficiary of a VIE is the party that both (1) has the power to direct the activities of a VIE that most significantly affect the VIE’s economic performance and (2) has an obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. The Company consolidates entities of which it is the primary beneficiary.
The Company’s variable interests in VIEs include debt and equity interests, commitments, guarantees, derivative instruments and certain fees. The Company’s involvement with VIEs arises primarily from:
Interests purchased in connection with market-making and retained interests held as a result of securitization activities.
Guarantees issued and residual interests retained in connection with municipal bond securitizations.
Loans and investments made to VIEs that hold debt, equity, real estate or other assets.
Derivatives entered into with VIEs.
Structuring of credit-linked notes (“CLNs”) or other asset-repackaged notes designed to meet the investment objectives of clients.
Other structured transactions designed to provide tax-efficient yields to the Company or its clients.
The Company determines whether it is the primary beneficiary of a VIE upon its initial involvement with the VIE and reassesses whether it is the primary beneficiary on an ongoing basis as long as it has any continuing involvement with the VIE. This determination is based upon an analysis of the design of the VIE, including the VIE’s structure and activities, the power to make significant economic decisions held by the Company and by other parties and the variable interests owned by the Company and other parties.
The power to make the most important decisions may take a number of different forms in different types of VIEs. The Company considers servicing or collateral management decisions as representing the power to make the most important economic decisions in transactions such as securitizations or collateral debt obligations.
For many transactions, such as CLNs and other asset-repackaged notes, there are no significant economic decisions made on an ongoing basis. In these cases, the Company focuses its analysis on decisions made prior to the initial closing of the transaction and at the termination of the transaction. Based upon factors, which include an analysis of the nature of the assets, the number of investors, the standardization of the legal documentation and the level of the continuing involvement by the Company, the Company concluded in most of these transactions that decisions made prior to the initial closing were shared between the Company and the initial investors. The Company focused its control decision on any right held by the Company or investors related to the termination of the VIE.
Except for consolidated VIEs included in other structured financings in the tables below, the Company accounts for the assets held by the entities primarily in Financial instruments owned and the liabilities of the entities as Other secured financings in the condensed consolidated statements of financial condition. The Company includes assets held by consolidated VIEs included in other structured financings in the tables below primarily in Receivables, Premises, equipment and software costs and Other assets and the liabilities primarily as Other liabilities and accrued expenses and Payables in the condensed consolidated statements of financial condition. Except for consolidated VIEs included in other structured financings, the assets and liabilities are measured at fair value, with changes in fair value reflected in earnings.
The assets owned by many consolidated VIEs cannot be removed unilaterally by the Company and are not generally available to the Company. The related liabilities issued by many consolidated VIEs are non-recourse to the Company. In certain other consolidated VIEs, the Company has the unilateral right to remove assets or provides additional recourse through derivatives such as total return swaps, guarantees or other forms of involvement.
The following tables present information at September 30, 2010 and December 31, 2009 about VIEs that the Company consolidates. Consolidated VIE assets and liabilities are presented after intercompany eliminations and include assets financed on a non-recourse basis. As a result of the accounting guidance adopted on January 1, 2010, the Company consolidated a number of VIEs that had not previously been consolidated and de-consolidated a number of VIEs that had previously been consolidated at December 31, 2009.
VIE assets
VIE liabilities
In general, the Company’s exposure to loss in consolidated VIEs is limited to losses that would be absorbed on the VIE’s assets recognized in its financial statements, net of losses absorbed by third-party holders of the VIE’s liabilities. At September 30, 2010, managed real estate partnerships reflected noncontrolling interests of $1,450 million. The Company also had additional maximum exposure to losses of approximately $1,051 million and $533 million at September 30, 2010 and December 31, 2009, respectively. This additional exposure related primarily to certain derivatives (e.g., credit derivatives in which the Company has sold unfunded protection in synthetic collateralized debt obligations, typically for the most senior tranche, in which the total protection sold by the VIE exceeds the amount of collateral held) and commitments, guarantees and other forms of involvement.
The following table presents information about certain non-consolidated VIEs in which the Company had variable interests at September 30, 2010. Many of the VIEs included in this table met the QSPE requirements under previous accounting guidance. QSPEs were not included as non-consolidated VIEs in prior periods. The table includes all VIEs in which the Company has determined that its maximum exposure to loss is greater than specific thresholds or meets certain other criteria. The non-consolidated VIEs included in the September 30, 2010 and December 31, 2009 tables are based on different criteria.
VIE assets that the Company does not consolidate (unpaid principal balance)(1)
Maximum exposure to loss:
Debt and equity interests(2)
Derivatives and other contracts
Commitments, guarantees and other
Total maximum exposure to loss
Carrying value of exposure to loss—Assets:
Total carrying value of exposure to loss—Assets
Carrying value of exposure to loss—Liabilities:
Total carrying value of exposure to loss—Liabilities
The Company’s maximum exposure to loss often differs from the carrying value of the VIE’s assets. The maximum exposure to loss is dependent on the nature of the Company’s variable interest in the VIEs and is limited to the notional amounts of certain liquidity facilities, other credit support, total return swaps, written put options, and the fair value of certain other derivatives and investments the Company has made in the VIEs. Liabilities issued by VIEs generally are non-recourse to the Company. Where notional amounts are utilized in quantifying maximum exposure related to derivatives, such amounts do not reflect fair value writedowns already recorded by the Company.
The Company’s maximum exposure to loss does not include the offsetting benefit of any financial instruments that the Company may utilize to hedge these risks associated with the Company’s variable interests. In addition,
the Company’s maximum exposure to loss is not reduced by the amount of collateral held as part of a transaction with the VIE or any party to the VIE directly against a specific exposure to loss.
Securitization transactions generally involve VIEs. The Company owned additional securities issued by securitization SPEs for which the maximum exposure to loss is less than specific thresholds. These additional securities totaled $5.4 billion at September 30, 2010. These securities were either retained in connection with transfers of assets by the Company or acquired in connection with secondary market-making activities. Securities issued by securitization SPEs consist of $1.7 billion of securities backed primarily by residential mortgage loans, $0.9 billion of securities backed by U.S. agency collateralized mortgage obligations, $1.1 billion of securities backed by commercial mortgage loans, $1.0 billion of securities backed by collateralized debt obligations or collateralized loan obligations and $0.7 billion backed by other consumer loans, such as credit card receivables, automobile loans and student loans. The Company’s primary risk exposure is limited to the securities issued by the SPE owned by the Company, with the risk highest on the most subordinate class of beneficial interests. These securities generally are included in Financial instruments owned—Corporate and other debt and are measured at fair value. The Company does not provide additional support in these transactions through contractual facilities, such as liquidity facilities, guarantees, or similar derivatives. The Company’s maximum exposure to loss is equal to the fair value of the securities owned.
The following table presents information about the Company’s non-consolidated VIEs at December 31, 2009 in which the Company had significant variable interests or served as the sponsor and had any variable interest as of that date. The non-consolidated VIEs included in the September 30, 2010 and December 31, 2009 tables are based on different criteria.
VIE assets that the Company does not consolidate
Debt and equity interests
The Company’s transactions with VIEs primarily includes securitizations, municipal tender option bond trusts, credit protection purchased through CLNs, collateralized loan and debt obligations, equity-linked notes, managed real estate partnerships and asset management investment funds. Such activities are described below.
Securitization Activities. In a securitization transaction, the Company transfers assets (generally commercial or residential mortgage loans or U.S. agency securities) to an SPE, sells to investors most of the beneficial interests, such as notes or certificates, issued by the SPE and in many cases retains other beneficial interests. In many securitization transactions involving commercial mortgage loans, the Company transfers a portion of the assets transferred to the SPE with unrelated parties transferring the remaining assets.
The purchase of the transferred assets by the SPE is financed through the sale of these interests. In some of these transactions, primarily involving residential mortgage loans in the U.S. and Europe and commercial mortgage loans in Europe, the Company serves as servicer for some or all of the transferred loans. In many securitizations, particularly involving residential mortgage loans, the Company also enters into derivative transactions, primarily interest rate swaps or interest rate caps, with the SPE.
In most of these transactions, the SPE met the criteria to be a QSPE under the accounting guidance effective prior to January 1, 2010 for the transfer and servicing of financial assets. The Company did not consolidate QSPEs if they met certain criteria regarding the types of assets and derivatives they held, the activities in which they engaged and the range of discretion they may have exercised in connection with the assets they held. SPEs that formerly met the criteria to be a QSPE are now subject to the same consolidation requirements as other VIEs.
The primary risk retained by the Company in connection with these transactions generally is limited to the beneficial interests issued by the SPE that are owned by the Company, with the risk highest on the most subordinate class of beneficial interests. These beneficial interests generally are included in Financial instruments owned—Corporate and other debt and are measured at fair value. The Company does not provide additional support in these transactions through contractual facilities, such as liquidity facilities, guarantees, or similar derivatives.
Although not obligated, the Company generally makes a market in the securities issued by SPEs in these transactions. As a market maker, the Company offers to buy these securities from, and sell these securities to, investors. Securities purchased through these market-making activities are not considered to be retained interests, although these beneficial interests generally are included in Financial instruments owned—Corporate and other debt and are measured at fair value.
The Company enters into derivatives, generally interest rate swaps and interest rate caps with a senior payment priority in many securitization transactions. The risks associated with these and similar derivatives with SPEs are essentially the same as similar derivatives with non-SPE counterparties and are managed as part of the Company’s overall exposure.
See Note 10 for further information on derivative instruments and hedging activities.
Municipal Tender Option Bond Trusts. In a municipal tender option bond transaction, the Company, on behalf of a client, transfers a municipal bond to a trust. The trust issues short-term securities which the Company, as the remarketing agent, sells to investors. The client retains a residual interest. The short-term securities are supported by a liquidity facility pursuant to which the investors may put their short-term interests. In some programs, the Company provides this liquidity facility; in most programs, a third-party provider will provide such liquidity facility. The Company may purchase short-term securities in its role either as remarketing agent or liquidity provider. The client can generally terminate the transaction at any time. The liquidity provider can generally terminate the transaction upon the occurrence of certain events. When the transaction is terminated, the municipal bond is generally sold or returned to the client. Any losses suffered by the liquidity provider upon the sale of the bond are the responsibility of the client. This obligation generally is collateralized.
Credit Protection Purchased Through CLNs. In a CLN transaction, the Company transfers assets (generally high quality securities or money market investments) to an SPE, enters into a derivative transaction in which the SPE writes protection on an unrelated reference asset or group of assets through a credit default swap, a total return swap or similar instrument, and sells to investors the securities issued by the SPE. In some transactions, the Company may also enter into interest rate or currency swaps with the SPE. Upon the occurrence of a credit event related to the reference asset, the SPE will sell the collateral securities in order to make the payment to the Company. The Company is generally exposed to price changes on the collateral securities in the event of a credit event and subsequent sale. These transactions are designed to provide investors with exposure to certain credit risk on the reference asset. In some transactions, the assets and liabilities of the SPE are recognized in the Company’s condensed consolidated financial statements. In other transactions, the transfer of the collateral securities is accounted for as a sale of assets and the SPE is not consolidated. The structure of the transaction determines the accounting treatment. CLNs are included in Other in the above VIE tables.
The derivatives in CLN transactions consist of total return swaps, credit default swaps or similar contracts in which the Company has purchased protection on a reference asset or group of assets. Payments by the SPE are collateralized. The risks associated with these and similar derivatives with SPEs are essentially the same as similar derivatives with non-SPE counterparties and are managed as part of the Company’s overall exposure.
Other Structured Financings. The Company primarily invests in equity interests issued by entities that develop and own low income communities (including low income housing projects) and entities that construct and own facilities that will generate energy from renewable resources. The equity interests entitle the Company to its share of tax credits and tax losses generated by these projects. In addition, the Company has issued guarantees to investors in certain low-income housing funds. The guarantees 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 the fund. The Company is also involved with entities designed to provide tax-efficient yields to the Company or its clients.
Collateralized Loan and Debt Obligations. A collateralized loan obligation (“CLO”) or a CDO is an SPE that purchases a pool of assets, consisting of corporate loans, corporate bonds, asset-backed securities or synthetic exposures on similar assets through derivatives and issues multiple tranches of debt and equity securities to investors.
Equity-Linked Notes. In an equity-linked note transaction included in the tables above, the Company typically transfers to an SPE either (1) a note issued by the Company, the payments on which are linked to the performance of a specific equity security, equity index or other index or (2) debt securities issued by other companies and a derivative contract, the terms of which will relate to the performance of a specific equity security, equity index or other index. These transactions are designed to provide investors with exposure to certain risks related to the specific equity security, equity index or other index. Equity-linked notes are included in Other in the above VIE tables.
Managed Real Estate Partnerships. The Company sponsors funds that invest in real estate assets. Certain of these funds are classified as VIEs primarily because the Company has provided financial support through lending facilities and other means. The Company also serves as the general partner for these funds and owns limited partnership interests in them. These funds are consolidated at September 30, 2010.
Asset Management Investment Funds. The tables above do not include certain investments made by the Company held by entities qualifying for accounting purposes as investment companies.
Transfers of Assets with Continuing Involvement.
The following table presents information at September 30, 2010 regarding transactions with SPEs in which the Company, acting as principal, transferred assets with continuing involvement and received sales treatment. The transferees in most of these transactions formerly met the criteria for QSPEs.
SPE assets (unpaid principal balance)(1)
Retained interests (fair value):
Investment grade
Non-investment grade
Total retained interests (fair value)
Interests purchased in the secondary market (fair value):
Total interests purchased in the secondary market (fair value)
Derivative assets (fair value)
Derivative liabilities (fair value)
Transferred assets are carried at fair value prior to securitization, 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. Investment banking 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.
Net gains at the time of securitization were not material in the nine months ended September 30, 2010.
During the nine months ended September 30, 2010, the Company received proceeds from new securitization transactions of $18.5 billion. During the nine months ended September 30, 2010, the Company received proceeds from cash flows from retained interests in securitization transactions of $5.0 billion.
The Company provides representations and warranties that certain assets transferred in securitization transactions conform to specific guidelines (see Note 11).
Failed Sales.
In order to be treated as a sale of assets for accounting purposes, a transaction must meet all of the criteria stipulated in the accounting guidance for the transfer of financial assets. If the transfer fails to meet these criteria, that transfer is treated as a failed sale. In such case, the Company continues to recognize the assets in Financial instruments owned and the Company recognizes the associated liabilities in Other secured financings in the condensed consolidated statements of financial condition.
The assets transferred to many unconsolidated VIEs in transactions accounted for as failed sales cannot be removed unilaterally by the Company and are not generally available to the Company. The related liabilities issued by many unconsolidated VIEs are non-recourse to the Company. In certain other failed sale transactions, the Company has the unilateral right to remove assets or provides additional recourse through derivatives such as total return swaps, guarantees or other forms of involvement.
The following tables present information about transfers of assets treated by the Company as secured financings:
Carrying value
Mortgage Servicing Activities.
Mortgage Servicing Rights. The Company may retain servicing rights to certain mortgage loans that are sold through its securitization activities. These transactions create an asset referred to as MSRs, which totaled approximately $139 million and $137 million at September 30, 2010 and December 31, 2009, respectively, and are included within Intangible assets and carried at fair value in the condensed consolidated statements of financial condition.
SPE Mortgage Servicing Activities. The Company services residential mortgage loans in the U.S. and Europe and commercial mortgage loans in Europe owned by SPEs, including SPEs sponsored by the Company and SPEs not sponsored by the Company. The Company generally holds retained interests in Company-sponsored SPEs. In some cases, as part of its market-making activities, the Company may own some beneficial interests issued by both Company-sponsored and non-Company sponsored SPEs.
The Company provides no credit support as part of its servicing activities. The Company is required to make servicing advances to the extent that it believes that such advances will be reimbursed. Reimbursement of servicing advances is a senior obligation of the SPE, senior to the most senior beneficial interests outstanding. Outstanding advances are included in Other assets and are recorded at cost. Advances at September 30, 2010 and December 31, 2009 totaled approximately $1.5 billion and $2.2 billion, respectively, net of reserves of $13 million and $23 million at September 30, 2010 and December 31, 2009, respectively.
The following tables present information about the Company’s mortgage servicing activities for SPEs to which the Company transferred loans at September 30, 2010 and December 31, 2009:
Assets serviced (unpaid principal balance)
Amounts past due 90 days or greater (unpaid principal balance)(1)
Percentage of amounts past due 90 days or greater(1)
Credit losses
The Company also serviced residential and commercial mortgage loans for SPEs sponsored by unrelated parties with unpaid principal balances totaling $15 billion and $20 billion at September 30, 2010 and December 31, 2009, respectively.
The Company tests goodwill for impairment on an annual basis and on an interim basis when certain events or circumstances exist. The Company tests for impairment at the reporting unit level, which is generally at the level of or one level below its business segments. Goodwill impairment is determined by comparing the estimated fair value of a reporting unit with its respective book value. If the estimated fair value exceeds the book value, goodwill at the reporting unit level is not deemed to be impaired. If the estimated fair value is below book value, however, further analysis is required to determine the amount of the impairment.
The estimated fair values of the reporting units are generally determined utilizing methodologies that incorporate price-to-book, price-to-earnings and assets under management multiples of certain comparable companies.
The Company completed its annual goodwill impairment testing as of July 1, 2010. The Company’s testing did not indicate any goodwill impairment. Due to the volatility in the equity markets, the economic outlook and the Company’s common shares trading below book value during the quarter ended September 30, 2010, the Company performed additional impairment testing at September 30, 2010, which did not result in any goodwill impairment. Adverse market or economic events could result in impairment charges in future periods.
Goodwill.
Changes in the carrying amount of the Company’s goodwill, net of accumulated impairment losses for the nine months ended September 30, 2010 were as follows:
Goodwill at December 31, 2009
Foreign currency translation adjustments and other
Goodwill disposed of during the period(1)
Goodwill at September 30, 2010(2)
Net Intangible Assets.
Changes in the carrying amount of the Company’s intangible assets for the nine months ended September 30, 2010 were as follows:
Amortizable net intangible assets at December 31, 2009
Mortgage servicing rights (see Note 7)
Indefinite-lived intangible assets
Net intangible assets at December 31, 2009
Amortization expense
Impairment losses(1)
Intangible assets acquired during the period(2)
Intangible assets disposed of during the period
Amortizable net intangible assets at September 30, 2010
Net intangible assets at September 30, 2010
The Company’s long-term borrowings included the following components:
Senior debt
Subordinated debt
Junior subordinated debentures
During the nine months ended September 30, 2010, the Company issued notes with a principal amount of approximately $27 billion representing senior unsecured notes that were not guaranteed by the Federal Deposit Insurance Corporation (“FDIC”). The amount included non-U.S. dollar currency notes aggregating approximately $5 billion. During the nine months ended September 30, 2010, approximately $21 billion of notes were repaid and $5,579 million of junior subordinated debentures related to CIC were redeemed. See Note 13 for additional information on the redemption of CIC Equity Units and issuance of common stock.
The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.0 years and 5.6 years at September 30, 2010 and December 31, 2009, respectively.
FDIC’s Temporary Liquidity Guarantee Program (“TLGP”).
At September 30, 2010 and December 31, 2009, the Company had long-term debt outstanding of $23.8 billion under the TLGP. These borrowings are senior unsecured debt obligations of the Company and guaranteed by the FDIC under the TLGP. The FDIC concluded that the guarantee is backed by the full faith and credit of the U.S. government.
10. Derivative Instruments and Hedging Activities.
The Company trades, makes markets and takes proprietary positions globally in listed futures, OTC swaps, forwards, options and other derivatives referencing, among other things, interest rates, currencies, investment grade and non-investment grade corporate credits, loans, bonds, U.S. and other sovereign securities, emerging market bonds and loans, credit indices, asset-backed security indices, property indices, mortgage-related and other asset-backed securities and real estate loan products. The Company uses these instruments for trading, foreign currency exposure management, and asset and liability management.
The Company manages its trading positions by employing a variety of risk mitigation strategies. These strategies include diversification of risk exposures and hedging. Hedging activities consist of the purchase or sale of positions in related securities and financial instruments, including a variety of derivative products (e.g., futures, forwards, swaps and options). The Company manages the market risk associated with its trading activities on a Company-wide basis, on a worldwide trading division level and on an individual product basis.
The Company incurs credit risk as a dealer in OTC derivatives. 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 derivative contracts reported as assets. The fair value of a derivative represents the amount at which the derivative could be exchanged in an orderly transaction between market participants, and is further described in Notes 2 and 4.
In connection with its derivative activities, the Company generally enters into master netting agreements and collateral arrangements with counterparties. These agreements provide the Company with the ability to offset a counterparty’s rights and obligations, request additional collateral when necessary or liquidate the collateral in the event of counterparty default.
The tables below present a summary by counterparty credit rating and remaining contract maturity of the fair value of OTC derivatives in a gain position at September 30, 2010 and December 31, 2009, respectively. Fair value is presented in the final column net of collateral received (principally cash and U.S. government and agency securities):
OTC Derivative Products—Financial Instruments Owned at September 30, 2010(1)
Credit Rating(2)
AAA
AA
A
BBB
OTC Derivative Products—Financial Instruments Owned at December 31, 2009(1)
The Company applies hedge accounting using various derivative financial instruments and non-U.S. dollar-denominated debt to hedge interest rate and foreign exchange risk arising from assets and liabilities not held at fair value as part of asset and liability management and foreign currency exposure management.
The Company’s hedges are designated and qualify for accounting purposes as one of the following types of hedges: hedges of exposure to changes in fair value of assets and liabilities being hedged (fair value hedges) and hedges of net investments in foreign operations whose functional currency is different from the reporting currency of the parent company (net investment hedges).
For all hedges where hedge accounting is being applied, effectiveness testing and other procedures to ensure the ongoing validity of the hedges are performed at least monthly.
Fair Value Hedges—Interest Rate Risk. The Company’s designated fair value hedges consisted primarily of interest rate swaps designated as fair value hedges of changes in the benchmark interest rate of fixed rate senior long-term borrowings. The Company uses regression analysis to perform an ongoing prospective and retrospective assessment of the effectiveness of these hedging relationships (i.e., the Company applies the “long-haul” method of hedge accounting). A hedging relationship is deemed effective if the fair values of the hedging instrument (derivative) and the hedged item (debt liability) change inversely within a range of 80% to 125%. The Company considers the impact of valuation adjustments related to the Company’s own credit spreads and counterparty credit spreads to determine whether they would cause the hedging relationship to be ineffective.
For qualifying fair value hedges of benchmark interest rates, the changes in the fair value of the derivative and the changes in the fair value of the hedged liability provide offset of one another and, together with any resulting ineffectiveness, are recorded in Interest expense. When a derivative is de-designated as a hedge, any basis adjustment remaining on the hedged liability is amortized to Interest expense over the remaining life of the liability using the effective interest method.
Net Investment Hedges. The Company may utilize forward foreign exchange contracts and non-U.S. dollar-denominated debt to manage the currency exposure relating to its net investments in non-U.S. dollar functional currency operations. No hedge ineffectiveness is recognized in earnings since the notional amounts of the hedging instruments equal the portion of the investments being hedged, and, where forward contracts are used, the currencies being exchanged are the functional currencies of the parent and investee; where debt instruments are used as hedges, they are denominated in the functional currency of the investee. The gain or loss from revaluing hedges of net investments in foreign operations at the spot rate is deferred and reported within Accumulated other comprehensive income (loss) in Equity, net of tax effects. The forward points on the hedging instruments are recorded in Interest income.
The following tables summarize the fair value of derivative instruments designated as accounting hedges and the fair value of derivative instruments not designated as accounting hedges by type of derivative contract on a gross basis. Fair values of derivative contracts in an asset position are included in Financial instruments owned—Derivative and other contracts. Fair values of derivative contracts in a liability position are reflected in Financial instruments sold, not yet purchased—Derivative and other contracts.
Derivatives designated as accounting hedges:
Total derivatives designated as accounting hedges
Derivatives not designated as accounting hedges(1):
Total derivatives not designated as accounting hedges
Total derivatives
Cash collateral netting
Counterparty netting
The following tables summarize the gains or losses reported on derivative instruments designated and qualifying as accounting hedges for the quarters and nine months ended September 30, 2010 and 2009, respectively.
Derivatives Designated as Fair Value Hedges.
The following table presents gains (losses) reported on derivative instruments and the related hedge item as well as the hedge ineffectiveness included in Interest expense in the condensed consolidated statements of income from interest rate contracts:
Product Type
Gain (loss) recognized on derivatives
(Loss) gain recognized on borrowings
Derivatives Designated as Net Investment Hedges.
Foreign exchange contracts(2)
Debt instruments
The table below summarizes gains (losses) on derivative instruments not designated as accounting hedges for the quarters and nine months ended September 30, 2010 and 2009, respectively:
Other contracts
Total derivative instruments
The Company also has certain embedded derivatives that have been bifurcated from the borrowings. Such derivatives are classified in Long-term borrowings and had a net fair value of $108 million and $110 million at September 30, 2010 and December 31, 2009, respectively, and a notional of $4,603 million and $3,442 million at September 30, 2010 and December 31, 2009, respectively. The Company recognized gains of $24 million and $69 million related to changes in the fair value of its bifurcated embedded derivatives for the quarter and nine months ended September 30, 2010, respectively. The Company recognized losses of $40 million and $23 million related to changes in the fair value of its bifurcated embedded derivatives for the quarter and nine months ended September 30, 2009, respectively.
At September 30, 2010 and December 31, 2009, the amount of payables associated with cash collateral received that was netted against derivative assets was $71.0 billion and $62.7 billion, respectively, and the amount of receivables in respect of cash collateral paid that was netted against derivative liabilities was $42.4 billion and $31.7 billion, respectively. Cash collateral receivables and payables of $400 million and $171 million, respectively, at September 30, 2010, and $62 million and $227 million, respectively, at December 31, 2009, were not offset against certain contracts that did not meet the definition of a derivative.
Credit-Risk-Related Contingencies.
In connection with certain OTC trading agreements, the Company may be required to provide additional collateral or immediately settle any outstanding liability balances with certain counterparties in the event of a credit ratings downgrade. At September 30, 2010 and December 31, 2009, the aggregate fair value of derivative contracts that contain credit-risk-related contingent features that are in a net liability position totaled $39,731 million and $23,052 million, respectively, for which the Company has posted collateral of $35,334 million and $20,607 million, respectively, in the normal course of business. At September 30, 2010 and December 31, 2009, the amount of additional collateral or termination payments that could be called by counterparties under the terms of such agreements in the event of a one-notch downgrade of the Company’s long-term credit rating was approximately $1,189 million and $717 million, respectively. Additional collateral or termination payments of approximately $1,595 million and $975 million could be called by counterparties in the event of a two-notch downgrade at September 30, 2010 and December 31, 2009, respectively. Of these amounts, $2,169 million and $1,203 million at September 30, 2010 and December 31, 2009, respectively, related to bilateral arrangements between the Company and other parties where upon the downgrade of one party, the downgraded party must deliver incremental collateral to the other party. These bilateral downgrade arrangements are a risk management tool used extensively by the Company as credit exposures are reduced if counterparties are downgraded.
Credit Derivatives and Other Credit Contracts.
The Company enters into credit derivatives, principally through credit default swaps, under which it provides counterparties protection against the risk of default on a set of debt obligations issued by a specified reference entity or entities. A majority of the Company’s counterparties are banks, broker-dealers, insurance and other financial institutions, and monoline insurers. The table below summarizes certain information regarding protection sold through credit default swaps and CLNs at September 30, 2010:
Credit Ratings of the Reference Obligation
Single name credit default swaps:
Index and basket credit default swaps:
Total credit default swaps sold
Other credit contracts(3)(4)
Total credit derivatives and other credit contracts
The table below summarizes certain information regarding protection sold through credit default swaps and CLNs at December 31, 2009:
Single Name Credit Default Swaps. A credit default swap protects the buyer against the loss of principal on a bond or loan in case of a default by the issuer. The protection buyer pays a periodic premium (generally quarterly) over the life of the contract and is protected for the period. The Company in turn will have to perform under a credit default swap if a credit event as defined under the contract occurs. Typical credit events include bankruptcy, dissolution or insolvency of the referenced entity, failure to pay and restructuring of the obligations of the referenced entity. In order to provide an indication of the current payment status or performance risk of the credit default swaps, the external credit ratings, primarily Moody’s Investors Service, Inc. (“Moody’s”) credit ratings, of the underlying reference entity of the credit default swaps are disclosed.
Index and Basket Credit Default Swaps. Index and basket credit default swaps are credit default swaps that reference multiple names through underlying baskets or portfolios of single name credit default swaps. Generally, in the event of a default on one of the underlying names, the Company will have to pay a pro rata portion of the total notional amount of the credit default index or basket contract. In order to provide an indication of the current payment status or performance risk of these credit default swaps, the weighted average external credit ratings, primarily Moody’s credit ratings, of the underlying reference entities comprising the basket or index were calculated and disclosed.
The Company also enters into index and basket credit default swaps where the credit protection provided is based upon the application of tranching techniques. In tranched transactions, the credit risk of an index or basket is separated into various portions of the capital structure, with different levels of subordination. The most junior tranches cover initial defaults, and once losses exceed the notional of the tranche, they are passed on to the next most senior tranche in the capital structure. As external credit ratings are not always available for tranched indices and baskets, credit ratings were determined based upon an internal methodology.
Credit Protection Sold Through CLNs and CDOs. The Company has invested in CLNs and CDOs, which are hybrid instruments containing embedded derivatives, in which credit protection has been sold to the issuer of the note. If there is a credit event of a reference entity underlying the instrument, the principal balance of the note may not be repaid in full to the Company.
Purchased Credit Protection. For single name credit default swaps and non-tranched index and basket credit default swaps, the Company has purchased protection with a notional amount of approximately $1.9 trillion at September 30, 2010 and December 31, 2009 compared with a notional amount of approximately $2.1 trillion at September 30, 2010 and December 31, 2009 of credit protection sold with identical underlying reference obligations. In order to identify purchased protection with the same underlying reference obligations, the notional amount for individual reference obligations within non-tranched indices and baskets was determined on a pro rata basis and matched off against single name and non-tranched index and basket credit default swaps where credit protection was sold with identical underlying reference obligations. The Company may also purchase credit protection to economically hedge loans and lending commitments. In total, not considering whether the underlying reference obligations are identical, the Company has purchased credit protection of $2.5 trillion with a positive fair value of $61 billion compared with $2.4 trillion of credit protection sold with a negative fair value of $45 billion at September 30, 2010. In total, not considering whether the underlying reference obligations are identical, the Company has purchased credit protection of $2.5 trillion with a positive fair value of $65 billion compared with $2.4 trillion of credit protection sold with a negative fair value of $44 billion at December 31, 2009.
The purchase of credit protection does not represent the sole manner in which the Company risk manages its exposure to credit derivatives. The Company manages its exposure to these derivative contracts through a variety of risk mitigation strategies, which include managing the credit and correlation risk across single name, non-tranched indices and baskets, tranched indices and baskets, and cash positions. Aggregate market risk limits have been established for credit derivatives, and market risk measures are routinely monitored against these limits. The Company may also recover amounts on the underlying reference obligation delivered to the Company under credit default swaps where credit protection was sold.
Commitments.
The Company’s commitments associated with outstanding letters of credit and other financial guarantees obtained to satisfy collateral requirements, investment activities, corporate lending and financing arrangements, mortgage lending and margin lending at September 30, 2010 are summarized below by period of expiration. Since commitments associated with these instruments may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements:
Letters of credit and other financial guarantees obtained to satisfy collateral requirements
Investment activities
Primary lending commitments—investment grade(1)(2)
Primary lending commitments—non-investment grade(1)
Secondary lending commitments(1)
Commitments for secured lending transactions
Forward starting reverse repurchase agreements(3)
Commercial and residential mortgage-related commitments
Underwriting commitments
Other commitments
For further description of these commitments, refer to Note 11 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K.
The Company sponsors several nonconsolidated investment funds for third-party investors where the Company typically acts as general partner of, and investment adviser to, these funds and typically commits to invest a minority of the capital of such funds with subscribing third-party investors contributing the majority. The Company’s employees, including its senior officers, as well as the Company’s directors may participate on the same terms and conditions as other investors in certain of these funds that the Company forms primarily for client investment, except that the Company may waive or lower applicable fees and charges for its employees. The Company has contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to these investment funds.
Guarantees.
The table below summarizes certain information regarding the Company’s obligations under guarantee arrangements at September 30, 2010:
Type of Guarantee
Credit derivative contracts(1)
Other credit contracts
Non-credit derivative contracts(1)(2)
Standby letters of credit and other financial guarantees issued(3)(4)
Market value guarantees
Liquidity facilities
Whole loan sales guarantees
General partner guarantees
The Company has obligations under certain guarantee arrangements, including contracts and indemnification agreements that contingently require a guarantor to make payments to the guaranteed party based on changes in an underlying measure (such as an interest or foreign exchange rate, security or commodity price, an index or the occurrence or non-occurrence of a specified event) related to an asset, liability or equity security of a guaranteed party. Also included as guarantees are contracts that contingently require the guarantor to make payments to the guaranteed party based on another entity’s failure to perform under an agreement, as well as indirect guarantees of the indebtedness of others.
Other Guarantees and Indemnities.
In the normal course of business, the Company provides guarantees and indemnifications in a variety of commercial transactions. These provisions generally are standard contractual terms. Certain of these guarantees and indemnifications are described below.
Trust Preferred Securities. The Company has established Morgan Stanley Capital Trusts for the limited purpose of issuing trust preferred securities to third parties and lending the proceeds to the Company in exchange for junior subordinated debentures. The Company has directly guaranteed the repayment of the trust preferred securities to the holders thereof to the extent that the Company has made payments to a Morgan Stanley Capital Trust on the junior subordinated debentures. In the event that the Company does not make payments to a Morgan Stanley Capital Trust, holders of such series of trust preferred securities would not be able to rely upon the guarantee for payment of those amounts. The Company has not recorded any liability in the condensed consolidated financial statements for these guarantees and believes that the occurrence of any events (i.e., non-performance on the part of the paying agent) that would trigger payments under these contracts is remote. See Note 13 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K for details on the Company’s junior subordinated debentures.
Indemnities. The Company provides standard indemnities to counterparties for certain contingent exposures and 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 or a change in factual circumstances. 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.
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 derivative 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. The maximum potential payout 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.
Representations and Warranties on Certain Securitized Assets. As part of the Company’s Institutional Securities business segment’s securitization and related activities, the Company has provided, or otherwise agreed to be responsible for, representations and warranties regarding certain assets transferred in securitization transactions sponsored by the Company. The extent and nature of the representations and warranties, if any, varies among different securitizations. Under certain circumstances, the Company may be required to repurchase such assets or make other payments related to such assets if such representations and warranties were breached. The maximum potential amount of future payments the Company could be required to make would be equal to the current outstanding balances of, or losses associated with, the assets subject to breaches of such representations and warranties. The Company has not accrued any amounts in the condensed consolidated financial statements for payments owed as a result of breach of representations and warranties made in connection with securitized assets since it currently believes that at September 30, 2010 the probability of any payments under these arrangements is remote. See “Contingencies—Legal” below.
Merger and Acquisition Guarantees. 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 Company believes 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.
Guarantees on Morgan Stanley Stable Value Program. On September 30, 2009, the Company entered into an agreement with the investment manager for the Stable Value Program (“SVP”), a fund within the Company’s 401(k) plan, and certain other third parties. Under the agreement, the Company contributed $20 million to the SVP on October 15, 2009 and recorded the contribution in Compensation and benefits expense. Additionally, the Company may have a future obligation to make a payment of $40 million to the SVP following the third anniversary of the agreement, after which the SVP would be wound down over a period of time. The future obligation is contingent upon whether the market-to-book value ratio of the portion of the SVP that is subject to certain book-value stabilizing contracts has fallen below a specific threshold and the Company and the other parties to the agreement all decline to make payments to restore the SVP to such threshold as of the third anniversary of the agreement. The Company has not recorded a liability for this guarantee in the condensed consolidated financial statements.
In the ordinary course of business, the Company guarantees the debt and/or certain trading obligations (including obligations associated with derivatives, foreign exchange contracts and the settlement of physical commodities) of certain subsidiaries. These guarantees generally are entity or product specific and are required by investors or trading counterparties. The activities of the subsidiaries covered by these guarantees (including any related debt or trading obligations) are included in the Company’s condensed consolidated financial statements.
Contingencies.
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. These actions have included, but are not limited to, residential mortgage-related matters, auction rate securities matters and executive compensation-related matters.
Certain of the actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or are in financial distress.
The Company is also involved, from time to time, in other reviews, investigations and proceedings (both formal and informal) by governmental and self-regulatory agencies 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 Company contests liability and/or the amount of damages as appropriate in each pending matter. Where available information indicates that it is probable a liability had been incurred at the date of the condensed consolidated financial statements and the Company can reasonably estimate the amount of that loss, the
Company accrues the estimated loss by a charge to income. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. In addition, even where loss is possible or an exposure to loss exists in excess of the liability already accrued with respect to a previously recognized loss contingency, it is not always possible to reasonably estimate the size of the possible loss or range of loss.
For certain legal proceedings, the Company can estimate possible losses, additional losses, ranges of loss or ranges of additional loss in excess of amounts accrued, but does not believe, based on current knowledge and after consultation with counsel, that such losses will have a material adverse effect on the Company’s condensed consolidated financial statements as a whole, other than the matters referred to in the next two paragraphs.
On September 25, 2009, the Company was named as a defendant in a lawsuit styled Citibank, N.A. v. Morgan Stanley & Co. International, PLC, which is pending in the United States District Court for the Southern District of New York (“SDNY”). The lawsuit relates to a credit default swap referencing the Capmark VI CDO (“Capmark”), which was structured by Citibank, N.A. (“Citi N.A.”). At issue is whether, as part of the swap agreement, Citi N.A. was obligated to obtain the Company’s prior written consent before it exercised a right to liquidate Capmark upon the occurrence of certain contractually-defined credit events. Citi N.A. is seeking approximately $245 million in compensatory damages plus interest and costs. On May 13, 2010, the court granted Citi N.A.’s motion for judgment on the pleadings on its claim for breach of contract. On October 8, 2010, the court issued an order denying Citi N.A.’s motion for judgment on the pleadings as to the Company’s counterclaim for reformation and granting Citi N.A.’s motion for judgment on the pleadings as to the Company’s counterclaim for estoppel. Based on currently available information, the Company believes it is reasonably possible it could incur a loss of approximately $245 million.
On January 16, 2009, the Company was named as a defendant in an interpleader lawsuit styled U.S. Bank, N.A. v. Barclays Bank PLC and Morgan Stanley Capital Services Inc., which is pending in the SDNY. The lawsuit relates to credit default swaps between the Company and Tourmaline CDO I LTD (“Tourmaline”), in which Barclays Bank PLC (“Barclays”) is the holder of the most senior and controlling class of notes. At issue is whether, pursuant to the terms of the swap agreements, the Company was required to post collateral to Tourmaline, or take any other action, after the Company’s credit ratings were downgraded in 2008 by certain ratings agencies. The Company and Barclays have a dispute regarding whether the Company breached any obligations under the swap agreements and, if so, whether any such breaches were cured. The trustee for Tourmaline, interpleader plaintiff U.S. Bank, N.A., has refrained from making any further distribution of Tourmaline’s funds pending the resolution of these issues and is seeking a judgment from the court resolving them. Based on currently available information, at September 30, 2010, the Company believes it is reasonably possible it may incur a loss of approximately $274 million, resulting from the write-off of receivables from Tourmaline. The trial is scheduled to begin November 17, 2010.
For certain other legal proceedings, the Company cannot reasonably estimate such losses, particularly for proceedings that are in their early stages of development or where plaintiffs seek substantial or indeterminate damages. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, and by addressing novel or unsettled legal questions relevant to the proceedings in question, before a loss or additional loss or range of loss or additional loss can be reasonably estimated for any proceeding.
Recently, the level of litigation activity focused on residential mortgage-related claims has increased materially in the financial services industry. As a result, the Company expects that it may become the subject of increased claims for damages and other relief regarding residential mortgages and related securities in the future and, while
the Company has identified above any individual proceedings where the Company believes a material loss to be possible and reasonably estimable, there can be no assurance that material losses will not be incurred from claims that have not yet been notified to the Company or are not yet determined to be probable or possible and reasonably estimable losses.
Morgan Stanley. The Company is a financial holding company under the Bank Holding Company Act of 1956 and is subject to the regulation and oversight of the Federal Reserve. The Federal Reserve establishes capital requirements for the Company, including well-capitalized standards, and evaluates the Company’s compliance with such capital requirements. The Office of the Comptroller of the Currency establishes similar capital requirements and standards for the Company’s national bank subsidiaries.
The Company calculates its capital ratios and Risk Weighted Assets (“RWAs”) in accordance with the capital adequacy standards for financial holding companies adopted by the Federal Reserve. These standards are based upon a framework described in the “International Convergence of Capital Measurement and Capital Standards,” July 1988, as amended, also referred to as Basel I. In December 2007, the U.S. banking regulators published final U.S. implementing regulation incorporating the Basel II Accord; which requires internationally active banking organizations, as well as certain of their U.S. bank subsidiaries, to implement Basel II standards over the next several years. The timeline set out in December 2007 for the implementation of Basel II in the U.S. may be impacted by the developments concerning Basel III described below. Starting July 2010, the Company has been reporting on a parallel basis under the current regulatory capital regime (Basel I) and Basel II followed by a three-year transitional period. There will be at least four quarters of parallel reporting before the Company enters the three-year transitional period to implement Basel II standards.
In December 2009, the Basel Committee of Banking Supervision (the “Basel Committee”) released proposals on risk-based capital, leverage and liquidity standards, known as “Basel III”. The proposal described new standards to raise the quality of capital and strengthen counterparty credit risk capital requirements; introduced a leverage ratio as a supplemental measure to the risk-based ratio and introduced a countercyclical buffer. The Basel III proposals complement an earlier proposal for revisions to Market Risk Framework that increases capital requirements for securitizations within the trading book. In July 2010, the Basel Committee refined some of the proposals. In September 2010, the Group of Governors and Heads of Supervision of the Basel Committee endorsed the proposals and introduced minimum capital requirements and timelines for implementation of the new standards.
The Basel Committee is expected to publish near final rules in November, which are expected to be ratified at the G20 Leaders Summit. The U.S. regulators will require implementation of Basel III subject to an extended phase-in period. The Basel Committee is also working with the Financial Stability Board to develop additional requirements for systemically important banks, which could include capital surcharges.
At September 30, 2010, the Company was in compliance with Basel I capital requirements with ratios of Tier 1 capital to RWAs of 16.5% and total capital to RWAs of 17.0% (6% and 10% being well-capitalized for regulatory purposes, respectively). In addition, financial holding companies are also subject to a Tier 1 leverage ratio as defined by the Federal Reserve. The Company calculated its Tier 1 leverage ratio as Tier 1 capital divided by adjusted average total assets (which reflects adjustments for disallowed goodwill, certain intangible assets, deferred tax assets and financial and non-financial equity investments). The adjusted average total assets are derived using weekly balances for the calendar quarter.
The following table summarizes the capital measures for the Company at September 30, 2010 and December 31, 2009:
Tier 1 capital
Total capital
RWAs
Adjusted average assets
Tier 1 leverage
The Company’s Significant U.S. Bank Operating Subsidiaries. The Company’s domestic bank operating subsidiaries are subject to various regulatory capital requirements as administered by U.S. federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional, discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s U.S. bank operating subsidiaries’ financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company’s U.S. bank operating subsidiaries must meet specific capital guidelines that involve quantitative measures of the Company’s U.S. bank operating subsidiaries’ assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.
At September 30, 2010, the Company’s U.S. bank operating subsidiaries met all capital adequacy requirements to which they are subject and exceeded all regulatory mandated and targeted minimum regulatory capital requirements to be well-capitalized. There are no conditions or events that management believes have changed the Company’s U.S. bank operating subsidiaries’ category.
The table below sets forth the Company’s significant U.S. bank operating subsidiaries’ capital at September 30, 2010 and December 31, 2009.
Total Capital (to RWAs):
Morgan Stanley Bank, N.A.
Morgan Stanley Private Bank, National Association(1)
Tier I Capital (to RWAs):
Leverage Ratio:
Under regulatory capital requirements adopted by the U.S. federal banking agencies, U.S. depository institutions, in order to be considered well-capitalized, must maintain a ratio of total capital to RWAs of 10%, a capital ratio of Tier 1 capital to RWAs of 6%, and a ratio of Tier 1 capital to average book assets (leverage ratio) of 5%. Each U.S. depository institution subsidiary of the Company must be well-capitalized in order for the Company to continue to qualify as a financial holding company and to continue to engage in the broadest range
of financial activities permitted to financial holding companies. At September 30, 2010, the Company’s three U.S. depository institutions maintained capital at levels in excess of the universally mandated well-capitalized levels. These subsidiary depository institutions maintain capital at levels sufficiently in excess of the “well-capitalized” requirements to address any additional capital needs and requirements identified by the federal banking regulators.
MS&Co. and Other Broker-Dealers. MS&Co. is a registered broker-dealer and registered futures commission merchant and, accordingly, is subject to the minimum net capital requirements of the Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority and the Commodity Futures Trading Commission. MS&Co. has consistently operated with capital in excess of its regulatory capital requirements. MS&Co.’s net capital totaled $8,067 million and $7,854 million at September 30, 2010 and December 31, 2009, respectively, which exceeded the amount required by $6,912 million and $6,758 million, respectively. Morgan Stanley Smith Barney LLC is a registered broker-dealer and registered futures commission merchant and has operated with capital in excess of its regulatory capital requirements. Morgan Stanley Smith Barney LLC clears certain customer activity directly and introduces other business to MS&Co. and Citi. MSIP, a London-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Authority, and MSMS, a Tokyo-based broker-dealer subsidiary, is subject to the capital requirements of the Financial Services Agency. MSIP and MSMS have consistently operated in excess of their respective regulatory capital requirements.
MS&Co. is required to hold tentative net capital in excess of $1 billion and net capital in excess of $500 million in accordance with the market and credit risk standards of Appendix E of Rule 15c3-1. MS&Co. is also required to notify the SEC in the event that its tentative net capital is less than $5 billion. At September 30, 2010, MS&Co. had tentative net capital in excess of the minimum and the notification requirements.
Other Regulated Subsidiaries. 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. (“MSDP”), a derivative products subsidiary rated Aa2 by Moody’s and AAA by Standard & Poor’s Ratings Services, a Division of the McGraw-Hill Companies Inc. (“S&P”), maintains certain operating restrictions that have been reviewed by Moody’s and S&P. On December 21, 2009, MSDP was downgraded from a triple-A rating to Aa2 rating by Moody’s but maintained its AAA rating by S&P. The downgrade did not significantly impact the Company’s results of operations or financial condition. MSDP is operated such that creditors of the Company should not expect to have any claims on the assets of MSDP, unless and until the obligations to its own creditors are satisfied in full. Creditors of MSDP should not expect to have any claims on the assets of the Company or any of its affiliates, other than the respective assets of MSDP.
Morgan Stanley Shareholders’ Equity.
Redemption of CIC Equity Units and Issuance of Common Stock.
In December 2007, the Company sold Equity Units that included contracts to purchase Company common stock to the CIC Entity for approximately $5,579 million. On July 1, 2010, Moody’s Investor Services announced that it was lowering the equity credit assigned to such Equity Units. The terms of the Equity Units permitted the Company to redeem the junior subordinated debentures underlying the Equity Units upon the occurrence and continuation of a Rating Agency Event. In response to this Rating Agency Event, the Company redeemed the
junior subordinated debentures in August 2010 and the redemption proceeds were subsequently used by the CIC Entity to settle its obligation under the purchase contracts. The settlement of the purchase contracts and delivery of 116,062,911 shares of Company common stock to the CIC Entity occurred in August 2010.
Common Equity Offerings.
During the quarters and nine months ended September 30, 2010 and September 30, 2009, the Company did not purchase any of its common stock as part of its share repurchase program. At September 30, 2010, the Company had approximately $1.6 billion remaining under its current share repurchase authorization. Share repurchases by the Company are subject to regulatory approval.
Preferred Stock.
In June 2009, the Company repurchased 10,000,000 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series D, par value $0.01 per share, liquidation preference $1,000 per share (the “Series D Preferred Stock”) that the Company issued to the U.S. Department of the Treasury (“U.S. Treasury”) in October 2008, at the liquidation preference amount plus accrued and unpaid dividends, for an aggregate repurchase price of $10,086 million.
As a result of the Company’s repurchasing the Series D Preferred Stock, the Company incurred a one-time negative adjustment of $850 million in its calculation of basic and diluted EPS (reduction to earnings (losses) applicable to the Company’s common shareholders) for the nine months ended September 30, 2009 due to the accelerated amortization of the issuance discount on the Series D Preferred Stock.
In connection with the issuance of the Series D Preferred Stock, the Company also issued a warrant to the U.S. Treasury under the Capital Purchase Program (the “CPP”) for the purchase of 65,245,759 shares of the Company’s common stock at an exercise price of $22.99 per share.
In August 2009, under the terms of the CPP securities purchase agreement, the Company repurchased the warrant from the U.S. Treasury in the amount of $950 million. The repurchase of the Series D Preferred Stock, in the amount of $10.0 billion and the warrant in the amount of $950 million, reduced the Company’s total equity by $10,950 million in the nine months ended September 30, 2009.
For further information on the Company’s preferred stock, refer to Note 13 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K.
Noncontrolling Interest.
Deconsolidation of Subsidiaries.
During the nine months ended September 30, 2009, the Company deconsolidated MSCI in connection with the Company’s disposition of its remaining ownership interest in MSCI and recognized an after-tax gain of approximately $310 million. The Company did not retain any investments in MSCI upon deconsolidation. See Note 1 for further information on discontinued operations.
Changes in the Company’s Ownership Interest in Subsidiaries.
The following table presents the effect on the Company’s shareholders’ equity from changes in ownership of subsidiaries resulting from transactions with noncontrolling interests.
Transfers from the noncontrolling interests:
Increase in paid-in capital in connection with MSSB
Increase in paid-in capital in connection with the MUFG transaction
Net transfers from noncontrolling interests
Change from net income applicable to Morgan Stanley and transfers from noncontrolling interests
The increase in paid-in capital in connection with MSSB results from Citi’s equity interest in MSSB, to which the Company had contributed certain businesses associated with the Company’s Global Wealth Management Group. The excess of the net fair value received by the Company over the increase in noncontrolling interest associated with Smith Barney is reflected as an increase in paid-in capital. See Note 3 for further information regarding the MSSB transaction.
In connection with the closing of the previously announced transaction between the Company and Mitsubishi UFJ Financial Group, Inc. (“MUFG”) to form a joint venture in Japan, the Company recorded an after-tax gain of $731 million from the sale of a noncontrolling interest in its Japanese institutional securities business. This gain was recorded in Paid-in capital in the Company’s condensed consolidated statements of financial condition at September 30, 2010 and changes in total equity for the nine months ended September 30, 2010. See Note 19 for further information regarding the MUFG transaction.
Basic EPS is computed by dividing income available to Morgan Stanley common shareholders by the weighted average number of common shares outstanding for the period. Common shares outstanding include common stock and vested restricted stock unit awards where recipients have satisfied either the explicit vesting terms or retirement eligibility requirements. Diluted EPS reflects the assumed conversion of all dilutive securities. The Company calculates EPS using the two-class method (see Note 2) and determines whether instruments granted in share-based payment transactions are participating securities. The following table presents the calculation of basic and diluted EPS (in millions, except for per share data):
Basic EPS:
Less: Preferred dividends (Series A Preferred Stock)
Less: Preferred dividends (Series B Preferred Stock)
Less: Preferred dividends (Series C Preferred Stock)
Less: Partial Redemption of Series C Preferred Stock
Less: Preferred dividends (Series D Preferred Stock)
Less: Amortization and acceleration of issuance discount for Series D Preferred Stock(1)
Less: Allocation of earnings to participating restricted stock units(2):
From continuing operations
From discontinued operations
Less: Allocation of undistributed earnings to Equity Units(1):
Weighted average common shares outstanding
Diluted EPS:
Impact on income of assumed conversions:
Assumed conversion of Equity Unit(1)(3)
Preferred stock dividends (Series B Preferred Stock)
Earnings (loss) applicable to common shareholders plus assumed conversions
Effect of dilutive securities:
Stock options and restricted stock units(2)
Warrants issued to U.S. Treasury
Equity units (1)(3)
Series B Preferred Stock
Weighted average common shares outstanding and common stock equivalents
The following securities were considered antidilutive, and therefore, were excluded from the computation of diluted EPS:
Number of Antidilutive Securities Outstanding at End of Period:
Stock options
Restricted stock units and performance stock units
Equity Units(1)
Details of Interest income and Interest expense were as follows:
Interest income(1):
Financial instruments owned(2)
Federal funds sold and securities purchased under agreements to resell and Securities borrowed
Total Interest income
Interest expense(1):
Long-term debt
Securities sold under agreements to repurchase and Securities loaned
Total Interest expense
The Company sponsors various pension plans for the majority of its U.S. and non-U.S. employees. The Company provides certain other postretirement benefits, primarily health care and life insurance, to eligible U.S. employees. The Company also provides certain postemployment benefits to certain former employees or inactive employees prior to retirement.
On June 1, 2010, the Morgan Stanley Employees Retirement Plan (the “Pension Plan”) for U.S. participants was amended to cease accruals of benefits under the Pension Plan effective January 1, 2011. Any benefits earned by participants under the Pension Plan at December 31, 2010 will be preserved and will be payable in the future based on the Pension Plan’s provisions. As a result, the Company reduced Compensation and benefits expense by approximately $51 million on the condensed consolidated statements of income for the nine months ended September 30, 2010. Additionally, the Company remeasured the obligation and assets of the Pension Plan at May 31, 2010 and recognized a gain of $166 million ($102 million after-tax) on the condensed consolidated statements of comprehensive income for the nine months ended September 30, 2010, after reflecting the $51 million reduction in Compensation and benefits expense.
During the quarter ended September 30, 2010, the Company revised its pension and postretirement benefits plans contribution estimate from $275 million to $50 million due to such cessation of accruals for benefits.
The components of the Company’s net periodic benefit expense for its pension and postretirement plans were as follows:
Service cost, benefits earned during the period
Interest cost on projected benefit obligation
Expected return on plan assets
Net amortization of prior service costs
Net amortization of actuarial loss
Curtailment gains
Net periodic benefit expense
The Company is under continuous examination by the Internal Revenue Service (the “IRS”) and other tax authorities in certain countries, such as Japan and the United Kingdom (the “U.K.”), and states in which the Company has significant business operations, such as New York. During the quarter ended September 30, 2010, the IRS concluded the field work portion of their examinations on issues covering tax years 1999 – 2005. Also during 2010, the Company expects to reach a conclusion with the U.K. tax authorities on substantially all issues through tax year 2007, including those in appeals. Additionally during 2010, the Company may reach a conclusion with the New York State and New York City tax authorities on issues covering years 2002—2006. During 2012, the Company expects to reach a conclusion with the Japanese tax authorities on substantially all issues covering tax years 2007—2008. The Company periodically assesses the likelihood of assessments in each of the taxing jurisdictions resulting from current and subsequent years’ examinations. The Company believes that the resolution of tax matters will not have a material effect on the condensed consolidated statements of financial condition of the Company, although a resolution could have a material impact on the Company’s condensed consolidated statements of income for a particular future period and on the Company’s effective income tax rate for any period in which such resolution occurs. The Company has established a liability for unrecognized tax benefits that the Company believes is adequate in relation to the potential for additional assessments. Once established, the Company adjusts unrecognized tax benefits only when more information is available or when an event occurs necessitating a change.
As part of the Company’s periodic review of unrecognized tax benefits, and based on new information regarding the status of federal and state examinations, the Company’s unrecognized tax benefits were remeasured. As a result of this remeasurement, the income tax provision for nine months ended September 30, 2010 included a benefit of $345 million.
It is reasonably possible that further significant changes in the gross balance of unrecognized tax benefits may occur within the next 12 months. At this time, however, it is not possible to reasonably estimate the expected change to the total amount of unrecognized tax benefits and impact on the effective tax rate over the next 12 months.
As part of the Company’s periodic review of the business, liquidity and capital requirements of its non-U.S. subsidiaries, it was determined that prior-years undistributed earnings of certain non-U.S. subsidiaries for which U.S. federal income taxes have been provided will remain indefinitely reinvested abroad. The Company does not intend to use these earnings as a source of funding of its operations in the U.S. in the foreseeable future. As a result of this determination, the income tax provision for the nine months ended September 30, 2010 included a benefit of $382 million associated with the release of the previously provided U.S. federal deferred tax liability associated with these earnings. In addition, the income tax provision for the quarter and nine months ended September 30, 2010 included a benefit of $176 million associated with the planned repatriation of non-U.S. earnings at a cost lower than originally estimated.
In accordance with the guidance for accounting for uncertainty in income taxes, penalties related to unrecognized tax benefits may be classified as either income taxes or another expense classification. During the quarter ended September 30, 2010, the Company changed the classification of penalties related to unrecognized tax benefits and began recording them in Provision for income taxes in the condensed consolidated statements of income. The Company previously recorded such penalties in Income (loss) from continuing operations before income taxes as part of Other expenses. The Company believes the change in classification of penalties is preferable, because such penalties are directly dependent on and correlated to related income tax positions. Additionally, the Company views penalties and interest on uncertain tax positions as part of the cost of managing the Company’s overall tax exposure, and the change in presentation aligns the classification of penalties related to unrecognized tax benefits with the classification of interest on unrecognized tax benefits already classified as part of Provision for income taxes. Penalties related to unrecognized tax benefits during the quarter ended September 30, 2010 and prior periods were not material. Accordingly, the Company did not retrospectively adjust prior periods. The change in classification did not impact Net income or Earnings per share and the impact on Income (loss) from continuing operations before income taxes was not material.
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, Global Wealth Management Group and Asset Management. For further discussion of the Company’s business segments, see Note 1.
Revenues and expenses directly associated with each respective segment are included in determining its 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 net revenues, non-interest expenses 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 business segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations primarily represents the effect of timing differences associated with the revenue and expense recognition of commissions paid by the Asset Management business segment to the Global Wealth Management Group business segment associated with sales of certain products and the related compensation costs paid to the Global Wealth Management Group business segment’s global representatives. Intersegment eliminations also reflect the effect of fees paid by the Institutional Securities business segment to the Global Wealth Management Group business segment related to the bank deposit program.
Selected financial information for the Company’s segments is presented below:
Three Months Ended September 30, 2010
Discontinued operations(1):
Provision for income taxes
Net gain (loss) from discontinued operations(2)
Net income (loss) applicable to Morgan Stanley
Three Months Ended September 30, 2009
Income (loss) from continuing operations before income taxes
Net income (loss) applicable to noncontrolling interest
Net income (loss) applicable to
Morgan Stanley
Provision for (benefit from) for income taxes
Net Interest
Total Assets(1)
At September 30, 2010
At December 31, 2009
The Company operates in both U.S. and non-U.S. markets. The Company’s non-U.S. business activities are principally conducted through European and Asian locations. The net revenues disclosed in the following table reflect the regional view of the Company’s consolidated net revenues on a managed basis, based on the following methodology:
Institutional Securities: advisory and equity underwriting—client location, debt underwriting—revenue recording location, sales and trading—trading desk location.
Global Wealth Management Group: global representative coverage location.
Asset Management: client location, except for merchant banking business, which is based on asset location.
Americas
Europe, Middle East, and Africa
Asia
On May 1, 2010, the Company and MUFG closed the previously announced transaction to form a joint venture in Japan of their respective investment banking and securities businesses. MUFG and the Company have integrated their respective Japanese securities companies by forming two joint venture companies. MUFG contributed the investment banking, wholesale and retail securities businesses conducted in Japan by Mitsubishi UFJ Securities Co., Ltd. into one of the joint venture entities named Mitsubishi UFJ Morgan Stanley Securities Co., Ltd. (“MUMSS”). The Company contributed the investment banking operations conducted in Japan by its subsidiary, MSMS, formerly known as Morgan Stanley Japan Securities Co., Ltd., into MUMSS (MSMS, together with MUMSS, the “Joint Venture”). MSMS will continue its sales and trading and capital markets business conducted in Japan. Following the respective contributions to the Joint Venture and a cash payment of 23 billion yen from MUFG to the Company, the Company owns a 40% economic interest in the Joint Venture and MUFG owns a 60% economic interest in the Joint Venture. The Company holds a 40% voting interest and MUFG holds a 60% voting interest in MUMSS, while the Company holds a 51% voting interest and MUFG holds a 49% voting interest in MSMS. The Company continued to include MSMS in its financial statements and, commencing on May 1, 2010, accounted for its interest in MUMSS as an equity method investment.
See Note 1 for a discussion of the Company’s discontinued operations.
The table below provides information regarding amounts included in discontinued operations:
Net revenues(1):
Revel
Crescent
Retail Asset Management
MSCI
CMB
Pre-tax gain (loss) on discontinued operations(1):
Revel(2)
Retail Asset Management(3)
MSCI(4)
DFS(5)
For the nine months ended September 30, 2009, Other revenues included gains of $485 million from repurchasing the Company’s debt in the open market.
FrontPoint.
In October 2010, the Company reached an agreement with the principals of FrontPoint Partners LLC (“FrontPoint”) whereby FrontPoint senior management and portfolio managers will own a majority equity stake in FrontPoint and the Company will retain a minority stake. FrontPoint will replace the Company’s affiliates as the investment advisor and general partner of the FrontPoint funds. The Company expects the restructuring to close in the fourth quarter of 2010, subject to closing conditions, and expects a pre-tax loss on the transaction of approximately $70 million.
Long-Term Borrowings.
Subsequent to September 30, 2010 and through November 3, 2010, the Company’s long-term borrowings (net of repayments) increased by approximately $1.8 billion.
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 (the “Company”) as of September 30, 2010, the related condensed consolidated statements of income and comprehensive income for the three-month and nine-month periods ended September 30, 2010 and 2009, and the condensed consolidated statements of cash flows and changes in total equity for the nine-month periods ended September 30, 2010 and 2009. These condensed consolidated financial statements are the responsibility of the management of the Company.
We conducted our reviews in accordance with the 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 the 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 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 the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition of the Company as of December 31, 2009, and the consolidated statements of income, comprehensive income, cash flows and changes in total equity for the year then ended (not presented herein) included in the Company’s Annual Report on Form 10-K; and in our report dated February 26, 2010, which report contains explanatory paragraphs concerning the adoption of Financial Accounting Standards Board (“FASB”) accounting guidance that addresses noncontrolling interests in consolidated financial statements, the computation of Earnings Per Share under the two-class method for share-based payment transactions that are participating securities and the accounting for uncertainties in income taxes and an explanatory paragraph concerning the Company changing its fiscal year end from November 30 to December 31, 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 December 31, 2009 is fairly stated, in all material respects, in relation to the consolidated statement of financial condition from which it has been derived.
As discussed in Note 2 to the condensed consolidated financial statements, effective January 1, 2010, the Company adopted FASB accounting guidance that addresses transfers of financial assets and extinguishments of liabilities and consolidation of variable interest entities.
/s/Deloitte & Touche LLP
New York, New York
November 8, 2010
Introduction.
Morgan Stanley, a financial holding company, is a global financial services firm that maintains significant market positions in each of its business segments—Institutional Securities, Global Wealth Management Group and Asset Management. The Company, through its subsidiaries and affiliates, provides a wide variety of products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. Unless the context otherwise requires, the terms “Morgan Stanley” and the “Company” mean Morgan Stanley and its consolidated subsidiaries.
A summary of the activities of each of the business segments is as follows:
Global Wealth Management Group, which includes the Company’s 51% interest in Morgan Stanley Smith Barney Holdings LLC (“MSSB”), provides brokerage and investment advisory services to individual investors and small-to-medium sized businesses and institutions covering various investment alternatives; financial and wealth planning services; annuity and other insurance products; credit and other lending products; cash management services; retirement services; and trust and fiduciary services.
Asset Management provides global asset management products and services in equity, fixed income, alternative investments, which includes hedge funds and funds of funds, and merchant banking, which includes real estate, private equity and infrastructure, to institutional and retail clients through proprietary and third-party distribution channels. Asset Management also engages in investment activities.
See Note 1 to the condensed consolidated financial statements for a discussion of the Company’s discontinued operations.
The Company’s results of operations may be materially affected by market fluctuations and by economic factors. In addition, results of operations in the past have been, and in the future may continue to be, materially affected by many factors of a global nature, including the effect of political and economic conditions and geopolitical events; the effect of market conditions, particularly in the global equity, fixed income and credit markets, including corporate and mortgage (commercial and residential) lending and commercial real estate investments; the impact of current, pending and future legislation (including the U.S. financial reform legislation), regulation (including capital requirements), and legal actions in the U.S. and worldwide, the level and volatility of equity, fixed income and commodity prices, and interest rates, currency values and other market indices; the availability and cost of both credit and capital as well as the credit ratings assigned to the Company’s unsecured short-term and long-term debt; investor sentiment and confidence in the financial markets; the Company’s reputation; the actions and initiatives of current and potential competitors; and technological changes. Such factors also may have an impact on the Company’s ability to achieve its strategic objectives on a global basis. For a further discussion of these and other important factors that could affect the Company’s business, see “Competition” and “Supervision and Regulation” in Part I, Item 1, and “Risk Factors” in Part I, Item 1A of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 (the “Form 10-K”) and “Other Matters—Regulatory Outlook” in Part I, Item 2 herein.
The discussion of the Company’s results of operations below 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 “Supervision and Regulation” in Part I, Item 1, “Risk Factors” in Part I, Item 1A and “Certain Factors Affecting Results of Operations” in Part II, Item 7 of the Form 10-K and “Other Matters—Regulatory Outlook” herein.
Executive Summary.
Financial Information and Statistical Data (dollars in millions, except where noted and per share amounts).
Net revenues:
Institutional Securities
Global Wealth Management Group
Asset Management
Intersegment Eliminations
Consolidated net revenues
Consolidated net income
Income (loss) from continuing operations applicable to Morgan Stanley:
Income from continuing operations applicable to Morgan Stanley
Net gain (loss) from discontinued operations applicable to Morgan Stanley(3)
Net gain (loss) from discontinued operations(3)
Earnings (loss) per basic common share(4)
Earnings (loss) per diluted common share(4)
Regional net revenues(5):
Europe, Middle East and Africa
Financial Information and Statistical Data (dollars in millions, except where noted and per share amounts)—(Continued).
Average common equity (dollars in billions)(6):
Parent capital(6)
Total from continuing operations
Discontinued operations
Consolidated average common equity
Return on average common equity(6):
Consolidated
Institutional Securities(6)
Book value per common share(7)
Tangible common equity(8)
Tangible book value per common share(9)
Effective income tax rate from continuing operations(10)
Worldwide employees
Average liquidity (dollars in billions)(11):
Parent company liquidity
Bank and other subsidiary liquidity
Total liquidity
Capital ratios at September 30, 2010 and 2009(12):
Total capital ratio
Tier 1 capital ratio
Tier 1 leverage ratio
Tier 1 common ratio(12)
Consolidated assets under management or supervision (dollars in billions)(13)(14):
Institutional Securities:
Pre-tax profit margin(15)
Global Wealth Management Group:
Global representatives
Annualized net revenue per global representative (dollars in thousands)(16)
Assets by client segment (dollars in billions):
$10 million or more
$1 million to $10 million
Subtotal $1 million or more
$100,000 to $1 million
Less than $100,000
Total client assets
Fee-based assets as a percentage of total client assets
Client assets per global representative (dollars in millions)(17)
Bank deposits (dollars in billions)(18)
Asset Management(13):
Assets under management or supervision (dollars in billions)(19)
N/M – Not Meaningful.
N/A – Not Available.
Book value per common share equals common shareholders’ equity of $47,279 million at September 30, 2010 and $36,752 million at September 30, 2009, divided by period end common shares outstanding of 1,513 million at September 30, 2010 and 1,359 million at September 30, 2009. Book value per common share included a benefit of $1.40 per share due to the issuance of 116 million shares of
common stock corresponding to the mandatory redemption of the junior subordinated debentures underlying $5.6 billion of equity units during the quarter ended September 30, 2010 (see “Other Matters—Redemption of CIC Equity Units and Issuance of Common Stock” herein).
Global Market and Economic Conditions.
In the U.S., major equity market indices ended the quarter and nine months ended September 30, 2010 higher compared with the beginning of the quarter and the year. The increase was primarily due to better than expected corporate earnings, partially offset by a weaker than expected economic recovery, a persistently high unemployment rate, continued investor concerns about U.S. regulatory reform within the financial services industry and the continued sovereign debt crisis within the European region. Government and business spending increased, while certain sectors of the real estate market and consumer spending remained challenged. The unemployment rate decreased to 9.6% at September 30, 2010 from 10.0% at December 31, 2009. The Board of Governors of the Federal Reserve System (the “Federal Reserve”) Federal Open Market Committee kept its interest rates at historically low levels and, at September 30, 2010, the federal funds target rate was between zero and 0.25% and the discount rate was 0.75%.
In Europe, major equity market indices ended the quarter higher compared with the beginning of the quarter, while results in the nine month indices were mixed compared with the beginning of the year. Adverse economic developments, investor concerns about the outcome of regulatory stress testing of European banks and the sovereign debt crisis continued to exert downward pressure on equity markets. Industrial output in the region was primarily driven by German exports. The euro area unemployment rate remained relatively unchanged at approximately 10% at September 30, 2010. At September 30, 2010, the European Central Bank benchmark interest rate was 1.00% and the Bank of England benchmark interest rate was 0.50%.
In Asia, industrial output was driven by exports from both China and Japan. China’s economy also continued to benefit from government spending for capital projects, a significant amount of foreign currency reserves and a relatively high domestic savings rate. Equity markets in China ended the quarter and nine months higher
compared with the beginning of the quarter and the year, while results in Japan were lower. In October 2010, the People’s Bank of China raised the one-year yuan lending rate by 0.25% from 5.31% to 5.56%, and the one-year yuan deposit rate by 0.25% from 2.25% to 2.50%.
Overview of the Quarter and Nine Months ended September 30, 2010 Financial Results.
Consolidated Review. The Company recorded net income applicable to Morgan Stanley of $131 million during the quarter ended September 30, 2010 compared with net income applicable to Morgan Stanley of $757 million in the quarter ended September 30, 2009. Results for the quarter ended September 30, 2010 included a loss of $229 million due to a write-down and related costs associated with the planned disposition of Revel Entertainment Group, LLC (“Revel”), a development stage enterprise and subsidiary of the Company that is primarily associated with a development property in Atlantic City, New Jersey. Comparisons with the nine months ended September 30, 2010 were affected by the results of MSSB, which closed on May 31, 2009.
Net revenues (total revenues less interest expense) decreased to $6,779 million in the quarter ended September 30, 2010 from $8,468 million in the quarter ended September 30, 2009 primarily driven by the Institutional Securities business segment. Non-interest expenses decreased 14% to $5,979 million from the prior year period, primarily due to lower compensation expense. Compensation and benefits expense decreased 25% compared with the prior year quarter primarily due to lower compensation costs in the Institutional Securities business segment due to lower net revenues. Non-compensation expenses increased 10%, primarily due to ongoing investments in technology. Diluted EPS were $(0.07) in the quarter ended September 30, 2010 compared with $0.38 in the prior year period. Diluted EPS from continuing operations were $0.05 in the quarter ended September 30, 2010 compared with $0.50 in the prior year period. Results for the quarter ended September 30, 2010 also included a tax benefit of $176 million associated with the planned repatriation of non-U.S. earnings at a cost lower than originally estimated.
For the nine months ended September 30, 2010, the Company recorded net income applicable to Morgan Stanley of $3,867 million compared with $729 million a year ago. Net revenues increased 43% to $23,805 million and non-interest expenses increased 15% to $18,793 million from the prior year period, primarily due to the inclusion of revenues and expenses of MSSB. Diluted EPS were $2.15 compared with $(1.13) a year ago. Diluted EPS from continuing operations were $1.98 compared with $(1.06) a year ago.
Taxes. The Company’s effective income tax rate from continuing operations was a benefit of (2.9)% and an expense of 13.0% for the quarter and nine months ended September 30, 2010 compared with an expense of 34.9% and a benefit of (118.9)% for the quarter and nine months ended September 30, 2009, respectively. The results from continuing operations included the previously mentioned tax benefit of $176 million, or $0.12 and $0.10 per diluted share in the quarter and nine months ended September 30, 2010, respectively. The results from continuing operations for the nine months ended September 30, 2010 also included an aggregate tax benefit of $727 million, or $0.45 per diluted share, of which $382 million related to the reversal of U.S. deferred tax liabilities associated with prior-years’ undistributed earnings of certain non-U.S. subsidiaries that were determined to be indefinitely reinvested abroad and $345 million associated with the remeasurement of net unrecognized tax benefits and related interest based on new information regarding the status of federal and state examinations. The results for the nine months ended September 30, 2009 included a tax benefit of $331 million, or $0.29 per diluted share, resulting from the cost of anticipated repatriation of non-U.S. earnings at lower than previously estimated tax rates. Excluding the benefits noted above, the effective tax rate from continuing operations in the quarter and nine months ended September 30, 2010 would have been 19.1% and 31.0%, respectively. Excluding the benefit noted above, the effective tax rate from continuing operations in the nine months ended September 30, 2009 would have been a benefit of (16.1)%. The increase in the effective tax rate in the quarter and nine months ended September 30, 2010 compared with the prior year periods is reflective of the level and geographic mix of earnings.
Institutional Securities. Income from continuing operations before income taxes was $240 million in the quarter ended September 30, 2010 compared with $1,339 million in the same period last year. Net revenues were
$2,894 million compared with $5,018 million in the same period last year. Investment banking revenues for the current quarter decreased 3%, primarily reflecting significantly lower revenues from equity underwriting, partially offset by higher advisory fees from merger, acquisition and restructuring transactions and higher revenues from fixed income underwriting. Equity sales and trading revenues decreased 22% to $925 million from the comparable period of 2009 primarily reflecting lower net revenues from cash and derivative products driven by reduced levels of both client activity and volatility. Fixed income sales and trading revenues decreased 58% to $846 million in the current quarter from $2,009 million in the prior year quarter primarily due to a decrease in interest rate, credit and currency product revenues. Principal transaction net investment gains of $387 million and $493 million were recognized in the quarter and nine months ended September 30, 2010, respectively, compared with net investment gains of $41 million and losses of $933 million in the quarter and nine months ended September 30, 2009, respectively. Non-interest expenses were $2,654 million in the current quarter compared with $3,679 million in the same period last year. Compensation and benefits expenses decreased 42% in the quarter ended September 30, 2010 and 8% in the nine months ended September 30, 2010 primarily due to lower net revenues.
Global Wealth Management Group. Income from continuing operations before income taxes was $281 million in the quarter ended September 30, 2010 compared with $280 million in the same period last year. Net revenues were $3,104 million compared with $3,029 million in the same period last year. Investment banking revenues increased 26% in the current quarter, primarily due to higher closed end fund activity. Principal transactions trading revenues increased 12% in the quarter ended September 30, 2010, primarily due to higher revenues from fixed income securities and net gains related to investments associated with certain employee deferred compensation plans. Commission revenues decreased 20% in the current quarter, reflecting lower client activity. Asset management, distribution and administration fees decreased 3%, primarily due to lower revenues in the bank deposit program, partially offset by higher fee-based revenues. Net interest increased 80%, primarily resulting from the securities available for sale portfolio and the change in classification of the bank deposit program. Non-interest expenses were $2,823 million in the quarter ended September 30, 2010 compared with $2,749 million in the same period last year.
Asset Management. Income from continuing operations before income taxes was $279 million in the quarter ended September 30, 2010 compared with a loss of $124 million in the same period last year. Net revenues were $802 million in the current quarter compared with $447 million in the same period last year. The Company recorded principal transactions net investment gains of $427 million compared with gains of $44 million in the quarter ended September 30, 2009. Non-interest expenses were $523 million in the quarter ended September 30, 2010 compared with $571 million in the same period last year, primarily reflecting a decrease in Compensation and benefits expense.
The following items also affected the Company during the quarters and nine months ended September 30, 2010 and 2009.
Morgan Stanley Debt. Net revenues reflected negative revenue of $731 million and gains of $72 million in the quarter and nine months ended September 30, 2010, respectively, from the tightening and widening, respectively, of the Company’s credit spreads on certain long-term and short-term borrowings, including structured notes and junior subordinated debentures that are accounted for at fair value. In the quarter and nine months ended September 30, 2009, net revenues reflected negative revenue of approximately $0.9 billion and $4.9 billion, respectively, from the tightening of the Company’s credit spreads on such borrowings.
In addition, in the quarter and nine months ended September 30, 2009, the Company recorded losses of approximately $29 million and gains of $485 million, respectively, from repurchasing its debt in the open market. Results in the quarter ended September 30, 2010 primarily reflected the amortization of the value of the de-designated hedges related to the Company’s repurchase of its debt in the open market in 2009 and 2008.
Mortgage-Related Trading. In the quarter and nine months ended September 30, 2010, the Company recorded mortgage-related trading gains of approximately $0.5 billion and $1.1 billion, respectively, primarily related to commercial mortgage-backed securities and commercial whole loan positions and non-subprime residential mortgages.
In the quarter and nine months ended September 30, 2009, the Company recorded mortgage-related trading losses of approximately $0.1 billion and $1.2 billion, respectively, relating primarily to commercial whole loan positions and U.S. subprime mortgage proprietary trading exposures.
Real Estate Investments. The Company recorded gains (losses) in the following business segments related to real estate investments. These amounts exclude investments associated with certain deferred compensation and employee co-investment plans.
Continuing operations(1)
Discontinued operations(2)
Total Institutional Securities
Asset Management:
Continuing operations(3)
Total Asset Management
Amounts applicable to noncontrolling interests
See “Other Matters—Real Estate” herein for further information.
Settlement with DFS. On June 30, 2007, the Company completed the spin-off of its business segment Discover Financial Services (“DFS”) to its shareholders. On February 11, 2010, DFS paid the Company $775 million in complete satisfaction of its obligations to the Company regarding the sharing of proceeds from the lawsuit against Visa and MasterCard. The payment was recorded as a gain in discontinued operations in the condensed consolidated statement of income for the nine months ended September 30, 2010.
Gain on Sale of Noncontrolling Interest. In connection with the closing of the previously announced transaction between the Company and Mitsubishi UFJ Financial Group, Inc. (“MUFG”) to form a joint venture in Japan, the Company recorded an after-tax gain of $731 million from the sale of a noncontrolling interest in its Japanese institutional securities business. This gain was recorded in Paid-in capital in the Company’s condensed consolidated statements of financial condition at September 30, 2010 and changes in total equity for the nine months ended September 30, 2010. See “Other Matters – Japan Securities Joint Venture” herein for further information.
Gain on Sale of Retail Asset Management. On June 1, 2010, the Company completed the sale of substantially all of its retail asset management business (“Retail Asset Management”), including Van Kampen Investments, Inc. (“Van Kampen”), to Invesco. The Company received $800 million in cash and approximately 30.9 million shares of Invesco stock upon sale, resulting in a cumulative after-tax gain of $673 million, of which $514 million was recorded in the quarter ended June 30, 2010. The remaining gain of $159 million, representing tax basis benefits, was recorded primarily in the quarter ended December 31, 2009. The results of Retail Asset Management are reported as discontinued operations within the Asset Management business segment for all periods presented. The Company recorded the 30.9 million shares as securities available for sale.
Monoline Insurers. Monoline insurers (“Monolines”) provide credit enhancement to capital markets transactions. The quarter ended September 30, 2010 included losses of $272 million related to Monoline credit exposures compared with losses of $345 million in the quarter ended September 30, 2009. The nine months ended September 30, 2010 included losses of $602 million compared with losses of $283 million in the prior year period. The current credit environment continued to affect the ability of such financial guarantors to provide credit enhancement to existing capital market transactions. The Company’s direct exposure to Monolines is limited to bonds that are insured by Monolines and to derivative contracts with a Monoline as counterparty (principally an affiliate of MBIA Inc. (“MBIA”)). The Company’s exposure to Monolines at September 30, 2010 consisted primarily of $1.5 billion in insured municipal bond securities, $214 million of mortgage and asset-backed securities enhanced by financial guarantees, and approximately $108 million in net counterparty exposure (gross exposure of approximately $4.9 billion net of cumulative credit valuation adjustments of approximately $2.6 billion and net of hedges). Net counterparty exposure is defined as potential loss to the Company over a period of time in an event of 100% default of a Monoline, assuming zero recovery. The Company’s hedging program for Monoline risk includes the use of transactions that effectively mitigate certain market risk components of existing underlying commercial mortgage-backed securities transactions with the Monolines. The Company’s hedging program for Monoline counterparty exposure has become more costly, and as such, the losses in the quarter ended September 30, 2010 reflected those additional costs, as well as volatility on those hedges caused by the tightening of MBIA’s credit spreads. The Company continues to proactively manage its Monoline exposure; however, as market conditions continue to evolve, additional losses could be incurred, which could be significant.
U.K. Tax. During the nine months ended September 30, 2010, the Company recognized a charge of approximately $360 million in Compensation and benefits expense relating to the U.K. government’s payroll tax on discretionary above-base compensation.
Corporate Lending. The Company recorded the following amounts primarily associated with loans and lending commitments carried at fair value within the Institutional Securities business segment:
Gains on loans and lending commitments
Losses on hedges
Total gains (losses)
MSSB. During the quarter and nine months ended September 30, 2010, the Company recorded integration costs of approximately $83 million and $289 million, respectively, related to the joint venture. During the quarter and nine months ended September 30, 2009, the Company recorded integration costs of approximately $63 million and $135 million, respectively. The nine months ended September 30, 2009 also included a one-time expense of $124 million for replacement of deferred compensation awards for MSSB retirement-eligible employees. The costs of these replacement awards were fully allocated to Citi and were included in noncontrolling interests.
Employee Benefit Plans. On June 1, 2010, the Morgan Stanley Employees Retirement Plan (the “Pension Plan”) for U.S. participants was amended to cease accruals of benefits under the Pension Plan effective January 1, 2011. Any benefits earned by participants under the Pension Plan at December 31, 2010 will be preserved and will be payable in the future based on the Pension Plan’s provisions. As a result, the Company reduced Compensation and benefits expense by approximately $51 million on the condensed consolidated statements of income for the nine months ended September 30, 2010. Additionally, the Company remeasured the obligation and assets of the Pension Plan at May 31, 2010 and recognized a gain of $166 million ($102 million after-tax) on the condensed consolidated statements of comprehensive income for the nine months ended September 30, 2010, after reflecting the $51 million reduction in Compensation and benefits expense (see Note 16 to the condensed consolidated financial statements).
Sale of Bankruptcy Claims. In the quarter and nine months ended September 30, 2009, the Company recorded a gain of approximately $334 million related to the sale of undivided participating interests in a portion of the Company’s claims against a derivative counterparty that filed for bankruptcy protection (see Note 16 to the consolidated financial statements for the year ended December 31, 2009 in the Form 10-K).
MSCI. In May 2009, the Company divested all of its remaining ownership interest in MSCI Inc. (“MSCI”). The gain on sale, net of taxes, was approximately $310 million for the nine months ended September 30, 2009. The results of MSCI are reported as discontinued operations for all periods presented. The results of MSCI were formerly included in the continuing operations of the Institutional Securities business segment.
Structured Investment Vehicles. The Company recognized gains of $171 million in the nine months ended September 30, 2009 related to securities issued by structured investment vehicles. The gains were recorded in the Asset Management business segment.
Business Segments.
Substantially all of the Company’s operating revenues and operating expenses can be directly attributed to its business segments. Certain revenues and expenses have been allocated to each business segment, generally in proportion to its 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 business segment results to the Company’s consolidated results. Income before taxes in Intersegment Eliminations primarily represents the effect of timing differences associated with the revenue and expense recognition of commissions paid by the Asset Management business segment to the Global Wealth Management Group business segment associated with sales of certain products and the related compensation costs paid to the Global Wealth Management Group business segment’s global representatives. Intersegment Eliminations also reflect the effect of fees paid by the Institutional Securities business segment to the Global Wealth Management Group business segment related to the bank deposit program. Losses from continuing operations before income taxes recorded in Intersegment Eliminations were zero and $2 million in the quarters ended September 30, 2010 and 2009, respectively, and $15 million and $9 million in the nine months ended September 30, 2010 and 2009, respectively.
See “Other Matters—Segments” herein for further information regarding transactions affecting the Global Wealth Management Group and Institutional Securities business segments.
INSTITUTIONAL SECURITIES
INCOME STATEMENT INFORMATION
Non-compensation expenses
In the third quarter of 2010, the Company completed the disposal of CityMortgage Bank (“CMB”), a Moscow-based mortgage bank. The results of CMB are reported as discontinued operations for all periods presented within the Institutional Securities business segment.
On March 31, 2010, the Board of Directors authorized a plan of disposal by sale for Revel. The results of Revel are reported as discontinued operations for all periods presented within the Institutional Securities business segment. The quarter and nine months ended September 30, 2010 include losses of approximately $229 million and approximately $1.2 billion, respectively, in connection with write-downs and related costs of such planned disposition.
Investment Banking. Investment banking revenues for the quarter ended September 30, 2010 decreased 3% from the comparable period of 2009, primarily reflecting significantly lower revenues from equity underwriting, partially offset by higher advisory fees from merger, acquisition and restructuring transactions and higher revenues from fixed income underwriting. Overall, underwriting revenues of $637 million decreased 16% from the quarter ended September 30, 2009. Equity underwriting revenues decreased 43% to $260 million primarily due to lower market volume. Fixed income underwriting revenues increased 25% to $377 million primarily due to increased high yield issuance volumes and higher loan syndication fees. Advisory fees from merger, acquisition and restructuring transactions were $371 million, an increase of 33% from the comparable period of 2009.
Investment banking revenues in the nine months ended September 30, 2010 decreased 7% from the comparable period of 2009, primarily due to lower equity underwritings, partially offset by higher fixed income underwritings and advisory revenues.
Sales and Trading Revenues. Sales and trading revenues are composed of principal transactions trading revenues, commissions, asset management, distribution and administration fees and net interest revenues (expenses). In assessing the profitability of its sales and trading activities, the Company views principal trading, commissions, asset management, distribution and administration fees and net interest revenues (expenses) in the aggregate. In addition, decisions relating to principal transactions are based on an overall review of aggregate revenues and costs associated with each transaction or series of transactions. This review includes, among other things, an assessment of the potential gain or loss associated with a transaction, including any associated commissions, dividends, the interest income or expense associated with financing or hedging the Company’s positions, and other related expenses.
See “Other Matters—Segments” and “Other Matters—Dividend Income” herein for further information.
Total sales and trading revenues decreased 63% in the quarter ended September 30, 2010 from the comparable period of 2009.
Sales and trading revenues by business were as follows:
Fixed income
Other(2)
Total sales and trading revenues
Equity. Equity sales and trading revenues decreased 22% to $925 million in the quarter ended September 30, 2010 from the comparable period of 2009 primarily reflecting lower net revenues from cash and derivative products driven by reduced levels of both client activity and volatility. Equity sales and trading revenues reflected negative revenue of approximately $196 million in the quarter ended September 30, 2010 due to the tightening of the Company’s credit spreads resulting from the increase in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected, compared with negative revenue of approximately $206 million in the quarter ended September 30, 2009.
In the quarter ended September 30, 2010 equity sales and trading revenues also reflected unrealized gains of approximately $27 million related to changes in the fair value of net derivative contracts attributable to the tightening of the counterparties’ credit default spreads compared with unrealized gains of approximately $54 million in the quarter ended September 30, 2009. The Company also recorded unrealized losses of $38 million in the quarter ended September 30, 2010 related to changes in the fair value of net derivative contracts attributable to the tightening of the Company’s credit default swap spreads compared with unrealized losses of approximately $32 million in the quarter ended September 30, 2009. The unrealized gains and losses on credit default spreads do not reflect any gains or losses on related hedging instruments.
Fixed Income. Fixed income sales and trading revenues decreased 58% to $846 million in the quarter ended September 30, 2010 from $2,009 million in the prior year quarter. Interest rate, credit and currency product revenues decreased 61% in the quarter ended September 30, 2010 reflecting lower trading results across most businesses. Interest rate, credit and currency product net revenues in the quarter ended September 30, 2009 reflected strong investment grade and distressed debt trading, partially offset by lower levels of client activity and market volatility. Interest rate, credit and currency product net revenues in the quarter ended September 30, 2010 were also negatively impacted by losses of $272 million from Monolines. Results in the quarter ended September 30, 2010 included negative revenue of approximately $464 million due to the tightening of the Company’s credit spreads resulting from the increase in the fair value of certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected compared with negative revenue of approximately $546 million in the quarter ended September 30, 2009. Commodity net revenues decreased 44% in the quarter ended September 30, 2010, primarily due to lower levels of client activity in most markets. Results in the quarter ended September 30, 2009 also included a gain of approximately $300 million related to the sale of undivided participating interests in a portion of the Company’s claims against a derivative counterparty that filed for bankruptcy protection (see Note 16 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K).
In the quarter ended September 30, 2010, fixed income sales and trading revenues reflected net unrealized gains of $77 million related to changes in the fair value of net derivative contracts attributable to the tightening of the counterparties’ credit default spreads compared with unrealized gains of approximately $1,307 million in the quarter ended September 30, 2009 from the tightening of the counterparties’ credit default spreads. The Company also recorded unrealized losses of $451 million in the quarter ended September 30, 2010 related to changes in the fair value of net derivative contracts attributable to the tightening of the Company’s credit default swap spreads compared with unrealized losses of approximately $219 million in the quarter ended September 30, 2009. The unrealized gains and losses on credit default spreads do not reflect any gains or losses on related hedging instruments.
Other. In addition to the equity and fixed income sales and trading revenues discussed above, sales and trading revenues include other trading revenues, consisting primarily of other corporate activities. In the quarter ended September 30, 2010, other sales and trading net revenues reflected a net loss of $341 million compared with net gains of $668 million in the quarter ended September 30, 2009. Results in the quarter ended September 30, 2010 primarily reflected the amortization of the value of the de-designated hedges related to the Company’s repurchase of its debt in the open market in 2009 and 2008 and the costs related to the amount of liquidity (“negative carry”) in the Company’s domestic subsidiary banks, Morgan Stanley Bank, N.A. and Morgan Stanley Private Bank, National Association (formerly, Morgan Stanley Trust) (the “Subsidiary Banks”). Results for the prior year quarter included net gains of approximately $506 million (mark-to-market valuations and realized gains of approximately $1,408 million partially offset by losses on related hedges of approximately $902 million) associated with loans and lending commitments. The valuation of these commitments could change in future periods depending on, among other things, the extent that they are renegotiated or repriced or if the associated acquisition transaction does not occur. Results in the quarter ended September 30, 2009 also included gains on other funding-related hedging activities.
Sales and Trading Revenues in the Nine Months Ended September 30, 2010. Total sales and trading revenues increased 31% in the nine months ended September 30, 2010 from the comparable period of 2009, reflecting higher fixed income and equity sales and trading revenues, partially offset by higher losses on other sales and trading revenues. Equity sales and trading revenues increased 29% primarily due to negative revenue of approximately $1.5 billion being recorded in the nine months ended September 30, 2009 from the tightening of the Company’s debt-related credit spreads. Lower net revenues from derivative and equity cash products were partially offset by higher revenues in prime brokerage. Fixed income sales and trading revenues increased 41% primarily due to negative revenue of approximately $2.9 billion being recorded in the nine months ended September 30, 2009 from the tightening of the Company’s debt-related credit spreads. The increase in fixed income sales and trading revenues was partially offset by lower revenues in interest rate, credit and currency products and commodity products. In the nine months ended September 30, 2010, other sales and trading losses were $443 million compared with losses of $100 million in the nine months ended September 30, 2009. Results in the nine months ended September 30, 2010 included losses related to certain activities associated with the Company’s corporate lending activities compared with gains in the nine months ended September 30, 2009. Results in the nine months ended September 30, 2009 were offset by a negative adjustment of $435 million, reflecting the improvement in the Company’s debt-related credit spreads on certain debt related to China Investment Corporation’s (“CIC’s”) investment in the Company. Results in the nine months ended September 30, 2010 and the nine months ended September 30, 2009 also included losses related to negative carry in the Subsidiary Banks.
Principal Transactions—Investments. Principal transaction net investment gains of $387 million and $493 million were recognized in the quarter and nine months ended September 30, 2010, respectively, compared with net investment gains of $41 million and losses of $933 million in the quarter and nine months ended September 30, 2009, respectively. The gains in the quarter ended September 30, 2010 primarily reflected a mark-up on a principal investment held by a consolidated investment partnership of $313 million, which is contracted to be sold in the fourth quarter of 2010. The portion of the gain related to third-party investors amounted to $183 million and was recorded in the net income applicable to noncontrolling interests in the condensed consolidated statement of income. The gains in the quarter ended September 30, 2009 were primarily related to investments associated with certain employee deferred compensation plans and co-investment plans and other investments. In addition to the mark-up on the principal investment noted above, the nine months ended September 30, 2010 also included gains related to principal investments in real estate funds and investments associated with certain employee deferred compensation plans. The losses in the nine months ended September 30, 2009 were primarily related to principal investments in real estate funds and investments associated with certain employee deferred compensation plans.
Other. Other revenues decreased 9% and 56% in the quarter and nine months ended September 30, 2010, respectively. The results in the quarter ended September 30, 2010 primarily reflected higher losses from unconsolidated investees partially offset by higher net servicing income. The quarter and nine months ended September 30, 2009 included losses of approximately $29 million and gains of approximately $485 million, respectively, from the Company’s repurchase of its debt in the open market.
Non-interest Expenses. Non-interest expenses decreased 28% and 2% in the quarter and nine months ended September 30, 2010, respectively, primarily due to lower compensation expense. Compensation and benefits expenses decreased 42% and 8% in the quarter and nine months ended September 30, 2010 primarily due to lower net revenues. Compensation and benefits expenses in the nine months ended September 30, 2010 included a charge of approximately $360 million related to the U.K. government’s payroll tax on discretionary above-base compensation. Non-compensation expenses increased 6% and 8% in the quarter and nine months ended September 30, 2010, respectively. Occupancy and equipment expense decreased 5% and 11% in the quarter and the nine months ended September 30, 2010, primarily due to lower leasing costs and lease exiting costs that were incurred in the prior year periods. Information processing and communications expense increased 9% in the quarter and nine months ended September 30, 2010, primarily due to ongoing investments in technology. Marketing and business development expense increased 42% and 46% in the quarter and nine months ended
September 30, 2010. Professional services expense increased 17% and 16% in the quarter and nine months ended September 30, 2010, respectively, primarily due to higher technology consulting expenses. The results in the nine months ended September 30, 2010 also included higher legal fees. Other expenses decreased 17% in the nine months ended September 30, 2010. The decrease in the nine months ended September 30, 2010 primarily related to an insurance recovery reflected in the nine months ended September 30, 2010 and a loss provision in deferred compensation plans reflected in the nine months ended September 30, 2009. The decrease in the nine months ended September 30, 2010 was partially offset by higher provisions for litigation and regulatory proceedings, including $102.7 million related to the Assurance of Discontinuance entered into by the Company and the Office of the Attorney General for the Commonwealth of Massachusetts.
GLOBAL WEALTH MANAGEMENT GROUP
On May 31, 2009, MSSB was formed (see Note 3 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K). The Company owns 51% of MSSB, which is consolidated. As a result, the operating results for MSSB are included in the Global Wealth Management Group business segment since May 31, 2009. Net income applicable to noncontrolling interests of $44 million and $195 million, respectively, in the quarter and nine months ended September 30, 2010 primarily represents Citi’s interest in MSSB. Net income (loss) applicable to noncontrolling interests of $83 million in the quarter ended September 30, 2009 and $(35) million for the nine months ended September 30, 2009 represents Citi’s interest in MSSB since May 31, 2009.
Investment Banking. Investment banking revenues increased 26% in the quarter ended September 30, 2010, primarily due to higher closed end fund activity. Investment banking revenues increased 48% in the nine months ended September 30, 2010, primarily due to the consolidation of operating revenues of MSSB.
Principal Transactions—Trading. Principal transactions trading revenues increased 12% in the quarter ended September 30, 2010, primarily due to higher revenues from fixed income securities and net gains related to investments associated with certain employee deferred compensation plans. Lower revenues from municipal securities partially offset the increase. Principal transactions trading revenues increased 9% in the nine months ended September 30, 2010, primarily due to the consolidation of the operating revenues of MSSB, partially offset
by lower revenues from municipal securities and net losses related to investments associated with certain employee deferred compensation plans.
Principal Transactions—Investments. Principal transaction net investment gains were $5 million in the quarter ended September 30, 2010 compared with net investment gains of $10 million in the quarter ended September 30, 2009. The decrease in the quarter primarily reflected lower gains related to investments associated with certain employee deferred compensation plans compared with such investments in the prior year period. Principal transaction net investment gains were $11 million in the nine months ended September 30, 2010 compared with net investment losses of $3 million in the nine months ended September 30, 2009. The results in the nine months ended September 30, 2010 primarily reflected gains related to investments associated with certain employee deferred compensation plans compared with losses on such investments in the prior year period.
Commissions. Commission revenues decreased 20% in the quarter ended September 30, 2010, reflecting lower client activity. Commission revenues increased 40% in the nine months ended September 30, 2010, reflecting the consolidation of operating revenues of MSSB and higher client activity.
Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees decreased 3% in the quarter ended September 30, 2010, primarily due to lower revenues in the bank deposit program, partially offset by higher fee-based revenues. Asset management, distribution and administration fees increased 63% in the nine months ended September 30, 2010, primarily due to the consolidation of the operating revenues of MSSB. From June 2009 until April 1, 2010, revenues in the bank deposit program were primarily included in Asset management, distribution and administration fees. Prior to June 2009, these revenues were previously reported in Interest income. The change was the result of agreements that were entered into in connection with the MSSB transaction. Beginning on April 1, 2010, revenues in the bank deposit program held at the Company’s depository institutions were recorded as Interest income, due to renegotiations of the revenue sharing agreement as part of the Global Wealth Management Group business segment’s retail banking strategy. The Global Wealth Management Group business segment will continue to earn referral fees for deposits placed with Citi depository institutions, and these fees will continue to be recorded in Asset management, distribution and administration fees until the legacy Smith Barney deposits are migrated to the Company’s depository institutions.
Balances in the bank deposit program decreased to $108.7 billion at September 30, 2010 from $110.4 billion at September 30, 2009, primarily due to the expiration of the unlimited FDIC program. The unlimited FDIC program expired on December 31, 2009 for deposits held by Citi depositories and June 30, 2010 for deposits held by the Company’s depositories. Deposits held by Company-affiliated FDIC-insured depositories were $52 billion of the $108.7 billion deposits at September 30, 2010.
Client assets in fee-based accounts increased to $437 billion and represented 27% of total client assets at September 30, 2010, compared with $365 billion and 24% at September 30, 2009, respectively. Total client asset balances increased to $1,603 billion at September 30, 2010 from $1,532 billion at September 30, 2009, primarily due to improved market conditions at September 30, 2010 compared with September 30, 2009. Net new assets for the quarter ended September 30, 2010 were $5.0 billion. Client asset balances in households with assets greater than $1 million increased to $1,163 billion at September 30, 2010 from $1,058 billion at September 30, 2009.
Other. Other revenues were $107 million in the quarter ended September 30, 2010, an increase of 98% from $54 million in the quarter ended September 30, 2009. Other revenues were $262 million in the nine months ended September 30, 2010, an increase of 58% from $166 million in the nine months ended September 30, 2009. The increase in the quarter is primarily due to increases in proxy and other fee services. The increase in the nine months ended September 30, 2010 is primarily due to the consolidation of the operating results of MSSB.
Net Interest. Net interest increased 80% in the quarter ended September 30, 2010, primarily resulting from the securities available for sale portfolio (see “Other Matters—Securities Available for Sale” herein) and the change in classification of the bank deposit program noted above. Net interest increased 52% in the nine months ended September 30, 2010, primarily due to the securities available for sale portfolio, the consolidation of operating results of MSSB and higher revenues due to the change in classification of the bank deposit program noted above.
Non-interest Expenses. Non-interest expenses increased 3% and 44% for the quarter and nine months ended September 30, 2010, respectively. Non-interest expenses in the nine months ended September 30, 2010 included higher costs related to the consolidation of operating expenses of MSSB and the amortization of MSSB’s intangible assets. Compensation and benefits expense decreased 2% in the quarter ended September 30, 2010, and increased 41% in the nine months ended September 30, 2010. The increase in the nine months ended September 30, 2010 was primarily due to the consolidation of compensation expenses of MSSB. Non-compensation expenses increased 13% and 50% in the quarter and nine months ended September 30, 2010, respectively. During the quarter ended September 30, 2010, information processing and communications expense increased 27% due to higher support service costs; professional services expense increased 49% due to increased information technology consulting costs; and other expenses increased 8% primarily due to higher FDIC insurance. During the nine months ended September 30, 2010, occupancy and equipment expense increased 37%, information processing and communications expense increased 72%, professional services expense increased 52%, brokerage and clearing expense increased 52% and other expenses increased 61%, primarily due to the consolidation of operating expenses of MSSB.
ASSET MANAGEMENT
On June 1, 2010, the Company completed the sale of Retail Asset Management, including Van Kampen, to Invesco. The Company recorded a cumulative after-tax gain of $673 million, of which $514 million was recorded in the quarter ended June 30, 2010. The remaining gain of $159 million, representing tax basis benefits, was recorded primarily in the quarter ended December 31, 2009. The results of Retail Asset Management are reported as discontinued operations through the date of sale within the Asset Management business segment.
In the third quarter of 2010, the Company completed a disposal of a real estate property within the Asset Management business segment. The results of operations are reported as discontinued operations for all periods presented.
Statistical Data.
The results presented in the statistical tables below exclude the operations of Retail Asset Management, as those results are included in discontinued operations for all periods presented through the date of sale (see Note 20 to the condensed consolidated financial statements).
Asset Management’s period-end and average assets under management or supervision were as follows:
Assets under management or supervision by asset class:
Core asset management:
Fixed income—long term
Money market
Alternatives(2)
Total core asset management
Merchant banking:
Private equity
Infrastructure
Real estate
Total merchant banking
Total assets under management or supervision
Share of minority stake assets(3)
Activity in Asset Management’s assets under management or supervision during the quarters and nine months ended September 30, 2010 and 2009 was as follows:
Balance at beginning of period
Net flows by asset class:
Total net flows
Net market appreciation
Total net increase (decrease)
Net increase in share of minority stake assets(3)
Balance at end of period
Principal Transactions—Trading. In the quarter and nine months ended September 30, 2010, the Company recognized losses of $34 million and $45 million, respectively, compared with losses of $22 million and $109 million in the quarter and nine months ended September 30, 2009, respectively. Trading results in the quarter and nine months ended September 30, 2010 primarily related to losses from hedges on certain investments and long-term debt. Trading results for the nine months ended September 30, 2010 also included contributions to money markets funds. Trading results in the quarter and nine months ended September 30, 2009 included losses from hedges on certain investments and long-term debt. Trading results in the nine months ended September 30, 2009 also included mark-to-market losses related to a lending facility to a real estate fund sponsored by the Company. Losses in the nine months ended September 30, 2009 were partially offset by gains of $171 million related to SIV positions that were held on the Company’s condensed consolidated statements of financial condition.
Principal Transactions—Investments. The Company recorded principal transactions net investment gains of $427 million in the quarter ended September 30, 2010 compared with gains of $44 million in the quarter ended September 30, 2009. The Company recorded net investment gains of $632 million in the nine months ended September 30, 2010 compared with losses of $244 million in the nine months ended September 30, 2009. The results in the quarter and nine months ended September 30, 2010 included gains of $206 million and $332 million, respectively, associated with certain consolidated real estate funds sponsored by the Company and net investment gains in merchant banking and core businesses, including certain investments associated with the Company’s employee deferred compensation and co-investment plans. The results in the quarter ended September 30, 2009 primarily related to net investment gains associated with the Company’s core business and gains related to certain investments associated with the Company’s employee deferred compensation and
co-investment plans. The results in the nine months ended September 30, 2009 primarily related to net investment losses associated with the Company’s real estate investments and losses related to certain investments associated with the Company’s employee deferred compensation and co-investment plans, partially offset by net investment gains associated with the Company’s alternatives business.
Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees decreased 3% in the quarter ended September 30, 2010 and increased 2% in the nine months ended September 30, 2010. The decrease in the quarter was primarily due to lower performance fees, partially offset by higher fund management and administration fees. The increase in the nine months reflected higher fund management and administration fees, partially offset by lower performance fees. The higher fund management and administration fees in both periods reflected an increase in average assets under management.
The Company’s assets under management increased $23 billion from September 30, 2009 to September 30, 2010 reflecting market appreciation and net customer inflows, primarily in the Company’s long-term fixed income funds. The Company recorded net customer inflows of $2.9 billion in the quarter ended September 30, 2010 compared with net outflows of $7.4 billion in the quarter ended September 30, 2009.
Other. Other revenues increased $2 million and $80 million in the quarter and nine months ended September 30, 2010 compared with the quarter and nine months ended September 30, 2009, respectively. The increase in the nine months ended September 30, 2010 reflected higher revenues associated with Lansdowne Partners, a London-based investment manager, and Avenue Capital Group, a New York-based investment manager, each of which the Company owns a minority stake.
Non-interest Expenses. Non-interest expenses decreased 8% in the quarter ended September 30, 2010 compared with the quarter ended September 30, 2009, primarily reflecting a decrease in Compensation and benefits expense. Non-interest expenses increased 4% in the nine months ended September 30, 2010 compared with the nine months ended September 30, 2009, primarily due to an increase in Compensation and benefits expense. Compensation and benefits expenses decreased 23% in the quarter ended September 30, 2010, primarily reflecting a reduction in the number of employees. Compensation and benefits expenses increased 6% in the nine months ended September 30, 2010 due to certain international tax equalization payments and principal investment gains in the current year related to employee deferred compensation and co-investment plans compared with losses in the prior year period. Non-compensation expenses for the quarter and nine months ended September 30, 2010 included intangible asset impairment charges related to certain investment management contracts of $31 million and $58 million, respectively.
Other Matters.
Real Estate.
The Company acts as the general partner for various real estate funds and also invests in certain of these funds as a limited partner. The Company’s real estate investments at September 30, 2010 and December 31, 2009 are described below. Such amounts exclude investments that benefit certain employee deferred compensation and co-investment plans.
At September 30, 2010 and December 31, 2009, the condensed consolidated statements of financial condition include amounts representing real estate investment assets of consolidated subsidiaries of approximately $1.7 billion and $2.1 billion, respectively, net of noncontrolling interests of approximately $1.4 billion and $0.6 billion, respectively. This net presentation is a non-GAAP financial measure that the Company considers to be a useful measure for investors as it represents the Company’s net exposure. The decrease from December 31, 2009 to September 30, 2010 was primarily due to the $1.2 billion write-off in connection with the planned disposition of Revel (see Note 1 to the condensed consolidated financial statements). In addition, the Company has contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to these investments of $1.2 billion at September 30, 2010 (see Note 11 to the condensed consolidated financial statements).
In addition to the Company’s real estate investments, the Company engages in various real estate-related activities including origination of loans secured by commercial and residential properties. The Company also securitizes and trades in a wide range of commercial and residential real estate and real estate-related whole loans, mortgages and other real estate. In connection with these activities, the Company provides representations and warranties that certain assets sold as whole loans or transferred to securitization transactions conform to certain guidelines. The Company continues to monitor its real estate-related activities in order to manage its exposures and potential liability from these markets and businesses. See “Legal Proceedings—Residential Mortgage-Related Matters” in Part II, Item 1 herein.
A subsidiary of the Company manages an open-ended real estate fund in Germany, which suspended redemptions during the global financial crisis in October 2008. In October 2010, the subsidiary announced that it will liquidate the open-ended real estate fund over a period of three years ending September 30, 2013 and distribute proceeds from the sale of real estate assets to its investors. The subsidiary will waive the transaction fees related to the sale of assets but will continue to charge management fees. The Company does not intend to provide any support to the fund.
See “Overview of the Quarter and Nine Months ended September 30, 2010 Financial Results—Real Estate Investments” herein for further information.
In December 2007, the Company sold Equity Units that included contracts to purchase Company common stock to a wholly owned subsidiary of CIC. See “Liquidity and Capital Resources—Redemption of CIC Equity Units and Issuance of Common Stock” herein.
Japan Securities Joint Venture.
On May 1, 2010, the Company and MUFG closed the previously announced transaction to form a joint venture in Japan of their respective investment banking and securities businesses. MUFG and the Company have integrated their respective Japanese securities companies by forming two joint venture companies. MUFG contributed the investment banking, wholesale and retail securities businesses conducted in Japan by Mitsubishi UFJ Securities Co., Ltd. into one of the joint venture entities named Mitsubishi UFJ Morgan Stanley Securities Co., Ltd. (“MUMSS”). The Company contributed the investment banking operations conducted in Japan by its subsidiary, Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”), formerly known as Morgan Stanley Japan Securities Co., Ltd., into MUMSS (MSMS, together with MUMSS, the “Joint Venture”). MSMS will continue its sales and trading and capital markets business conducted in Japan. Following the respective contributions to the Joint Venture and a cash payment of 23 billion yen from MUFG to the Company, the Company owns a 40% economic interest in the Joint Venture and MUFG owns a 60% economic interest in the Joint Venture. The Company holds a 40% voting interest and MUFG holds a 60% voting interest in MUMSS, while the Company holds a 51% voting interest and MUFG holds a 49% voting interest in MSMS. The Company continued to include MSMS in its financial statements and, commencing on May 1, 2010, accounted for its interest in MUMSS as an equity method investment.
See “Overview of the Quarter and Nine Months ended September 30, 2010 Financial Results—Gain on Sale of Noncontrolling Interests” herein for further information.
Segments.
From June 2009 until April 1, 2010, revenues in the bank deposit program were primarily included in Asset management, distribution and administration fees. Prior to June 2009, these revenues were previously reported in Interest income. The change was the result of agreements that were entered into in connection with the MSSB transaction. Beginning on April 1, 2010, revenues in the bank deposit program held at the Company’s depository institutions are recorded as Interest income, due to renegotiations of the revenue sharing agreement as part of the Global Wealth Management Group business segment’s retail banking strategy. The Global Wealth Management Group business segment will continue to earn referral fees for deposits placed with Citi depository institutions, and these fees will continue to be recorded in Asset management, distribution and administration fees until the legacy Smith Barney deposits are migrated to the Company’s depository institutions.
Effective January 1, 2010, certain transfer pricing arrangements between the Global Wealth Management Group business segment and the Institutional Securities business segment relating to Global Wealth Management Group business segment’s fixed income trading activities were modified to conform to agreements with Citi in connection with MSSB. In addition, with an effective date of January 1, 2010, the Global Wealth Management Group business segment sold approximately $3 billion of Auction Rate Securities to the Institutional Securities business segment at book value.
The Company changed the allocation methodology in the Institutional Securities business segment for funding costs between equity and fixed income sales and trading to more accurately reflect business activity. Effective January 1, 2010, funding costs are allocated 35% to equity sales and trading and 65% to fixed income sales and trading. Prior to January 1, 2010, funding costs were allocated 20% and 80% to equity and fixed income sales and trading, respectively.
Effective January 1, 2010, in the Institutional Securities business segment, Equity sales and trading revenues include Asset management, distribution and administration fees as these fees relate to administrative services primarily provided to the Company’s prime brokerage clients and, therefore closely align to equity sales and trading revenues. Prior periods have been adjusted to conform to the current presentation.
Dividend Income.
During the first quarter of 2010, the Company established a portfolio of debt securities in order to manage interest rate risk. The securities have been classified as securities available for sale (“AFS”) in accordance with accounting guidance for investments in debt and equity securities and are included within the Global Wealth Management Group business segment.
During the second quarter of 2010, the Company classified certain marketable equity securities received in connection with the Company’s sale of Retail Asset Management as AFS securities (see Note 1 to the condensed consolidated financial statements for further information) and these equity securities are included within the Asset Management business segment.
See Note 5 to the condensed consolidated financial statements for further information on securities available for sale.
Regulatory Outlook.
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) into law. While certain portions of the Dodd-Frank Act will be effective immediately, other portions will be effective only following extended transition periods. At this time, it is difficult to assess fully the impact that the Dodd-Frank Act will have on the Company and on the financial services industry generally. Implementation of the Dodd-Frank Act will be accomplished through numerous rulemakings by several governmental agencies. Therefore, it will take some time for the comprehensive effects of the legislation to emerge and be understood. The Dodd-Frank Act also mandates the preparation of studies on a wide range of issues, which could lead to additional legislation or regulatory changes.
In addition, various legislative and regulatory initiatives continue outside the United States which may also affect the Company’s business and operations. For example, the Basel Committee on Banking Supervision (the “Basel Committee”) has proposed new standards to raise the quality of capital and strengthen counterparty credit risk capital requirements, introduced a leverage ratio as a supplemental measure to the risk-based ratio and introduced a countercyclical buffer, and it is not clear how the Basel Committee proposals, when finalized and adopted, will interact with the capital and leverage standards set forth in the Dodd-Frank Act. For a discussion of the potential impact of Basel Committee’s proposed new standards on the Company’s Risk Weighted Assets (“RWAs”) and Tier 1 capital, see “Liquidity and Capital Resources—The Balance Sheet” and “Liquidity and Capital Resources—Regulatory Requirements” herein.
The Dodd-Frank Act will significantly affect a wide range of the Company’s business and operations, including: limiting the Company’s ability to engage in private equity, hedge fund and proprietary trading activities; subjecting swap dealers and major swap participants to extensive new oversight and regulations, including new capital, margin, exchange trading, clearing and settlement requirements and business conduct standards and position limits; imposing heightened capital, leverage, prudential and other requirements under the new systemic risk regime, limiting the Company’s concentration of risk and credit exposure to non-affiliates and enhancing lending limits between depository institutions and their affiliates; applying a new orderly liquidation authority for liquidating financial companies and certain of their subsidiaries if the U.S. Department of the Treasury makes
certain financial distress and systemic risk determinations; requiring the Company to develop a credible plan to help unwind in the event of failure; enhancing corporate governance and imposing certain compensation reforms; creating a new agency, the Bureau of Consumer Financial Protection, which will have exclusive rulemaking and primary enforcement and examination authority over the Company with respect to federal consumer financial laws to the extent applicable to the Company; and imposing a new standard of care with respect to brokerage accounts. See also “Supervision and Regulation” in Part I, Item 1 of the Form 10-K.
Critical Accounting Policies.
The Company’s 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 (see Note 2 to the condensed consolidated financial statements). The Company believes that of its significant accounting policies (see Note 2 to the consolidated financial statements for the year ended December 31, 2009 in the Form 10-K), the following involve a higher degree of judgment and complexity.
Fair Value.
Financial Instruments Measured at Fair Value. A significant number of the Company’s financial instruments are carried at fair value. The Company makes estimates regarding valuation of assets and liabilities measured at fair value in preparing the condensed consolidated financial statements. These assets and liabilities include but are not limited to:
Financial instruments owned and Financial instruments sold, not yet purchased;
Securities available for sale;
Securities received as collateral and Obligation to return securities received as collateral;
Certain Commercial paper and other short-term borrowings, primarily structured notes;
Certain Deposits;
Certain Securities sold under agreements to repurchase;
Certain Other secured financings; and
Certain Long-term borrowings, primarily structured notes and certain junior subordinated debentures.
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the “exit price”) in an orderly transaction between market participants at the measurement date.
In determining fair value, the Company uses various valuation approaches. A hierarchy for inputs is used in measuring fair value that maximizes the use of observable prices and inputs and minimizes the use of unobservable prices and inputs by requiring that the relevant observable inputs be used when available. The hierarchy is broken down into three levels, wherein Level 1 uses observable prices in active markets, and Level 3 consists of valuation techniques that incorporate significant unobservable inputs and therefore require the greatest use of judgment. In periods of market disruption, the observability of prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to Level 3. In addition, a downturn in market conditions could lead to declines in the valuation of many instruments. For further information on the fair value definition, Level 1, Level 2, Level 3 and related valuation techniques, see Notes 2 and 4 to the condensed consolidated financial statements.
Level 3 Assets and Liabilities. The Company’s Level 3 assets before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $34.2 billion and $43.4 billion at September 30, 2010 and December 31, 2009, respectively, and represented approximately 9% and 14% at September 30, 2010 and December 31, 2009, respectively, of the assets measured at fair value (4% and 6% of total assets at September 30, 2010 and December 31, 2009, respectively). Level 3 liabilities before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $7.2 billion and $15.4 billion at September 30, 2010 and December 31, 2009, respectively, and represented approximately 3% and 9% of the Company’s liabilities measured at fair value at September 30, 2010 and December 31, 2009, respectively.
Transfers In/Out of Level 3 During the Quarter Ended September 30, 2010. During the quarter ended September 30, 2010, the Company reclassified approximately $3.9 billion of certain Corporate and other debt, primarily loans and hybrid contracts, from Level 3 to Level 2. The Company reclassified these loans and hybrid contracts as external prices and/or spread inputs became observable and certain unobservable inputs were deemed insignificant to the overall measurement.
During the quarter ended September 30, 2010, the Company reclassified approximately $1.0 billion of Other secured financings from Level 3 to Level 2. The reclassifications were due to an increase in available broker quotes and/or consensus pricing such that significant inputs for the fair value measurement were observable.
Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis. Certain of the Company’s assets were measured at fair value on a non-recurring basis. The Company incurs losses or gains for any adjustments of these assets to fair value. A downturn in market conditions could result in impairment charges in future periods.
For further information on financial assets and liabilities that are measured at fair value on a non-recurring basis, see Note 4 to the condensed consolidated financial statements.
Fair Value Control Processes. The Company employs control processes to validate the fair value of its financial instruments, including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and that the assumptions are reasonable. These control processes include reviews of the pricing model’s theoretical soundness and appropriateness by Company personnel with relevant expertise who are independent from the trading desks. Additionally, groups independent from the trading divisions within the Financial Control Group, Market Risk Department and Credit Risk Management Department participate in the review and validation of the fair values generated from pricing models, as appropriate. Where a pricing model is used to determine fair value, recently executed comparable transactions and other observable market data are considered for purposes of validating assumptions underlying the model.
Consistent with market practice, the Company has individually negotiated agreements with certain counterparties to exchange collateral (“margining”) based on the level of fair values of the derivative contracts they have executed. Through this margining process, one party or each party to a derivative contract provides the other party with information about the fair value of the derivative contract to calculate the amount of collateral required. This sharing of fair value information provides additional support of the Company’s recorded fair value for the relevant over-the-counter (“OTC”) derivative products. For certain OTC derivative products, the Company, along with other market participants, contributes derivative pricing information to aggregation services that synthesize the data and make it accessible to subscribers. This information is then used to evaluate the fair value of these OTC derivative products. For more information regarding the Company’s risk management practices, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.
Goodwill. The Company tests goodwill for impairment on an annual basis and on an interim basis when certain events or circumstances exist. The Company tests for impairment at the reporting unit level, which is generally at the level of or one level below its business segments. Goodwill no longer retains its association with a particular acquisition once it has been assigned to a reporting unit. As such, all of the activities of a reporting unit, whether acquired or organically grown, are available to support the value of the goodwill. Goodwill impairment is determined by comparing the estimated fair value of a reporting unit with its respective book value. If the
estimated fair value exceeds the book value, goodwill at the reporting unit level is not deemed to be impaired. If the estimated fair value is below book value, however, further analysis is required to determine the amount of the impairment. The estimated fair values of the reporting units are derived based on valuation techniques the Company believes market participants would use for each of the reporting units. The estimated fair values are generally determined utilizing methodologies that incorporate price-to-book, price-to-earnings and assets under management multiples of certain comparable companies.
Intangible Assets. Amortizable intangible assets are amortized over their estimated useful lives and reviewed for impairment on an interim basis when certain events or circumstances exist. For amortizable intangible assets, an impairment exists when the carrying amount of the intangible asset exceeds its fair value. An impairment loss will be recognized only if the carrying amount of the intangible asset is not recoverable and exceeds its fair value. The carrying amount of the intangible asset is not recoverable if it exceeds the sum of the expected undiscounted cash flows.
Indefinite-lived intangible assets are not amortized but are reviewed annually (or more frequently when certain events or circumstances exist) for impairment. For indefinite-lived intangible assets, an impairment exists when the carrying amount exceeds its fair value.
See Note 4 to the condensed consolidated financial statements for intangible asset impairments recorded during the quarter and nine months ended September 30, 2010.
For both goodwill and intangible assets, to the extent an impairment loss is recognized, the loss establishes the new cost basis of the asset. Subsequent reversal of impairment losses is not permitted. For amortizable intangible assets, the new cost basis is amortized over the remaining useful life of that asset. Adverse market or economic events could result in impairment charges in future periods.
See Note 8 to the condensed consolidated financial statements for further information on goodwill and intangible assets.
Legal, Regulatory and Tax Contingencies.
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 actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.
Accruals for litigation and regulatory proceedings are generally determined on a case-by-case basis. Where available information indicates that it is probable a liability had been incurred at the date of the condensed consolidated financial statements and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. For certain legal proceedings, the Company can estimate possible losses, additional losses, ranges of loss or ranges of additional loss in excess of amounts accrued. For certain other legal proceedings, the Company cannot reasonably estimate such losses, particularly for proceedings that are in their early stages of development or
where plaintiffs seek substantial or indeterminate damages. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, and by addressing novel or unsettled legal questions relevant to the proceedings in question, before a loss or additional loss or range of loss or additional loss can be reasonably estimated for any proceeding.
The Company is subject to the income and indirect tax laws of the U.S., its states and municipalities and those of the foreign jurisdictions in which the Company has significant business operations. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant governmental taxing authorities. The Company must make judgments and interpretations about the application of these inherently complex tax laws when determining the provision for income taxes and the expense for indirect taxes and must also make estimates about when in the future certain items affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be settled with the taxing authority upon examination or audit. The Company periodically assesses the likelihood of assessments in each of the taxing jurisdictions resulting from current and subsequent years’ examinations, and unrecognized tax benefits are established as appropriate. The Company establishes a liability for unrecognized tax benefits for potential losses that may arise out of tax audits in accordance with accounting for income taxes. Once established, unrecognized tax benefits are adjusted when there is more information available or when an event occurs requiring a change.
Significant judgment is required in making these estimates, and the actual cost of a legal claim, tax assessment or regulatory fine/penalty may ultimately be materially different from the recorded accruals and unrecognized tax benefits, if any. See Notes 11 and 17 to the condensed consolidated financial statements for additional information on legal proceedings and tax examinations.
Special Purpose Entities and Variable Interest Entities.
The Company’s involvement with special purpose entities (“SPEs”) consists primarily of the following:
Transferring financial assets into SPEs;
Acting as an underwriter of beneficial interests issued by securitization vehicles;
Holding one or more classes of securities issued by, or making loans to or investments in, SPEs that hold debt, equity, real estate or other assets;
Purchasing and selling (in both a market-making and a proprietary-trading capacity) securities issued by SPEs/variable interest entities (“VIE”), whether such vehicles are sponsored by the Company or not;
Entering into derivative transactions with SPEs (whether or not sponsored by the Company);
Providing warehouse financing to collateralized debt obligations and collateralized loan obligations;
Entering into derivative agreements with non-SPEs whose value is derived from securities issued by SPEs;
Servicing assets held by SPEs or holding servicing rights related to assets held by SPEs that are serviced by others under subservicing arrangements;
Serving as an asset manager to various investment funds that may invest in securities that are backed, in whole or in part, by SPEs; and
Structuring and/or investing in other structured transactions designed to provide enhanced, tax-efficient yields to the Company or its clients.
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 instruments. The Company’s involvement with SPEs is discussed further in Note 7 to the condensed consolidated financial statements.
In most cases, these SPEs are deemed for accounting purposes to be variable interest entities (“VIEs”). The Company applies accounting guidance for consolidation of VIEs 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. Entities that previously met the criteria as qualifying special purpose entities that were not subject to consolidation prior to January 1, 2010 became subject to the consolidation requirements for VIEs on that date. Excluding entities subject to the Deferral (as described in Note 2 to the condensed consolidated financial statements), effective January 1, 2010, the primary beneficiary of a VIE is the party that both (1) has the power to direct the activities of a VIE that most significantly affect the VIE’s economic performance and (2) has an obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. The Company consolidates entities of which it is the primary beneficiary.
In addition, the Company serves as an investment advisor to unconsolidated money market and other funds.
See Note 2 to the condensed consolidated financial statements for information on accounting guidance adopted on January 1, 2010 for transfers of financial assets.
Liquidity and Capital Resources.
The Company’s senior management establishes the liquidity and capital policies of the Company. Through various risk and control committees, the Company’s senior management reviews business performance relative to these policies, monitors the availability of alternative sources of financing, and oversees the liquidity and interest rate and currency sensitivity of the Company’s asset and liability position. The Company’s Treasury Department, Firm Risk Committee (“FRC”), Asset and Liability Management Committee (“ALCO”) and other control groups assist in evaluating, monitoring and controlling the impact that the Company’s business activities have on its condensed consolidated statements of financial condition, liquidity and capital structure.
The Balance Sheet.
The Company actively monitors and evaluates the composition and size of its balance sheet. A substantial portion of the Company’s total assets consists of liquid marketable securities and short-term receivables arising principally from sales and trading activities in the Institutional Securities business segment. The liquid nature of these assets provides the Company with flexibility in managing the size of its balance sheet. The Company’s total assets increased to $841,372 million at September 30, 2010 from $771,462 million at December 31, 2009. The increase in total assets was primarily due to higher financial instruments owned and securities financing activities.
Within the sales and trading related assets and liabilities are transactions attributable to securities financing activities. At September 30, 2010, securities financing assets and liabilities were $387 billion and $339 billion, respectively. At December 31, 2009, securities financing assets and liabilities were $376 billion and $316 billion, respectively. Securities financing transactions include repurchase and resale agreements, securities borrowed and loaned transactions, securities received as collateral and obligation to return securities received. Securities borrowed or purchased under agreements to resell and securities loaned or sold under agreements to repurchase are treated as collateralized financings (see Note 2 to the condensed consolidated financial statements). Securities sold under agreements to repurchase and securities loaned were $198 billion at September 30, 2010 and averaged $207 billion and $216 billion during the quarter and nine months ended September 30, 2010, respectively. Securities purchased under agreements to resell and securities borrowed were $316 billion at September 30, 2010 and averaged $308 billion and $311 billion during the quarter and nine months ended September 30, 2010, respectively.
Securities financing assets and liabilities also include matched book transactions with minimal market, credit and/or liquidity risk. Matched book transactions accommodate customers, as well as obtain securities for the settlement and financing of inventory positions. The customer receivable portion of the securities financing transactions includes customer margin loans, collateralized by customer owned securities, and customer cash, which is segregated according to regulatory requirements. The customer payable portion of the securities financing transactions primarily includes customer payables to the Company’s prime brokerage clients. The Company’s risk exposure on these transactions is mitigated by collateral maintenance policies that limit the Company’s credit exposure to customers. Included within securities financing assets was $17 billion and $14 billion at September 30, 2010 and December 31, 2009, respectively, recorded in accordance with accounting guidance for the transfer of financial assets that represented equal and offsetting assets and liabilities for fully collateralized non-cash loan transactions.
The Company uses the Tier 1 leverage ratio, risk-based capital ratios (see “Regulatory Requirements” herein), Tier 1 common ratio and the balance sheet leverage ratio as indicators of capital adequacy when viewed in the context of the Company’s overall liquidity and capital policies. These ratios are commonly used measures to assess capital adequacy and frequently referred to by investors.
The following table sets forth the Company’s total assets and leverage ratios at September 30, 2010 and December 31, 2009 and average balances during the nine months ended September 30, 2010:
Common equity
Preferred equity
Morgan Stanley shareholders’ equity
Junior subordinated debentures issued to capital trusts
Subtotal
Less: Goodwill and net intangible assets(2)
Tangible Morgan Stanley shareholders’ equity
Tangible common equity(3)
Leverage ratio(4)
Tier 1 common ratio(5)
Balance Sheet and Funding Activity for the Nine Months Ended September 30, 2010.
During the nine months ended September 30, 2010, the Company issued notes with a principal amount of approximately $27 billion, including non-U.S. dollar currency notes aggregating approximately $5 billion. In connection with the note issuances, the Company generally enters into certain transactions to obtain floating interest rates based primarily on short-term London Interbank Offered Rates trading levels. The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.0 years at September 30, 2010. Subsequent to September 30, 2010 and through November 3, 2010, the Company’s long-term borrowings (net of repayments) increased by approximately $1.8 billion.
At September 30, 2010, the aggregate outstanding principal amount of the Company’s senior indebtedness was approximately $188 billion (including guaranteed obligations of the indebtedness of subsidiaries).
In December 2007, the Company sold Equity Units that included contracts to purchase Company common stock to a wholly owned subsidiary of CIC (the “CIC Entity”) for approximately $5,579 million. On July 1, 2010, Moody’s Investor Services announced that it was lowering the equity credit assigned to such Equity Units. The terms of the Equity Units permitted the Company to redeem the junior subordinated debentures underlying the Equity Units upon the occurrence and continuation of such a change in equity credit (a “Rating Agency Event”). In response to this Rating Agency Event, the Company redeemed the junior subordinated debentures in August 2010 and the redemption proceeds were subsequently used by the CIC Entity to settle its obligation under the purchase contracts. The settlement of the purchase contracts and delivery of 116,062,911 shares of Company common stock to the CIC Entity occurred in August 2010.
Capital Management Policies.
The Company’s senior management views capital as an important source of financial strength. The Company actively manages its consolidated capital position based upon, among other things, business opportunities, risks, capital availability and rates of return together with internal capital policies, regulatory requirements and rating agency guidelines and, therefore, in the future may expand or contract its capital base to address the changing needs of its businesses. The Company attempts to maintain total capital, on a consolidated basis, at least equal to the sum of its operating subsidiaries’ equity.
At September 30, 2010, the Company had approximately $1.6 billion remaining under its current share repurchase program out of the $6 billion authorized by the Company’s Board of Directors (the “Board”) in December 2006. The share repurchase program is for capital management purposes and considers, among other things, business segment capital needs as well as equity-based compensation and benefit plan requirements. Share repurchases by the Company are subject to regulatory approval. During the quarter and nine months ended September 30, 2010, the Company did not repurchase common stock as part of its capital management share repurchase program (see also “Unregistered Sales of Equity Securities and Use of Proceeds” in Part II, Item 2).
The Board determines the declaration and payment of dividends on a quarterly basis. In October 2010, the Company announced that the Board declared a quarterly dividend per common share of $0.05. During the quarter, the Company also announced that the Board declared a quarterly dividend of $255.56 per share of Series A Floating Rate Non-Cumulative Preferred Stock (represented by depositary shares, each representing 1/1,000th interest in a share of preferred stock and each having a dividend of $0.25556), a quarterly dividend of $25.00 per share of Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock and a quarterly dividend of $25.00 per share of Series C Non-Cumulative Non-Voting Perpetual Preferred Stock.
Required Capital.
Beginning with the quarter ended June 30, 2010, the Company’s capital estimation is based on the Required Capital framework, an internal capital adequacy measure. This framework is a risk-based internal use of capital measure, which is compared with the Company’s regulatory Tier 1 capital to help ensure the Company maintains an amount of risk-based going concern capital after absorbing potential losses from extreme stress events at a point in time. The difference between the Company’s Tier 1 capital and aggregate Required Capital is the Company’s Parent capital. Average Tier 1 capital, Required Capital and Parent capital for the quarter ended September 30, 2010 was approximately $53.8 billion, $31.2 billion and $22.6 billion, respectively. The Company generally holds Parent capital for prospective regulatory requirements, including Basel III, organic growth, acquisitions and other capital needs.
Tier 1 capital and common equity attribution to the business segments is based on capital usage calculated by Required Capital. In principle, each business segment is capitalized as if it were an independent operating entity with limited diversification benefit between the business segments. Required Capital is assessed at each business segment and further attributed to product lines. This process is intended to align capital with the risks in each business segment in order to allow senior management to evaluate returns on a risk-adjusted basis. The Required Capital framework will evolve over time in response to changes in the business and regulatory environment, including Basel III, and to incorporate enhancements in modeling techniques (see “Regulatory Requirements” herein for further information on Basel III).
For a further discussion of the Company’s Tier 1 capital, see “Regulatory Requirements” herein.
The following table presents the Company’s and business segments’ average Tier 1 capital and average common equity for the quarter ended September 30, 2010 and the quarter ended June 30, 2010.
Parent capital
Average common equity allocated to Parent capital increased from the quarter ended June 30, 2010 driven by the common stock issuance corresponding to the redemption of the junior subordinated debentures underlying the CIC Equity Units. See “Redemption of CIC Equity Units and Issuance of Common Stock” herein for further information.
Capital Covenants.
In October 2006 and April 2007, the Company executed replacement capital covenants in connection with offerings by Morgan Stanley Capital Trust VII and Morgan Stanley Capital Trust VIII (the “Capital Securities”). Under the terms of the replacement capital covenants, the Company has agreed, for the benefit of certain specified holders of debt, to limitations on its ability to redeem or repurchase any of the Capital Securities for specified periods of time. For a complete description of the Capital Securities and the terms of the replacement capital covenants, see the Company’s Current Reports on Form 8-K dated October 12, 2006 and April 26, 2007.
Liquidity and Funding Management Policies.
The primary goal of the Company’s liquidity management and funding activities is to ensure adequate funding over a wide range of market conditions. Given the mix of the Company’s business activities, funding requirements are fulfilled through a diversified range of secured and unsecured financing.
The Company’s liquidity and funding risk management framework, including policies and governance structure, helps mitigate the potential risk that the Company may not have access to adequate financing. The framework is designed to help ensure that the Company fulfills its financial obligations and to support the execution of the
Company’s business strategies. The principal elements of the Company’s liquidity and funding risk management framework are the Contingency Funding Plan and the Global Liquidity Reserve that support the target liquidity profile (see “Contingency Funding Plan” and “Global Liquidity Reserve” herein).
Contingency Funding Plan.
The Contingency Funding Plan (“CFP”) is the Company’s primary liquidity and funding risk management tool. The CFP outlines the Company’s response to liquidity stress in the markets and incorporates stress testing to identify potential liquidity risk. Liquidity stress tests model multiple scenarios related to idiosyncratic, systemic or a combination of both types of events, across various time horizons. Based on the results of stress testing, the CFP sets forth a course of action to effectively manage through a stressed liquidity event. Liquidity risk exposures are evaluated on an ongoing basis and reported to the FRC, ALCO and other appropriate risk committees.
The Company’s CFP incorporates a number of assumptions including, but not limited to, the following:
No government support;
No access to unsecured debt markets;
Repayment of all unsecured debt maturing within one year;
Higher haircuts and significantly lower availability of secured funding;
Additional collateral that would be required by trading counterparties and certain exchanges and clearing organizations related to multi-notch credit rating downgrades;
Discretionary unsecured debt buybacks;
Drawdowns on unfunded commitments provided to third parties;
Client cash withdrawals;
Limited access to the foreign exchange swap markets;
Return of securities borrowed on an uncollateralized basis; and
Maturity roll-off of outstanding letters of credit with no further issuance.
The CFP is produced at the Parent and major operating subsidiary levels, as well as at major currency levels, to capture specific cash requirements and cash availability across the Company. The CFP assumes the subsidiaries will use their own liquidity first to fund their obligations before drawing liquidity from the Parent company. The CFP also assumes that the Parent will support its subsidiaries and will not have access to their liquidity reserves due to regulatory, legal or tax constraints.
At September 30, 2010, the Company maintained sufficient liquidity to meet funding and contingent obligations as modeled in its liquidity stress tests.
Global Liquidity Reserve.
The Company maintains sufficient liquidity reserves (“Global Liquidity Reserve”) to cover daily funding needs and meet strategic liquidity targets sized by the CFP. The Global Liquidity Reserve is held within the Parent company and major operating subsidiaries. It is comprised of cash and cash equivalents, securities that have been reversed into the Company on an overnight basis (consisting of U.S. and European government bonds, U.S. agency and agency mortgage-backed securities) and pools of Federal Reserve-eligible (eligible to be pledged to the Federal Reserve’s Discount Window) securities which are held in the Company’s U.S. banking subsidiaries (see table below). The assets that make up the Global Liquidity Reserve are all unencumbered and are not pledged as collateral on either a mandatory or a voluntary basis. They do not include other unencumbered assets that are available to the Company for additional monetization.
Global Liquidity Reserve by Type of Investment
The table below summarizes the Company’s Global Liquidity Reserve by type of investment:
Cash and cash equivalents
Securities purchased under agreements to resell
Federal Reserve-eligible securities
Global Liquidity Reserve
The vast majority of the assets held in the Global Liquidity Reserve can be monetized on a next day basis in a stressed environment given the highly liquid and diversified nature of the reserves. The remainder of the assets can be monetized within two to five business days.
The currency composition of the Global Liquidity Reserve is consistent with the CFP on a currency level. The Company’s funding requirements and target liquidity reserves may vary based on changes to the level and composition of its balance sheet, subsidiary funding needs, timing of specific transactions, client financing activity, market conditions and seasonal factors.
Global Liquidity Reserve held by the Parent and Subsidiaries
The table below summarizes the Global Liquidity Reserve held by the Parent and subsidiaries:
Parent
Non-Bank Subsidiaries
Bank Subsidiaries
Funding Management Policies.
The Company’s funding management policies are designed to provide for financings that are executed in a manner that reduces the risk of disruption to the Company’s operations. The Company pursues a strategy of diversification of secured and unsecured funding sources (by product, by investor and by region) and attempts to ensure that the tenor of the Company’s liabilities equals or exceeds the expected holding period of the assets being financed. Maturities of financings are designed to manage exposure to refinancing risk in any one period.
The Company funds its balance sheet on a global basis through diverse sources. These sources may include the Company’s equity capital, long-term debt, repurchase agreements, securities lending, deposits, commercial paper, letters of credit and lines of credit. The Company has active financing programs for both standard and structured products in the U.S., European and Asian markets, targeting global investors and currencies such as the U.S. dollar, euro, British pound, Australian dollar and Japanese yen.
Secured Financing. A substantial portion of the Company’s total assets consists of liquid marketable securities and short-term collateralized receivables arising principally from its Institutional Securities sales and trading activities. The liquid nature of these assets provides the Company with flexibility in financing these assets with collateralized borrowings.
The Company’s goal is to achieve an optimal mix of secured and unsecured funding while ensuring continued growth in stable funding sources. The Institutional Securities business segment emphasizes the use of collateralized short-term borrowings to limit the growth of short-term unsecured funding, which is generally more subject to disruption during periods of financial stress. The ability to fund less liquid assets on a secured basis may be impaired in a stress environment. To manage this risk, the Company obtains longer-term secured financing for less liquid assets and does not generally rely on overnight financing, with the exception of highly liquid collateral consistent with the standards of the Global Liquidity Reserve. In addition, the Company holds a portion of its Global Liquidity Reserve against a potential disruption to its secured financing capabilities. This potential disruption may be in the form of additional margin or reduced capacity to refinance maturing trades. The Company continues to extend the tenor of secured financing for less liquid collateral and seeks to build a sufficient buffer to offset the risks discussed above.
Unsecured Financing. The Company views long-term debt and deposits as stable sources of funding for core inventories, less liquid and illiquid assets. Securities inventories not financed by secured funding sources and the majority of current assets are financed with a combination of short-term funding, floating rate long-term debt or fixed rate long-term debt swapped to a floating rate and deposits. The Company uses derivative products (primarily interest rate, currency and equity swaps) to assist in asset and liability management and to hedge interest rate risk (see Note 10 to the consolidated financial statements for the year ended December 31, 2009 included in the Form 10-K).
Temporary Liquidity Guarantee Program (“TLGP”). In October 2008, the Secretary of the U.S. Treasury invoked the systemic risk exception of the FDIC Improvement Act of 1991, and the FDIC announced the TLGP. Based on the Final Rule adopted on November 21, 2008, the TLGP provides a guarantee, through the earlier of maturity or June 30, 2012, of certain senior unsecured debt issued by participating Eligible Entities (including the Company) between October 14, 2008 and June 30, 2009. At September 30, 2010 and December 31, 2009, the Company had $23.8 billion of senior unsecured debt outstanding under the TLGP. There have been no issuances under the TLGP since March 31, 2009.
Short-Term Borrowings. The Company’s unsecured short-term borrowings consist of commercial paper, bank loans, bank notes and structured notes with maturities of 12 months or less at issuance.
The table below summarizes the Company’s short-term unsecured borrowings:
Commercial paper
Other short-term borrowings
Deposits. The Company’s bank subsidiaries’ funding sources include bank deposits, repurchase agreements, federal funds purchased, certificates of deposit, money market deposit accounts, commercial paper and Federal Home Loan Bank advances.
Deposits were as follows:
Savings and demand deposits
Time deposits(2)
With the passage of the Dodd-Frank Act, the statutory standard maximum deposit insurance amount was permanently increased to $250,000 per depositor and is in effect for the Company’s relevant U.S. subsidiary banks.
The Company’s FDIC-insured subsidiaries elected to opt out of the Transaction Account Guarantee Program (“TAGP”) effective July 1, 2010. Thus, after June 30, 2010, funds held in noninterest-bearing transaction accounts, and certain Negotiable Order of Withdrawal and linked Money Market Deposit accounts are no longer guaranteed in full under the TAGP, but will be insured up to $250,000 under the FDIC’s general deposit rules.
Long-Term Borrowings. The Company uses a variety of long-term debt funding sources to generate liquidity, taking into consideration the results of the CFP requirements. In addition, the issuance of long-term debt allows the Company to reduce reliance on short-term credit sensitive instruments (e.g., commercial paper and other unsecured short-term borrowings). Long-term borrowings are generally structured to ensure staggered maturities, thereby mitigating refinancing risk, and to maximize investor diversification through sales to global institutional and retail clients. Availability and cost of financing to the Company can vary depending on market conditions, the volume of certain trading and lending activities, the Company’s credit ratings and the overall availability of credit. During the nine months ended September 30, 2010, the Company issued approximately $27 billion principal amount of unsecured debt, which included approximately $5 billion of non-U.S. dollar currency notes.
The Company may from time to time engage in various transactions in the credit markets (including, for example, debt repurchases) that it believes are in the best interests of the Company and its investors. During the nine months ended September 30, 2010 approximately $26 billion in aggregate long-term borrowings matured.
Long-term borrowings at September 30, 2010 consisted of the following:
Due in 2010
Due in 2011
Due in 2012
Due in 2013
Due in 2014
Thereafter
Credit Ratings.
The Company relies on external sources to finance a significant portion of its day-to-day operations. The cost and availability of financing generally is dependent on the Company’s credit ratings. In addition, the Company’s debt ratings can have a significant impact on certain trading revenues, particularly in those businesses where longer term counterparty performance is critical, such as OTC derivative transactions, including credit derivatives and interest rate swaps. Factors that are important to the determination of the Company’s credit ratings include the level and quality of earnings, capital adequacy, liquidity, risk appetite and management, asset quality, business mix and perceived levels of government support.
The rating agencies have stated that they currently incorporate various degrees of uplift from perceived government support in the credit ratings of systemically important banks including the credit ratings of the Company. The U.S. financial reform legislation may be seen as limiting the possibility of extraordinary
government support for the financial system in any future financial crises, which may lead to reduced uplift assumptions for U.S. banks and thereby place downward pressure on credit ratings. At the same time, the U.S. financial reform legislation also has credit ratings positive features such as higher standards for capital and liquidity levels. The net result on credit ratings and the timing of any rating agency actions is currently uncertain (see “Other Matters—Regulatory Outlook” herein).
In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business segment, the Company may be required to provide additional collateral or immediately settle any outstanding liability balances with certain counterparties in the event of a credit rating downgrade. At September 30, 2010, the amount of additional collateral or termination payments that could be called by counterparties under the terms of such agreements in the event of a one-notch downgrade of the Company’s long-term credit rating was $1,775 million. A total of $3,997 million in collateral or termination payments could be called in the event of a two-notch downgrade. A total of $4,754 million in collateral or termination payments could be called in the event of a three-notch downgrade.
Also, the Company is required to pledge additional collateral to certain exchanges and clearing organizations in the event of a credit ratings downgrade. At September 30, 2010, the increased collateral requirement at certain exchanges and clearing organizations was $249 million in the event of a one-notch downgrade of the Company’s long-term credit rating. A total of $1,691 million of collateral is required in the event of a two-notch downgrade and a total of $2,537 million of collateral is required in the event of a three-notch downgrade.
The liquidity impact of additional collateral requirements is accounted for in the Company’s CFP.
At October 31, 2010, the Company’s and Morgan Stanley Bank, N.A.’s senior unsecured ratings were as set forth below:
Dominion Bond Rating Service Limited
Fitch Ratings
Moody’s
Rating and Investment Information, Inc.
Standard & Poor’s
Regulatory Requirements.
The Company is a financial holding company under the Bank Holding Company Act of 1956 and is subject to the regulation and oversight of the Federal Reserve. The Federal Reserve establishes capital requirements for the Company, including well-capitalized standards, and evaluates the Company’s compliance with such capital requirements (see “Supervision and Regulation—Financial Holding Company” in Part I, Item 1 of the Form 10-K). The Office of the Comptroller of the Currency establishes similar capital requirements and standards for the Company’s national bank subsidiaries (see “Other Matters—Regulatory Outlook” herein).
The Company calculates its capital ratios and RWAs in accordance with the capital adequacy standards for financial holding companies adopted by the Federal Reserve. These standards are based upon a framework described in the “International Convergence of Capital Measurement and Capital Standards,” July 1988, as amended, also referred to as Basel I. In December 2007, the U.S. banking regulators published final U.S. implementing regulation incorporating the Basel II Accord, which requires internationally active banking organizations, as well as certain of their U.S. bank subsidiaries, to implement Basel II standards over the next several years. The timeline set out in December 2007 for the implementation of Basel II in the U.S. may be impacted by the developments concerning Basel III described below. Starting July 2010, the Company has been reporting on a parallel basis under the current regulatory capital regime (Basel I) and Basel II. During the parallel run period, the Company continues to be subject to Basel I but simultaneously calculates its risks under Basel II.
The Company reports the capital ratios under both of these standards to the regulators. There will be at least four quarters of parallel reporting before the Company enters the three-year transitional period to implement Basel II standards.
In December 2009, the Basel Committee on Banking Supervision (the “Basel Committee”) released proposals on risk-based capital, leverage and liquidity standards, known as “Basel III”. The proposal described new standards to raise the quality of capital and strengthen counterparty credit risk capital requirements and introduced a leverage ratio as a supplemental measure to the risk-based ratio and also introduced a countercyclical buffer. The Basel III proposals complement an earlier proposal for revisions to Market Risk Framework that increases capital requirements for securitizations within the trading book. In July 2010, the Basel Committee refined some of the proposals. In September 2010, the Group of Governors and Heads of Supervision of the Basel Committee endorsed the proposals and introduced minimum capital requirements and timelines for implementation of the new standards.
Under the Basel Committee’s proposed framework, based on a preliminary analysis of the guidelines published to date, the Company estimates its RWAs at September 30, 2010 could increase by approximately $240 billion, partially offset by a decrease of approximately $100 billion related to runoff and mitigation opportunities by the end of 2012. The net increase in RWAs is estimated to be $140 billion, or approximately 40%, primarily driven by higher market risk for securitization, structured credit and correlation products and credit risk for counterparty exposures. These are preliminary estimates and they will change based on finalization of the Basel Committee’s framework and are subject to guidelines for implementation to be issued by the Federal Reserve.
The new proposed framework includes new standards to raise the quality of capital which may impact the components of Tier 1 capital and Tier 1 common equity. The Company currently defines Tier 1 common equity as Tier 1 capital less qualifying perpetual preferred stock, qualifying trust preferred securities and qualifying restricted core capital elements, adjusted for the portion of goodwill and non-servicing intangible assets associated with MSSB’s noncontrolling interests (i.e., Citi’s share of MSSB’s goodwill and intangibles). This definition of Tier 1 common equity may evolve in the future as regulatory rules may be implemented based on a final proposal regarding noncontrolling interest as initially presented by the Basel Committee. For the discussion of Tier 1 common equity, please see “The Balance Sheet” herein.
Pursuant to provisions of the Dodd-Frank Act, over time, the trust preferred securities will no longer qualify as Tier 1 capital but will only qualify as Tier 2 capital. This change in regulatory capital treatment will be phased in incrementally during a transition period that will start on January 1, 2013 and end on January 1, 2016. This provision of the Dodd-Frank Act accelerates the phase in of disqualification of the trust preferred securities as provided for by Basel III. At September 30, 2010, the Company had $4.7 billion of trust preferred securities included in the qualifying restricted core capital elements.
The following table reconciles the Company’s total shareholders’ equity to Tier 1 and Total Capital as defined by the regulations issued by the Federal Reserve and presents the Company’s consolidated capital ratios at September 30, 2010 and December 31, 2009:
Allowable capital
Tier 1 capital:
Common shareholders’ equity
Qualifying preferred stock
Qualifying mandatorily convertible trust preferred securities
Qualifying restricted core capital elements
Less: Goodwill
Less: Non-servicing intangible assets
Less: Net deferred tax assets
Less: Debt valuation adjustment
Other deductions
Total Tier 1 capital
Tier 2 capital:
Other components of allowable capital:
Qualifying subordinated debt
Other qualifying amounts
Total Tier 2 capital
Total allowable capital
Total risk-weighted assets
Capital ratios
Total allowable capital is composed of Tier 1 and Tier 2 capital. Tier 1 capital consists predominately of common shareholders’ equity as well as qualifying preferred stock, trust preferred securities mandatorily convertible to common equity (see “Redemption of CIC Equity Units and Issuance of Common Stock” herein for further information) and qualifying restricted core capital elements (including other junior subordinated debt issued to trusts and noncontrolling interests) less goodwill, non-servicing intangible assets (excluding allowable mortgage servicing rights), net deferred tax assets (recoverable in excess of one year) and a debt valuation adjustment. The debt valuation adjustment in the above table represents the cumulative change in fair value of certain long-term and short-term borrowings that was attributable to the Company’s own instrument-specific credit spreads and is included in retained earnings. For a further discussion of fair value, see Note 4 to the condensed consolidated financial statements.
In August 2010, the Company redeemed the junior subordinated debentures underlying the Equity Units and issued 116 million shares of common stock to the CIC Entity (see “Redemption of CIC Equity Units and Issuance of Common Stock” herein for further information).
At September 30, 2010, the Company calculated its RWAs in accordance with the regulatory capital requirements of the Federal Reserve, which is consistent with guidelines described under Basel I. RWAs reflect
both on and off-balance sheet risk of the Company. The risk capital calculations will evolve over time as the Company enhances its risk management methodology and incorporates improvements in modeling techniques while maintaining compliance with the regulatory requirements and interpretations.
Market RWAs reflect capital charges attributable to the risk of loss resulting from adverse changes in market prices and other factors. For a further discussion of the Company’s market risks and Value-at-Risk (“VaR”) model, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A, of the Form 10-K and in Part I, Item 3 herein. Market RWAs incorporate two components: systematic risk and specific risk. Systematic and specific risk charges are computed using either the Company’s VaR model or Standardized Approach in accordance with regulatory requirements.
Credit RWAs reflect capital charges attributable to the risk of loss arising from a borrower or counterparty failing to meet its financial obligations. For a further discussion of the Company’s credit risks, see “Quantitative and Qualitative Disclosures about Market Risk—Credit Risk” in Part II, Item 7A, of the Form 10-K and in Part I, Item 3 herein. Credit RWAs are determined using Basel I regulatory capital guidelines for U.S. banking organizations issued by the Federal Reserve.
Market Risk.
The Company uses Value-at-Risk (“VaR”) as one of a range of risk management tools. VaR methodology has various strengths and limitations, which include, but are not limited to: use of historical changes in market risk factors, which may not be accurate predictors of future market conditions and may not fully incorporate the risk of extreme market events that are outsized relative to observed historical market behavior or reflect the historical distribution of results beyond the 95% confidence interval; and reporting of losses in a single day, which does not reflect the risk of positions that cannot be liquidated or hedged in one day. A small proportion of market risk generated by trading positions is not included in VaR. The modeling of the risk characteristics of some positions relies on approximations that, under certain circumstances, could produce significantly different results from those produced using more precise measures. For a further discussion of the Company’s VaR methodology and its limitations, and the Company’s risk management policies and control structure, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.
The tables below present the VaR for the Company’s Aggregate, Trading, and Non-Trading portfolios, on a quarter end, quarterly average, and quarterly high, and low basis (see Table 1 below). The VaR statistics that would result if the Company were to adopt alternative parameters for its calculations, such as a higher reported confidence level (99% rather than 95%) or a shorter historical time series of market data (one year rather than four years) are also disclosed (see Table 2 below).
Aggregate VaR incorporates certain non-trading risks, including the interest rate risk generated by funding liabilities related to institutional trading positions, public company equity positions recorded as investments by the Company and corporate loan exposures that are awaiting distribution to the market. Investments made by the Company that are not publicly traded are not reflected in the VaR results presented below. Aggregate VaR also excludes the credit spread risk generated by the Company’s funding liabilities and the interest rate risk associated with approximately $7.3 billion of certain funding liabilities primarily related to fixed and other non-trading assets at both September 30, 2010 and June 30, 2010. The credit spread risk sensitivity of the Company’s mark-to-market funding liabilities corresponded to an increase in value of approximately $14 million and $11 million for each +1 basis point widening in the Company’s credit spread level at September 30, 2010 and June 30, 2010, respectively.
The credit spread risk relating to the Company’s mark-to-market derivative counterparty exposure is also managed separately from VaR. The credit spread risk sensitivity of this exposure corresponds to an increase in value of approximately $8 million and $6 million for each +1 basis point widening in the Company’s credit spread level at September 30, 2010 and June 30, 2010, respectively.
The counterparty portfolio, which reflects adjustments, net of hedges, relating to counterparty credit risk and other market risks, was reclassified from Non-Trading VaR into Trading VaR as of January 1, 2010. This reclassification reflects regulatory considerations surrounding the Company’s conversion to a financial holding company, and the trading book nature of the Company’s counterparty risk-hedging activities. Aggregate VaR was not affected by this change; however, this reclassification increased Trading VaR and decreased Non-Trading VaR.
Since the VaR statistics reported below are estimates based on historical position and market data, VaR should not be viewed as predictive of the Company’s future revenues or financial performance or of its ability to monitor and manage risk. There can be no assurance that the Company’s actual losses on a particular day will not exceed the VaR amounts indicated below or that such losses will not occur more than five times in 100 trading days. VaR does not predict the magnitude of losses which, should they occur, may be significantly greater than the VaR amount.
Table 1 below presents 95%/one-day VaR for each of the Company’s primary market risk exposures and on an aggregate basis at September 30, 2010 and June 30, 2010. The average, high and low figures for the quarters ended September 30, 2010 and June 30, 2010 are also included.
Primary Market Risk Category
Interest rate and credit spread
Equity price
Foreign exchange rate
Commodity price
Less Diversification benefit(1)
Total Trading VaR
Total Non-Trading VaR
Aggregate VaR
The Company’s average Trading VaR for the quarter ended September 30, 2010 was $142 million compared with $139 million for the quarter ended June 30, 2010. Increases in interest rate and credit risk were offset by reduced G10 and emerging market foreign currency risk.
The Company’s average Non-Trading VaR for the quarter ended September 30, 2010 was $103 million compared with $67 million for the quarter ended June 30, 2010. The increase in Non-Trading VaR was due primarily to increased exposure to Invesco, driven by a price rally in the stock, as well as increased interest rate sensitivity of deposits in the declining rate environment.
The Company’s average Aggregate VaR for the quarter ended September 30, 2010 was $189 million compared with $164 million for the quarter ended June 30, 2010. The increase in Aggregate VaR was driven by the same factors that contributed to the increase in Non-Trading VaR.
VaR Statistics under Varying Assumptions.
VaR statistics are not readily comparable across firms because of differences in the breadth of products included in each firm’s VaR model, in the statistical assumptions made when simulating changes in market factors, and in the methods used to approximate portfolio revaluations under the simulated market conditions. These differences can result in materially different VaR estimates for similar portfolios. The impact varies depending on the factor history assumptions, the frequency with which the factor history is updated, and the confidence level. As a result, VaR statistics are more reliable and relevant when used as indicators of trends in risk taking rather than as a basis for inferring differences in risk taking across firms.
Table 2 below presents the VaR statistics that would result if the Company were to adopt alternative parameters for its calculations, such as the reported confidence level (95% versus 99%) for the VaR statistic or a shorter historical time series (four years versus one year) for market data upon which it bases its simulations:
Table 2: 95% and 99% Average
Trading VaR with Four-Year / One-
Year Historical Time Series
Distribution of VaR Statistics and Net Revenues for the quarter ended September 30, 2010.
As shown in Table 1 above, the Company’s average 95%/one-day Trading VaR for the quarter ended September 30, 2010 was $142 million. The histogram below presents the distribution of the Company’s daily 95%/one-day Trading VaR for the quarter ended September 30, 2010. The most frequently occurring value was between $138 million and $141 million, while for approximately 59% of trading days during the quarter, VaR ranged between $132 million and $141 million.
One method of evaluating the reasonableness of the Company’s VaR model as a measure of the Company’s potential volatility of net revenue is to compare the VaR with actual trading revenue. Assuming no intra-day trading, for a 95%/one-day VaR, the expected number of times that trading losses should exceed VaR during the year is 13, and, in general, if trading losses were to exceed VaR more than 21 times in a year, the accuracy of the VaR model could be questioned. Accordingly, the Company evaluates the reasonableness of its VaR model by comparing the potential declines in portfolio values generated by the model with actual trading results. For days where losses exceed the 95% or 99% VaR statistic, the Company examines the drivers of trading losses to evaluate the VaR model’s accuracy relative to realized trading results.
The Company did not incur daily trading losses in excess of the 95%/one-day Trading VaR for the quarter ended September 30, 2010. Over the longer term, trading losses are expected to exceed VaR an average of three times per quarter at the 95% confidence level. The Company bases its VaR calculations on the long term (or unconditional) distribution with four years of observations, and therefore evaluates its risk from a longer-term perspective. The Company is evaluating enhancements to its VaR model to make it more responsive to more recent market conditions, while maintaining a longer-term perspective.
The histogram below shows the distribution of daily net trading revenue for the quarter ended September 30, 2010 for the Company’s trading businesses (these figures include revenue from the counterparty portfolio and also include net interest and non-agency commissions but exclude certain non-trading revenues such as primary, fee-based and prime brokerage revenue credited to the trading businesses). During the quarter ended September 30, 2010, the Company experienced net trading losses on 10 days.
Credit Risk.
For a further discussion of the Company’s credit risks, see “Quantitative and Qualitative Disclosures about Market Risk—Credit Risk” in Part II, Item 7A of the Form 10-K.
Credit Exposure—Corporate Lending. In connection with certain of its Institutional Securities business activities, the Company provides loans or lending commitments (including bridge financing) to selected clients. Such loans and lending commitments can generally be classified as either “relationship-driven” or “event-driven.”
“Relationship-driven” loans and lending commitments are generally made to expand business relationships with select clients. The commitments associated with “relationship-driven” activities may not be indicative of the Company’s actual funding requirements, as the commitment may expire unused or the borrower may not fully utilize the commitment. The borrowers of “relationship-driven” lending transactions may be investment grade or non-investment grade. The Company may hedge its exposures in connection with “relationship-driven” transactions.
“Event-driven” loans and lending commitments refer to activities associated with a particular event or transaction, such as to support client merger, acquisition or recapitalization transactions. The commitments associated with these “event-driven” activities may not be indicative of the Company’s actual funding requirements since funding is contingent upon a proposed transaction being completed. In addition, the borrower may not fully utilize the commitment or the Company’s portion of the commitment may be reduced through the syndication process. The borrower’s ability to draw on the commitment is also subject to certain terms and conditions, among other factors. The borrowers of “event-driven” lending transactions may be investment grade or non-investment grade. The Company risk manages its exposures in connection with “event-driven” transactions through various means, including syndication, distribution and/or hedging.
The following table presents information about the Company’s corporate funded loans and lending commitments at September 30, 2010. The “total corporate lending exposure” column includes both lending commitments and funded loans. Fair value of corporate lending exposure represents the fair value of loans that have been drawn by the borrower and lending commitments that were outstanding at September 30, 2010. Lending commitments represent legally binding obligations to provide funding to clients at September 30, 2010 for both “relationship-driven” and “event-driven” lending transactions. As discussed above, these loans and lending commitments have varying terms, may be senior or subordinated, may be secured or unsecured, are generally contingent upon representations, warranties and contractual conditions applicable to the borrower, and may be syndicated, traded or hedged by the Company.
At September 30, 2010, the aggregate amount of investment grade loans was $4.6 billion and the aggregate amount of non-investment grade loans was $6.8 billion. At September 30, 2010, the aggregate amount of lending commitments outstanding was $60.4 billion. In connection with these corporate lending activities (which include corporate funded loans and lending commitments), the Company had hedges (which include “single name,” “sector” and “index” hedges) with a notional amount of $21.3 billion related to the total corporate lending exposure of $71.7 billion at September 30, 2010.
The table below shows the Company’s credit exposure from its corporate lending positions and lending commitments at September 30, 2010. Since commitments associated with these business activities may expire unused, they do not necessarily reflect the actual future cash funding requirements:
Corporate Lending Commitments and Funded Loans at September 30, 2010
Credit Rating(1)
“Event-driven” Loans and Lending Commitments at September 30, 2010.
Included in the total corporate lending exposure amounts in the table above at September 30, 2010 is “event-driven” exposure of $5.3 billion composed of funded loans of $1.2 billion and lending commitments of $4.1 billion. Included in the $5.3 billion of “event-driven” exposure at September 30, 2010 were $4.0 billion of loans and lending commitments to non-investment grade borrowers that were closed.
Activity associated with the corporate “event-driven” lending exposure during the nine months ended September 30, 2010 was as follows (dollars in millions):
“Event-driven” lending exposures at December 31, 2009
Closed commitments
Net reductions, primarily through distributions
Mark-to-market adjustments
“Event-driven” lending exposures at September 30, 2010
Credit Exposure—Derivatives. The table below presents a summary by counterparty credit rating and remaining contract maturity of the fair value of OTC derivatives in a gain position at September 30, 2010. Fair value is presented in the final column net of collateral received (principally cash and U.S. government and agency securities):
The following table summarizes the fair values of the Company’s OTC derivative products recorded in Financial instruments owned and Financial instruments sold, not yet purchased by product category and maturity at September 30, 2010, including on a net basis, where applicable, reflecting the fair value of related non-cash collateral for financial instruments owned:
OTC Derivative Products—Financial Instruments Owned at September 30, 2010
Interest rate and currency swaps, interest rate options, credit derivatives and other fixed income securities contracts
Foreign exchange forward contracts and options
Equity securities contracts (including equity swaps, warrants and options)
Commodity forwards, options and swaps
OTC Derivative Products—Financial Instruments Sold, Not Yet Purchased at September 30, 2010(1)
The Company’s derivatives (both listed and OTC), on a net of counterparty and cash collateral basis, at September 30, 2010 and December 31, 2009 are summarized in the table below, showing the fair value of the related assets and liabilities by product category:
Each category of derivative products in the above tables includes a variety of instruments, which can differ substantially in their characteristics. Instruments in each category can be denominated in U.S. dollars or in one or more non-U.S. currencies.
The Company determines the fair values recorded in the above tables using various pricing models. For a discussion of fair value as it affects the condensed consolidated financial statements, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies” in Part I, Item 2, herein and Notes 2 and 4 to the condensed consolidated financial statements.
Credit Derivatives. A credit derivative is a contract between a seller (guarantor) and buyer (beneficiary) of protection against the risk of a credit event occurring on a set of debt obligations issued by a specified reference entity. The beneficiary pays a periodic premium (typically quarterly) over the life of the contract and is protected for the period. If a credit event occurs, the guarantor is required to make payment to the beneficiary based on the terms of the credit derivative contract. Credit events include bankruptcy, dissolution or insolvency of the referenced entity, failure to pay, obligation acceleration, repudiation and payment moratorium. Debt restructurings are also considered a credit event in some cases. In certain transactions referenced to a portfolio of referenced entities or asset-backed securities, deductibles and caps may limit the guarantor’s obligations.
The Company trades in a variety of derivatives and may either purchase or write protection on a single name or portfolio of referenced entities. The Company is an active market-maker in the credit derivatives markets. As a market-maker, the Company works to earn a bid-offer spread on client flow business and manage any residual credit or correlation risk on a portfolio basis. Further, the Company uses credit derivatives to manage its exposure to residential and commercial mortgage loans and corporate lending exposures.
The Company actively monitors its counterparty credit risk related to credit derivatives. A majority of the Company’s counterparties are banks, broker-dealers, insurance, and other financial institutions and Monolines. Contracts with these counterparties do not include ratings-based termination events but do include counterparty rating downgrades, which may result in additional collateral being required by the Company. For further information on the Company’s exposure to Monolines, see “Overview of the Quarter and Nine Months ended September 30, 2010 Financial Results—Monoline Insurers” herein. The master agreements with these Monoline counterparties are generally unsecured, and the few ratings-based triggers (if any) generally provide the Company the ability to terminate only upon significant downgrade. As with all derivative contracts, the Company considers counterparty credit risk in the valuation of its positions and recognizes credit valuation adjustments as appropriate.
The following table summarizes the key characteristics of the Company’s credit derivative portfolio by counterparty at September 30, 2010. The fair values shown are before the application of any counterparty or cash collateral netting:
Banks and securities firms
Insurance and other financial institutions
Monolines
Non-financial entities
Country Exposure. At September 30, 2010, primarily based on the domicile of the counterparty, approximately 6% of the Company’s credit exposure (for credit exposure arising from corporate loans and lending commitments as discussed above and current exposure arising from the Company’s OTC derivative contracts) was to emerging markets, and no one emerging market country accounted for more than approximately 1% of the Company’s credit exposure.
The Company defines emerging markets to include generally all countries where the economic, legal and political systems are transitional and in the process of developing into more transparent and accountable systems that are consistent with advanced countries.
The following tables show the Company’s percentage of credit exposure from its primary corporate loans and lending commitments and OTC derivative products by country at September 30, 2010:
Country
United States
United Kingdom
Germany
Netherlands
Canada
France
Luxembourg
Switzerland
Cayman Islands
United Arab Emirates
Italy
Japan
Spain
Jersey
Chile
Industry Exposure. The Company also monitors its credit exposure to individual industries for credit exposure arising from corporate loans and lending commitments as discussed above and current exposure arising from the Company’s OTC derivative contracts.
The following table shows the Company’s percentage of credit exposure from its primary corporate loans and lending commitments and OTC derivative products by industry at September 30, 2010:
Industry
Utilities
Financial institutions(1)
Energy
Pharmaceutical and healthcare
Media
Technology
Chemicals, metals, mining and other materials
Telecommunications services
Food, beverage and tobacco
Insurance
Capital goods
Sovereign governments
Regional governments
Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this report.
No change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) occurred during the period covered by this report that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
FINANCIAL DATA SUPPLEMENT (Unaudited)
Average Balances and Interest Rates and Net Interest Income
Interest earning assets:
Financial instruments owned(1):
U.S
Non-U.S
Loans:
Interest bearing deposits with banks:
Federal funds sold and securities purchased under agreements to resell and Securities borrowed:
Other:
Non-interest earning assets
Interest bearing liabilities:
Commercial paper and other short-term borrowings:
Deposits:
Long-term debt:
Financial instruments sold, not yet purchased(1):
Securities sold under agreements to repurchase and Securities loaned:
Non-interest bearing liabilities and equity
Net interest income and net interest rate spread
FINANCIAL DATA SUPPLEMENT (Unaudited)—Continued
Financial instruments sold, not yet purchased(1)
Rate/Volume Analysis
The following table sets forth an analysis of the effect on net interest income of volume and rate changes:
Interest earning assets
Financial instruments owned
Change in interest income
Interest bearing liabilities
Change in interest expense
Change in net interest income
Part II—Other Information.
In addition to the matters described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 (the “Form 10-K”), the Company’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2010 (the “First Quarter Form 10-Q”) and June 30, 2010 ( the “Second Quarter Form 10-Q”) and those described below, 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 actual or threatened legal actions include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages. In some cases, the entities that would otherwise be the primary defendants in such cases are bankrupt or in financial distress.
The Company contests liability and/or the amount of damages as appropriate in each pending matter. Where available information indicates that it is probable a liability had been incurred at the date of the condensed consolidated financial statements and the Company can reasonably estimate the amount of that loss, the Company accrues the estimated loss by a charge to income.
In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount of any loss. The Company cannot predict with certainty if, how or when such proceedings will be resolved or what the eventual settlement, fine, penalty or other relief, if any, may be, particularly for proceedings that are in their early stages of development or where plaintiffs seek substantial or indeterminate damages. Numerous issues may need to be resolved, including through potentially lengthy discovery and determination of important factual matters, and by addressing novel or unsettled legal questions relevant to the proceedings in question, before a loss or additional loss or range of loss or additional loss can be reasonably estimated for any proceeding. Subject to the foregoing, the Company believes, based on current knowledge and after consultation with counsel, that the outcome of such proceedings will not have a material adverse effect on the consolidated financial condition of the Company, although the outcome of such proceedings could be material to the Company’s operating results and cash flows for a particular period depending on, among other things, the level of the Company’s revenues or income for such period.
Recently, the level of litigation activity focused on residential mortgage-related claims has increased materially in the financial services industry. As a result, the Company expects that it may become the subject of increased claims for damages and other relief regarding residential mortgages and related securities in the future and, while the Company has identified below and in previously filed reports with the SEC, certain proceedings that the Company believes to be material, individually or collectively, there can be no assurance that additional material losses will not be incurred from residential mortgage claims that have not yet been notified to the Company or are not yet determined to be material.
The following developments have occurred with respect to certain matters previously reported in the Form 10-K, the First Quarter Form 10-Q and/or the Second Quarter Form 10-Q:
Residential Mortgage-Related Matters.
Class Actions.
On August 17, 2010, the court presiding over the action styled In re Morgan Stanley Mortgage Pass-Through Certificates Litig., pending in the United States District Court for the Southern District of New York (“SDNY”), dismissed the claims brought by the lead plaintiff, but gave a different plaintiff leave to file a second amended
complaint. On September 10, 2010, that plaintiff, together with several new plaintiffs, filed a second amended complaint which purports to assert claims against the Company and others on behalf of a class of investors who purchased approximately $4.7 billion of mortgage pass through certificates issued in 2006 by seven trusts collectively containing residential mortgage loans. The amended complaint asserts claims under Sections 11, 12 and 15 of the Securities Act of 1933, as amended (the “Securities Act”), and alleges, among other things, that the registration statements and offering documents related to the offerings contained false and misleading information concerning the pools of residential loans that backed these securitizations. The plaintiffs are seeking, among other relief, class certification, unspecified compensatory and recissionary damages, costs, interest and fees. On October 11, 2010, defendants filed a motion to dismiss the amended complaint.
On October 12, 2010, the court presiding over the action styled In re Washington Mutual, Inc. Securities Litigation, pending in the United States District Court for the Western District of Washington, issued an order certifying a class of plaintiffs asserting claims under the Securities Act related to three offerings by Washington Mutual Inc. in 2006 and 2007 in which the Company participated as an underwriter. The Company underwrote approximately $1.3 billion of the securities covered by the class certified by the court.
Other Litigation.
On October 8, 2010, the court presiding over the action styled Citibank, N.A. v. Morgan Stanley & Co., Int’l, PLC, pending in the SDNY issued an order denying Citibank, N.A.’s (“Citi N.A.”) motion for judgment on the pleadings as to the Company’s counterclaim for reformation and granting Citi N.A.’s motion for judgment on the pleadings as to the Company’s counterclaim for estoppel.
On December 23, 2009, the Federal Home Loan Bank Board of Seattle filed a complaint against the Company and another defendant in the Superior Court of the State of Washington, styledFederal Home Loan Bank of Seattle v. Morgan Stanley & Co. Inc., et al. An amended complaint was filed on September 28, 2010. The complaint alleges that defendants made untrue statements and material omissions in the sale to plaintiff of certain mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The total amount of certificates allegedly sold to plaintiff by the Company was approximately $233 million. The complaint raises claims under the Washington State Securities Act and seeks, among other things, to rescind the plaintiff’s purchase of such certificates. On October 18, 2010, defendants filed a motion to dismiss the action.
On March 15, 2010, the Federal Home Loan Bank Board of San Francisco filed two complaints against the Company and other defendants in the Superior Court of the State of California. These actions are styled Federal Home Loan Bank of San Francisco v. Credit Suisse Securities (USA) LLC, et al., and Federal Home Loan Bank of San Francisco v. Deutsche Bank Securities Inc. et al., respectively. Amended complaints were filed on June 10, 2010. The complaints allege that defendants made untrue statements and material omissions in connection with the sale to plaintiff of a number of mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The amount of certificates allegedly sold to plaintiff by the Company in these cases was approximately $704 million and $276 million, respectively. The complaints raise claims under both the federal securities laws and California law and seek, among other things, to rescind the plaintiff’s purchase of such certificates. On July 12, 2010, defendants removed these actions to the United States District Court for the Northern District of California, and on August 11, 2010, plaintiff filed motions to remand the cases to the state court.
On July 9, 2010, Cambridge Place Investment Management Inc. filed a complaint against the Company and other defendants in the Superior Court of the Commonwealth of Massachusetts, styledCambridge Place Investment Management Inc. v. Morgan Stanley & Co., Inc., et al. The complaint asserts claims on behalf of certain of plaintiff’s clients and alleges that defendants made untrue statements and material omissions in the sale of a number of mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The total amount of certificates allegedly sold to plaintiff’s clients by the Company was approximately $220 million. The complaint raises claims under the Massachusetts Uniform Securities Act and seeks, among
other things, to rescind the plaintiff’s purchase of such certificates. On August 13, 2010, defendants removed this action to the United States District Court for the District of Massachusetts and on September 13, 2010, plaintiff filed a motion to remand the case to the state court.
On July 15, 2010, The Charles Schwab Corp. filed a complaint against the Company and other defendants in the Superior Court of the State of California, styled The Charles Schwab Corp. v. BNP Paribas Securities Corp., et al. The complaint alleges that defendants made untrue statements and material omissions in the sale to one of plaintiff’s subsidiaries of a number of mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The total amount of certificates allegedly sold to plaintiff’s subsidiary by the Company was approximately $180 million. The complaint raises claims under both the federal securities laws and California law and seeks, among other things, to rescind the plaintiff’s purchase of such certificates. On September 8, 2010, defendants removed this action to the United States District Court for the Northern District of California and on October 1, 2010, plaintiff filed a motion to remand the case to the state court.
On October 15, 2010, the Federal Home Loan Bank of Chicago filed two complaints against the Company and other defendants. One was filed in the Circuit Court of the State of Illinois and is styled Federal Home Loan Bank of Chicago v. Bank of America Funding Corporation et al. The other was filed in the Superior Court of the State of California and is styled Federal Home Loan Bank of Chicago v. Bank of America Securities LLC, et al. The complaints allege that defendants made untrue statements and material omissions in the sale to plaintiff of a number of mortgage pass through certificates backed by securitization trusts containing residential mortgage loans. The total amount of certificates allegedly sold to plaintiff by the Company in the two actions was approximately $203 million and $75 million respectively. The complaint filed in Illinois raises claims under Illinois law. The complaint filed in California raises claims under both the federal securities laws and California law. Both complaints seek, among other things, to rescind the plaintiff’s purchase of such certificates.
For a discussion of the risk factors affecting the Company, see “Risk Factors” in Part I, Item 1A of the Form 10-K.
The table below sets forth the information with respect to purchases made by or on behalf of the Company of its common stock during the quarterly period ended September 30, 2010.
Issuer Purchases of Equity Securities
(dollars in millions, except per share amounts)
Period
Month #1
(July 1, 2010—July 31, 2010)
Share Repurchase Program (A)
Employee Transactions (B)
Month #2
(August 1, 2010—August 31, 2010)
Month #3
(September 1, 2010—September 30, 2010)
An exhibit index has been filed as part of this Report on Page E-1.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
Ruth Porat
Executive Vice President and
Chief Financial Officer
Paul C. Wirth
Finance Director and Controller
Date: November 8, 2010
EXHIBIT INDEX
Quarter Ended September 30, 2010
Exhibit No.
Description
E-1