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 June 30, 2011
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 ofincorporation 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):
Large Accelerated Filer x
Non-Accelerated Filer ¨
(Do not check if a smaller reporting company)
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 July 31, 2011, there were 1,927,916,237 shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding.
QUARTERLY REPORT ON FORM 10-Q
For the quarter ended June 30, 2011
Part I—Financial Information
Item 1.
Condensed Consolidated Statements of Financial Condition—June 30, 2011 and December 31, 2010
Condensed Consolidated Statements of Income—Three and Six Months Ended June 30, 2011 and 2010
Condensed Consolidated Statements of Comprehensive Income—Three and Six Months Ended June 30, 2011 and 2010
Condensed Consolidated Statements of Cash Flows—Six Months Ended June 30, 2011 and 2010
Condensed Consolidated Statements of Changes in Total Equity—Six Months Ended June 30, 2011 and 2010
Item 2.
Introduction
Executive Summary
Business Segments
Accounting Developments
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 at www.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; Compensation, Management Development and Succession Committee; Nominating and Governance Committee; Operations and Technology 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 Deputy Chief Financial Officer. 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 ($254 and $297 at June 30, 2011 and December 31, 2010, respectively, 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 $122,209 and $129,969 were pledged to various parties at June 30, 2011 and December 31, 2010, respectively):
U.S. government and agency securities
Other sovereign government obligations
Corporate and other debt ($4,005 and $3,816 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)
Corporate equities ($100 and $625 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)
Derivative and other contracts
Investments ($2,012 and $1,873 at June 30, 2011 and December 31, 2010, respectively, 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, at fair value
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 (net of allowances of $36 and $82 at June 30, 2011 and December 31, 2010, respectively)
Other investments
Premises, equipment and software costs (net of accumulated depreciation of $4,524 and $4,476 at June 30, 2011 and December 31, 2010, respectively) ($310 and $321 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)
Goodwill
Intangible assets (net of accumulated amortization of $779 and $605 at June 30, 2011 and December 31, 2010, respectively) (includes $133 and $157 at fair value at June 30, 2011 and December 31, 2010, respectively)
Other assets ($371 and $118 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities, generally not available to the Company)
Total assets
See Notes to Condensed Consolidated Financial Statements.
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION—(Continued)
Liabilities and Equity
Deposits (includes $2,830 and $3,027 at fair value at June 30, 2011 and December 31, 2010, respectively)
Commercial paper and other short-term borrowings (includes $1,710 and $1,799 at fair value at June 30, 2011 and December 31, 2010, respectively)
Financial instruments sold, not yet purchased, at fair value:
Corporate and other debt
Corporate equities
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 $358 and $849 at fair value at June 30, 2011 and December 31, 2010, respectively )
Securities loaned
Other secured financings (includes $16,632 and $8,490 at fair value at June 30, 2011 and December 31, 2010, respectively) ($3,157 and $2,656 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities and are non-recourse to the Company)
Payables:
Interest and dividends
Other liabilities and accrued expenses ($132 and $117 at June 30, 2011 and December 31, 2010, respectively, related to consolidated variable interest entities and are non-recourse to the Company)
Long-term borrowings (includes $43,434 and $42,709 at fair value at June 30, 2011 and December 31, 2010, respectively)
Commitments and contingent liabilities (see Note 11)
Equity
Morgan Stanley shareholders’ equity:
Preferred stock
Common stock, $0.01 par value;
Shares authorized: 3,500,000,000 at June 30, 2011 and December 31, 2010;
Shares issued: 1,989,377,171 at June 30, 2011 and 1,603,913,074 at December 31, 2010;
Shares outstanding: 1,929,032,583 at June 30, 2011 and 1,512,022,095 and December 31, 2010
Paid-in capital
Retained earnings
Employee stock trust
Accumulated other comprehensive loss
Common stock held in treasury, at cost, $0.01 par value; 60,344,588 shares at June 30, 2011 and 91,890,979 shares at December 31, 2010
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 income taxes
Income from continuing operations
Discontinued operations:
Gain from discontinued operations
Net gain from discontinued operations
Net income
Net income 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, postretirement and other 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 (loss) to net cash provided by (used for) operating activities:
(Gain) loss on equity method investees
Compensation payable in common stock and options
Depreciation and amortization
Gain on business dispositions
Gain on sale of securities available for sale
Loss 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 proceeds from (payments for):
Premises, equipment and software costs
Business acquisitions, net of cash acquired
Business dispositions, net of cash disposed
Japanese securities joint venture with MUFG
Purchases of securities available for sale
Sales and redemptions of securities available for sale
Net cash provided by (used for) investing activities
CASH FLOWS FROM FINANCING ACTIVITIES
Commercial paper and other short-term borrowings
Dividends related to noncontrolling interests
Derivatives financing activities
Other secured financings
Deposits
Net proceeds from:
Excess tax benefits associated with stock-based awards
Public offerings and other issuances of common stock
Issuance of long-term borrowings
Payments for:
Long-term borrowings
Repurchases of common stock for employee tax withholding
Cash dividends
Net cash provided by (used for) financing activities
Effect of exchange rate changes on cash and cash equivalents
Effect of cash and cash equivalents related to variable interest entities
Net increase 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 $3,144 million and $3,302 million for the six months ended June 30, 2011 and 2010, respectively.
Cash payments for income taxes were $530 million and $236 million for the six months ended June 30, 2011 and 2010, respectively.
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN TOTAL EQUITY
Six Months Ended June 30, 2011
BALANCE AT
DECEMBER 31, 2010
Dividends
Shares issued under employee plans and related tax effects
Repurchases of common stock
Net change in cash flow hedges
Pension, postretirement and other related adjustments
Foreign currency translation adjustments
Change in net unrealized gains on securities available for sale
Other increase in equity method investments
MUFG stock conversion
Decrease in noncontrolling interests related to dividends of noncontrolling interests
Other increases in noncontrolling interests
BALANCE AT JUNE 30, 2011
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN TOTAL EQUITY—(Continued)
Six Months Ended June 30, 2010
BALANCE AT DECEMBER 31, 2009
Pension and postretirement adjustments
Gain on Japanese securities joint venture with MUFG
Increase in noncontrolling interests related to Japanese securities joint venture with MUFG
Increase in noncontrolling interests related to the consolidation of certain real estate partnerships sponsored by the Company
BALANCE AT JUNE 30, 2010
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 provides 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”), 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 and engages in fixed income principal trading, which primarily facilitates clients’ trading or investments in such securities.
Asset Management provides a broad array of investment strategies that span the risk/return spectrum across geographies, asset classes and public and private markets to a diverse group of clients across the institutional and intermediary channels as well as high net worth clients (see “Discontinued Operations—Retail Asset Management Business” herein).
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 the sale. 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. In the fourth quarter of 2010, the Company sold its investment in Invesco.
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 was primarily associated with a development property in Atlantic City, New Jersey. On February 17, 2011, the Company completed the sale of Revel to a group of investors led by Revel’s chief executive officer. The Company did not retain any stake or ongoing involvement. The sale price approximated the carrying value of Revel and, accordingly, the Company did not recognize any pre-tax gain or loss on the sale. Total assets of Revel included in the Company’s condensed consolidated statement of financial condition at December 31, 2010 approximated $28 million. The results of Revel are reported as discontinued operations within the Institutional Securities business segment for all periods presented through the date of sale. The three and six months ended June 30, 2010 included losses of approximately $19 million and $951 million, respectively, in connection with such planned disposition. See Note 17 for additional information about an income tax benefit related to Revel.
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 through the date of disposal 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 through the date of disposal.
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 a lawsuit against Visa and MasterCard. The payment was recorded as a gain in discontinued operations for the six months ended June 30, 2010.
Prior period amounts have been recast for discontinued operations. 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 United States of America (“U.S.”), which require the Company to make estimates and assumptions regarding the valuations of certain financial instruments, the valuation of goodwill, compensation, deferred tax assets, 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.
At June 30, 2011, the Company recorded approximately $5.6 billion in Financial instruments owned—Corporate and other debt, $3.4 billion of physical commodities within Financial instruments owned—Physical commodities, and $9.0 billion of financing obligations within Other secured financing in the condensed consolidated statements of financial condition in connection with certain physical commodities swap transactions. Prior to June 30, 2011, the Company accounted for these types of transfers of assets as sales and purchases instead of financings. There was no impact on the Company’s results of operations in any period presented as a result of this change. The Company did not restate the balances in connection with such transactions at December 31, 2010 as amounts did not materially affect the Company’s condensed consolidated statement of financial condition.
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, 2010 (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 (“VIE”) (see Note 6). 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 in 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.
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 3).
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. LLC (“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., Morgan Stanley Private Bank, National Association 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, primarily in its Institutional Securities business segment, the Company considers its principal trading, investment banking, commissions and interest income, along with the associated interest expense, as one integrated activity.
For a detailed discussion about the Company’s significant accounting policies, see Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.
During the six months ended June 30, 2011, other than the following, no other updates were made to the Company’s significant accounting policies.
Financial Instruments and Fair Value.
Fair value for many cash instruments 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, creditworthinness of the counterparty, creditworthiness of the Company, 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, model uncertainty and concentration risk. 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 (primarily structured notes) 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 the 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 are unavailable for a specific counterparty, bond market spreads, CDS spread data based on the counterparty’s credit rating or CDS spread data that reference 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. The Company may apply a concentration adjustment to certain of its OTC derivatives portfolios to reflect the additional cost of closing out a particularly large risk position. Where possible, these adjustments are based on observable market information but in many instances significant judgment is required to estimate the costs of closing out concentrated risk positions due to the lack of liquidity in the marketplace.
Allowance for Loan Losses.
The Company places loans on nonaccrual status if principal or interest is past due for a period of 90 days or more or payment of principal or interest is in doubt unless the obligation is well secured and in the process of collection. Payments received on nonaccrual loans held for investment are applied to principal if there is doubt regarding the ultimate collectability of principal (cost recovery method). If collection of the principal of nonaccrual loans held for investment is not in doubt, interest income is recognized on a cash basis. If neither principal nor interest collection is in doubt, loans are on accrual status and interest income is recognized using the effective interest method.
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, and are held for investment purposes. At June 30, 2011, Mitsubishi UFJ Financial Group, Inc. (“MUFG”) and the Company converted MUFG’s outstanding Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock (“Series B Preferred Stock”) in the Company with a face value of $7.8 billion (carrying value $8.1 billion) into the Company’s common stock. As a result of the adjustment to the conversion ratio, pursuant to the transaction agreement, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the quarter and six months ended June 30, 2011 (see Note 13). In addition, in the six months ended June 30, 2010, 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.
Accounting Developments.
Goodwill Impairment Test.
In December 2010, the Financial Accounting Standards Board (the “FASB”) issued accounting guidance that modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For those reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity shall consider whether there are any adverse qualitative factors indicating that an impairment may exist. The qualitative factors are consistent with the existing guidance. This guidance became effective for the Company on January 1, 2011. The adoption of this accounting guidance did not have a material impact on the Company’s condensed consolidated financial statements.
3. Fair Value Disclosures.
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 composed of three main categories consisting of agency-issued debt, agency mortgage pass-through pool 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 pool 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 pool 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. In addition, for RMBS borrowers, Fair Isaac Corporation (“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 transaction. 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 generally categorized in Level 2 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, then RMBS, CMBS and other ABS are categorized in Level 3 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 (“CDO”). 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 loans and lending commitments also takes into account fee income that is considered an attribute of the contract. Corporate loans and lending commitments are categorized in Level 2 of the fair value hierarchy except in instances where prices or significant spread inputs are unobservable, in which case they are categorized in Level 3 of the fair value hierarchy.
Mortgage Loans. Mortgage loans are valued using observable prices based on transactional data or third party pricing 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 market 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 the comparability assessment related to mortgage loan vintage, geographical concentration, prepayment speed and projected loss assumptions, mortgage loans are categorized 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.
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.
For further information on derivative instruments and hedging activities, see Note 10.
Investments.
The Company’s investments include investments in private equity funds, real estate funds and hedge funds (which include investments made in connection with certain employee deferred compensation plans) as well as direct investments in equity securities. Direct 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 generally 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 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.
Securities Available for Sale.
Securities available for sale are composed of U.S. government and agency securities, including U.S. Treasury securities, agency-issued debt, agency mortgage pass-through securities and collateralized mortgage obligations. Actively traded U.S. Treasury securities and 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. For further information on securities available for sale, see Note 4.
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.
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.
Securities Sold under Agreements to Repurchase.
In 2010, the fair value option was elected for certain 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. In instances where the unobservable inputs are deemed significant, repurchase agreements are categorized in Level 3 of the fair value hierarchy; otherwise, they are categorized in Level 2 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 June 30, 2011 and December 31, 2010.
Assets and Liabilities Measured at Fair Value on a Recurring Basis at June 30, 2011
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:
Private equity funds
Real estate funds
Hedge funds
Principal investments
Total investments
Total financial instruments owned
Securities available for sale:
Securities received as collateral
Intangible assets(3)
Liabilities
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 June 30, 2011.
Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the quarter ended June 30, 2011, the Company reclassified approximately $0.9 billion of derivative assets and approximately $1.3 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.
Transfers Between Level 1 and Level 2 During the Six Months Ended June 30, 2011.
Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the six months ended June 30, 2011, the Company reclassified approximately $1.1 billion of derivative assets and approximately $0.9 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.
Assets and Liabilities Measured at Fair Value on a Recurring Basis at December 31, 2010
Other(3)
Intangible assets(4)
Transfers Between Level 1 and Level 2 during the Quarter Ended June 30, 2010.
Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the quarter ended June 30, 2010, the Company reclassified approximately $1.5 billion of derivative assets and approximately $1.5 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.
Financial instruments owned—Corporate equities. During the quarter ended June 30, 2010, the Company reclassified approximately $0.5 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. During the quarter ended June 30, 2010, the Company reclassified approximately $1.0 billion of certain Corporate equities from Level 1 to Level 2 as transactions in these securities did not occur with sufficient frequency and volume to constitute an active market.
Transfers Between Level 1 and Level 2 During the Six Months Ended June 30, 2010.
Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the six months ended June 30, 2010, the Company reclassified approximately $1.8 billion of derivative assets and approximately $1.9 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.
Financial instruments owned—Corporate equities. During the six months ended June 30, 2010, the Company reclassified approximately $1.1 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.
Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis.
The following tables present additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter and six months ended June 30, 2011 and for the quarter and six months ended June 30, 2010, 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 within 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 June 30, 2011
Net derivative and other contracts(3):
Total net derivative and other contracts
Intangible assets
Financial instruments owned—Corporate and other debt. During the quarter ended June 30, 2011, the Company reclassified approximately $1.2 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified the corporate loans as external prices and/or spread inputs for these instruments became observable.
The Company also reclassified approximately $0.8 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to 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.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Six Months Ended June 30, 2011
Financial instruments owned—Corporate and other debt. During the six months ended June 30, 2011, the Company reclassified approximately $1.8 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified these corporate loans as external prices and/or spread inputs for these instruments became observable.
The Company also reclassified approximately $0.6 billion of certain Corporate and other debt from Level 2 to Level 3. The reclassifications were primarily related to 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.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Three Months Ended June 30, 2010
Foreign exchange rate contracts
Financial instruments owned—Corporate and other debt. During the quarter ended June 30, 2010, the Company reclassified approximately $1.9 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified the corporate loans as external prices and/or spread inputs for these instruments became observable.
The Company also reclassified approximately $0.6 billion of certain Corporate and other debt from Level 2 to Level 3. The Company reclassified corporate loans as external prices and/or spread inputs became unobservable.
Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Six Months Ended June 30, 2010
Financial instruments owned—Corporate and other debt. During the six months ended June 30, 2010, the Company reclassified approximately $1.4 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified the corporate loans as external prices and/or spread inputs for these instruments became observable.
The Company also reclassified approximately $0.8 billion of certain Corporate and other debt from Level 2 to Level 3. The Company reclassified corporate loans as external prices and/or spread inputs became unobservable.
Fair Value of Investments that Calculate Net Asset Value.
The Company’s Investments measured at fair value were $9,020 million and $9,752 million at June 30, 2011 and December 31, 2010, respectively. The following table presents information solely 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 June 30, 2011 and December 31, 2010, 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 June 30, 2011, it is estimated that 7% of the fair value of the funds will be liquidated in the next five years, another 32% of the fair value of the funds will be liquidated between five to 10 years and the remaining 61% of the fair value of the funds have a remaining life of greater than 10 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 June 30, 2011, it is estimated that 18% of the fair value of the funds will be liquidated within the next five years, another 35% of the fair value of the funds will be liquidated between five to 10 years and the remaining 47% of the fair value of the funds have a remaining life of greater than 10 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 that 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 12% 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 these investments subject to lock-up restrictions ranged from one to three years at June 30, 2011. Investments representing approximately 26% 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 these investments subject to an exit restriction was primarily two years or less at June 30, 2011.
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 overvalued securities that are primarily debt or credit related. At June 30, 2011, investments representing approximately 36% 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 subject to lock-up restrictions was one year or less at June 30, 2011.
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 June 30, 2011, investments representing approximately 34% 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 primarily one year or less at June 30, 2011.
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 June 30, 2011, investments representing approximately 76% 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 these investments subject to lock-up restrictions was primarily three years or less at June 30, 2011. Investments representing approximately 9% of the fair value of investments in multi-strategy hedge funds cannot be redeemed currently because of an exit restriction that has been imposed by the hedge fund manager. The restriction period for these investments subject to an exit restriction was indefinite at June 30, 2011.
Fair Value Option.
The Company elected the fair value option for certain eligible instruments that are risk managed on a fair value basis to mitigate income statement volatility caused by measurement basis differences between the elected instruments and their associated risk management transactions or to eliminate complexities of applying certain accounting models. 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 six months ended June 30, 2011 and 2010, respectively.
Three Months Ended June 30, 2011
Three Months Ended June 30, 2010
In addition to the amounts in the above table, as discussed in Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K, 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 changes in overall fair value of the short-term and long-term borrowings (primarily structured notes) are attributable to changes in foreign currency exchange rates, interest rates, movements in the reference price or index for structured notes and (as presented in the table below) an adjustment to reflect the change in credit quality of the Company.
The following tables present information on the Company’s short-term and long-term borrowings (primarily structured notes), loans and unfunded lending commitments for which the fair value option was elected.
Gains (Losses) due to Changes in Instrument Specific Credit Risk
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 and/or on non-accrual status(2)(3)
The tables above exclude non-recourse debt from consolidated VIEs, liabilities related to failed sales, pledged commodities and other liabilities that have specified assets attributable to them.
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 statements 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 six months ended June 30, 2011 and 2010, respectively.
Three and Six Months Ended June 30, 2011.
Loans(3)
Other investments(4)
Intangible assets(5)
There were no liabilities measured at fair value on a non-recurring basis during the quarter and six months ended June 30, 2011.
Three and Six Months Ended June 30, 2010.
In addition to the losses included in the table above, the Company incurred a loss of approximately $951 million in connection with the planned disposition of Revel, which was included in discontinued operations. The loss primarily related to premises and equipment 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 $240 million at June 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 six months ended June 30, 2010.
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, certain Deposits and certain Other secured financings.
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 June 30, 2011, the carrying value of the Company’s long-term borrowings not measured at fair value was approximately $1.0 billion higher than fair value. At December 31, 2010, the carrying value of the Company’s long-term borrowings not measured at fair value was approximately $1.8 billion higher than fair value.
The following table presents information about the Company’s available for sale (“AFS”) securities:
Debt securities available for sale:
The table below presents the fair value of investments in debt securities available for sale that have been in an unrealized loss position:
At June 30, 2011
Fair Value
GrossUnrealizedLosses
At December 31, 2010
Gross unrealized losses are recorded in Accumulated other comprehensive income.
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 June 30, 2011 and December 31, 2010.
The following table presents the amortized cost and fair value of debt securities available for sale by contractual maturity dates at June 30, 2011.
U.S. Treasury securities:
Due within 1 year
After 1 year but through 5 years
After 5 years
U.S. agency securities:
Total U.S. government and agency securities:
The following table presents information pertaining to sales of debt securities available for sale:
Gross realized gains
Gross realized losses
Proceeds of sales of debt securities available for sale
Gross realized gains and losses are recognized in Other revenues in the condensed consolidated statements of income. There were no sales of AFS securities during the three and six months ended June 30, 2010.
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 received as collateral, Securities purchased under agreements to resell and Securities borrowed. 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.
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. Customer receivables generated from margin lending activity are collateralized by customer-
owned securities held by the Company. The Company monitors required margin levels and established credit limits daily and, pursuant to such guidelines, requires customers to deposit additional collateral, or reduce positions, when necessary. Margin loans are extended on a demand basis and are not committed facilities. Factors considered in the review of margin loans are the amount of the loan, the intended purpose, the degree of leverage being employed in the account, and overall evaluation of the portfolio to ensure proper diversification or, in the case of concentrated positions, appropriate liquidity of the underlying collateral or potential hedging strategies to reduce risk. Additionally, transactions relating to concentrated or restricted positions require a review of any legal impediments to liquidation of the underlying collateral. Underlying collateral for margin loans is reviewed with respect to the liquidity of the proposed collateral positions, valuation of securities, historic trading range, volatility analysis and an evaluation of industry concentrations. 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 June 30, 2011 and December 31, 2010, there were approximately $20.7 billion and $18.0 billion, respectively, of customer margin loans outstanding.
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 other secured borrowings. These liabilities are generally payable from the cash flows of the related assets accounted for as Financial instruments owned (see Note 6).
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 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. 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 June 30, 2011 and December 31, 2010, the fair value of financial instruments received as collateral where the Company is permitted to sell or repledge the securities was $585 billion and $537 billion, respectively, and the fair value of the portion that had been sold or repledged was $416 billion and $390 billion, respectively.
At June 30, 2011 and December 31, 2010, cash and securities deposited with clearing organizations or segregated under federal and other regulations or requirements were as follows:
Securities(1)
The Company is involved with various 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. Excluding entities subject to the Deferral (as defined in Note 2 to the consolidated financial statements included in the Form 10-K), 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, including re-securitization transactions.
Guarantees issued and residual interests retained in connection with municipal bond securitizations.
Servicing residential and commercial mortgage loans held by VIEs.
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 (“CLN”) 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 significant economic 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 significant economic decisions in transactions such as securitizations or CDOs. As a result, the Company does not consolidate securitizations or CDOs for which it does not act as the servicer or collateral manager unless it holds certain other rights to replace the servicer or collateral manager or to require the liquidation of the entity. If the Company serves as servicer or collateral manager, or has certain other rights described in the previous sentence, the Company analyzes the interests in the VIE that it holds and consolidates only those VIEs for which it holds a potentially significant interest, generally based on the fair value of interests held by the Company relative to the fair value of the assets of the VIE.
The structure of securitization vehicles and CDOs are driven by several parties, including loan seller(s) in securitization transactions, the collateral manager in a CDO, one or more rating agencies, a financial guarantor in some transactions and the underwriter(s) of the transactions, who serve to reflect specific investor demand. In addition, subordinate investors, such as the “B-piece” buyer in commercial mortgage backed securitizations or equity investors in CDOs, can influence whether specific loans are excluded from a CMBS transaction or investment criteria in a CDO.
For many transactions, such as re-securitization transactions, 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, including whether the assets were issued in a transaction sponsored by the Company and the extent of the information available to the Company and to investors, the number, nature and involvement of investors, other rights held by the Company and investors, the standardization of the legal documentation and the level of the continuing involvement by the Company, including the amount and type of interests owned by the Company and by other investors, 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. Most re-securitization transactions, CLNs and other asset-repackaged notes have no such termination rights.
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. For consolidated VIEs included in other structured financings, the Company accounts for the assets held by the entities primarily in Premises, equipment and software costs, and Other assets 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 June 30, 2011 and December 31, 2010 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.
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 June 30, 2011 and December 31, 2010, managed real estate partnerships reflected noncontrolling interests in the Company’s condensed consolidated financial statements of $1,627 million and $1,508 million, respectively. The Company also had additional maximum exposure to losses of approximately $471 million and $884 million at June 30, 2011 and December 31, 2010, respectively. This additional exposure related primarily to certain derivatives (e.g., instead of purchasing senior securities, the Company has sold credit protection to synthetic CDOs through credit derivatives that are typically related to the most senior tranche of the CDO) and commitments, guarantees and other forms of involvement.
The following tables present information about certain non-consolidated VIEs in which the Company had variable interests at June 30, 2011 and December 31, 2010. The tables include all VIEs in which the Company has determined that its maximum exposure to loss is greater than specific thresholds or meets certain other criteria. Most of the VIEs included in the tables below are sponsored by unrelated parties; the Company’s involvement generally is the result of the Company’s secondary market-making activities.
VIE assets that the Company does not consolidate (unpaid principal balance)(1)
Maximum exposure to loss:
Debt and equity interests(2)
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. Primarily as a result of its secondary market-making activities, 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 $5.0 billion at June 30, 2011. 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 $1.8 billion of securities backed primarily by residential mortgage loans, $1.0 billion of securities backed by U.S. agency collateralized mortgage obligations, $0.9 billion of securities backed by commercial mortgage loans, $0.8 billion of securities backed by collateralized debt obligations or collateralized loan obligations and $0.5 billion backed by other consumer loans, such as credit card receivables, automobile loans and student loans. The Company’s primary risk exposure is 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 generally equals the fair value of the securities owned.
The Company’s transactions with VIEs primarily includes securitizations, municipal tender option bond trusts, credit protection purchased through CLNs, other structured financings, collateralized loan and debt obligations, equity-linked notes, managed real estate partnerships and asset management investment funds. The Company’s continuing involvement in VIEs that it does not consolidate can include ownership of retained interests in Company-sponsored transactions, interests purchased in the secondary market (both for Company-sponsored transactions and transactions sponsored by third parties), derivatives with securitization SPEs (primarily interest rate derivatives in commercial mortgage and residential mortgage securitizations and credit derivatives in which the Company has purchased protection in synthetic CDOs), and as servicer in residential mortgage securitizations in the U.S. and Europe and commercial mortgage securitizations in Europe. Such activities are further described in Note 7 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.
Transfers of Assets with Continuing Involvement.
The following tables present information at June 30, 2011 regarding transactions with SPEs in which the Company, acting as principal, transferred financial assets with continuing involvement and received sales treatment.
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)
The following tables present information at December 31, 2010 regarding transactions with SPEs in which the Company, acting as principal, transferred assets with continuing involvement and received sales treatment.
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 on sales of assets in securitization transactions at the time of the sale were not material in the six months ended June 30, 2011 and 2010.
During the six months ended June 30, 2011 and 2010, the Company received proceeds from new securitization transactions of $15.0 billion and $10.0 billion, respectively. During the six months ended June 30, 2011 and 2010, the Company received proceeds from cash flows from retained interests in securitization transactions of $3.9 billion and $2.8 billion, respectively.
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 (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 of financial assets 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 provide additional recourse through derivatives such as total return swaps, guarantees or other forms of involvement.
The following table presents information about the carrying value of assets and liabilities resulting from transfers of financial assets treated by the Company as secured financings:
Commercial mortgage loans
Credit-linked notes
Equity-linked transactions
Mortgage Servicing Activities.
Mortgage Servicing Rights. The Company may retain servicing rights to certain mortgage loans that are sold. These transactions create an asset referred to as MSRs, which totaled approximately $133 million and $157 million at June 30, 2011 and December 31, 2010, 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 June 30, 2011 and December 31, 2010 totaled approximately $1.4 billion and $1.5 billion, respectively, net of allowance of $6 million and $10 million at June 30, 2011 and December 31, 2010, respectively.
The following tables present information about the Company’s mortgage servicing activities for SPEs to which the Company transferred loans at June 30, 2011 and December 31, 2010:
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 $12 billion and $13 billion at June 30, 2011 and December 31, 2010, respectively.
Loans held for investment.
The Company’s loans held for investment are recorded at amortized cost and classified as Loans in the condensed consolidated statements of financial condition.
The Company’s loans held for investment at June 30, 2011 and December 31, 2010 included the following:
Commercial and industrial
Consumer loans
Residential real estate loans
Wholesale real estate loans
Total loans held for investment(1)
The above table does not include loans held for sale of $110 million and $165 million at June 30, 2011 and December 31, 2010.
The Company’s Credit Risk Management Department evaluates new obligors before credit transactions are initially approved, and at least annually thereafter for consumer and industrial loans. For corporate and commercial loans, credit evaluations typically involve the evaluation of financial statements, assessment of leverage, liquidity, capital strength, asset composition and quality, market capitalization and access to capital markets, cash flow projections and debt service requirements, and the adequacy of collateral, if applicable. The Company’s Credit Risk Management Department will also evaluate strategy, market position, industry dynamics, obligor’s management and other factors that could affect the obligor’s risk profile. For residential real estate and consumer loans, the initial credit evaluation includes, but is not limited to review of the obligor’s income, net
worth, liquidity, collateral, loan-to-value ratio, and credit bureau information. Subsequent credit monitoring for residential real estate loans is performed at the portfolio level and for consumer loans collateral, values are monitored on an ongoing basis.
At June 30, 2011, the Company collectively evaluated for impairment gross commercial and industrial loans, consumer loans, residential real estate loans and wholesale real estate loans of $3,993 million, $4,325 million, $3,321 million and $335 million, respectively. The Company individually evaluated for impairment gross commercial and industrial loans, consumer and wholesale real estate loans of $212 million, $71 million and $145 million, respectively. Commercial and industrial loans of approximately $70 million and wholesale real estate loans of approximately $72 million were impaired at June 30, 2011. Approximately 99% of the Company’s loan portfolio was current at June 30, 2011.
At December 31, 2010, the Company collectively evaluated for impairment gross commercial and industrial loans, consumer loans, residential real estate loans and wholesale real estate loans of $3,791 million, $3,890 million, $1,915 million and $90 million, respectively. The Company individually evaluated for impairment gross commercial and industrial loans, consumer and wholesale real estate loans of $307 million, $85 million and $415 million, respectively. Commercial and industrial loans of approximately $170 million and wholesale real estate loans of approximately $108 million were impaired at December 31, 2010. Approximately 99% of the Company’s loan portfolio was current at December 31, 2010.
The Company assigned an internal grade of “doubtful” to certain commercial asset-backed and wholesale real estate loans totaling $145 million and $500 million at June 30, 2011 and December 31, 2010, respectively. Doubtful loans can be classified as current if the borrower is making payments in accordance with the loan agreement. The Company assigned an internal grade of “pass” to the majority of the remaining loans.
For a description of the Company’s loan portfolio and credit quality indicators utilized in its credit monitoring process, see Note 8 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.
Employee Loans.
Employee loans are granted primarily in conjunction with a program established in the Global Wealth Management Group business segment to retain and recruit certain employees. These loans are recorded in Receivables—Fees, interest and other in the condensed consolidated statements of financial condition. These loans are full recourse, require periodic payments and have repayment terms ranging from four to 12 years. The Company establishes a reserve for loan amounts it does not consider recoverable from terminated employees, which is recorded in Compensation and benefits expense. At June 30, 2011, the Company had $5,502 million of employee loans, net of an allowance of approximately $112 million. At December 31, 2010, the Company had $5,831 million of employee loans, net of an allowance of approximately $111 million.
Collateralized Transactions.
In certain instances, the Company enters into reverse repurchase agreements and securities borrowed transactions to acquire securities to cover short positions, to settle other securities obligations and to accommodate customers’ needs. The Company also engages in securities financing transactions for customers through margin lending (see Note 5).
Servicing Advances.
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 (see Note 6).
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. Additionally, if the book value of a reporting unit is zero or a negative value and it is determined that it is more likely than not the goodwill is impaired, further analysis is required.
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 also utilizes a discounted cash flow methodology for certain reporting units.
Due to the volatility in the equity markets, the economic outlook and the Company’s common shares trading below book value during the quarters ended December 31, 2010 and June 30, 2011, the Company performed additional impairment testing at December 31, 2010 and June 30, 2011, 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 six months ended June 30, 2011, were as follows:
Goodwill at December 31, 2010(1)
Foreign currency translation adjustments and other
Goodwill at June 30, 2011(1)
Net Intangible Assets.
Changes in the carrying amount of the Company’s intangible assets for the six months ended June 30, 2011 were as follows:
Amortizable net intangible assets at December 31, 2010
Mortgage servicing rights (see Note 6)
Indefinite-lived intangible assets
Net intangible assets at December 31, 2010
Amortization expense
Impairment losses
Intangible assets disposed of during the period
Amortizable net intangible assets at June 30, 2011
Net intangible assets at June 30, 2011
The Company’s long-term borrowings included the following components:
Senior debt
Subordinated debt
Junior subordinated debentures
During the six months ended June 30, 2011, the Company issued notes with a principal amount of approximately $23 billion. During the six months ended June 30, 2011, approximately $24 billion of notes were repaid.
The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.1 years and 5.2 years at June 30, 2011 and December 31, 2010, respectively.
FDIC’s Temporary Liquidity Guarantee Program.
At June 30, 2011 and December 31, 2010, the Company had long-term debt outstanding of $18.3 billion and $21.3 billion, respectively, under the Temporary Liquidity Guarantee Program (“TLGP”). The issuance of debt under the TLGP expired on December 31, 2010, but the existing long-term debt outstanding is guaranteed
until June 30, 2012. These borrowings are senior unsecured debt obligations of the Company and guaranteed by the Federal Deposit Insurance Corporation (“FDIC”) under the TLGP. The FDIC has concluded that the guarantee is backed by the full faith and credit of the U.S. government.
Other Secured Financings.
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, pledged commodities, certain equity-linked notes and other secured borrowings. See Note 6 for further information on other secured financings related to variable interest entities and securitization activities.
The Company’s other secured financings consisted of the following:
Secured financings with original maturities greater than one year
Secured financings with original maturities one year or less
Failed sales(1)
Total(2)
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’s derivative products consist of the following:
Exchange traded derivative products
OTC derivative products
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 3.
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 June 30, 2011 and December 31, 2010, 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 June 30, 2011(1)
Credit Rating(2)
AAA
AA
A
BBB
OTC Derivative Products—Financial Instruments Owned at December 31, 2010(1)
Hedge Accounting.
The Company applies hedge accounting using various derivative financial instruments 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 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 the currencies being exchanged are the functional currencies of the parent and 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 Total 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 six months ended June 30, 2011 and 2010, 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 recognized on derivatives
Gain (loss) recognized on borrowings
Derivatives Designated as Net Investment Hedges.
Foreign exchange contracts(1)
The table below summarizes gains (losses) on derivative instruments not designated as accounting hedges for the quarters and six months ended June 30, 2011 and 2010, respectively:
Other contracts
Total derivative instruments
The Company also has certain embedded derivatives that have been bifurcated from the related structured borrowings. Such derivatives are classified in Long-term borrowings and had a net fair value of $98 million and $109 million at June 30, 2011 and December 31, 2010, respectively, and a notional of $4,085 million and $4,256 million at June 30, 2011 and December 31, 2010, respectively. The Company recognized gains of $21 million and $2 million related to changes in the fair value of its bifurcated embedded derivatives for the quarter and six months ended June 30, 2011, respectively. The Company recognized gains of $27 million and $40 million related to changes in the fair value of its bifurcated embedded derivatives for the quarter and six months ended June 30, 2010, respectively.
At June 30, 2011 and December 31, 2010, the amount of payables associated with cash collateral received that was netted against derivative assets was $53.8 billion and $61.9 billion, respectively, and the amount of receivables in respect of cash collateral paid that was netted against derivative liabilities was $30.0 billion and $37.6 billion, respectively. Cash collateral receivables and payables of $413 million and $114 million, respectively, at June 30, 2011 and $435 million and $37 million, respectively, at December 31, 2010, 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 June 30, 2011 and December 31, 2010, the aggregate fair value of derivative contracts that contain credit-risk-related contingent features that are in a net liability position totaled $29,003 million and $32,567 million, respectively, for which the Company has posted collateral of $22,813 million and $26,904 million, respectively, in the normal course of business. At June 30, 2011 and December 31, 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 approximately $600 million and $873 million, respectively. Additional collateral or termination payments of approximately $1,393 million and $1,537 million could be called by counterparties in the event of a two-notch downgrade at June 30, 2011 and December 31, 2010, respectively. Of these amounts, $1,419 million and $1,766 million at June 30, 2011 and December 31, 2010, 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 receives or provides 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 tables below summarize the notional and fair value of protection sold and protection purchased through credit default swaps at June 30, 2011 and December 31, 2010:
Single name credit default swaps
Index and basket credit default swaps
Tranched index and basket credit default swaps
The table below summarizes the credit ratings and maturities of protection sold through credit default swaps and other credit contracts at June 30, 2011:
Credit Ratings of the Reference Obligation
Single name credit default swaps:
Index and basket credit default swaps(3):
Total credit default swaps sold
Other credit contracts(4)(5)
Total credit derivatives and other credit contracts
The table below summarizes the credit ratings and maturities of protection sold through credit default swaps and other credit contracts at December 31, 2010:
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 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 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.
When external credit ratings are not available, 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 with Identical Underlying Reference Obligations. 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 $2.3 trillion and $1.8 trillion at June 30, 2011 and December 31, 2010, compared with a notional amount of approximately $2.5 trillion and $2.0 trillion, at June 30, 2011 and December 31, 2010, respectively, 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 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 June 30, 2011 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)
Primary lending commitments—non-investment grade
Secondary lending commitments(2)
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 13 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.
The Company sponsors several non-consolidated investment funds for third-party investors where the Company typically acts as general partner of, and investment advisor 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 June 30, 2011:
Collateral/Recourse
Type of Guarantee
Credit derivative contracts(1)
Other credit contracts
Non-credit derivative contracts(1)
Standby letters of credit and other financial guarantees issued(2)(3)
Market value guarantees
Liquidity facilities
Whole loan sales representations and warranties
Securitization representations and warranties
General partner guarantees
For further description of these guarantees, refer to Note 13 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.
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 15 to the consolidated financial statements for the year ended December 31, 2010 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.
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. 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. These actions have included, but are not limited to, residential mortgage and credit crisis related matters and a Foreign Corrupt Practices Act related matter in China. Recently, the level of litigation activity focused on residential mortgage and credit crisis related matters 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 any individual proceedings where the Company believes a material loss to be reasonably 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.
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 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, determination of issues related to class certification and the calculation of damages, 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.
For certain other legal proceedings, the Company can estimate reasonably 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 three 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 12, 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. On May 25, 2011, the court denied the Company’s motion for summary judgment and granted Citi N.A.’s cross motion for summary judgment. On June 27, 2011, the court entered a judgment in favor of Citi N.A. for $269 million plus post-judgment interest and the Company filed a notice of appeal to the United States Court of Appeals for the Second Circuit. Based on currently available information, the Company believes it could incur a loss of up to approximately $269 million plus post-judgment interest.
On August 25, 2008, the Company and two ratings agencies were named as defendants in a purported class action related to securities issued by a structured investment vehicle called Cheyne Finance (the “Cheyne SIV”). The case is styled Abu Dhabi Commercial Bank, et al. v. Morgan Stanley & Co. Inc., et al. and is pending in the SDNY. The complaint alleges, among other things, that the ratings assigned to the securities issued by the Cheyne SIV were false and misleading because the ratings did not accurately reflect the risks associated with the subprime residential mortgage backed securities held by the Cheyne SIV. On September 2, 2009, the court dismissed all of the claims against the Company except for plaintiffs’ claims for common law fraud. On June 15, 2010, the court denied plaintiffs’ motion for class certification. On July 20, 2010, the court granted plaintiffs leave to replead their aiding and abetting common law fraud claims against the Company, and those claims were added in an amended complaint filed on August 5, 2010. Since the filing of the initial complaint, various additional plaintiffs have been added to the case. The deadline for new plaintiffs to join the case expired on March 11, 2011. There are currently 15 plaintiffs asserting individual claims related to approximately $983 million of securities issued by the Cheyne SIV. Plaintiffs have not provided information quantifying the amount of compensatory damages they are seeking and are also seeking unspecified punitive damages. Based on currently available information, the Company believes that the defendants could incur a loss up to the amount of plaintiffs’ claimed compensatory damages, once specified, related to their alleged purchase of approximately $983 million of securities issued by the Cheyne SIV plus pre- and post-judgment interest, fees and costs.
On July 15, 2010, China Development Industrial Bank (“CDIB”) filed a complaint against the Company, which is styled China Development Industrial Bank v. Morgan Stanley & Co. Incorporated et al. and is pending in the
Supreme Court of the State of New York, New York County. The complaint relates to a $275 million credit default swap referencing the super senior portion of the STACK 2006-1 CDO. The complaint asserts claims for common law fraud, fraudulent inducement and fraudulent concealment and alleges that the Company misrepresented the risks of the STACK 2006-1 CDO to CDIB, and that the Company knew that the assets backing the CDO were of poor quality when it entered into the credit default swap with CDIB. The complaint seeks compensatory damages related to the approximately $228 million that CDIB alleges it has already lost under the credit default swap, rescission of CDIB’s obligation to pay an additional $12 million, punitive damages, equitable relief, fees and costs. On February 28, 2011, the court presiding over this action denied the Company’s motion to dismiss the complaint. On March 21, 2011, the Company appealed the order denying its motion to dismiss the complaint. On July 7, 2011, the appellate court affirmed the lower court’s decision denying the motion to dismiss. Based on currently available information, the Company believes it could incur a loss of up to approximately $240 million plus pre- and post-judgment interest, fees and costs.
On December 6, 2010, MBIA Insurance Corporation (“MBIA”) filed a complaint against the Company related to MBIA’s contract to insure approximately $223 million of residential mortgage backed securities related to a second lien residential mortgage backed securitization sponsored by the Company in June 2007. The complaint is styled MBIA Insurance Corporation v. Morgan Stanley, et al. and is pending in New York Supreme Court, Westchester County. The complaint asserts claims for fraud, breach of contract and unjust enrichment and alleges, among other things, that the Company misled MBIA regarding the quality of the loans contained in the securitization, that loans contained in the securitization breached various representations and warranties and that the loans have been serviced inadequately. The complaint seeks, among other relief, compensatory and punitive damages, an order requiring the Company to comply with the loan breach remedy procedures in the transaction documents and/or to indemnify MBIA for losses resulting from the Company’s alleged breach of the transaction documents, as well as costs, interests and fees. On May 26, 2011, the court presiding over this case partially denied the Company’s motion to dismiss the complaint. On June 28, 2011, the Company filed a notice appealing that decision to the Appellate Division of the New York Supreme Court, First Department. Based on currently available information, the Company believes it could incur a loss of up to approximately $223 million plus pre- and post-judgment interest, fees and costs.
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 Board of Governors of the Federal Reserve System (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 (“RWA”) 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 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 addition, under provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the generally applicable capital standards, which are currently based on Basel I standards, but may themselves change over time, will serve as a permanent floor to minimum capital requirements calculated under the Basel II standard the Company is currently required to implement, as well as future capital 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 the Market Risk Framework that increases capital requirements for securitizations within the Company’s trading book. The Basel Committee published final rules in December 2010, which were ratified at the G-20 Leaders Summit in November 2010. 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 financial institutions, which could include capital surcharges.
At June 30, 2011, the Company was in compliance with Basel I capital requirements with ratios of Tier 1 capital to RWAs of 16.7% and total capital to RWAs of 18.3% (6% and 10% being well-capitalized for regulatory purposes, respectively). In addition, financial holding companies are 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:
Tier 1 capital
Total capital
RWAs
Adjusted average assets
Tier 1 leverage
Tier 1 capital ratio increased in the six month period due to a decrease of RWAs. Tier 1 leverage decreased in the six month period due to an increase of adjusted average assets and a decrease in Tier 1 capital.
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 June 30, 2011, 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.
Total capital (to RWAs):
Morgan Stanley Bank, N.A.
Morgan Stanley Private Bank, National Association
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 June 30, 2011 and December 31, 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 U.S. Securities and Exchange Commission (“SEC”), the Financial Industry Regulatory Authority, Inc. and the U.S. Commodity Futures Trading Commission. MS&Co. has consistently operated with capital in excess of its regulatory capital requirements. MS&Co.’s net capital totaled $6,474 million and $7,463 million at June 30, 2011 and December 31, 2010, respectively, which exceeded the amount required by $5,309 million and $6,355 million, respectively. 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 SEC 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 June 30, 2011, MS&Co. had tentative net capital in excess of the minimum and the notification requirements.
Morgan Stanley Smith Barney LLC is a registered broker-dealer and registered futures commission merchant and, accordingly, is subject to the minimum net capital requirements of the SEC, the Financial Industry Regulatory Authority, Inc. and the U.S. Commodity Futures Trading Commission. Morgan Stanley Smith Barney LLC has consistently 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 Citigroup, Inc. 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.
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 Aa3 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 17, 2010, MSDP was downgraded from an Aa2 rating to an Aa3 rating by Moody’s but maintained its AAA rating by S&P. While MSDP has made substantial effort to address Moody’s comments, MSDP’s counterparty rating remains on review for possible downgrade while Moody’s continues to evaluate MSDP’s capital adequacy. The recent 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.
Common Equity Offerings. During the quarters and six months ended June 30, 2011 and 2010, the Company did not purchase any of its common stock as part of its share repurchase program. At June 30, 2011, the Company had approximately $1.6 billion remaining under its current share repurchase authorization. Share repurchases by the Company are subject to regulatory approval.
MUFG Stock Conversion.
As previously disclosed, on April 21, 2011, MUFG and the Company announced that they had entered into an agreement to convert MUFG’s outstanding Series B Preferred Stock in the Company into the Company’s common stock. On June 30, 2011 the Company and MUFG completed the conversion, whereby MUFG exchanged the Series B Preferred Stock with a face value of $7.8 billion (carrying value $8.1 billion) and a 10% dividend for 385,464,097 shares of the Company’s common stock, including approximately 75 million shares resulting from the adjustment to the conversion ratio pursuant to the transaction agreement. As a result of the adjustment to the conversion ratio, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the quarter and six months ended June 30, 2011. As a result of the conversion, MUFG did not receive the previously declared dividend that would otherwise have been payable on July 15, 2011 in respect of the Series B Preferred Stock.
Noncontrolling Interest.
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 the MUFG transaction
Net transfers from noncontrolling interests
Change from net income applicable to Morgan Stanley and transfers from noncontrolling interests
In connection with the transaction between the Company and MUFG to form a joint venture in Japan, the Company recorded an after-tax gain of $717 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 June 30, 2010 and changes in total equity for the six months ended June 30, 2010. See “Other Matters—Japanese Securities Joint Venture” in Part I, Item 2 herein for further information.
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. Common shares outstanding include common stock and vested restricted stock units (“RSUs”) 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 and determines whether instruments granted in share-based payment transactions are participating securities (see Note 2 to the consolidated financial statements for the year ended December 31, 2010 in the Form 10-K). 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: MUFG stock conversion
Less: Preferred dividends (Series C Preferred Stock)
Less: Allocation of earnings to participating RSUs(1):
From continuing operations
From discontinued operations
Less: Allocation of undistributed earnings to Equity Units(2):
Weighted average common shares outstanding
Diluted EPS:
Impact on income of assumed conversions:
Assumed conversion of Equity Units(2)
Preferred stock dividends (Series B Preferred Stock)
Earnings (loss) applicable to common shareholders plus assumed conversions
Effect of dilutive securities:
Stock options and RSUs(1)
Series B Preferred Stock
Equity Units(2)
Weighted average common shares outstanding and common stock equivalents
Net income from discontinued operations
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:
RSUs and Performance-based stock units
Stock options
Details of Interest income and Interest expense were as follows:
Interest income(1):
Financial instruments owned(2)
Securities available for sale
Loans
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.
Effective January 1, 2011, the Morgan Stanley Employees Retirement Plan (the “Pension Plan”) for U.S. participants ceased accruals of benefits under the Pension Plan. Any benefits earned by participants under the Pension Plan at December 31, 2010 were preserved and will be payable in the future based on the Pension Plan’s provisions.
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 gain
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. The Company is currently in the early stages of an IRS audit for tax years 2006 – 2008. During 2012, the Company expects to reach a conclusion with the IRS on issues covering tax years 1999 – 2005. During 2011, the Company expects to commence an audit with New York State and New York City covering tax years 2007 – 2009. Also during 2011, the Company expects to reach a conclusion with the U.K. tax authorities on substantially all issues through tax year 2008, including those in appeals. 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 evaluates the likelihood of assessments in each taxing jurisdiction 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.
It is reasonably possible that 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.
The Company’s effective tax rate from continuing operations for the six months ended June 30, 2011 included a $447 million net tax benefit from the remeasurement of a deferred tax asset and the reversal of a related valuation allowance. The deferred tax asset and valuation allowance were recognized in income from discontinued operations during 2010 in connection with the recognition of a $1.2 billion loss due to writedowns and related costs following the Company’s commitment to a plan to dispose of Revel. The Company recorded the valuation allowance because the Company did not believe it was more likely than not that it would have sufficient future net capital gain to realize the benefit of the expected capital loss to be recognized upon the disposal of Revel. During the quarter ended March 31, 2011, the disposal of Revel was restructured as a tax-free like kind exchange and the disposal was completed. The restructured transaction changed the character of the future taxable loss to
ordinary. The Company reversed the valuation allowance because the Company believes it is more likely than not that it will have sufficient future ordinary taxable income to recognize the recorded deferred tax asset. In accordance with the applicable accounting literature, this reversal of a previously established valuation allowance due to a change in circumstances was recognized in income from continuing operations during the quarter ended March 31, 2011.
Segment Information.
The Company structures its segments primarily based upon the nature of the financial products and services provided to customers and the Company’s management organization. The Company provides a wide range of financial products and services to its customers in each of its business segments: Institutional Securities, 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. 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:
Net revenues(1)
Discontinued operations(2):
Provision from income taxes
Net gain on discontinued operations
Income (loss) from continuing operations before income taxes
Provision for (benefit from) income taxes
Gain (loss) from discontinued operations
Net gain (loss) on discontinued operations
Net income (loss)
Net income (loss) applicable to noncontrolling interests
Net income (loss) applicable to Morgan Stanley
Net gain (loss) from discontinued operations(3)
Net Interest
Total Assets(1)
Geographic Information.
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 and Real Estate Investing businesses, which are based on asset location.
2011
2010
Americas
Europe, Middle East, and Africa
Asia
The Company records investments accounted for under the equity method of accounting (see Note 1) in Other investments in the condensed consolidated statements of financial condition. See Note 24 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K for further information.
Huaxin Securities Joint Venture.
In June 2011, the Company and Huaxin Securities Co., Ltd. (“Huaxin Securities”) (also known as China Fortune Securities Co., Ltd.) jointly announced the operational commencement of their securities joint venture in China. The establishment of the joint venture was approved by China Securities Regulatory Commission (“CSRC”) on December 31, 2010 and was subject to receipt of a business license from the State Administration for Industry & Commerce of the People’s Republic of China, which was obtained in May 2011. Final CSRC approval for the commencement of business operations was obtained in June 2011. In the quarter ended June 30, 2011, the Company recorded initial costs of $130 million related to the formation of this new Chinese securities joint venture in Other expenses in the condensed consolidated statement of income.
The joint venture, Morgan Stanley Huaxin Securities Company Limited, is registered and principally located in Shanghai. Huaxin Securities holds a two-thirds interest in the joint venture while the Company owns a one-third interest. The establishment of the joint venture allows the Company to further build on its established onshore businesses in China. The joint venture’s business includes underwriting and sponsorship of shares in the domestic China market (including A shares and foreign investment shares), as well as underwriting, sponsorship and principal trading of bonds (including government and corporate bonds).
Japanese Securities Joint Venture.
On May 1, 2010, the Company and MUFG formed 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 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”). 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 continues to consolidate MSMS in its condensed consolidated financial statements and, commencing on May 1, 2010, accounted for its interest in MUMSS as an equity method investment within the Institutional Securities business segment.
During the three and six months ended June 30, 2011, the Company recorded losses of $17 million and $672 million, respectively, arising from the Company’s 40% stake in MUMSS, recorded within Other revenues in the condensed consolidated statements of income. In order to enhance the risk management at MUMSS, during the six months ended June 30, 2011, the Company entered into a transaction with MUMSS whereby the risk associated with the fixed income trading positions that previously caused the majority of the aforementioned MUMSS losses were transferred to MSMS. In return for entering into the transaction, the Company received total consideration of $659 million, which represented the estimated fair value of the transaction.
MUFG is responsible for ensuring that MUMSS remains adequately capitalized, and the Company is not obligated to contribute additional capital to MUMSS. Because of the losses incurred by MUMSS, MUFG contributed approximately $370 million of capital to MUMSS on April 22, 2011. The MUFG capital injection improved the capital base and restored the capital adequacy ratio of MUMSS. As a result of the capital injection, during the quarter ended June 30, 2011, the Company recorded an increase of approximately $148 million in the carrying amount of the equity method investment in MUMSS, reflecting the Company’s 40% share of the increase in the net asset value of MUMSS, and an increase in the Company’s Paid-in capital of approximately $86 million (after-tax).
During the quarter ended June 30, 2011, the Company performed an impairment review of its equity method investment in MUMSS in view of the deterioration in the financial performance of MUMSS and the earthquake in Japan on March 11, 2011. The Company recorded no other-than-temporary impairment loss at June 30, 2011. Adverse market or economic events, as well as further deterioration of post-earthquake economic performance could result in impairment charges of this investment in future periods.
FrontPoint.
On March 1, 2011, the Company and the principals of FrontPoint Partners LLC (“FrontPoint”) completed a transaction, whereby FrontPoint senior management and portfolio managers own a majority equity stake in FrontPoint, and the Company retains a minority stake. FrontPoint has replaced the Company’s affiliates as the investment advisor and general partner of the FrontPoint funds. Beginning March 1, 2011, the Company accounts for its interest in FrontPoint as an equity method investment within the Asset Management business segment. The Company recorded a loss of approximately $20 million related to the writedown of the minority stake investment in FrontPoint for the quarter ended June 30, 2011. The loss was included in Other revenues in the condensed consolidated statement of income.
See Note 1 for a discussion of the Company’s discontinued operations.
The table below provides information regarding amounts included in discontinued operations:
Pre-tax gain (loss) on discontinued operations(1):
Revel(2)
Retail Asset Management
DFS(3)
CMB
Net revenues included in discontinued operations for the quarter ended June 30, 2011 was $5 million related to Retail Asset Management. Net revenues included in discontinued operations for the six months ended June 30, 2011 included $6 million related to CMB and $5 million related to Retail Asset Management. Net revenues included in discontinued operations for the quarter ended June 30, 2010 included $1,019 million related to Retail Asset Management and a net loss of $2 million related to CMB. Net revenues included in discontinued operations for the six months ended June 30, 2010 included $1,204 million related to Retail Asset Management and $4 million related to CMB.
Common Dividend.
On July 19, 2011, the Company announced that its Board of Directors declared a quarterly dividend per common share of $0.05. The dividend is payable on August 15, 2011 to common shareholders of record on July 29, 2011.
Long-Term Borrowings.
Subsequent to June 30, 2011 and through July 31, 2011, the Company’s long-term borrowings (net of repayments) increased by approximately $1.5 billion.
U.K. Bank Levy.
In July 2011, the U.K. Government enacted legislation imposing a bank levy on relevant liabilities and equities on the consolidated balance sheets of “U.K. Banking Groups,” as defined under the bank levy legislations at December 31, 2011. The Company continues to evaluate the impact of this legislation and expects to incur a charge of approximately $125 million for the full year. Due to the charge being determined on relevant liabilities and equities at December 31, 2011, the final charge may differ from this estimate. The levy is not deductible for U.K. Corporation Tax purposes. The Company will start to accrue this charge in the third quarter of 2011.
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 June 30, 2011, the related condensed consolidated statements of income and comprehensive income for the three-month and six-month periods ended June 30, 2011 and 2010, and the condensed consolidated statements of cash flows and changes in total equity for the six-month periods ended June 30, 2011 and 2010. 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, 2010, 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 28, 2011, which report contains 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, 2010 is fairly stated, in all material respects, in relation to the consolidated statement of financial condition from which it has been derived.
/s/ Deloitte & Touche LLP
New York, New York
August 8, 2011
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.
Asset Management provides a broad array of investment strategies that span the risk/return spectrum across geographies, asset classes and public and private markets to a diverse group of clients across the institutional and intermediary channels as well as high net worth clients.
See Note 1 to the condensed consolidated financial statements for a discussion of the Company’s discontinued operations.
The results of operations in the past have been, and in the future may continue to be, materially affected by many factors, 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 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)), regulation (including capital requirements), and legal actions in the United States of America (“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 performance of the Company’s acquisitions, joint ventures, strategic alliances or other strategic arrangements (including MSSB and with Mitsubishi UFJ Financial Group, Inc. (“MUFG”)); the Company’s reputation; inflation, natural disasters, and acts of war or terrorism; the actions and initiatives of current and potential competitors and technological changes; or a combination of these or other factors. In addition, legislative, legal and regulatory developments related to the Company’s businesses are likely to increase costs, thereby affecting results of operations. These factors also may have an impact on the Company’s ability to achieve its strategic objectives. 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, 2010 (the “Form 10-K”) and “Other Matters” in Part I, Item 2 and “Risk Factors” in Part II, Item 1A 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 “Executive Summary—Significant Items” in Part II, Item 7 of the Form 10-K and “Other Matters” 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
Income from continuing operations applicable to Morgan Stanley:
Income from continuing operations applicable toMorgan Stanley
Income from continuing operations applicable to Morgan Stanley
Net gain from discontinued operations applicable to Morgan Stanley
Net gain from discontinued operations(1)
Earnings (loss) per basic common share(2)
Earnings (loss) per diluted common share(2)
Regional net revenues(3):
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)(4):
Parent capital
Total from continuing operations
Discontinued operations
Consolidated average common equity
Return on average common equity(4):
Consolidated
Institutional Securities(4)
Book value per common share(5)
Tangible common equity(6)
Tangible book value per common share(7)
Effective income tax rate provision from continuing operations(8)
Worldwide employees
Average liquidity (dollars in billions)(9):
Parent company liquidity
Bank and other subsidiary liquidity
Total liquidity
Capital ratios at June 30, 2011 and 2010(10):
Total capital ratio
Tier 1 capital ratio
Tier 1 leverage ratio
Tier 1 common ratio(10)
Consolidated assets under management or supervision(dollars in billions)(11):
Asset Management(12)
Institutional Securities:
Pre-tax profit margin(13)
Global Wealth Management Group:
Global representatives
Annualized net revenue per global representative(dollars in thousands)(14)
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(15)
Global retail net new assets (dollars in billions)
Global fee-based asset flows (dollars in billions)
Global retail locations
Bank deposits (dollars in billions)(16)
Asset Management:
Assets under management or supervision (dollars in billions)
Global Market and Economic Conditions.
During the six months ended June 30, 2011, global market and economic conditions were negatively impacted by concern about a sovereign debt crisis in Europe and the U.S. federal debt ceiling. Global economic conditions in the quarter ended June 30, 2011 were more challenging than the quarter ended March 31, 2011, which was affected by the natural disaster in Japan, political unrest in the Middle East and military operations in Libya. In the second quarter of 2011, global equity markets were strong in April, but pulled back in May and June as investors reacted to slowing global economic growth.
In the U.S., major equity market indices ended the first six months of 2011 higher compared with the beginning of the year primarily due to better than expected corporate earnings. However, the volatile second quarter of 2011 left the Dow Jones Industrial Average relatively flat and both the NASDAQ Composite and Standard & Poor’s 500-stock index were slightly lower from the beginning of the quarter. Negative market and economic developments in the second quarter of 2011 included the slowing pace of economic recovery, the increase in the unemployment rate and the continued sovereign debt crisis within the European region. Certain sectors of the residential real estate market and investments in commercial real estate projects remained challenged in the second quarter. Growth in consumer spending declined in recent months from the already modest pace in the first quarter. Inflation rose in recent months, mainly reflecting higher prices for some commodities and imported goods, as well as the recent supply chain disruptions associated with the natural disaster in Japan. Concerns about crude oil supplies contributed to a rise in oil prices in the beginning of the second quarter of 2011 and prices then fell sharply in May and June as investors feared the economic recovery was in jeopardy. The U.S. federal debt ceiling, deficit reductions, balanced budgets, and underfunded public pension liabilities remained critical focus items at the federal, state and local levels of government during the first six months of 2011. The unemployment rate, which declined in the first quarter to 8.8% from 9.4% at December 31, 2010, rose during the second quarter to 9.2% at June 30, 2011. The Federal Open Market Committee (“FOMC”) of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) kept key interest rates at historically low levels, and at June 30, 2011, the federal funds target rate was between zero and 0.25%, and the discount rate was 0.75%. FOMC completed its quantitative easing policies, in which the FOMC purchased securities with the objective of improving economic conditions by increasing the money supply and its $600 billion bond-buying program, commonly referred to as “quantitative easing 2” on June 30, 2011.
In Europe, equity market indices in the United Kingdom (“U.K.”) and France were relatively unchanged during the second quarter, while Germany’s DAX index was 5% higher compared with the beginning of the second quarter. During the first six months of 2011, U.K.’s FTSE 100 index was slightly higher while Germany and France’s indices were 6.3% and 4.5% higher respectively. Results in the European equity markets were affected by adverse economic developments, including investor concerns about the sovereign debt crisis, especially in Greece, Portugal, Ireland, Spain and Italy. The euro area unemployment rate remained relatively unchanged at approximately 10% at June 30, 2011. In April 2011, the European Central Bank (“ECB”) increased its benchmark interest rate by 0.25% from 1.00% to 1.25%. In July 2011, it increased such rate by another 0.25% to 1.50% and signaled further ECB rate increases in coming months. The Bank of England’s (“BOE”) benchmark interest rate was kept at 0.50%. The BOE continued to pursue quantitative easing policies, in which the BOE purchased securities, including U.K. Government Gilts, with the objective of improving economic conditions by increasing the money supply.
In Asia, major stock markets closed out the second quarter lower compared with the beginning of the quarter and the year. Japan’s economy picked up in the second quarter as supply constraints from the March natural disaster eased. In July 2011, the Bank of Japan kept its benchmark interest rate steady at a range of zero to 0.1% and refrained from loosening monetary policy further. The Nikkei 225 Index was relatively flat in the second quarter, and was 6% lower during the first six months of 2011. China’s gross domestic product growth moderated slightly during the second quarter of 2011 as Chinese policy makers tightened monetary policy to combat inflation. The People’s Bank of China (“PBOC”) raised benchmark interest rates by 0.25% twice during the first six months of 2011. In early July 2011, PBOC raised the benchmark interest rates by another 0.25%, which takes the one-year yuan lending rate from 2010 year-end’s 5.81% to 6.56% and one-year yuan deposit rate from 2010 year-end’s 2.75% to 3.5%. The Shanghai Composite Index and the Hang Seng Index decreased 6% and 5%, respectively, during the second quarter and decreased 2% and 3%, respectively, during the first six months of 2011.
Overview of the Quarter and Six Months Ended June 30, 2011 Financial Results.
Consolidated Results. The Company recorded net income applicable to Morgan Stanley of $1,193 million on net revenues of $9,282 million during the quarter ended June 30, 2011, compared with $1,960 million of net income applicable to Morgan Stanley and net revenues of $7,963 million in the prior year period. Net revenues in the current quarter included gains of $244 million due to the widening of the Company’s credit spreads and other credit factors on certain of the Company’s long-term and short-term borrowings, primarily structured notes, for which the fair value option was elected, compared with gains of approximately $750 million in the quarter ended June 30, 2010. Non-interest expenses increased 17% to $7,338 million in the quarter ended June 30, 2011. Compensation and benefits expense increased 20% quarter over quarter, primarily due to increased compensation costs in the Institutional Securities business segment due to higher net revenues. Non-compensation expenses increased 12%, primarily due to an increase in Other expenses in the Institutional Securities business segment related to business activity and ongoing investments in technology. Diluted EPS and diluted EPS from continuing operations were both $(0.38) in the quarter ended June 30, 2011 compared with $1.09 and $0.80, respectively in the prior year period. The earnings per share calculation for the current quarter included a negative adjustment of approximately $1.7 billion, or $1.02 per diluted share (calculated using 1.79 billion diluted average shares outstanding under the if-converted method), related to the conversion of MUFG’s outstanding Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock (“Series B Preferred Stock”) in the Company into the Company’s common stock.
For the six months ended June 30, 2011, the Company recorded net income applicable to Morgan Stanley of $2,161 million compared with net income applicable to Morgan Stanley of $3,736 million a year ago. Net revenues were $16,917 million in the six months ended June 30, 2011, compared to $17,035 million in the prior year period. Non-interest expenses increased 10% to $14,101 million from the prior year period. Diluted EPS were $0.13 in the six months ended June 30, 2011 compared with $2.08 a year ago. Diluted EPS from continuing operations were $0.12 in the six months ended June 30, 2011 compared with $1.82 a year ago.
The Company’s effective income tax rate from continuing operations was 27.9% and 10.2% for the quarter and six months ended June 30, 2011, respectively. The effective tax rate for the six months ended June 30, 2011 included a net tax benefit of $447 million, or $0.30 per diluted share, from the remeasurement of a deferred tax asset and the reversal of a related valuation allowance. The deferred tax asset and valuation allowance were recognized in income from discontinued operations during 2010 in connection with the recognition of a $1.2 billion loss due to writedowns and related costs following the Company’s commitment to a plan to dispose of Revel Entertainment Group, LLC (“Revel”). Excluding this discrete tax benefit, the annual effective tax rate for the six months ended June 30, 2011 would have been 26.0%. For further discussion of the discrete tax benefit, see “Executive Summary—Significant Items—Income Tax Benefit” herein.
The Company’s effective income tax rate from continuing operations was 14.1% and 16.0% for the quarter and six months ended June 30, 2010, respectively. The effective tax rate for the quarter and six months ended June 30, 2010 included a net tax benefit of $345 million, or $0.20 per diluted share, 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 six months ended June 30, 2010 also included a net tax benefit of $382 million, or $0.20 per diluted share, 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. Excluding the benefits noted above, the annual effective tax rate for the quarter and six months ended June 30, 2010 would have been 34.4% and 33.3%, respectively.
Institutional Securities. Income from continuing operations before income taxes was $1,457 million in the quarter ended June 30, 2011 compared with $1,595 million in the prior year period. Net revenues were $5,189 million in the quarter ended June 30, 2011 compared with $4,515 million in the prior year period. Investment banking revenues for the quarter ended June 30, 2011 increased 66% from the comparable period in 2010, reflecting higher revenues in all categories—equity and fixed income underwriting transactions and advisory fees. Equity sales and trading revenues increased 31% to $1,853 million in the quarter ended June 30, 2011, primarily reflecting higher revenues in derivatives and equity financing. Results in the quarter ended June 30, 2011 included positive revenue of $52 million due to the widening of the Company’s credit spreads and other credit factors resulting from the decrease 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 positive revenue of $129 million in the quarter ended June 30, 2010. Fixed income and commodities sales and trading revenues decreased 10% to $2,093 million in the quarter ended June 30, 2011 from the comparable period of 2010, reflecting decreased revenues in commodities, partially offset by gains on monoline insurers (“Monolines”) and higher revenues in credit. Results in the quarter ended June 30, 2011 included positive revenue of $192 million due to the widening of the Company’s credit spreads and other credit factors resulting from the decrease 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 positive revenues of $602 million in the quarter ended June 30, 2010. Principal transaction net investment gains of $150 million were recognized in the quarter ended June 30, 2011 compared with net investment losses of $68 million in the prior year period. Other revenues of $130 million were recognized in the quarter ended June 30, 2011 compared with other revenues of $51 million in the quarter ended June 30, 2010. Non-interest expenses increased 28% in the quarter ended June 30, 2011, primarily due to higher compensation expenses and higher non-compensation expenses. Compensation and benefits expenses increased 37% in the quarter ended June 30, 2011, primarily due to higher net revenues. Non-compensation expenses increased 16% in the quarter ended June 30, 2011 from a year ago, primarily due to an increase in Other expenses, which include the initial costs of $130 million associated with the new Chinese securities joint venture, Morgan Stanley Huaxin Securities Company Limited, which closed in the second quarter of 2011. In addition, the Institutional Securities business segment incurred higher non-compensation expenses in the quarter ended June 30, 2011 resulting from higher levels of business activity and ongoing investments in technology.
Global Wealth Management Group. Income from continuing operations before income taxes was $322 million in the quarter ended June 30, 2011 compared with $207 million in the prior year period. Net revenues were $3,476 million in the quarter ended June 30, 2011 compared with $3,074 million in the prior year period. Investment banking revenues increased 9% in the quarter ended June 30, 2011, primarily due to higher equity underwriting and unit investment trusts activity, partially offset by lower fixed income underwriting activity. Principal transactions trading revenues increased 16% in the quarter ended June 30, 2011 primarily due to gains related to investments associated with certain employee deferred compensation plans and higher revenues from municipal securities and structured notes, partially offset by lower revenues from corporate equity and government securities. Asset management, distribution and administration fees increased 13% in the quarter ended June 30, 2011, primarily due to higher fee-based revenues. Other revenues increased 101% in the quarter ended June 30, 2011, primarily due to gains on sales of securities available for sale. Net interest increased 21% in the quarter ended June 30, 2011, primarily resulting from an increase in Interest income due to interest on the securities available for sale portfolio and mortgages. Non-interest expenses increased 10% in the quarter ended June 30, 2011, due to increased compensation and non-compensation expenses.
Asset Management. Income from continuing operations before income taxes was $165 million in the quarter ended June 30, 2011 compared with a loss of $86 million in the prior year period. Net revenues were $645 million in the quarter ended June 30, 2011 compared with $410 million in the prior year period. Principal transactions net investment gains were $247 million in the quarter ended June 30, 2011 compared with gains of $16 million in the quarter ended June 30, 2010, primarily related to net investment gains associated with the Real Estate Investing business, as a result of valuation gains within certain consolidated real estate funds sponsored by the Company, as well as net gains on Merchant Banking and Traditional Asset Management investments. Asset management, distribution and administration fees increased 8% in the quarter ended June 30, 2011, primarily reflecting higher performance fees and fund management and administration fees, due to an increase in average assets under management. Non-interest expenses decreased 3% to $480 million in the quarter ended June 30, 2011, primarily reflecting a decrease in non-compensation expenses.
Significant Items.
Japanese Securities Joint Venture. During the three and six months ended June 30, 2011, the Company recorded a pre-tax loss of $17 million and $672 million, respectively, within Other revenues in the condensed consolidated statement of income, arising from the Company’s 40% stake in Mitsubishi UFJ Morgan Stanley Securities Co., Ltd. (“MUMSS”) (see Note 19 to the condensed consolidated financial statements). See “Other Matters—Japanese Securities Joint Venture” herein for further information.
MUFG Stock Conversion. As previously disclosed, on April 21, 2011, MUFG and the Company announced that they had entered into an agreement to convert MUFG’s outstanding Series B Preferred Stock in the Company into the Company’s common stock. On June 30, 2011 the Company and MUFG completed the conversion, whereby MUFG exchanged the Series B Preferred Stock with a face value of $7.8 billion (carrying value $8.1 billion) and a 10% dividend for 385,464,097 shares of the Company’s common stock, including approximately 75 million shares resulting from the adjustment to the conversion ratio pursuant to the transaction agreement. As a result of the adjustment to the conversion ratio, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the quarter and six months ended June 30, 2011. As a result of the conversion, MUFG did not receive the previously declared dividend that would otherwise have been payable on July 15, 2011 in respect of the Series B Preferred Stock.
Monoline Insurers. The quarter and six months ended June 30, 2011 included gains of $471 million and $153 million, respectively, related to the Company’s Monoline counterparty credit exposures, principally MBIA Insurance Corporation (“MBIA”), compared with losses of $186 million and $330 million, respectively, in the prior year comparative periods.
Monolines provide credit enhancement to capital markets transactions. The current credit environment continues to affect the ability of such financial guarantors to provide 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. The Company’s exposure to Monolines at June 30, 2011 includes $1.7 billion of insured municipal bond securities, $145 million of mortgage and asset-backed securities enhanced by financial guarantees, and positive net derivative counterparty exposure of $1.6 billion (gross counterparty exposure of approximately $4.8 billion net of cumulative credit valuation adjustments and counterparty hedges), which was primarily related to MBIA.
At June 30, 2011 and December 31, 2010, the Company’s positive net derivative counterparty exposure to MBIA was as follows:
Gross counterparty exposure(1)
Less: Credit valuation adjustments(2)
Subtotal
Less: Counterparty hedges(3)
Positive net derivative counterparty exposure(4)(5)
The increase in positive net derivative counterparty exposure from December 31, 2010 is primarily due to a reduction in counterparty hedges and a reduction of the credit valuation adjustment from the tightening of MBIA spreads.
The Company’s hedging program primarily includes the use of single name credit default swaps that mitigate credit exposure to the Monolines and is conducted as part of the Company’s overall market risk management. The Company’s hedging program for Monoline counterparty exposure continues to be costly and difficult to effect because of the basis risk (risk associated with imperfect hedging) between the Monoline counterparty exposure and counterparty hedges as well as costs the Company incurs from premiums paid on counterparty hedges. The Company proactively manages its Monoline exposure; however, as market conditions continue to evolve, significant additional gains or losses could be incurred. See “Qualitative and Quantitative Disclosures about Market Risk—Risk Management—Market Risk” in Part II, Item 7A of the Form 10-K.
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 (see “Business Segments—Institutional Securities—Sales and Trading Revenues” herein):
Losses on loans and lending commitments
Gains (losses) on hedges
Total losses
Income Tax Benefit. The Company’s effective tax rate from continuing operations for the six months ended June 30, 2011 included a $447 million net tax benefit from the remeasurement of a deferred tax asset and the reversal of a related valuation allowance. The deferred tax asset and valuation allowance were recognized in income from discontinued operations during 2010 in connection with the recognition of a $1.2 billion loss due to writedowns and related costs following the Company’s commitment to a plan to dispose of Revel. The Company recorded the valuation allowance because the Company did not believe it was more likely than not that it would have sufficient future net capital gain to realize the benefit of the expected capital loss to be recognized upon the disposal of Revel. During the quarter ended March 31, 2011, the disposal of Revel was restructured as a tax-free like kind exchange and the disposal was completed. The restructured transaction changed the character of the future taxable loss to ordinary. The Company reversed the valuation allowance because the Company believes it is more likely than not that it will have sufficient future ordinary taxable income to recognize the recorded deferred tax asset. In accordance with the applicable accounting literature, this reversal of a previously established valuation allowance due to a change in circumstances was recognized in income from continuing operations during the quarter ended March 31, 2011.
The Company’s effective tax rate from continuing operations for the quarter and six months ended June 30, 2010 included a net tax benefit of $345 million and $727 million, respectively. The quarter and six months ended June 30, 2010 included a tax benefit of $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 six months ended June 30, 2010 also included a tax benefit of $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.
Morgan Stanley Debt. Net revenues reflected gains of $244 million and $55 million in the quarter and six months ended June 30, 2011, respectively, and $750 million and $803 million in the quarter and six months ended June 30, 2010, respectively from the widening of the Company’s credit spreads and other credit factors on certain long-term and short-term borrowings, primarily structured notes that are accounted for at fair value.
During the quarter and six months ended June 30, 2011, net revenues included losses on economic hedges related to the Company’s long-term debt (see “Business Segments—Institutional Securities—Sales and Trading Revenues” herein).
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.
(dollars in billions)
Continuing operations(1)
Discontinued operations(2)
Total Institutional Securities
Continuing operations(3)
Total Asset Management
Amounts applicable to noncontrolling interests
Huaxin Securities Joint Venture. In June 2011, the Company and Huaxin Securities Co., Ltd. (“Huaxin Securities”) (also known as China Fortune Securities Co., Ltd.) jointly announced the operational commencement of their securities joint venture in China. The establishment of the joint venture was approved by China Securities Regulatory Commission (“CSRC”) on December 31, 2010 and was subject to receipt of a business license from the State Administration for Industry & Commerce of the People’s Republic of China, which was obtained in May 2011. Final CSRC approval for the commencement of business operations was obtained in June 2011. In the quarter ended June 30, 2011, the Company recorded initial costs of $130 million related to the formation of this new Chinese securities joint venture in Other expenses in the condensed consolidated statement of income.
FrontPoint. The Company recorded a loss of approximately $20 million related to the writedown of its minority stake investment in FrontPoint Partners LLC (“FrontPoint”) for the quarter ended June 30, 2011. The loss was included in Other revenues in the condensed consolidated statement of income. Beginning March 1, 2011, the Company accounts for its interest in FrontPoint as an equity method investment within the Asset Management business segment (see Note 19 to the condensed consolidated financial statements).
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 a lawsuit against Visa and MasterCard. The payment was recorded as a gain in discontinued operations in the condensed consolidated statement of income for the six months ended June 30, 2010.
Gain on Sale of Noncontrolling Interest. In connection with the transaction between the Company and MUFG to form a joint venture in Japan, the Company recorded an after-tax gain of $717 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 June 30, 2010 and changes in total equity for the six months ended June 30, 2010. See “Other Matters—Japanese 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 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. The Company recorded the 30.9 million shares as securities available for sale and subsequently sold the shares in the fourth quarter of 2010.
U.K. Tax. During the quarter ended June 30, 2010, the Company recognized a charge of $361 million in Compensation and benefits expense relating to the U.K. government’s payroll tax on discretionary above-based compensation.
Employee Benefit Plans. On June 1, 2010, the Morgan Stanley Employees Retirement Plan (the “Pension Plan”) for U.S. participants was amended to cease future benefit accruals after December 31, 2010. Any benefits earned by participants under the Pension Plan at December 31, 2010 were preserved and payable based on the Pension Plan’s provisions. As a result, the Company recorded a curtailment gain that reduced Compensation and benefits expense by approximately $51 million in the condensed consolidated statement of income for the quarter ended June 30, 2010. Additionally, the Company remeasured the obligation and assets of the Pension Plan at May 31, 2010 due to such cessation of accruals for benefits, and recognized a gain of $166 million ($102 million after-tax) in the condensed consolidated statements of comprehensive income for the quarter and six months ended June 30, 2010, after reflecting the $51 million reduction in Compensation and benefits expense (see Note 16 to the condensed consolidated financial statements).
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. 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. The Company did not recognize any Intersegment Elimination gains or losses in the quarter and six months ended June 30, 2011, and losses from continuing operations before income taxes recorded in Intersegment Eliminations were $13 million and $15 million in the quarter and six months ended June 30, 2010, respectively.
Net Revenues Discussion.
Principal Transactions—Trading. Principal transactions—Trading revenues include revenues from customers’ purchases and sales of financial instruments in which the Company acts as principal and gains and losses on the Company’s positions, as well as proprietary trading activities for its own account. Principal transactions—Trading revenues also includes the realized gains and losses from sales of cash instruments and derivative settlements, and unrealized gains and losses from ongoing fair value changes of the Company’s positions related to market-making activities. In many markets, the realized and unrealized gains and losses from the purchase and sale transactions will include any spreads between bids and offers. Fees received on loans carried at fair value and dividends from equity securities are also recorded in this line item since they relate to market-making positions. Commissions received for purchasing and selling listed equity securities and options are recorded separately in the Commissions line item. Other cash and derivative instruments typically do not have fees associated with them.
Principal Transactions—Investments. The Company’s investments generally are held for long-term appreciation and generally are subject to significant sales restrictions. Estimates of the fair value of the investments may involve significant judgment and may fluctuate significantly over time in light of business, market, economic and financial conditions generally or in relation to specific transactions. In some cases, such investments are required or are a necessary part of offering other products. The revenues recorded are the result of realized gains and losses from sales and unrealized gains and losses from ongoing fair value changes of the Company’s holdings as well as from investments associated with certain employee deferred compensation plans. Typically, there are no fee revenues from these investments. The sales restrictions on the investments relate primarily to redemption and withdrawal restrictions on investments in real estate funds, hedge funds and private equity funds, which includes investments made in connection with certain employee deferred compensation plans (see Note 3 to the condensed consolidated financial statements). Restrictions on interests in exchanges and clearinghouses generally include a requirement to hold those interests for the period of time that the Company is clearing trades on that exchange or clearinghouse. Additionally, there are certain principal investments related to assets held by consolidated real estate funds, which are primarily related to holders of non-controlling interests.
Commissions. Commission revenues primarily arise from agency transactions in listed and over-the-counter (“OTC”) equity securities and sales of mutual funds, futures, insurance products and options.
Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees include fees associated with the management and supervision of assets, account services and administration, performance-based fees relating to certain funds, separately managed accounts, shareholder servicing, and the distribution of certain open-ended mutual funds.
Net Interest. Interest income and Interest expense are a function of the level and mix of total assets and liabilities, including financial instruments owned and financial instruments sold, not yet purchased, securities available for sale, reverse repurchase and repurchase agreements, loans, trading strategies, customer activity in the Company’s prime brokerage business, and the prevailing level, term structure and volatility of interest rates. Certain Securities purchased under agreements to resell (“reverse repurchase agreements”) and Securities sold under agreements to repurchase (“repurchase agreements”) and Securities borrowed and Securities loaned transactions may be entered into with different customers using the same underlying securities, thereby generating a spread between the interest revenue on the reverse repurchase agreements or securities borrowed transactions and the interest expense on the repurchase agreements or securities loaned transactions.
Market Making.
As a market maker, the Company stands ready to buy, sell or otherwise transact with customers under a variety of market conditions and provide firm or indicative prices in response to customer requests. The Company’s liquidity obligations can be explicit and obligatory in some cases, and in others, customers expect the Company to be willing to transact with them. In order to most effectively fulfill its market-making function, the Company engages in activities, across all of its trading businesses, that include, but are not limited to, (i) taking positions in anticipation of, and in response to customer demand to buy or sell, and—depending on the liquidity of the relevant market and the size of the position—holding those positions for a period of time; (ii) managing and assuming basis risk (risk associated with imperfect hedging) between customized customer risks and the standardized products available in the market to hedge those risks; (iii) building, maintaining, and re-balancing inventory, through trades with other market participants, and engaging in accumulation activities to accommodate anticipated customer demand; (iv) trading in the market to remain current on pricing and trends; and (v) engaging in arbitrage activities to provide efficiency and liquidity for markets. Interest income and expense are also impacted by market-making activities as debt securities held by the Company earn interest and securities are loaned, borrowed, sold with agreement to repurchase and purchased with agreement to resell.
INSTITUTIONAL SECURITIES
INCOME STATEMENT INFORMATION
Non-compensation expenses
Income (loss) from discontinued operations
Net gain (losses) on discontinued operations
Net gain (losses) from discontinued operations
On February 17, 2011, the Company completed the sale of Revel. The sale price approximated the carrying value of Revel and, accordingly, the Company did not recognize any pre-tax gain or loss on the sale. The results of Revel are reported as discontinued operations within the Institutional Securities business segment for all periods presented through the date of sale. The six months ended June 30, 2010 included losses of approximately $1.2 billion in connection with writedowns and related costs of such planned disposition. For further information on Revel, see “Executive Summary—Significant Items—Income Tax Benefit” herein and Note 28 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K.
Investment Banking.
Investment banking revenues were as follows:
Advisory revenues
Underwriting revenues:
Equity underwriting revenues
Fixed income underwriting revenues
Total underwriting revenues
Total investment banking revenues
The following table presents the Company’s volumes of announced and completed mergers and acquisitions, equity and equity-related offerings and fixed income offerings:
Announced mergers and acquisitions(2)
Completed mergers and acquisitions(2)
Equity and equity-related offerings(3)
Fixed income offerings(4)
Investment banking revenues for the quarter ended June 30, 2011 increased 66% from the comparable period in 2010, reflecting higher revenues in all categories—equity and fixed income underwriting transactions and advisory fees. Overall, underwriting revenues of $940 million increased 57% from the quarter ended June 30, 2010. Equity underwriting revenues increased 56% to $419 million, reflecting revenue growth across all regions. Fixed income underwriting revenues increased 59% to $521 million, primarily due to higher loan syndication fees and an increase in non-investment grade bond issuances. Advisory revenues from merger, acquisition and restructuring transactions were $533 million, an increase of 85% from the comparable period of 2010, reflecting higher revenues across all regions.
Investment banking revenues for the six months ended June 30, 2011 increased 40% from the comparable period in 2010, reflecting higher revenues from equity and fixed income underwriting transactions and higher 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 these net revenues 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 Note 10 to the condensed consolidated financial statements for further information related to gains (losses) on derivative instruments.
Effective March 31, 2011, the Institutional Securities business segment’s “fixed income” business has been renamed the “fixed income and commodities” business. The interest rate, credit and currency business has been renamed the “fixed income” business. These name changes did not affect current or previously reported results for these businesses.
Total sales and trading revenues decreased 6% in the quarter ended June 30, 2011 from the comparable period of 2010, reflecting lower fixed income sales and trading revenues and higher losses in other sales and trading revenues, partially offset by higher equity sales and trading revenues.
Sales and trading revenues were as follows:
Fixed income and commodities
Other(2)
Total sales and trading revenues
Equity. Equity sales and trading revenues increased 31% to $1,853 million in the quarter ended June 30, 2011 from the comparable period of 2010. The increase primarily reflected higher revenues in derivatives and equity financing driven by strong client activity and to a lesser extent structured transactions. Prime Brokerage net revenues also increased from the prior year quarter primarily reflecting higher average client balances. Results in equity sales and trading revenues also included positive revenue of $52 million in the quarter ended June 30, 2011 due to the widening of the Company’s credit spreads and other credit factors, resulting in a decrease 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 positive revenue of $129 million in the quarter ended June 30, 2010.
In the quarter ended June 30, 2011, equity sales and trading revenues also reflected unrealized losses of $6 million related to changes in the fair value of net derivative contracts attributable to the widening of counterparties’ credit default swap spreads and other credit factors compared with unrealized losses of $60 million in the quarter ended June 30, 2010. The Company also recorded unrealized gains of $69 million in the quarter ended June 30, 2011 related to changes in the fair value of net derivative contracts attributable to the widening of the Company’s credit default swap spreads and other credit factors compared with unrealized gains of $80 million in the quarter ended June 30, 2010. The unrealized gains and losses on credit default swap spreads do not reflect any gains or losses on related hedging instruments.
Fixed Income and Commodities. Fixed income and commodities sales and trading revenues decreased 10% to $2,093 million in the quarter ended June 30, 2011 from the comparable period of 2010. Fixed income product revenues in the quarter ended June 30, 2011 increased 32%, primarily reflecting higher results in credit products due to higher revenues related to structured transactions, partially offset by lower revenues from unfavorable positioning in interest rate products. Fixed income product net revenues in the quarter ended June 30, 2011 were
positively impacted by gains of $471 million from Monolines compared with losses of $186 million in the quarter ended June 30, 2010 (see “Executive Summary—Significant Items—Monoline Insurers” herein for further information). Commodity net revenues decreased 83% in the quarter ended June 30, 2011, primarily due to lower levels of client activity across all sectors. Results in the quarter ended June 30, 2011 included positive revenue of $192 million due to the widening of the Company’s credit spreads and other credit factors, resulting in a decrease 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 positive revenues of $602 million in the quarter ended June 30, 2010.
In the quarter ended June 30, 2011, fixed income and commodities sales and trading revenues reflected net unrealized gains of $129 million related to changes in the fair value of net derivative contracts attributable to the tightening of counterparties’ credit default swap spreads and other credit factors compared with unrealized losses of $820 million in the quarter ended June 30, 2010 due to the widening of such spreads and other credit factors. The Company also recorded unrealized gains of $138 million in the quarter ended June 30, 2011 related to changes in the fair value of net derivative contracts attributable to the widening of the Company’s credit default swap spreads and other credit factors compared with gains of $919 million in the quarter ended June 30, 2010. The unrealized gains and losses on credit default swap spreads do not reflect any gains or losses on related hedging instruments.
Other. In addition to the equity and fixed income and commodities sales and trading revenues discussed above, sales and trading revenues included other trading revenues, consisting of certain activities associated with the Company’s lending activities, losses on economic hedges related to the Company’s long-term debt and negative carry in the Subsidiary Banks. In the quarter ended June 30, 2011, other sales and trading revenues reflected a net loss of $510 million compared with a net loss of $100 million in the quarter ended June 30, 2010. Results in the quarter ended June 30, 2011 included net losses related to negative carry in the Subsidiary Banks and net losses of $252 million associated with loans and lending commitments (mark-to-market valuations and realized losses of $173 million and losses on related hedges of $79 million). The results in the current quarter also reflected net losses on economic hedges related to the Company’s long-term debt compared with net gains in the prior year quarter. Results for the prior year quarter included net losses of $277 million (mark-to-market valuations and realized losses of $388 million, partially offset by gains on related hedges of $111 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.
Sales and Trading Revenues in the Six Months Ended June 30, 2011. Total sales and trading revenues decreased 17% in the six months ended June 30, 2011 from the comparable period of 2010, reflecting lower fixed income and commodities sales and trading revenues and higher losses in other sales and trading revenues, partially offset by higher equity sales and trading revenues. Equity sales and trading revenues increased 25% primarily due to higher revenues in the derivatives and cash businesses and higher revenues from prime brokerage. The results in equity sales and trading revenues in the six months ended June 30, 2011 also included positive revenues of $22 million due to the widening of the Company’s debt-related credit spreads and other credit factors compared with positive revenues of $177 million in the six months ended June 30, 2010. Fixed income and commodities sales and trading revenues decreased 23% primarily due to lower revenues in credit, currency and commodity products. The decrease in fixed income and commodities sales and trading revenues in the six months ended June 30, 2011 were also due to the inclusion of positive revenues of only $33 million due to the widening of the Company’s debt-related credit spreads and other credit factors compared with positive revenues of $604 million in the six months ended June 30, 2010. In the six months ended June 30, 2011, other sales and trading losses were $968 million compared with losses of $101 million in the six months ended June 30, 2010. Results in the six months ended June 30, 2011 included net losses on economic hedges related to the Company’s long-term debt and higher net losses related to negative carry in the Subsidiary Banks, partially offset by lower losses related to certain activities associated with the Company’s corporate lending activities.
Principal Transactions—Investments. Principal transaction net investment gains of $150 million and $293 million were recognized in the quarter and six months ended June 30, 2011 compared with net investment losses of $68 million and net investment gains of $106 million in the quarter and six months ended June 30, 2010, respectively. The gains in the quarter ended June 30, 2011 primarily reflected higher equity valuations compared with lower equity valuations in the quarter ended June 30, 2010. The gains in the six months ended June 30, 2011 and June 30, 2010 were primarily due to principal investments in real estate funds and investments associated with certain employee deferred compensation plans.
Other. Other revenues of $130 million and other losses of $443 million were recognized in the quarter and six months ended June 30, 2011, respectively, compared with other revenues of $51 million and $193 million in the quarter and six months ended June 30, 2010, respectively. The increase in the quarter ended June 30, 2011 was primarily due to higher revenues from equity method investments. The results in the quarter and six months ended June 30, 2011 included pre-tax losses of $17 million and $672 million, respectively, arising from the Company’s 40% stake in MUMSS (see “Executive Summary—Significant Items—Japanese Securities Joint Venture” herein).
Non-interest Expenses. Non-interest expenses increased 28% and 12% in the quarter and six months ended June 30, 2011, respectively. The increase in both periods was primarily due to higher compensation expenses and higher non-compensation expenses. Compensation and benefits expenses increased 37% in the quarter ended June 30, 2011 primarily due to higher net revenues. Compensation and benefits expenses increased 10% in the six months ended June 30, 2011 primarily due to higher net revenues, excluding gains due to the widening of the Company’s credit spreads and other credit factors on long-term and short-term borrowings carried at fair value and a pre-tax loss of $672 million arising from the Company’s 40% stake in MUMSS (see “Executive Summary—Significant Items—Japanese Securities Joint Venture” herein). Brokerage, clearing and exchange fees increased 10% and 12% in the quarter and six months ended June 30, 2011, respectively, primarily due to higher levels of business activity. Information processing and communications expense increased 12% in both periods, primarily due to ongoing investments in technology. Professional services expense decreased 9% and 10% in the quarter and six months ended June 30, 2011, respectively, primarily due to lower legal fees and consulting expenses. Other expenses increased 82% and 72% in the quarter and six months ended June 30, 2011, respectively, primarily due to the initial costs of $130 million associated with Morgan Stanley Huaxin Securities Company Limited.
GLOBAL WEALTH MANAGEMENT GROUP
Global Wealth Management Group’s net revenues are composed of Transactional, Asset management, Net interest and Other revenues. Transactional revenues include investment banking, Principal transactions—Trading and Commissions. Asset management revenues include asset management, distribution and administration fees and fees related to the bank deposit program. Net interest revenues include net interest revenues related to the bank deposit program, interest on securities available for sale and all other net interest revenues.
Transactional
Asset management
Transactional.
Investment Banking. Investment banking revenues increased 9% and 13% in the quarter and six months ended June 30, 2011, respectively, from the comparable period of 2010, primarily due to higher equity underwriting and unit investment trusts activity, partially offset by lower fixed income underwriting activity.
Principal Transactions—Trading. Principal transactions—Trading revenues increased 16% and 5% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to gains related to investments associated with certain employee deferred compensation plans, higher revenues from municipal securities and structured notes, partially offset by lower revenues from corporate equity and government securities.
Commissions. Commission revenues increased 7% in the six months ended June 30, 2011, from the comparable periods of 2010, primarily due to higher client activity.
Asset Management.
Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees increased 13% and 8% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to higher fee-based revenues. Revenues for the six months ended June 30, 2011 were partially offset by the change in classification of the bank deposit program. From June 2009 until April 1, 2010, revenues in the bank deposit program were primarily included in Asset management, distribution and administration fees. Beginning on April 1, 2010, revenues in the bank deposit program held at the Company’s U.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 U.S. depository institutions. The referral fees for deposits were $61 million and $65 million for the quarters ended June 30, 2011 and 2010, respectively, and $126 million and $166 million for the six months ended June 30, 2011 and 2010, respectively.
Balances in the bank deposit program increased to $110.4 billion at June 30, 2011 from $109.5 billion at June 30, 2010. The unlimited FDIC program expired on June 30, 2010 for deposits held by the Company’s depository institutions. Deposits held by Company-affiliated FDIC-insured depository institutions were $55.9 billion of the $110.4 billion deposits at June 30, 2011.
Client assets in fee-based accounts increased to $509 billion and represented 30% of total client assets at June 30, 2011, compared with $396 billion and 26% at June 30, 2010, respectively. Total client asset balances increased to $1,709 billion at June 30, 2011 from $1,500 billion at June 30, 2010, primarily due to improved market conditions and an increase in net new assets. Net new assets for the quarter ended June 30, 2011 were an inflow of $2.9 billion compared with an outflow of $5.5 billion for the quarter ended June 30, 2010. Client asset balances in households with assets greater than $1 million increased to $1,274 billion at June 30, 2011 from $1,067 billion at June 30, 2010. Global fee-based asset net flows increased to $9.7 billion for the quarter ended June 30, 2011 from $6.3 billion for the quarter ended June 30, 2010.
Net Interest.
Net interest increased 21% and 44% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily resulting from an increase in Interest income due to interest on the securities available for sale portfolio and mortgages. The increase in Interest income for the six months ended June 30, 2011 was also due to a change in classification of the bank deposit program noted above.
Other.
Principal Transactions—Investments. Principal transaction net investment gains were $5 million and $9 million in the quarter and six months ended June 30, 2011, respectively, compared with net investment gains of $0 and $6 million in the quarter and six months ended June 30, 2010, respectively. The increase primarily reflected gains related to investments associated with certain employee deferred compensation plans compared with such investments in the prior year period.
Other. Other revenues were $145 million and $236 million in the quarter and six months ended June 30, 2011, respectively, an increase of 101% and 52% from the quarter and six months ended June 30, 2010, respectively. The increase was primarily due to gains on sales of securities available for sale.
Non-interest Expenses. Non-interest expenses increased 10% in the quarter and six months ended June 30, 2011 from the comparable periods of 2010. Compensation and benefits expense increased 9% in the quarter and six months ended June 30, 2011, from the comparable periods of 2010, primarily reflecting higher net revenues, higher expenses associated with certain employee deferred compensation plans and higher amortization of deferred compensation awards. In addition, the quarter and six months ended June 30, 2010 included a pension credit (see “Executive Summary—Significant Items—Employee Benefit Plans” herein). Non-compensation expenses increased 11% and 12% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010. In the quarter and six months ended June 30, 2011, marketing and business development expense increased 17% and 29%, respectively, from the comparable periods of 2010, primarily due to higher costs associated with conferences and seminars. Professional services expense increased 18% and 25% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to increased technology consulting costs and sub-advisory fees. Brokerage, clearing and exchange fees increased 18% and 20% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to higher volumes. Information processing and communications expense increased 9% and 12% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to higher telecommunications and data storage costs. Other expenses increased 14% and 10% in the quarter and six months ended June 30, 2011, respectively, from the comparable periods of 2010, primarily due to a $45 million increase in the FDIC assessment on deposits and higher bad debt expense. The six months ended June 30, 2011 was also impacted by higher litigation costs, as well as costs associated with printing, taxes, licenses and fees.
ASSET MANAGEMENT
On March 1, 2011, the Company and the principals of FrontPoint completed a transaction whereby FrontPoint senior management and portfolio managers own a majority equity stake in FrontPoint and the Company retained a minority stake. FrontPoint has replaced the Company’s affiliates as the investment advisor and general partner of the FrontPoint funds. The investment in FrontPoint is accounted for under the equity method of accounting. Prior to March 1, 2011, the Company consolidated FrontPoint. The Company recorded a loss of approximately $20 million related to the writedown of the minority stake investment in FrontPoint for the quarter ended June 30, 2011. The loss was included in Other revenues in the condensed consolidated statements of income.
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 within the Asset Management business segment for all periods presented.
Beginning in the quarter ended March 31, 2011, the Asset Management business segment was reorganized into three businesses: Traditional Asset Management, Real Estate Investing and Merchant Banking. Traditional Asset Management includes Long-only, which is comprised of Equity and Fixed Income, Liquidity and the Alternative Investment Products fund-of-funds businesses. Real Estate Investing was previously reported as part of Merchant Banking. Merchant Banking includes the Private Equity and Infrastructure business and hedge fund stake investments. The Company’s equity investment in FrontPoint, subsequent to the restructuring of that business, is included in Merchant Banking. The results of the FrontPoint business for all periods prior to the restructuring are also included in Merchant Banking.
Statistical Data.
The Asset Management business segment’s period-end and average assets under management or supervision were as follows:
Assets under management or supervision by asset class:
Traditional Asset Management:
Fixed income
Liquidity
Alternatives(2)
Total Traditional Asset Management
Real Estate Investing
Merchant Banking:
Private Equity
FrontPoint(3)
Total Merchant Banking
Total assets under management or supervision
Share of minority stake assets(3)(4)
Activity in the Asset Management business segment’s assets under management or supervision during the quarters and six months ended June 30, 2011 and 2010 was as follows:
Balance at beginning of period
Net flows by asset class:
Fixed income(2)
Alternatives(3)
Private equity
FrontPoint(4)
Total net flows
Net market appreciation (depreciation)
Decrease due to FrontPoint transaction
Total net increase (decrease)
Balance at end of period
Principal Transactions—Investments. The Company recorded principal transactions net investment gains of $247 million and $429 million in the quarter and six months ended June 30, 2011, respectively, compared with gains of $16 million and $205 million in the quarter and six months ended June 30, 2010, respectively. The increase in both periods was primarily related to net investment gains associated with the Company’s Real Estate Investing business, as a result of valuation gains within certain consolidated real estate funds sponsored by the Company, as well as net gains on the Company’s Merchant Banking and Traditional Asset Management investments.
Asset Management, Distribution and Administration Fees. Asset management, distribution and administration fees increased 8% and 3% in the quarter and six months ended June 30, 2011, respectively, primarily reflecting higher performance fees and fund management and administration fees. The higher fund management and administration fees were driven by an increase in average assets under management.
The Company’s assets under management increased $52 billion from $244 billion at June 30, 2010 to $296 billion at June 30, 2011 reflecting market appreciation and net customer inflows. The Company recorded net customer inflows of $15.7 billion and $17.1 billion in the quarter and six months ended June 30, 2011, respectively, compared with net outflows of $1.2 billion and $8.0 billion in the quarter and six months ended
June 30, 2010, respectively. The increase in flows for the quarter and six months ended June 30, 2011 reflected the sweep of MSSB client cash balances of approximately $18.5 billion into Morgan Stanley managed liquidity funds.
Other. Other revenues decreased 92% and 58% in the quarter and six months ended June 30, 2011, respectively, primarily reflecting a loss of approximately $20 million related to the writedown of the Company’s minority stake investment in FrontPoint (see “Executive Summary—Significant Items—FrontPoint” herein). The results also included lower revenues associated with the Company’s minority stake investments in Avenue Capital Group, a New York-based investment manager, and Lansdowne Partners, a London-based investment manager.
Non-interest Expenses. Non-interest expenses decreased 3% in the quarter ended June 30, 2011 compared with the quarter ended June 30, 2010, primarily reflecting a decrease in Non-compensation expenses. Non-compensation expenses decreased 9% in the quarter ended June 30, 2011 compared with the prior year quarter primarily due to the absence of FrontPoint in the current quarter. Non-compensation expenses increased 5% in the six months ended June 30, 2011 compared with the prior year period due to indemnification losses related to the FrontPoint transaction and higher distribution expenses.
Reconsideration of Effective Control for Repurchase Agreements.
In April 2011, the FASB issued accounting guidance that removes the requirement to consider whether sufficient collateral is held when determining whether to account for repurchase agreements and other agreements that both entitle and obligate the transferor to repurchase or redeem financial assets before their maturity as sales or as secured financings. The guidance is effective for the Company prospectively for transactions beginning on January 1, 2012. The Company does not believe the adoption of this accounting guidance will have a material impact on the Company’s condensed consolidated financial statements.
Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.
In May 2011, the FASB issued an accounting update that clarifies the existing fair value measurement guidance and changes certain principles or requirements for measuring fair value or disclosing information about fair value measurements. This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurement in accordance with U.S. GAAP and International Financial Reporting Standards. The guidance is effective for the Company prospectively beginning on January 1, 2012. The Company is currently evaluating the impact of adopting this accounting guidance on the Company’s condensed consolidated financial statements.
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 June 30, 2011 and December 31, 2010 are described below. Such amounts exclude investments associated with certain employee deferred compensation and co-investment plans.
At June 30, 2011 and December 31, 2010, the condensed consolidated statements of financial condition included amounts representing real estate investment assets of consolidated subsidiaries of approximately $2.0 billion and $1.9 billion, respectively, including noncontrolling interests of approximately $1.6 billion and $1.5 billion, respectively, for a net amount of $0.4 billion. This net presentation is a non-GAAP financial measure that the Company considers to be the most useful measure for the Company and investors to use in assessing the Company’s net exposure. In addition, the Company has contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to real estate investments of $1.0 billion at June 30, 2011 (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 has provided, or otherwise agreed to be responsible for, representations and warranties. 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 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 and Credit Crisis Related Matters” in Part II, Item 1, herein and see Note 11 to the condensed consolidated financial statements.
See “Executive Summary—Significant Items—Real Estate Investments” herein for further information.
See Note 19 to the condensed consolidated financial statements and “Executive Summary—Significant Items” herein for further information.
Institutional Securities.
Sales and Trading Activities-Commodities. The Company invests and makes markets in various types of commodities and commodity-related assets or instruments, not in the sense of a traditional market maker as exists in the equity markets in which one would be expected to quote a two-sided market for all relevant products. Rather, the Company conducts these activities as a commodity merchant that provides liquidity to the markets by providing liquidity to clients, customers and counterparties. In connection with the provision of market-making related services, the Company conducts activities that include, but are not limited to: (i) taking positions in anticipation of, and in response to, customer demand to buy or sell, and—depending on the liquidity of the relevant market and the size of the position—holding those positions for a period of time; (ii) managing and assuming basis risk between customized customer risks and the standardized products available in the market to hedge those risks; (iii) building, maintaining, and re-balancing inventory, through trades with other market participants, and engaging in accumulation activities to accommodate anticipated customer demand; (iv) trading in the market to remain current on pricing and trends; and (v) engaging in arbitrage activities to provide efficiency and liquidity for markets.
Revenue streams are generated by each of these market-making related activities either individually or in combination with one or more of the other activities as part of an overall portfolio of positions assumed by traders in physical and financial markets. Transaction price spreads to existing market levels together with market movement on the portfolio of managed market risk generate revenue. To a lesser extent, there are also revenue streams from service fees, lease fees, and investment appreciation or depreciation.
Within the commodity sector, the types of other parties that make markets in the same commodities vary by asset class. Further, within each of the commodity asset groups, the types of other parties that make markets vary based on the type of physical or financial instruments in which positions are taken. For example, depending upon the relevant market segment, other parties that make markets in the same commodities or commodity-related instruments include subsidiaries of bank holding companies and foreign banks, major oil companies, energy merchant companies, and non-regulated U.S.-based and foreign owned commodity trading companies.
The Company’s other energy related activities include the production, storage and transportation of several commodities, including crude oil, oil products, natural gas, electric power, emission credits, coal, freight, liquefied natural gas and related products. For example, the Company is an electricity power marketer in the U.S. and owns electricity generating facilities in the U.S. and Europe.
The Company conducts its other energy related activities through several subsidiaries, including Morgan Stanley Capital Group Inc., and also participates in these activities through investments in certain non-consolidated entities.
Similar to its market-making activities, revenue streams are generated by each of these other energy-related activities either individually or in combination with one or more of the other activities as part of an overall portfolio of positions assumed by traders in physical and financial markets.
Regulatory Outlook.
On July 21, 2010, President Obama signed the Dodd-Frank Act into law. While certain portions of the Dodd-Frank Act were effective immediately, other portions will be effective only following extended transition and implementation 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 in general. Implementation of the Dodd-Frank Act will be accomplished through numerous rulemakings by multiple governmental agencies. 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, legislative and regulatory initiatives continue outside the U.S. which may also affect the Company’s business and operations. For example, the Basel Committee on Banking Supervision (the “Basel Committee”) has issued new capital, leverage and liquidity standards, known as “Basel III,” which U.S. banking regulators are expected to introduce in the U.S. The Financial Stability Board and the Basel Committee are also developing standards designed to apply to systemically important financial institutions, such as the Company. In addition, initiatives are under way in the European Union and Japan, among other jurisdictions, that would require centralized clearing, reporting and recordkeeping with respect to various kinds of financial transactions and other regulatory requirements that are in some cases similar to those required under the Dodd-Frank Act.
It is likely that the year 2011 and subsequent years will see further material changes in the way major financial institutions are regulated in both the U.S. and other markets in which the Company operates, though it is difficult to predict which further reform initiatives will become law, how such reforms will be implemented or the exact impact they will have on the Company’s business, financial condition, results of operations and cash flows for a particular future period.
Other than the following, no other updates were made to the Company’s supervision and regulation disclosure. For a further discussion regarding the regulatory outlook for the Company, please refer to “Supervision and Regulation” in Part I, Item 1 and “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Regulatory Outlook” in Part II, Item 7, included in the Form 10-K.
Scope of Permitted Activities. The Bank Holding Company Act of 1956, as amended (the “BHC Act”) provides a two-year period from September 21, 2008, the date that the Company became a bank holding company, for the Company to conform its activities to the BHC Act, subject to three one-year extensions that may be granted by the Federal Reserve upon approval of the Company's application. The Company has received the first of these extensions with respect to certain activities relating to its real estate and other funds businesses. Although conformance activities continue with respect to these businesses, the Company is in the process of seeking a second extension, and it is possible that the Company will be required, in 2012, to seek
Federal Reserve approval for the third additional year permitted by the BHC Act. The Federal Reserve may grant an extension, one year at a time, if it finds that the extension will not be detrimental to the public interest. Based on the real estate and other investments and businesses which are required to be sold, there would be no material adverse impact on the Company's condensed consolidated financial statements.
In addition, the Company is engaged in discussions with the Federal Reserve regarding its commodities activities, as the BHC Act also grandfathers any “activities related to the trading, sale or investment in commodities and underlying physical properties,” provided that the Company was engaged in “any of such activities as of September 30, 1997 in the United States” and provided that certain other conditions that are within the Company’s reasonable control are satisfied. If the Federal Reserve were to determine that any of the Company’s commodities activities did not qualify for the BHC Act grandfather exemption, then the Company would likely be required to divest any such activities that did not otherwise conform to the BHC Act by the end of any extensions of the grace period. At this time the Company does not believe, based on its interpretation of applicable law, that any such required divestment would have a material adverse impact on its condensed consolidated financial statements.
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 1 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, 2010 included in the Form 10-K and Note 2 to the condensed consolidated financial statements), 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.
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 Note 2 to the consolidated financial statements for the year ended December 31, 2010 included in Form 10-K and Notes 2 and 3 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 $36.3 billion and $34.9 billion at June 30, 2011 and December 31, 2010, respectively, and represented approximately 12% and 10% at June 30, 2011 and December 31, 2010, respectively, of the assets measured at fair value (4% of total assets at June 30, 2011 and December 31, 2010). Level 3 liabilities before the impact of cash collateral and counterparty netting across the levels of the fair value hierarchy were $9.5 billion and $8.5 billion at June 30, 2011 and December 31, 2010, respectively, and represented approximately 4% of the Company’s liabilities measured at fair value.
Transfers In/Out of Level 3 During the Quarter Ended June 30, 2011. During the quarter ended June 30, 2011, the Company reclassified approximately $1.2 billion of certain Corporate and other debt, primarily corporate loans, from Level 3 to Level 2. The Company reclassified the corporate loans as external prices and/or spread inputs for these instruments became 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, primarily relating to loans, other investments, goodwill and intangible assets. 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 non-recurring basis, see Note 3 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 Finance, 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 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 and Intangible Assets.
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 developed, 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. Additionally, if the book value of a reporting unit is zero or a negative value and it is determined that it is more likely than not the goodwill is impaired, further analysis is required. 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. The Company also utilizes a discounted cash flow methodology for certain reporting units.
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.
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 3 and Note 8 to the condensed consolidated financial statements for additional information about 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 evaluates the likelihood of assessments in each taxing jurisdiction resulting from current and subsequent years’ examinations, and unrecognized tax benefits are established as appropriate. The Company establishes a liability for unrecognized tax benefits related to potential losses that may arise from tax audits in accordance with the guidance on accounting for unrecognized tax benefits. 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 reserves, 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 (“SPE”) 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 6 to the condensed consolidated financial statements.
In most cases, these SPEs are deemed for accounting purposes 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 qualifying SPEs 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 to the consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K),
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 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.
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. Liquidity and capital matters are reported regularly to the Board’s Risk Committee.
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 $830,747 million at June 30, 2011 from $807,698 million at December 31, 2010. The increase in total assets was primarily due to securities financing activities.
The Company’s assets and liabilities are primarily related to transactions attributable to sales and trading and securities financing activities. At June 30, 2011, securities financing assets and liabilities were $394 billion and $323 billion, respectively. At December 31, 2010, securities financing assets and liabilities were $358 billion and $321 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 consolidated financial statements for the year ended December 31, 2010 included in the Form 10-K). Securities sold under agreements to repurchase and Securities loaned were $169 billion at June 30, 2011 and averaged $195 billion and $197 billion during the quarter and six months ended June 30, 2011, respectively. Securities purchased under agreements to resell and Securities borrowed were $313 billion at June 30, 2011 and averaged $319 billion and $309 billion during the quarter and six months ended June 30, 2011, 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 were $16 billion and $17 billion at June 30, 2011 and December 31, 2010, respectively, recorded in accordance with accounting guidance for the transfer of financial assets that represented offsetting assets and liabilities for fully collateralized non-cash loan transactions.
The following table sets forth the Company’s tangible common equity and Tier 1 common ratios at June 30, 2011 and December 31, 2010 and average balances during the six months ended June 30, 2011:
Common equity
Preferred equity
Morgan Stanley shareholders’ equity
Junior subordinated debentures issued to capital trusts
Less: Goodwill and net intangible assets(2)
Tangible Morgan Stanley shareholders’ equity
Tangible common equity(3)
Tier 1 common ratio(4)
Balance Sheet and Funding Activity for the Six Months Ended June 30, 2011.
During the six months ended June 30, 2011, the Company issued notes with a principal amount of approximately $23 billion. In connection with the note issuances, the Company generally enters into certain transactions to obtain floating interest rates based primarily on short-term LIBOR trading levels. The weighted average maturity of the Company’s long-term borrowings, based upon stated maturity dates, was approximately 5.1 years at June 30, 2011. Subsequent to June 30, 2011 and through July 31, 2011, the Company’s long-term borrowings (net of repayments) increased by approximately $1.5 billion.
At June 30, 2011, the aggregate outstanding principal amount of the Company’s senior indebtedness was approximately $187 billion (including guaranteed obligations of the indebtedness of subsidiaries) compared with $183 billion at December 31, 2010. The increase in the amount of senior indebtedness was primarily due to foreign currency translation adjustments.
As previously disclosed, on April 21, 2011, MUFG and the Company announced that they had entered into an agreement to convert MUFG’s outstanding Series B Preferred Stock in the Company into the Company’s common stock. On June 30, 2011, the Company and MUFG completed the conversion (see “Executive Summary—Significant Items—MUFG Stock Conversion” herein).
Capital Management.
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 June 30, 2011, the Company had approximately $1.6 billion remaining under its current share repurchase program out of the $6 billion authorized by 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 six months ended June 30, 2011, 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 July 2011, the Company announced that its Board declared a quarterly dividend per common share of $0.05. The Company also announced that the Board declared a quarterly dividend of $252.78 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 $0.25278) and a quarterly dividend of $25.00 per share of Series C Non-Cumulative Non-Voting Perpetual Preferred Stock. As a result of the recently completed MUFG stock conversion (see “Executive Summary—Significant Items—MUFG Stock Conversion” herein), MUFG did not receive the previously declared dividend that would otherwise have been payable on July 15, 2011 in respect of the Series B 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 June 30, 2011 was approximately $50.6 billion, $29.9 billion and $20.7 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 and to incorporate enhancements in modeling techniques. During 2011, the Company will continue to evaluate the framework with respect to the impact of future regulatory requirements, as appropriate.
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 June 30, 2011 and the quarter ended March 31, 2011.
On March 31, 2011, the Federal Reserve implemented a limit on the amount of the restricted core capital elements (trust preferred securities and certain noncontrolling interests) to 15% of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. This restriction resulted in approximately $3.9 billion of restricted capital being reclassed from Tier 1 capital to Tier 2 capital for March 31, 2011. To enhance the comparability of the current quarter’s average Tier 1 capital and average common equity by segment to subsequent quarterly averages, the Company applied this limitation to the full quarter average, as if the rule were in place from the beginning of first quarter 2011 (see “Regulatory Requirements” herein for more 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”), which become effective after the scheduled redemption date in 2046. 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.
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 “Liquidity Management—Contingency Funding Plan” and “Liquidity Management—Global Liquidity Reserve” herein).
Liquidity Management.
Contingency Funding Plan.
The Contingency Funding Plan (“CFP”) is the Company’s primary liquidity 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.
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 if there are any regulatory, legal or tax constraints.
At June 30, 2011, 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 operating subsidiaries. The Company’s Global Liquidity Reserve is comprised of highly liquid and diversified assets including cash and cash equivalents, and unencumbered highly liquid securities such as U.S. government securities, U.S. agency securities, U.S. agency mortgage-backed securities, FDIC-guaranteed corporate debt and non-U.S. government securities.
Global Liquidity Reserve by Type of Investment
The table below summarizes the Company’s Global Liquidity Reserve by type of investment:
Cash deposits with banks
Cash deposits with central banks
Unencumbered highly liquid securities:
U.S. Government obligations
U.S. agency and agency MBS
Non-U.S. sovereign obligations(1)
Investments in money market funds
Other investment grade securities
Global Liquidity Reserve
The ability to monetize assets during the start of a liquidity crisis is critical. The Company believes that the assets held in the Global Liquidity Reserve can be monetized within five business days in a stressed environment given the highly liquid and diversified nature of the reserves.
The currency composition of the Global Liquidity Reserve is consistent with the CFP. 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.
In addition to the Global Liquidity Reserve, the Company has other unencumbered assets that are available for monetization and the Company has not included these balances in the table above.
Global Liquidity Reserve Held by the Parent and Operating Subsidiaries
The table below summarizes the Global Liquidity Reserve held by the Parent and operating subsidiaries:
Parent
Non-Bank Subsidiaries:
Domestic
Foreign
Total Non-Bank Subsidiaries
Bank Subsidiaries:
Total Bank Subsidiaries
As mentioned previously in the Contingency Funding Plan section, the CFP assumes that the Parent will support its subsidiaries and will not have access to their liquidity reserves if there are any regulatory, legal or tax constraints.
Funding Management.
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 targeting global investors and currencies.
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 has minimal reliance on overnight financing. At June 30, 2011, the weighted average maturity of the Company’s secured financing against less liquid collateral was greater than 120 days. The Company defines less liquid collateral as those that are not consistent with the standards of the Global Liquidity Reserve. In addition, the Company minimizes refinancing risk by diversifying across both counterparties and maturities. 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 and less liquid assets. Securities inventories not financed by secured funding sources and the majority of current assets are financed with a combination of short-term funding, deposits, floating rate long-term debt and fixed rate long-term debt swapped to a floating rate. 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 12 to the consolidated financial statements for the year ended December 31, 2010 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. Of the $23.8 billion issued under the TLGP, $5.5 billion (including $1.7 billion of debt buybacks) were retired through the six months ended June 30, 2011.
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 Subsidiary Banks.
On November 9, 2010, the FDIC issued a Final Rule implementing Section 343 of the Dodd-Frank Act that provides for unlimited insurance coverage of non-interest bearing transaction accounts. Beginning December 31, 2010 through December 31, 2012, all non-interest bearing transaction accounts are fully insured, regardless of the balance of the account, at all FDIC-insured institutions, including the Company’s FDIC-insured subsidiaries. This unlimited insurance coverage is available to all depositors and is separate from, and in addition to, the insurance coverage provided to a depositor’s other deposit accounts held at an FDIC-insured institution. Money Market Deposit Accounts (“MMDA”) and Negotiable Order of Withdrawal (“NOW”) accounts are not eligible for this unlimited insurance coverage, regardless of the interest rate, even if no interest is paid on the account.
Long-Term Borrowings. The Company uses a variety of long-term debt funding sources to generate liquidity, taking CFP requirements into consideration. 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 six months ended June 30, 2011, the Company issued notes with a principal amount of approximately $23 billion.
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 six months ended June 30, 2011, approximately $24 billion in aggregate long-term borrowings were repaid.
Long-term borrowings at June 30, 2011 consisted of the following:
Due in 2011
Due in 2012
Due in 2013
Due in 2014
Due in 2015
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 impacted by the Company’s credit ratings. In addition, the Company’s credit 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 has rating agencies reviewing their methodologies and may be seen as limiting the possibility of extraordinary government support for the financial system in any future financial crises. This 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.
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 June 30, 2011, 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 $1,245 million. A total of $3,258 million in collateral or termination payments could be called in the event of a two-notch downgrade.
Also, the Company is required to pledge additional collateral to certain exchanges and clearing organizations in the event of a credit rating downgrade. At June 30, 2011, the increased collateral requirement at certain exchanges and clearing organizations was $178 million in the event of a one-notch downgrade of the Company’s long-term credit rating. A total of $1,371 million of collateral is required in the event of a two-notch downgrade.
The liquidity impact of additional collateral requirements is accounted for in the Company’s CFP.
At July 31, 2011, 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
Off-Balance Sheet Arrangements with Unconsolidated Entities.
The Company enters into various arrangements with unconsolidated entities, including VIEs, primarily in connection with its Institutional Securities business segment. See “Off-Balance Sheet Arrangements with Unconsolidated Entities” included in Part II, Item 7, of the Form 10-K for further information.
See Note 11 to the condensed consolidated financial statements for further information on Guarantees.
Regulatory Requirements.
Capital.
The Company is a financial holding company under the BHC Act 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 (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 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 addition, under provisions of the Dodd-Frank Act, the generally applicable capital standards, which are currently based on Basel I standards, but may themselves change over time, will serve as a permanent floor to minimum capital requirements calculated under the Basel II standard the Company is currently required to implement, as well as future capital standards.
Basel III contains new capital standards that raise the quality of capital and strengthen counterparty credit risk capital requirements and introduces a leverage ratio as a supplemental measure to the risk-based ratio. Basel III includes a new capital conservation buffer, which imposes a common equity requirement above the new minimum that can be depleted under stress, subject to restrictions on capital distributions, a new additional loss absorbency capital requirement for global systematically important financials institutions and a new countercyclical buffer which regulators can activate during periods of excessive credit growth in their jurisdiction. The Basel III proposals complement an earlier proposal for revisions to the Market Risk Framework that increases capital requirements for securitizations within the Company’s trading book. In 2011, the U.S. regulators have issued proposed rules that are intended to implement certain aspects of the Market Risk Framework proposals. The U.S. regulators will require implementation of Basel III subject to an extended phase-in period.
Under the Basel Committee’s proposed framework, based on a preliminary analysis of the guidelines published to date, the Company estimates its Tier 1 common ratio will be in a range between 8% and 10% by the end of 2012. This is a preliminary estimate and may change based on 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 restricted core capital elements (including junior subordinated debt issued to trusts (“trust preferred securities”) and noncontrolling interest), 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, see “The Balance Sheet” herein.
Pursuant to provisions of the Dodd-Frank Act, over time, 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 phasing in of the disqualification of the trust preferred securities as provided for by Basel III.
At June 30, 2011, the Company was in compliance with Basel I capital requirements with ratios of Tier 1 capital to RWAs of 16.7% and total capital to RWAs of 18.3% (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 year.
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 June 30, 2011 and December 31, 2010:
Allowable capital
Tier 1 capital:
Common shareholders’ equity
Qualifying preferred stock
Qualifying restricted core capital elements
Less: Goodwill
Less: Non-servicing intangible assets
Less: Net deferred tax assets
Less: After-tax debt valuation adjustment
Other deductions
Total Tier 1 capital
Tier 2 capital:
Other components of allowable capital:
Qualifying subordinated debt and restricted core capital elements
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 and qualifying restricted core capital elements (trust preferred securities and noncontrolling interests) less goodwill, non-servicing intangible assets (excluding allowable mortgage servicing rights), net deferred tax assets (recoverable in excess of one year), an after-tax debt valuation adjustment and certain other deductions, including equity investments. 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 3 to the condensed consolidated financial statements.
At June 30, 2011, 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. RWAs decreased from December 31, 2010 to June 30, 2011 as a result of a combination of business mix, analytics and collateral changes.
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—Risk Management—Credit Risk” in Part II, Item 7A, of the Form 10-K and in Part I, Item 3 herein.
Liquidity.
The Basel Committee on Banking Supervision has developed two standards for supervisors to use in liquidity risk supervision. The first standard’s objective is to promote the short-term resilience of the liquidity risk profile of banks and bank holding companies. The Committee developed the Liquidity Coverage Ratio (“LCR”) to ensure banks have sufficient high-quality liquid assets to cover net outflows arising from significant stress lasting 30 calendar days. The standard requires that the value of the ratio be no lower than 100%. The second standard’s objective is to promote resilience over a longer time horizon. The Net Stable Funding Ratio (“NSFR”) has a time horizon of one year and builds on traditional “net liquid asset” and “cash capital” methodologies used widely by internationally active banking organizations to provide a sustainable maturity structure of assets and liabilities. The NSFR is defined as the amount of available stable funding to the amount of required stable funding. This ratio must be greater than 100%. After an observation period beginning in 2011, the LCR, including any revisions, will be introduced on January 1, 2015. The NSFR, including any revisions, will move to a minimum standard by January 1, 2018. The Company will continue to monitor the development and the potential impact of these standards.
Market Risk.
Market risk refers to the risk that a change in the level of one or more market prices, rates, indices, implied volatilities (the price volatility of the underlying instrument imputed from option prices), correlations or other market factors, such as market liquidity, will result in losses for a position or portfolio. Generally, the Company incurs market risk as a result of trading, investing and client facilitation activities, principally within the Institutional Securities business segment where the substantial majority of the Company’s VaR for market risk exposures is generated. In addition, the Company incurs trading related market risk within the Global Wealth Management Group business segment. The Asset Management business segment incurs principally non-trading market risk primarily from capital investments in real estate funds and investments in private equity vehicles. Regarding sales and trading and related activities, the Company is exposed to concentration risk in certain of its OTC derivatives portfolios related to the additional cost of closing out particularly large risk positions. For a further discussion of the Company’s Market Risk, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.
VaR.
The Company uses 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.
The Company’s VaR model evolves over time in response to changes in the composition of trading portfolios and to improvements in modeling techniques and systems capabilities. The Company is committed to continuous review and enhancement of VaR methodologies and assumptions in order to capture evolving risks associated with changes in market structure and dynamics. As part of regular process improvement, additional systematic and name-specific risk factors may be added to improve the VaR model’s ability to more accurately estimate risks to specific asset classes or industry sectors. Additionally, the Company continues to evaluate enhancements to the VaR model to make it more responsive to recent market conditions, while maintaining a longer-term perspective.
The Company also performs routine stress testing to more comprehensively monitor the risks in the portfolio. Morgan Stanley utilizes Stress VaR (“S-VaR”), which is a proprietary methodology that seeks to measure both the Company’s market and credit risks, while adjusting for the different liquidity characteristics of the underlying risks (in contrast to traditional VaR measures which are typically calculated using the same horizon for all risks). It is an important metric used in establishing the Company’s risk tolerance and its capital allocation framework. Further information on S-VaR can be found in “Quantitative and Qualitative Disclosures about Market Risk—Risk Management” in Part II, Item 7A of the Form 10-K.
Since the reported VaR statistics are estimates based on historical positions 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 for a 95%/one-day VaR. VaR does not predict the magnitude of losses which, should they occur, may be significantly greater than the VaR amount.
The table below presents VaR for the Company’s Trading portfolio, on a quarter-end, quarterly average and quarterly high and low basis (see Table 1 below). The VaR that would result if the Company were to adopt alternative parameters for its calculations, such as a higher confidence level for the VaR statistic (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).
The Company’s Trading VaR includes mark-to-market lending exposures and associated hedges. In addition, counterparty credit valuation adjustments and related hedges are also included in Trading VaR.
Trading Risks.
The table below presents the Company’s 95%/one-day Trading VaR:
Primary Market Risk Category
Interest rate and credit spread
Equity price
Foreign exchange rate
Commodity price
Less Diversification benefit(1)(2)
Total Trading VaR
The Company’s average Trading VaR for the quarter ended June 30, 2011 was $145 million compared with $121 million for the quarter ended March 31, 2011. The increase was driven by the interest rate and credit spread asset class.
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 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-year versus one-year) for market data upon which it bases its simulations. The four-year VaR measure continues to reflect the high market volatilities experienced in the latter half of 2007 through 2008, while the one-year VaR is no longer affected by these phenomena.
Table 2: 95% and 99% Average Trading VaR with
Four-Year / One-Year Historical Time Series
Less Diversification benefit(1)
Distribution of VaR Statistics and Net Revenues for the quarter ended June 30, 2011.
As shown in Table 1, the Company’s average 95%/one-day Trading VaR for the quarter ended June 30, 2011 was $145 million. The histogram below presents the distribution of the Company’s daily 95%/one-day Trading VaR for the quarter ended June 30, 2011. The most frequently occurring value was between $145 million and $150 million, while for approximately 72% of trading days during the quarter, VaR ranged between $135 million and $155 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 both the Company as well as individual business units. 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 histogram below shows the distribution of daily net trading revenue for the quarter ended June 30, 2011 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 June 30, 2011, the Company experienced net trading losses on 8 days, none of which were in excess of the 95%/one-day Trading VaR. The lack of realized trading losses that exceeded the VaR statistic over recent history is largely due to the inclusion of the high market volatilities experienced in the latter half of 2007 through 2008 in the calculation of the VaR statistic, while recent realized market volatilities have been more subdued.
Non-Trading Risks.
The Company believes that sensitivity analysis is an appropriate representation of the Company’s non-trading risks. Reflected below is this analysis, which covers substantially all of the non-trading risk in the Company’s portfolio.
Counterparty Exposure Related to the Company’s Own Spread.
The credit spread risk relating to the Company’s own mark-to-market derivative counterparty exposure is managed separately from VaR. The credit spread risk sensitivity of this exposure corresponds to an increase in value of approximately $8 million for each 1 basis point widening in the Company’s credit spread level for both June 30, 2011 and March 31, 2011.
Funding Liabilities.
The credit spread risk sensitivity of the Company’s mark-to-market funding liabilities corresponded to an increase in value of approximately $12 million and $13 million for each 1 basis point widening in the Company’s credit spread level at June 30, 2011 and March 31, 2011, respectively.
Interest Rate Risk Sensitivity on Income from Continuing Operations.
The Company measures the interest rate risk of certain assets and liabilities not included in Trading VaR by calculating the hypothetical sensitivity of income from continuing operations (before income taxes) to potential changes in the level of interest rates over the next twelve months. This sensitivity analysis includes positions that are mark-to-market as well as positions that are accounted for on an accrual basis.
Given the currently low interest rate environment, the Company uses the following two interest rate scenarios to quantify the Company’s sensitivity: instantaneous parallel shocks of 100 and 200 basis point increases to all points on all yield curves simultaneously. With respect to MSSB, the Company’s assessment of interest rate risk focuses on its economic investment in MSSB (the Company’s 51% share of MSSB’s income from continuing operations before income taxes).
For non-interest-bearing positions and for interest-sensitive positions that are not mark-to-market, the Company measures the incremental impact of the funding expense or coupon accrual over the next 12 months. For interest rate-sensitive positions that are mark-to-market, the sensitivities include the income impact of the instantaneous yield curve shock on the present value of the positions. For interest rate derivatives that are perfect economic hedges to non-mark-to-market assets or liabilities, the disclosed sensitivities include only the impact of the coupon accrual mismatch. This treatment mitigates the effects caused by the measurement basis differences between the economic hedge and the corresponding hedged instrument.
The hypothetical model does not assume any growth, change in business focus, asset pricing philosophy or asset/liability funding mix and does not capture how the Company would respond to significant changes in market conditions. Furthermore, the model does not reflect the Company’s expectations regarding the movement of interest rates in the near term, nor the actual effect on income from continuing operations before income taxes if such changes were to occur.
Impact on income from continuing operations before income taxes
Impact on income from continuing operations before income taxes excluding Citi’s shares of MSSB(1)
Principal Investments.
The Company makes investments in both public and private companies. These investments are predominantly equity positions with long investment horizons, the majority of which are for business facilitation purposes. The market risk related to these investments is measured by estimating the potential reduction in net revenues associated with a 10% decline in asset values.
Investments related to Asset Management activities:
Hedge fund investments
Private equity and infrastructure funds
Other investments:
Mitsubishi UFJ Financial Group JV
Other Company investments
Credit Risk.
For a further discussion of the Company’s credit risks, see “Quantitative and Qualitative Disclosures about Market Risk—Risk Management—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 segment activities, the Company provides loans or lending commitments (including bridge financing) to selected corporate clients. Such loans and lending commitments can generally be classified as either “relationship-driven” or “event-driven”. 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.
“Relationship-driven” loans and lending commitments are generally made to expand business relationships with select clients. 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 Company may hedge its exposures in connection with “relationship-driven” transactions, and commitments may be subject to conditions including financial covenants. These loans are carried either at fair value with changes in fair value recorded in earnings or amortized cost in the condensed consolidated statements of financial condition.
“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 activities. 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 or sales process. The “event-driven” loans are typically syndicated or sold to third party institutional investors. The Company may have a custodial relationship with these institutional investors, for instance, prime brokerage clients. The borrower’s ability to draw on the commitment is also subject to certain terms and conditions, among other factors. The Company risk manages its exposures in connection with “event-driven” transactions through various means, including syndication, distribution and/or hedging. The Company’s “event-driven” loans and lending commitments consist of term loans, bridge loans and revolving lines of credit. These loans are carried at fair value in the condensed consolidated statements of financial condition with changes in fair value recorded in earnings.
At June 30, 2011, the aggregate amount of investment grade loans was $7.2 billion and the aggregate amount of non-investment grade loans was $7.0 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 $34.0 billion related to the total corporate lending exposure of $86.0 billion at June 30, 2011.
The table below also presents the Company’s credit exposure from its corporate lending positions and lending commitments at June 30, 2011. The “total corporate lending exposure” column includes both lending commitments and funded loans. Lending commitments represent legally binding obligations to provide funding to clients at June 30, 2011 for both “relationship-driven” and “event-driven” lending transactions. 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 June 30, 2011
Credit Rating(1)
“Event-Driven” Loans and Lending Commitments at June 30, 2011.
Included in the total corporate lending exposure amounts in the table above at June 30, 2011 is “event-driven” exposure of $11.1 billion composed of funded loans of $2.0 billion and lending commitments of $9.1 billion. Included in the “event-driven” exposure at June 30, 2011 were $7.2 billion of loans and lending commitments to non-investment grade borrowers. The maturity profile of the “event-driven” loans and lending commitments at June 30, 2011 was as follows: 52% will mature in less than 1 year, 9% will mature within 1 to 3 years, 9% will mature within 3 to 5 years, and 30% will mature in over 5 years.
At June 30, 2011, $224 million of the Company’s “event-driven” loans were on non-accrual basis. These loans primarily are those the Company originated prior to the financial crisis in 2008 and was unable to sell or syndicate due to the financial crisis. For loans carried at fair value that are on non-accrual status, interest income is recognized on a cash basis.
Activity associated with the corporate “event-driven” lending exposure during the six months ended June 30, 2011 was as follows (dollars in millions):
“Event-driven” lending exposures at December 31, 2010
Closed commitments
Net reductions, primarily through syndication or sales
Mark-to-market adjustments
“Event-driven” lending exposures at June 30, 2011
Credit Exposure—Derivatives. For credit exposure information on the Company’s OTC derivative products, see Note 10 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 during the periods presented.
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 provisions related to 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 “Executive Summary—Significant Items—Monoline Insurers” in Part I, Item 2 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 within Principal transactions—Trading.
The following table summarizes the key characteristics of the Company’s credit derivative portfolio by counterparty at June 30, 2011. 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(2)
Non-financial entities
See Note 10 to the condensed consolidated financial statements for further information on credit derivatives.
Country Exposure—Exposure to European Peripherals. In connection with certain of its Institutional Securities business segment activities, the Company has exposure to European peripheral countries, which are defined as exposures in Greece, Ireland, Italy, Portugal and Spain. At June 30, 2011, gross funded exposure before the benefit of hedges was approximately $5 billion and net funded exposure after hedges was approximately $2 billion. Gross funded exposure includes obligations from sovereign governments, corporations, and financial institutions. In addition to the gross funded exposure, at June 30, 2011, the Company had European peripheral country exposure for overnight deposits with banks of approximately $2 billion and unfunded loans to corporations of approximately $1.5 billion.
Country Exposure—Corporate Lending and OTC Derivative products. At June 30, 2011 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 June 30, 2011:
Country
United States
United Kingdom
Germany
France
Netherlands
Canada
Luxembourg
Spain
Cayman Islands
Italy
Australia
Japan
Chile
Austria
Industry Exposure—Corporate Lending and OTC Derivative products. 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 tables show the Company’s percentage of credit exposure from its primary corporate loans and lending commitments and OTC derivative products by industry at June 30, 2011:
Industry
Utilities
Energy
Financial institutions(1)
Pharmaceutical and healthcare
Technology
Chemicals, metals, mining and other materials
Telecommunications services
Media-related entities
Capital goods
Insurance
Food, beverage and tobacco
Transportation
Banks
Real estate
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:
Deposits:
Commercial paper and other short-term borrowings:
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
Rate/Volume Analysis
The following tables set forth an analysis of the effect on net interest income of volume and rate changes:
Interest earning assets
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, 2010 (the “Form 10-K”), the Company’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2011 (the “First 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 and credit crisis related matters 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 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 and the First Quarter Form 10-Q or concern new actions that have been filed since the first quarter Form 10-Q:
Residential Mortgage and Credit Crisis Related Matters.
Class Actions.
On June 9, 2011, plaintiffs in Joel Stratte-McClure, et al. v. Morgan Stanley, et al., filed a Second Amended Complaint in response to the court’s order of April 4, 2011.
On July 21, 2011, the court presiding over In re Washington Mutual, Inc. Securities Litigationissued an order preliminarily approving the settlement of this litigation by the Company and other defendants.
On July 27, 2011, the court presiding over In re: Lehman Brothers Equity/Debt Securities Litigation issued an opinion granting in part and denying in part the underwriter defendants’ motion to dismiss the current amended complaint.
Other Litigation.
On May 25, 2011, the court presiding over Citibank, N.A. v. Morgan Stanley & Co. International, PLC issued an order denying the Company’s motion for summary judgment and granting Citibank, N.A.’s cross motion for summary judgment. On June 27, 2011, the court entered a final judgment against the Company for approximately $269 million plus post-judgment interest. On June 27, 2011, the Company filed a notice of appeal with United States Court of Appeals for the Second Circuit.
By orders dated June 23, 2011 and July 18, 2011, the court presiding over Federal Home Loan Bank of Seattle v. Morgan Stanley & Co. Inc., et al. denied defendants’ omnibus motion to dismiss the Amended Complaint. The Company’s individual motion to dismiss remains pending before the court.
On May 26, 2011, the court presiding over MBIA Insurance Corporation v. Morgan Stanley, et al. partially denied the Company’s motion to dismiss. On June 28, 2011, the Company filed a notice appealing this decision to the Appellate Division of the New York Supreme Court, First Department.
On July 5, 2011, Allstate Insurance Company and certain of its affiliated entities filed a complaint against the Company in New York State Supreme Court styled Allstate Insurance Company v. Morgan Stanley, et al. 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 amount of certificates allegedly sold to plaintiffs by the Company was approximately $104 million. The complaint raises common law claims of fraud, fraudulent inducement, aiding and abetting fraud and negligent misrepresentation and seeks, among other things, compensatory and/or rescissionary damages associated with plaintiffs’ purchases of such certificates.
On July 7, 2011, the appellate court in China Development Industrial Bank v. Morgan Stanley & Co. Incorporated et al. affirmed the lower court’s decision denying the Company’s motion to dismiss.
On July 18, 2011, the Western and Southern Life Insurance Company and certain affiliated companies filed a complaint against the Company and other defendants in the Court of Common Pleas in Ohio, styled Western and Southern Life Insurance Company, et al. v. Morgan Stanley Mortgage Capital Inc., et al. 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 amount of certificates allegedly sold to plaintiffs by the Company was approximately $130 million. The complaint raises claims under the Ohio Securities Act and federal securities laws and seeks, among other things, to rescind the plaintiffs’ purchases of such certificates.
Concerns regarding downgrade of the U.S. credit rating and the sovereign debt crisis in Europe could have a material adverse effect on our business, financial condition and liquidity.
On August 5, 2011, Standard & Poor’s lowered its long term sovereign credit rating on the United States of America from AAA to AA+. While U.S. lawmakers reached agreement to raise the federal debt ceiling on August 2, 2011, the downgrade reflected Standard & Poor’s view that the fiscal consolidation plan within that agreement fell short of what would be necessary to stabilize the U.S. government’s medium term debt dynamics. This downgrade could have material adverse impacts on financial markets and economic conditions in the United
States and throughout the world and, in turn, the market’s anticipation of these impacts could have a material adverse effect on our business, financial condition and liquidity. In particular, it could disrupt payment systems, money markets, long-term or short-term fixed income markets, foreign exchange markets, commodities markets and equity markets and adversely affect the cost and availability of funding and certain impacts, such as increased spreads in money market and other short term rates, have been experienced already as the market anticipated the downgrade. In addition, it could adversely affect our credit ratings, as well as those of our clients and/or counterparties and could require us to post additional collateral on loans collateralized by U.S. Treasury securities. Because of the unprecedented nature of negative credit rating actions with respect to U.S. government obligations, the ultimate impacts on global markets and our business, financial condition and liquidity are unpredictable and may not be immediately apparent.
In addition, global markets and economic conditions have been negatively impacted by the ability of certain European Union (“EU”) member states to service their sovereign debt obligations. The continued uncertainty over the outcome of the EU governments’ financial support programs and the possibility that other EU member states may experience similar financial troubles could further disrupt global markets. In particular, it has and could in the future disrupt equity markets and result in volatile bond yields on the sovereign debt of EU members. These factors could have an adverse effect on our business, financial condition and liquidity. In particular, in connection with certain of our Institutional Securities business segment activities, we have exposure to European peripheral countries, which are defined as exposures in Greece, Ireland, Italy, Portugal and Spain. At June 30, 2011, gross funded exposure before the benefit of hedges to European peripheral countries was approximately $5 billion and net funded exposure after hedges was approximately $2 billion. Gross funded exposure includes obligations from sovereign governments, corporations, and financial institutions. In addition to the gross funded exposure, at June 30, 2011, the Company had European peripheral country exposure for overnight deposits with banks of approximately $2 billion and unfunded loans to corporations of approximately $1.5 billion.
The financial services industry is subject to extensive regulation, which is undergoing major changes that will impact our business.
As a major financial services firm, we are subject to extensive regulation by U.S. federal and state regulatory agencies and securities exchanges and by regulators and exchanges in each of the major markets where we operate. We also face the risk of investigations and proceedings by governmental and self-regulatory agencies in all countries in which we conduct our business. Interventions by authorities may result in adverse judgments, settlements, fines, penalties, injunctions or other relief. In addition to the monetary consequences, these measures could, for example, impact our ability to engage in, or impose limitations on, certain of our businesses. The number of these investigations and proceedings, as well as the amount of penalties and fines sought, has increased substantially in recent years with regard to many firms in the financial services industry, including us. Significant regulatory action against us could materially adversely affect our business, financial condition or results of operations or cause us significant reputational harm, which could seriously harm our business. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) also provides a bounty to whistleblowers who present the Securities and Exchange Commission (“SEC”) with information related to securities laws violations that leads to a successful enforcement action. As a result of this bounty, we may face an increased number of investigations by the SEC.
In response to the financial crisis, legislators and regulators, both in the U.S. and worldwide, have adopted, or are currently considering enacting, financial market reforms that have resulted and could result in major changes to the way our global operations are regulated. In particular, as a result of the Dodd-Frank Act, we are subject to significantly revised and expanded regulation and supervision, to new activities limitations, to a systemic risk regime which will impose especially high capital and liquidity requirements, and to comprehensive new derivatives regulation. Additional restrictions on our activities would result if we were to no longer meet certain capital or management requirements at the financial holding company level. Certain portions of the Dodd-Frank Act were effective immediately, while other portions will be effective only following extended transition periods, but many of these changes could in the future materially impact the profitability of our businesses, the value of assets we hold, expose us to additional costs, require changes to business practices or force us to discontinue
businesses, could adversely affect our ability to pay dividends, or could require us to raise capital, including in ways that may adversely impact our shareholders or creditors.
For example, the Volcker Rule provision of the Dodd-Frank Act will have an impact on us, including potentially limiting various aspects of our business. With respect to the “proprietary trading” prohibition of the Volcker Rule, we have previously announced plans to dispose of our in-house proprietary quantitative trading unit, Process-Driven Trading (“PDT”), in 2012. For the year ended December 31, 2010, PDT did not have a material impact on our financial condition, results of operations and liquidity. We have also previously exited other standalone proprietary trading businesses (defined as those businesses that were dedicated solely to investing our capital), and we are continuing to liquidate legacy positions related to those businesses. Beyond the restriction on standalone proprietary trading businesses, any additional limitations will depend on the details of agency rulemaking, which have not been published. Given the lack of clarity, we are unable to identify which other parts of our business will or might be defined to be “proprietary trading” or, even if defined as “proprietary trading,” whether we would benefit from a “permitted activity” exception, such as market-making or hedging. We are closely monitoring regulatory developments related to the Volcker Rule, and when the regulations are final, we will be in a position to complete a review of our relevant activities and make plans to implement compliance with the Volcker Rule, which will likely not require full conformance until July 2014, subject to extensions.
Holding large and concentrated positions may expose us to losses.
Concentration of risk may reduce revenues or result in losses in our market-making, investing, block trading, underwriting and lending businesses in the event of unfavorable market movements. We commit substantial amounts of capital to these businesses, which often results in our taking large positions in the securities of, or making large loans to, a particular issuer or issuers in a particular industry, country or region. For example, our exposure to monoline insurers (“Monolines”) at June 30, 2011 includes $1.7 billion of bonds that are insured by Monolines and $1.6 billion of positive net derivative counterparty exposure (principally MBIA Insurance Corporation). Our hedging program for Monoline counterparty exposure continues to become more costly and difficult to effect because of the basis risk (risk associated with imperfect hedging) between the Monoline counterparty exposure and the related hedges. The quarter and six months ended June 30, 2011 included gains of $471 million and $153 million, respectively, compared with losses of $186 million and $330 million, respectively, in the prior year comparative periods. Although we proactively manage our Monoline exposure, as market conditions continue to evolve, significant additional gains or losses could be incurred. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Executive Summary—Significant Items—Monoline Insurers” in Part I, Item 2, herein.
Our borrowing costs and access to the debt capital markets depend significantly on our credit ratings.
The cost and availability of unsecured financing generally are dependent on our short-term and long-term credit ratings. Factors that are important to the determination of our credit ratings include the level and quality of our earnings, capital adequacy, liquidity, risk appetite and management, asset quality, business mix and actual and perceived levels of government support.
Our debt ratings also can have a significant impact on certain trading revenues, particularly in those businesses where longer term counterparty performance is critical, such as over-the-counter (“OTC”) derivative transactions, including credit derivatives and interest rate swaps. In connection with certain OTC trading agreements and certain other agreements associated with the Institutional Securities business segment, we may be required to provide additional collateral to certain counterparties in the event of a credit ratings downgrade. At June 30, 2011, 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 our long-term credit rating was $1,245 million. A total of $3,258 million in collateral or termination payments could be called in the event of a two-notch downgrade. In addition, we may be required to pledge additional collateral to certain exchanges and
clearing organizations in the event of a credit ratings downgrade. At June 30, 2011, the increased collateral requirement at certain exchanges and clearing organizations was $178 million in the event of a one-notch downgrade of our long-term credit rating. A total of $1,371 million of collateral is required in the event of a two-notch downgrade.
The rating agencies are considering the impact of the Dodd-Frank Act’s resolution authority provisions on large banking institutions and it is possible that they could downgrade our ratings and those of similar institutions.
We have incurred, and may continue to incur, significant losses in the real estate sector.
We finance and acquire principal positions in a number of real estate and real estate-related products for our own account, for investment vehicles managed by affiliates in which we also may have a significant investment, for separate accounts managed by affiliates and for major participants in the commercial and residential real estate markets. At June 30, 2011, the condensed consolidated statements of financial condition included amounts representing real estate investment assets of consolidated subsidiaries of approximately $2.0 billion, net of noncontrolling interests of approximately $1.6 billion. In addition, we had contractual capital commitments, guarantees, lending facilities and counterparty arrangements with respect to real estate investments of $1.0 billion at June 30, 2011.
We also originate loans secured by commercial and residential properties. Further, we securitize and trade in a wide range of commercial and residential real estate and real estate-related whole loans, mortgages and other real estate and commercial assets and products, including residential and commercial mortgage-backed securities. These businesses have been, and may continue to be, adversely affected by the downturn in the real estate sector. In connection with these activities, we have provided, or otherwise agreed to be responsible for, certain representations and warranties. Under certain circumstances, we may be required to repurchase such assets or make other payments related to such assets if such representations and warranties were breached. Between 2004 and June 30, 2011, we sponsored approximately $147 billion of residential mortgage-backed securities (“RMBS”) primarily containing U.S. residential loans. Of that amount, we made representations and warranties concerning approximately $46 billion of loans and agreed to be responsible for the representations and warranties made by third-party sellers, many of which are now insolvent, on approximately $21 billion of loans. At June 30, 2011, the current unpaid principal balance (“UPB”) for all the residential assets subject to such representations and warranties was approximately $25.1 billion and the cumulative losses associated with U.S. RMBS were approximately $9.6 billion. We did not make, or otherwise agree to be responsible, for the representations and warranties made by third party sellers on approximately $80 billion of residential loans that we securitized during that time period. We have not sponsored any U.S. RMBS transactions since 2007.
We have also made representations and warranties in connection with our role as an originator of certain commercial mortgage loans that we securitized in commercial mortgage-backed securities (“CMBS”). Between 2004 and 2010, we originated approximately $43 billion and $29 billion of U.S. and non-U.S. commercial mortgage loans, respectively, that were placed into CMBS sponsored by us. At June 30, 2011, the current UPB for all U.S. commercial mortgage loans subject to such representations and warranties was $36.6 billion. At June 30, 2011, the current UPB for all non-U.S. commercial mortgage loans, subject to such representations and warranties was approximately $17 billion.
Recently, the level of litigation activity focused on residential mortgage and credit crisis-related matters has increased materially in the financial services industry. As a result, we expect that we may become the subject of increased claims for damages and other relief regarding residential mortgages and related securities in the future. We continue to monitor our real estate-related activities in order to manage our exposures and potential liability from these markets and businesses. See “Legal Proceedings—Residential Mortgage and Credit Crisis Related Matters” in Part II, Item 1 herein. For a discussion of additional risk factors affecting the Company, see also “Risk Factors” in Part I, Item 1A of the Form 10-K.
We may be unable to fully capture the expected value from acquisitions, joint ventures, minority stakes and strategic alliances.
In connection with past or future acquisitions, joint ventures (including Morgan Stanley Smith Barney Holdings LLC) or strategic alliances (including with Mitsubishi UFJ Financial Group, Inc. (“MUFG”)), we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls and to integrate relationships with clients, trading counterparties and business partners. In the case of joint ventures and minority stakes, we are subject to additional risks and uncertainties because we may be dependent upon, and subject to liability, losses or reputational damage relating to, systems, controls and personnel that are not under our control.
For example, the ownership arrangements relating to the Company’s joint venture in Japan with MUFG of their respective investment banking and securities businesses are complex. MUFG and the Company have integrated their respective Japanese securities businesses by forming two joint venture companies, Mitsubishi UFJ Morgan Stanley Securities Co., Ltd. (“MUMSS”) and Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Other Matters—Japanese Securities Joint Venture” in Part I, Item 2 herein. For the quarter ended March 31, 2011, the Company recorded a loss of $655 million arising from its 40% stake in MUMSS related to certain fixed income trading positions at MUMSS, which is a subsidiary of MUFG that is controlled and risk managed by MUFG. As a result of this loss, during the quarter ended March 31, 2011, the Company entered into a transaction with MUMSS, whereby the fixed income trading positions that previously caused the majority of the aforementioned MUMSS losses were transferred to MSMS, a subsidiary of the Company that is controlled and risk managed by the Company. While MUFG contributed $370 million in capital to MUMSS in connection with the trading losses and has or will take certain other actions, including the replacement of certain management personnel and enhancement of risk management processes and controls, additional losses could be incurred by MUMSS in the future.
In addition, conflicts or disagreements between us and any of our joint venture partners may negatively impact the benefits to be achieved by the relevant joint venture.
There is no assurance that any of our acquisitions will be successfully integrated or yield all of the positive benefits anticipated. If we are not able to integrate successfully our past and future acquisitions, there is a risk that our results of operations, financial condition and cash flows may be materially and adversely affected.
Certain of our business initiatives, including expansions of existing businesses, may bring us into contact, directly or indirectly, with individuals and entities that are not within our traditional client and counterparty base and may expose us to new asset classes and new markets. These business activities expose us to new and enhanced risks, greater regulatory scrutiny of these activities, increased credit-related, sovereign and operational risks, and reputational concerns regarding the manner in which these assets are being operated or held.
See also “Risk Factors” in Part I, Item 1A of the Form 10-K and “Supervision and Regulation” in Part I, Item 1 of the 2010 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 June 30, 2011.
Issuer Purchases of Equity Securities
(dollars in millions, except per share amounts)
Period
Month #1
(April 1, 2011—April 30, 2011)
Share Repurchase Program(A)
Employee Transactions(B)
Month #2
(May 1, 2011—May 31, 2011)
Month #3
(June 1, 2011—June 30, 2011)
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
Deputy Chief Financial Officer
Date: August 8, 2011
EXHIBIT INDEX
Quarter Ended June 30, 2011
Exhibit No.
Description
E-1