EXHIBIT 99.3
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
--------
(1)Amounts have been restated to reflect the Company's two-for-one stock
splits.
See Notes to the Supplemental Consolidated Financial Statements.
1
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN MILLIONS, EXCEPT SHARE AND PER SHARE DATA)
--------
(1) Amounts shown are used to calculate primary earnings per common share.
(2) Per share and share data have been restated to reflect the Company's two-
for-one stock splits.
See Notes to the Supplemental Consolidated Financial Statements.
2
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(DOLLARS IN MILLIONS)
-------
(1)Amounts have been restated to reflect the Company's two-for-one stock
splits.
See Notes to the Supplemental Consolidated Financial Statements.
3
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
See Notes to the Supplemental Consolidated Financial Statements.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS
1. INTRODUCTION AND BASIS OF PRESENTATION
The Merger
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged
with and into Dean Witter, Discover & Co. ("Dean Witter Discover") (the
"Merger"). At that time, Dean Witter Discover changed its corporate name to
Morgan Stanley, Dean Witter, Discover & Co. (the "Company"). In conjunction
with the Merger, each share of Morgan Stanley common stock then outstanding
was converted into the right to receive 1.65 shares of the Company's common
stock (the "Exchange Ratio"), and each share of Morgan Stanley preferred stock
was converted into the right to receive one share of a corresponding series of
preferred stock of the Company. The Merger was treated as a tax free exchange.
The Company
The Company's supplemental consolidated financial statements include the
accounts of Morgan Stanley, Dean Witter Discover and their U.S. and
international subsidiaries, including Morgan Stanley & Co. Incorporated
("MS&Co."), Morgan Stanley & Co. International Limited ("MSIL"), Morgan
Stanley Japan Limited ("MSJL"), Dean Witter Reynolds Inc. ("DWR"), Dean Witter
InterCapital Inc. ("ICAP"), and NOVUS Credit Services Inc.
The Company, through its subsidiaries, provides a wide range of financial
securities services on a global basis and credit services nationally. Its
securities businesses include securities underwriting, distribution and
trading; merger, acquisition, restructuring, real estate, project finance and
other corporate finance advisory activities; asset management; merchant
banking and other principal investment activities; brokerage and research
services; the trading of foreign exchange and commodities as well as
derivatives on a broad range of asset categories, rates and indices; and
global custody, securities clearance services and securities lending. The
Company's credit services businesses include the operation of the NOVUS(R)
Network, a proprietary network of merchant and cash access locations, and the
issuance of proprietary general purpose credit cards. The Company's services
are provided to a large and diversified group of clients and customers,
including corporations, governments, financial institutions and individual
investors.
Basis of Financial Information
The supplemental consolidated financial statements give retroactive effect
to the merger of Dean Witter Discover and Morgan Stanley in a transaction
accounted for as a pooling of interests. The pooling of interests method of
accounting requires the restatement of all periods presented as if Dean Witter
Discover and Morgan Stanley had always been combined. Generally accepted
accounting principles proscribe giving effect to a consummated business
combination accounted for by the pooling of interests method in financial
statements that do not include the date of consummation. The supplemental
consolidated financial statements do not extend through the date of
consummation. However, they will become the historical consolidated financial
statements of the Company and its subsidiaries after financial statements
covering the date of consummation of the business combination are issued. The
supplemental consolidated statement of changes in shareholders' equity
reflects the accounts of the Company as if the additional preferred and common
stock had been issued during all the periods presented. The supplemental
consolidated financial statements, including the notes thereto, should be read
in conjunction with the historical consolidated financial statements of Dean
Witter Discover and Morgan Stanley, included in their Annual Reports on Form
10-K for the fiscal years ended December 31, 1996 and November 30, 1996,
respectively.
Prior to the consummation of the merger, Dean Witter Discover's fiscal year
ended on December 31 and Morgan Stanley's fiscal year ended on November 30. In
recording the pooling of interests combination, Dean Witter Discover's
financial statements for the fiscal years ended December 31, 1996, 1995 and
1994 were
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
combined with Morgan Stanley's financial statements for the fiscal years ended
November 30, 1996, 1995 and 1994 (on a combined basis, "fiscal year 1996,"
"fiscal year 1995," and "fiscal year 1994," respectively).
The supplemental consolidated financial statements are prepared in
accordance with generally accepted accounting principles which require
management to make estimates and assumptions regarding certain trading
inventory valuations, consumer loan loss levels, the potential outcome of
litigation and other matters that affect the financial statements and related
disclosures. Management believes that the estimates utilized in the
preparation of the supplemental consolidated financial statements are prudent
and reasonable. Actual results could differ from these estimates.
Certain reclassifications have been made to prior year amounts to conform to
the current presentation. All material intercompany balances and transactions
have been eliminated. The supplemental consolidated financial statements are
hereinafter referred to as "consolidated financial statements" or
"statements."
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Consolidated Statements of Cash Flows
For purposes of these statements, cash and cash equivalents consist of cash
and highly liquid investments not held for resale with maturities, when
purchased, of three months or less.
In connection with the purchase of Miller Anderson & Sherrerd, LLP ("MAS"),
the Company issued approximately $66 million of notes payable, as well as 3.3
million shares of common stock having a fair value on the date of acquisition
of approximately $83 million. In addition, in connection with the purchase of
VK/AC Holding, Inc., the parent of Van Kampen American Capital, Inc. ("VKAC"),
the Company assumed approximately $162 million of long-term debt (see Note
16).
Consumer Loans
Consumer loans, which consist primarily of credit card, real estate-secured
and other consumer installment loans, are reported at their principal amounts
outstanding, less applicable allowances and unearned finance charges. Interest
on consumer loans is credited to income as earned.
Interest is accrued on credit card loans until the date of charge-off, which
generally occurs at the end of the month during which an account becomes 180
days past due, except in the case of bankruptcies and fraudulent transactions,
which are charged off earlier. The interest portion of charged off credit card
loans is written off against interest revenue. Origination costs related to
the issuance of credit cards are charged to earnings over periods not
exceeding twelve months.
Interest generally is not accrued on real estate-secured loans which are
delinquent by six monthly payments and other consumer installment loans which
are delinquent by four or more monthly payments. Origination fees, net of
certain direct loan origination costs, are deferred and amortized over the
estimated life of the loans using the interest method. Any unamortized net
origination fees and costs on real estate-secured and other consumer
installment loans fully repaid are recognized as income in the period such
loans are repaid.
Allowance for Consumer Loan Losses
The allowance for consumer loan losses is a significant estimate that is
regularly evaluated by management for adequacy on a portfolio by portfolio
basis and is established through a charge to the provision for loan losses.
The evaluations take into consideration such factors as changes in the nature
and volume of the loan portfolio,
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
overall portfolio quality, review of specific problem loans and current
economic conditions that may affect the borrower's ability to pay.
The Company uses the results of these evaluations to provide an allowance
for loan losses. The exposure for credit losses for owned loans is influenced
by the performance of the portfolio and other factors discussed above, with
the Company absorbing all related losses. The exposure for credit losses for
securitized loans is represented by the Company retaining a contingent risk
based on the amount of credit enhancement provided.
Management believes that its estimates have been historically prudent in
light of the need to allow the market for asset securitizations, in particular
those backed by credit card receivables, to mature, and in light of the
uncertainty of accounting standards for asset securitizations. In fiscal 1996,
the Company revised its estimate of the allowance for losses for loans
intended to be securitized. This revision was based on the Company's
experience with credit losses related to securitized loans in a mature asset
securitization market and the recent issuance of Statement of Financial
Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities", by the Financial
Accounting Standards Board ("FASB"), which eliminated the uncertainty
surrounding the appropriate accounting treatment for asset securitization
transactions. The Company intends to maintain existing loan loss allowances
for securitizations outstanding until the related loans are liquidated.
Securitization of Consumer Loans
The Company periodically sells consumer loans through asset securitizations
and continues to service these loans. The revenues derived from servicing
these loans are recorded in the consolidated statements of income as servicing
fees over the term of the securitized loans rather than at the time the loans
are sold. The effects of recording these revenues over the term of the
securitized loans rather than at the time the loans were sold have not been
material.
Financial Instruments Used for Trading and Investment
Financial instruments, including derivatives, used in the Company's trading
activities are recorded at fair value, and unrealized gains and losses are
reflected in trading revenues. Interest revenue and expense arising from
financial instruments used in trading activities are reflected in the
consolidated statements of income as interest revenue or expense. The fair
values of the trading positions generally are based on listed market prices.
If listed market prices are not available or if liquidating the Company's
positions would reasonably be expected to impact market prices, fair value is
determined based on other relevant factors, including dealer price quotations
and price quotations for similar instruments traded in different markets,
including markets located in different geographic areas. Fair values for
certain derivative contracts are derived from pricing models which consider
current market and contractual prices for the underlying financial instruments
or commodities, as well as time value and yield curve or volatility factors
underlying the positions. Purchases and sales of financial instruments are
recorded in the accounts on trade date. Unrealized gains and losses arising
from the Company's dealings in over-the-counter ("OTC") financial instruments,
including derivative contracts related to financial instruments and
commodities, are presented in the accompanying consolidated statements of
financial condition on a net-by-counterparty basis consistent with FASB
Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts."
Equity securities purchased in connection with merchant banking and other
principal investment activities are initially carried in the consolidated
financial statements at their original costs. The carrying value of such
equity securities is adjusted when changes in the underlying fair values are
readily ascertainable, generally as evidenced by listed market prices or
transactions which directly affect the value of such equity securities.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Downward adjustments relating to such equity securities are made in the event
that the Company determines that the eventual realizable value is less than
the carrying value. The carrying value of investments made in connection with
principal real estate activities which do not involve equity securities are
adjusted periodically based on independent appraisals, estimates prepared by
the Company of discounted future cash flows of the underlying real estate
assets or other indicators of fair value.
Loans made in connection with merchant banking and investment banking
activities are carried at cost plus accrued interest less reserves, if deemed
necessary, for estimated losses.
Financial Instruments Used for Asset and Liability Management
The Company has entered into various contracts as hedges against specific
assets, liabilities or anticipated transactions. These contracts include
interest rate swap, foreign exchange forward, foreign currency exchange, cost
of funds and interest rate cap agreements. The Company uses interest rate and
currency swaps to manage the interest rate and currency exposure arising from
certain borrowings and to match the refinancing characteristics of consumer
loans with the borrowings that fund these loans. For contracts that are
designated as hedges of the Company's assets and liabilities, gains and losses
are deferred and recognized as adjustments to interest revenue or expense over
the remaining life of the underlying assets or liabilities. For contracts that
are hedges of asset securitizations, gains and losses are recognized as
adjustments to servicing fees. Gains and losses resulting from the termination
of hedge contracts prior to their stated maturity are recognized ratably over
the remaining life of the instrument being hedged. The Company also uses
foreign exchange forward contracts to manage the currency exposure relating to
its net monetary investment in non-U.S. dollar functional currency operations.
The gain or loss from revaluing these contracts is deferred and reported
within cumulative translation adjustments in shareholders' equity, net of tax
effects, with the related unrealized amounts due from or to counterparties
included in receivables from or payables to brokers, dealers and clearing
organizations.
Securities Transactions
Clients' securities transactions are recorded on a settlement date basis
with related commission revenues and expenses recorded on trade date.
Securities are recorded at fair value, with gains and losses reflected in
income. Securities purchased under agreements to resell (reverse repurchase
agreements) and securities sold under agreements to repurchase (repurchase
agreements), principally government and agency securities, are treated as
financing transactions and are carried at the amounts at which the securities
will subsequently be resold or reacquired as specified in the respective
agreements; such amounts include accrued interest. Reverse repurchase and
repurchase agreements are presented net-by-counterparty in the accompanying
consolidated statements of financial condition where net presentation is
consistent with FASB Interpretation No. 41, "Offsetting of Amounts Related to
Certain Repurchase and Reverse Repurchase Agreements." It is the Company's
policy to take possession of securities purchased under agreements to resell.
The Company 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. Where deemed appropriate, the
Company's agreements with third parties specify its rights to request
additional collateral.
Securities borrowed and securities loaned are carried at the amounts of cash
collateral advanced and received in connection with the transactions. The
Company measures the fair value of the securities borrowed and loaned against
the cash collateral on a daily basis. Additional cash is obtained as necessary
to ensure such transactions are adequately collateralized.
Office Facilities
Office facilities are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization of buildings and improvements are
provided principally by the straight-line method, while
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
depreciation and amortization of furniture, fixtures and equipment is provided
by both straight-line and accelerated methods. Property and equipment are
depreciated over the estimated useful lives of the related assets, while
leasehold improvements are amortized over the lesser of the economic useful
life of the asset or, where applicable, the remaining term of the lease.
Income Taxes
Income tax expense is provided for using the asset and liability method,
under which deferred tax assets and liabilities are determined based upon the
temporary differences between the financial statement and income tax bases of
assets and liabilities, using currently enacted tax rates.
Earnings Per Share
The calculations of earnings per common share are based on the weighted
average number of common shares and share equivalents outstanding and gives
effect to preferred stock dividend requirements. All per share and share
amounts reflect stock splits enacted by Dean Witter Discover and Morgan
Stanley prior to the Merger, as well as the additional shares issued to Morgan
Stanley shareholders pursuant to the Exchange Ratio.
Cardmember Rewards
The liability for cardmember rewards expense, included in other liabilities
and accrued expenses, is accrued at the time that qualified cardmember
transactions occur and is calculated on an individual cardmember basis.
Stock-Based Compensation
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation." SFAS No. 123 encourages, but does not require, companies to
record compensation cost for stock-based employee compensation plans at fair
value. The Company has elected to continue to account for its stock-based
compensation plans using the intrinsic value method prescribed by Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
("APB No. 25"). Under the provisions of APB No. 25, compensation cost for
stock options is measured as the excess, if any, of the quoted market price of
the Company's common stock at the date of the grant over the amount an
employee must pay to acquire the stock.
Translation of Foreign Currencies
Assets and liabilities of operations having non-U.S. dollar functional
currencies are translated at year-end rates of exchange, and the income
statements are translated at weighted average rates of exchange for the year.
In accordance with SFAS No. 52, "Foreign Currency Translation," gains or
losses resulting from translating foreign currency financial statements, net
of hedge gains or losses and related tax effects, are reflected in cumulative
translation adjustments, a separate component of shareholders' equity. Gains
or losses resulting from foreign currency transactions are included in net
income.
Goodwill and Other Intangible Assets
Goodwill and other intangible assets are amortized on a straight-line basis
over periods from 5 to 40 years, generally not exceeding 25 years, and are
periodically evaluated for impairment. At fiscal year end 1996, goodwill of
approximately $1.5 billion is included in the Company's consolidated
statements of financial condition as a component of Other Assets. (See Note
16.)
Other Accounting Pronouncements
Beginning with the fiscal year 1996, the Company adopted SFAS Nos. 121 and
122. SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of",
9
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
generally requires that long-lived assets be reported at the lower of their
carrying cost or net realizable value. SFAS No. 122, "Accounting for Mortgage
Servicing Rights, an amendment of SFAS No. 65", requires that rights to
service mortgage loans for others, however acquired, be recorded as separate
assets when the mortgage loans are sold and the servicing rights are retained.
This statement also requires that capitalized mortgage servicing rights be
assessed for impairment based on the fair value of those rights. The adoption
of these statements was not material to the Company's financial position or
results of operations.
The FASB has issued SFAS No. 125, effective for transfers of financial
assets made after December 31, 1996, except for transfers of certain financial
assets for which the effective date has been delayed for one year. SFAS No.
125 provides financial reporting standards for the derecognition and
recognition of financial assets, including the distinction between transfers
of financial assets which should be recorded as sales and those which should
be recorded as secured borrowings. SFAS No. 125 supersedes and incorporates
the essential provisions of SFAS No. 122. The Company believes that the effect
of the adoption of SFAS No. 125 will not be material to its financial position
or results of operations.
3. CONSUMER LOANS
Consumer loans were as follows.
Activity in the allowance for consumer loan losses was as follows.
--------
(1) Primarily reflects net transfers related to asset securitizations.
10
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Interest accrued on loans subsequently charged off, recorded as a reduction
of interest revenue, was $181 million, $115 million and $70 million in fiscal
1996, 1995 and 1994.
At fiscal year end 1996 and 1995, $5,789 million and $7,000 million of the
Company's consumer loans had minimum contractual maturities of less than one
year. Because of the uncertainty regarding consumer loan repayment patterns,
which historically have been higher than contractually required minimum
payments, and variable rate loan pricing utilized by the Company, this amount
may not necessarily be indicative of the Company's consumer loan repricing
schedule.
At fiscal year end 1996 and 1995, the Company had commitments to extend
credit in the amounts of $156.6 billion and $133.3 billion. Commitments to
extend credit arise from agreements to extend to customers unused lines of
credit on certain credit cards and home equity lines of credit issued by the
Company, provided there is no violation of conditions established in the
related agreement. These commitments, substantially all of which the Company
can terminate at any time and which do not necessarily represent future cash
requirements, are periodically reviewed based on account usage and customer
creditworthiness.
The Company received proceeds from asset securitizations of $4,528 million,
$1,827 million, and $1,970 million in fiscal 1996, 1995 and 1994. The
uncollected balances of consumer loans sold through asset securitizations were
$13,385 million and $10,220 million at fiscal year end 1996 and 1995. The
allowance for loan losses related to securitized loans, included in other
liabilities and accrued expenses, was $447 million and $342 million at fiscal
year end 1996 and 1995.
The Company uses interest rate exchange agreements to hedge the risk from
changes in interest rates on servicing fee revenues (which are derived from
loans sold through asset securitizations). Gain and losses from these
agreements are recognized as adjustments to servicing fees. At fiscal year end
1996 and 1995, notional amounts of these interest rate exchange agreements
outstanding were $2,919 million and $2,575 million with fair values of $(32)
million and $28 million. Under these interest rate exchange agreements the
Company primarily pays floating rates and receives fixed rates.
In connection with certain asset securitizations, the Company has written
interest rate cap agreements with notional amounts of $240 million and strike
rates of 11%. Any settlement payments made under these agreements will
generally be passed back to the Company through an adjustment of servicing
fees, although this is subject to the risk of counterparty nonperformance. At
fiscal year end 1996 and 1995, the fair values of these agreements were not
material. No payments have been made by the Company under these agreements,
which expire in 1997.
The estimated fair value of the Company's consumer loans approximated
carrying value at fiscal year end 1996 and 1995. The Company's consumer loan
portfolio, including securitized loans, is geographically diverse, with a
distribution approximating that of the population of the United States.
4. DEPOSITS
Deposits were as follows.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The weighted average interest rates of interest-bearing deposits outstanding
during fiscal 1996 and 1995 were 6.3% and 6.6%.
At fiscal year end 1996 and 1995, the notional amounts of interest rate
exchange agreements that hedged deposits outstanding were $495 million and $20
million and had fair values of $5 million and $0.4 million. Under these
interest rate exchange agreements the Company primarily pays fixed rates and
receives floating rates. At fiscal year end 1996, the weighted average
interest rate of the Company's deposits including the effect of interest rate
exchange agreements was 6.2%.
At fiscal year end 1996, certificate accounts maturing over the next five
years were as follows (dollars in millions).
The estimated fair value of the Company's deposits, using current rates for
deposits with similar maturities, approximated carrying value at fiscal year
end 1996 and 1995.
5. SHORT-TERM BORROWINGS
At fiscal year end 1996 and 1995, commercial paper in the amount of $18,890
million and $13,101 million, with weighted average interest rates of 5.4% and
5.9%, was outstanding.
At fiscal year end 1996 and 1995, the notional amounts of interest rate
contracts that hedged commercial paper outstanding were $808 million and
$1,032 million and had fair values of $(7) million and $(14) million. These
interest rate contracts converted the commercial paper to fixed rates. These
contracts had no material effect on the weighted average interest rates of
commercial paper.
At fiscal year end 1996 and 1995, other short-term borrowings of $7,436
million and $4,928 million were outstanding. These borrowings included bank
loans, federal funds, proceeds from revolving credit agreements and bank
notes.
The Company maintains a senior revolving credit agreement with a group of
banks to support general liquidity needs, including the issuance of commercial
paper (the "Morgan Stanley Facility"). Under the terms of the credit
agreement, the banks are committed to provide up to $2.5 billion. At fiscal
year end 1996, $365 million was outstanding under the Morgan Stanley Facility
which was repaid in full subsequent to fiscal year end 1996. The Company has
assumed the Morgan Stanley Facility as part of the Merger.
The Company also maintains a second senior revolving credit agreement with a
group of banks to support general liquidity needs, including the issuance of
commercial paper (the "DWD Facility"). Under the terms of the credit
agreement, the banks are committed to provide up to $4.0 billion. As of fiscal
year end 1996, the Company has never borrowed from the DWD Facility. In April
1997, DWD renewed this facility which expires in April of 1998.
The Morgan Stanley Facility and the DWD Facility both contain covenants that
require the Company to maintain minimum net worth requirements and specified
financial ratios. The Company believes that the covenant restrictions will not
impair the Company's ability to pay its current level of dividends. Prior to
the closing of the Merger, the Morgan Stanley Facility and the DWD Facility
were amended to conform such facilities to insure that they remain effective
subsequent to the closing of the Merger and to accommodate the Company's post-
Merger business activities and financing needs. After the consummation of the
Merger, the Company expects that a new credit facility of the Company will
replace the Morgan Stanley Facility and the DWD Facility.
12
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Riverwoods Funding Corporation ("RFC"), an entity included in the
consolidated financial statements of the Company, maintains a senior bank
credit facility to support the issuance of asset-backed commercial paper. In
fiscal 1996, RFC renewed this facility and increased its amount to $2.1
billion from $1.75 billion. RFC currently plans to renew or replace this
facility prior to its expiration in October 1997. Under the terms of the
asset-backed commercial paper program, certain assets of RFC were subject to a
lien in the amount of $2.2 billion at fiscal year end 1996. RFC has never
borrowed from its senior bank credit facility.
The Company maintains a master collateral facility that enables MS&Co. to
pledge certain collateral to secure loan arrangements, letters of credit and
other financial accommodations (the "MS&Co. Facility"). As part of the MS&Co.
Facility, MS&Co. also maintains a secured committed credit agreement with a
group of banks that are parties to the master collateral facility under which
such banks are committed to provide up to $1.25 billion. The credit agreement
contains restrictive covenants which require, among other things, that MS&Co.
maintain specified levels of consolidated shareholders' equity and Net
Capital, as defined. In January 1997, the MS&Co. Facility was renewed and the
amount of the commitment of the credit agreement was increased to $1.5
billion. At fiscal year end 1996, no borrowings were outstanding under the
MS&Co. Facility.
The Company also maintains a revolving committed financing facility that
enables MSIL to secure committed funding from a syndicate of banks by
providing a broad range of collateral under repurchase agreements (the "MSIL
Facility"). Such banks are committed to provide up to an aggregate of $1.25
billion available in 12 major currencies. The facility agreements contain
restrictive covenants which require, among other things, that MSIL maintain
specified levels of Shareholders' Equity and Financial Resources, each as
defined. In December 1996, the MSIL Facility was renewed, and the amount of
the commitment was increased to $1.55 billion. At fiscal year end 1996, no
borrowings were outstanding under the MSIL Facility.
The Company anticipates that it will utilize the Morgan Stanley Facility,
the DWD Facility, the MS&Co. Facility or the MSIL Facility for short-term
funding from time to time. RFC anticipates that it will utilize its facility
for short-term funding from time to time.
6. LONG-TERM BORROWINGS
Maturities And Terms
Long-term borrowings at fiscal year end consist of the following:
--------
(1)Weighted average coupon was calculated utilizing non-U.S. dollar interest
rates.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Medium-Term Notes
Included in the table above are medium-term notes of $13,272 million and
$6,022 million at fiscal year end 1996 and 1995. The effective weighted
average interest rate on all medium-term notes was 5.8% in fiscal 1996 and
6.2% in fiscal 1995. Maturities of these notes range from fiscal 1997 through
fiscal 2023.
Structured Borrowings
U.S. dollar index/equity linked borrowings includes various structured
instruments whose payments and redemption values are linked to the performance
of a specific index (i.e., Standard & Poor's 500), a basket of stocks or a
specific equity security. To minimize the exposure resulting from movements in
the underlying equity position or index, the Company has entered into various
equity swap contracts and purchased options which effectively convert the
borrowing costs into floating rates based upon London Interbank Offered Rates
("LIBOR"). These instruments are included in the preceding table at their
redemption values based on the performance of the underlying indices, baskets
of stocks, or specific equity securities at fiscal year end 1996 and 1995.
Other Borrowings
U.S. dollar contractual floating rate borrowings bear interest based on a
variety of money market indices, including LIBOR and Federal Funds rates. Non-
U.S. dollar contractual floating rate borrowings bear interest based on Euro
floating rates.
Included in the Company's long-term borrowings are subordinated notes of
$1,325 million and $1,298 million at fiscal year end 1996 and 1995. The
effective weighted average interest rate on these subordinated notes was 7.0%
in fiscal 1996 and fiscal 1995. Maturities of the subordinated notes range
from fiscal 1999 to fiscal 2016.
Certain of the Company's long-term borrowings are redeemable prior to
maturity at the option of the holder. These notes contain certain provisions
which effectively enable noteholders to put the notes back to the Company and
therefore are scheduled in the foregoing table to mature in fiscal 1997
through fiscal 1999. The stated maturities of these notes, which aggregate
$1,480 million, are from 1998 to 2004.
In fiscal 1995, MS&Co., a registered U.S. broker-dealer subsidiary of the
Company, issued approximately $263 million of 6.81% fixed rate subordinated
Series C notes, $96 million of 7.03% fixed rate subordinated Series D notes,
$82 million of 7.28% fixed rate subordinated Series E notes and $25 million of
7.82% fixed rate subordinated Series F notes. These notes have maturities from
2001 to 2016. The terms of such notes contain restrictive covenants which
require, among other things, that MS&Co. maintain specified levels of
Consolidated Tangible Net Worth and Net Capital, each as defined. In fiscal
1996, MS&Co. issued an additional $50 million of Series C notes.
Asset and Liability Management
A portion of the Company's fixed rate long-term borrowings is used to fund
highly liquid marketable securities, short-term receivables arising from
securities transactions and consumer loans. The Company uses interest rate
swaps to more closely match the duration of these borrowings to the duration
of the assets being funded and to minimize interest rate risk. These swaps
effectively convert certain of the Company's fixed rate borrowings into
floating rate obligations. In addition, for non-U.S. dollar currency
borrowings that are not used to fund assets in the same currency, the Company
has entered into currency swaps which effectively convert the
14
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
borrowings into U.S. dollar obligations. The Company's use of swaps for asset
and liability management reduced its interest expense and effective average
borrowing rate as follows:
--------
(1) Included in the weighted average and effective average calculations are
non-U.S. dollar interest rates.
The effective weighted average interest rate on the Company's index/equity
linked notes, which is not included in the table above, was 5.6% and 6.0% in
fiscal 1996 and fiscal 1995, respectively, after giving effect to the related
hedges.
The table below summarizes the notional or contract amounts of these swaps
by maturity and weighted average interest rates to be received and paid at
fiscal year end 1996. Swaps utilized to hedge the Company's structured
borrowings are presented at their redemption values:
--------
(1) The differences between the receive rate and the pay rate may reflect
differences in the rate of interest associated with the underlying
currency.
(2) These amounts include currency swaps used to effectively convert
borrowings denominated in one currency into obligations denominated in
another currency.
(3) The table was prepared under the assumption that interest rates remain
constant at year-end levels. The variable interest rates to be received or
paid will change to the extent that rates fluctuate. Such changes may be
substantial. Variable rates presented generally are based on LIBOR or
Treasury bill rates.
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MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
As noted above, the Company uses interest rate and currency swaps to modify
the terms of its existing borrowings. Activity during the periods in the
notional value of the swap contracts used by the Company for asset and
liability management (and the unrecognized gain at period end) is summarized
in the table below:
Purchased interest rate cap agreements, which effectively establish a
maximum interest rate on certain of the Company's floating rate financings,
are derivative financial instruments which, by their nature, have no off-
balance sheet risk of loss due to unfavorable interest rate movements. The
Company pays an initial premium, which is recorded on the balance sheet and
amortized to interest expense over the term of the cap agreement. Benefits
received are recorded as a reduction of interest expense. The Company had
outstanding purchased interest rate cap agreements with notional amounts of
$40 million and $415 million at fiscal year end 1996 and 1995, of which $40
million were in effect at fiscal year end 1996 and 1995.
The Company also uses interest rate swaps to modify certain of its
repurchase financing agreements. The Company had interest rate swaps with
notional values of approximately $1.1 billion and $2.1 billion at fiscal year
end 1996 and 1995, and unrecognized gains of approximately $14 million and $45
million as of fiscal year end 1996 and 1995, for such purpose. The
unrecognized gains on these swaps were offset by unrecognized losses on
certain of the Company's repurchase financing agreements.
The estimated fair value of the Company's long-term borrowings approximated
carrying value based on rates available to the Company at year end for
borrowings with similar terms and maturities.
Cash paid for interest for the Company's borrowings and deposits
approximated interest expense in fiscal 1996, 1995 and 1994.
7. COMMITMENTS AND CONTINGENCIES
The Company has non-cancelable operating leases covering office space and
equipment. At fiscal year end 1996, future minimum rental commitments under
such leases (net of subleases, principally on office rentals) were as follows
(dollars in millions).
16
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Occupancy lease agreements, in addition to base rentals, generally provide
for rent and operating expense escalations resulting from increased
assessments for real estate taxes and other charges. Total rent expense, net
of sublease rental income, was $264 million, $271 million and $253 million in
fiscal 1996, 1995 and 1994.
The Company has an agreement with Advantis, a joint venture between Sears
and IBM, under which the Company receives information processing, data
networking and related services. Under the terms of the agreement, the Company
has an aggregate minimum annual commitment of $166 million subject to annual
cost of living adjustments.
During fiscal 1995, the Company recognized a pretax charge of $59 million
($39 million after tax, which reduced primary and fully diluted earnings per
share by $0.06). The charge was in connection with the relocation of the
majority of Morgan Stanley's New York City employees from leased space at 1221
and 1251 Avenue of the Americas to space in the Company's buildings at 1585
Broadway and 750 Seventh Avenue that were purchased in fiscal 1993 and fiscal
1994, respectively, as well as a move to new leased office space in Tokyo. The
charge specifically covered the Company's termination of certain leased office
space and the write-off of remaining leasehold improvements in both cities.
In the normal course of business, the Company has been named as a defendant
in various lawsuits and has been involved in certain investigations and
proceedings. Some of these matters involve claims for substantial amounts.
Although the ultimate outcome of these matters cannot be ascertained at this
time, it is the opinion of management, after consultation with outside
counsel, that the resolution of such matters will not have a material adverse
effect on the consolidated financial condition of the Company, but may be
material to the Company's operating results for any particular period,
depending upon the level of the Company's income for such period.
The Company had approximately $3.4 billion of letters of credit outstanding
at fiscal year end 1996 to satisfy various collateral requirements.
Financial instruments sold, not yet purchased represent obligations of the
Company to deliver specified financial instruments at contracted prices,
thereby creating commitments to purchase the financial instruments in the
market at prevailing prices. Consequently, the Company's ultimate obligation
to satisfy the sale of financial instruments sold, not yet purchased may
exceed the amounts recognized in the consolidated statements of financial
condition.
The Company also has commitments to fund certain fixed assets and other less
liquid investments, including at fiscal year end 1996, approximately $208
million in connection with its merchant banking and other principal investment
activities. Additionally, the Company has provided and will continue to
provide financing, including margin lending and other extensions of credit to
clients (including subordinated loans on an interim basis to leveraged
companies associated with its investment banking and its merchant banking and
other principal investment activities), that may subject the Company to
increased credit and liquidity risks.
8. TRADING ACTIVITIES
Trading Revenues
The Company's trading activities include providing securities brokerage,
derivatives dealing, and underwriting services to clients. While trading
activities are generated by client order flow, the Company also takes
proprietary positions based on expectations of future market movements and
conditions. The Company's trading strategies rely on the integrated management
of its client-driven and proprietary transactions, along with the hedging and
financing of these positions.
17
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company manages its trading businesses by product groupings and
therefore has established distinct, worldwide trading divisions having
responsibility for equity, fixed income, foreign exchange and commodities
products. Because of the integrated nature of the markets for such products,
each product area trades cash instruments as well as related derivative
products (i.e., options, swaps, futures, forwards and other contracts with
respect to such underlying instruments or commodities). Revenues related to
principal trading are summarized below by trading division:
Interest revenue and expense are integral components of trading activities.
In assessing the profitability of trading activities, the Company views net
interest and principal trading revenues in the aggregate.
The Company's trading portfolios are managed with a view toward the risk and
profitability of the portfolios to the Company. The nature of the equities,
fixed income, foreign exchange and commodities activities conducted by the
Company, including the use of derivative products in these businesses, and the
market, credit and concentration risk management policies and procedures
covering these activities are discussed below.
Equities
The Company makes markets and trades in the global secondary markets for
equities and convertible debt and is a dealer in equity warrants, exchange
traded and OTC equity options, index futures, equity swaps and other
sophisticated equity derivatives. The Company's activities as a dealer
primarily are client-driven, with the objective of meeting clients' needs
while earning a spread between the premiums paid or received on its contracts
with clients and the cost of hedging such transactions in the cash or forward
market or with other derivative transactions. The Company limits its market
risk related to these contracts, which stems primarily from underlying
equity/index price and volatility movements, by employing a variety of hedging
strategies, such as delta hedging (delta is a measure of a derivative
contract's price movement based on the movement of the price of the security
or index underlying the contract). The Company also takes proprietary
positions in the global equity markets by using derivatives, most commonly
futures and options, in addition to cash positions, intending to profit from
market price and volatility movements in the underlying equities or indices
positioned.
Equity option contracts give the purchaser of the contract the right to buy
(call) or sell (put) the equity security or index underlying the contract at
an agreed-upon price (strike price) during or at the conclusion of a specified
period of time. The seller (writer) of the contract is subject to market risk,
and the purchaser is subject to market risk (to the extent of the premium
paid) and credit risk. Equity swap contracts are contractual agreements
whereby one counterparty receives the appreciation (or pays the depreciation)
on an equity investment in return for paying another rate, often based upon
equity index movements or interest rates. The counterparties to the Company's
equity transactions include commercial banks, investment banks, broker-
dealers, investment funds and industrial companies.
18
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Fixed Income
The Company is a market-maker for U.S. and non-U.S. government securities,
corporate bonds, money market instruments, medium-term notes and Eurobonds,
high-yield securities, emerging market securities, mortgage- and other asset-
backed securities, preferred stock and tax-exempt securities. In addition, the
Company is a dealer in interest rate and currency swaps and other related
derivative products, OTC options on U.S. and foreign government bonds and
mortgage-backed forward agreements ("TBA"), options and swaps. In this
capacity, the Company facilitates asset and liability management for its
customers in interest rate and currency swaps and related products and OTC
government bond options.
Swaps used in fixed income trading are, for the most part, contractual
agreements to exchange interest payment streams (i.e., an interest rate swap
may involve exchanging fixed for floating interest payments) or currencies
(i.e., a currency swap may involve exchanging yen for U.S. dollars in one year
at an agreed-upon exchange rate). The Company profits by earning a spread
between the premium paid or received for these contracts and the cost of
hedging such contracts. The Company seeks to manage the market risk of its
swap portfolio, which stems from interest rate and currency movements and
volatility, by using modeling that quantifies the sensitivity of its portfolio
to movements in interest rates and currencies and by adding positions to or
selling positions from its portfolio as needed to minimize such sensitivity.
Typically, the Company adjusts its positions by entering into additional swaps
or interest rate and foreign currency futures, foreign currency forwards and
underlying government bonds. The Company manages the risk related to its
option portfolio by using a variety of hedging strategies such as delta
hedging, which includes the use of futures and forward contracts to hedge
market risk. The Company also is involved in using debt securities to
structure products with multiple risk/return factors designed to suit investor
objectives.
The Company is an underwriter of and a market-maker in mortgage-backed
securities and collateralized mortgage obligations ("CMO") as well as
commercial, residential and real estate loan products. The Company also
structures mortgage-backed swaps for its clients, enabling them to derive the
cash flows from an underlying mortgage-backed security without purchasing the
cash position. It earns the spread between the premium inherent in the swap
and the cost of hedging the swap contract through the use of cash positions or
TBA contracts. The Company also uses TBAs in its role as a dealer in mortgage-
backed securities and facilitates customer trades by taking positions in the
TBA market. Typically, these positions are hedged by offsetting TBA contracts
or underlying cash positions. The Company profits by earning the bid-offer
spread on such transactions. Further, the Company uses TBAs to ensure delivery
of underlying mortgage-backed securities in its CMO issuance business. As is
the case with all mortgage-backed products, market risk associated with these
instruments results from interest rate fluctuations and changes in mortgage
prepayment speeds. The counterparties to the Company's fixed income
transactions include investment advisors, commercial banks, insurance
companies, investment funds and industrial companies.
Foreign Exchange
The Company is a market-maker in a number of foreign currencies. In this
business, it actively trades currencies in the spot and forward markets
earning a dealer spread. The Company seeks to manage its market risk by
entering into offsetting positions. The Company conducts an arbitrage business
in which it seeks to profit from inefficiencies between the futures, spot and
forward markets. The Company also makes a market in foreign currency options.
This business largely is client-driven and involves the purchasing and writing
of European and American style options and certain sophisticated products to
meet specific client needs. The Company profits in this business by earning
spreads between the options' premiums and the cost of the hedging of such
positions. The Company limits its market risk by using a variety of hedging
strategies, including the buying and selling of the currencies underlying the
options based upon the options' delta equivalent. Foreign exchange option
contracts give the purchaser of the contract the right to buy (call) or sell
(put) the currency underlying the contract at an
19
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
agreed-upon strike price at or over a specified period of time. Forward
contracts and futures represent commitments to purchase or sell the underlying
currencies at a specified future date at a specified price. The Company also
takes proprietary positions in major currencies to profit from market price
and volatility movements in the currencies positioned.
The majority of the Company's foreign exchange business relates to major
foreign currencies such as deutsche marks, yen, pound sterling, French francs,
Swiss francs, lire and Canadian dollars. The balance of the business covers a
broad range of other currencies. The counterparties to the Company's foreign
exchange transactions include commercial banks, investment banks, broker-
dealers, investment funds and industrial companies.
Commodities
The Company, as a major participant in the world commodities markets, trades
in physical precious, base and platinum group metals, electricity, energy
products (principally oil, refined oil products and natural gas) as well as a
variety of derivatives related to these commodities such as futures, forwards
and exchange traded and OTC options and swaps. Through these activities, the
Company provides clients with a ready market to satisfy end users' current raw
material needs and facilitates their ability to hedge price fluctuations
related to future inventory needs. The former activity at times requires the
positioning of physical commodities. Derivatives on those commodities, such as
futures, forwards and options, often are used to hedge price movements in the
underlying physical inventory. The Company profits as a market-maker in
physical commodities by capturing the bid and offer spread inherent in the
physical markets.
To facilitate hedging for its clients, the Company often is required to take
positions in the commodity markets in the form of forward, option and swap
contracts involving oil, natural gas and electricity. The Company generally
hedges these positions by using a variety of hedging techniques such as delta
hedging, whereby the Company takes positions in the physical markets and/or
positions in other commodity derivatives such as futures and forwards to
offset the market risk in the underlying derivative. The Company profits from
this business by earning a spread between the premiums paid or received for
these derivatives and the cost of hedging such derivatives.
The Company also maintains proprietary trading positions in commodity
derivatives, including futures, forwards and options in addition to physical
commodities, to profit from price and volatility movements in the underlying
commodities markets.
Forward, option and swap contracts on commodities are structured similarly
to like-kind derivative contracts for cash financial instruments. The
counterparties to OTC commodity contracts include precious metals producers,
refiners and consumers as well as shippers, central banks, and oil, gas and
electricity producers.
The following discussions of risk management, market risk, credit risk,
concentration risk and customer activities relates to the Company's securities
businesses.
Securities Risk Management
Risk management at the Company is an integrated process with independent
oversight which requires constant communication, judgment and knowledge of
specialized products and markets. The Company's senior management takes an
active role in the risk management process and has developed policies and
procedures that require specific administrative and business functions to
assist in the identification, assessment and control of various risks. In
recognition of the increasingly varied and complex nature of the financial
services business, the
20
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Company's risk management policies and procedures are evolutionary in nature
and are subject to ongoing review, modification and revision. Many of the
Company's risk management and control practices are subject to periodic review
by the Company's internal auditors and independent accountants, as well as
interactions with various regulatory authorities. The Company continues to be
committed to employing qualified personnel with appropriate expertise in each
of its various administrative and business areas to implement effectively the
Company's risk management and monitoring systems and processes.
The Company has developed a multi-tiered approach for monitoring and
managing its risks. The Finance and Risk Committee, authorized by the
Company's Board of Directors, is chaired by the Company's Chief Financial
Officer and is composed of senior officers with familiarity and expertise in
dealing with risk management principles. It establishes the overall risk
management policies of the Company, reviews the Company's performance relative
to these policies, allocates capital among business activities of the Company,
monitors the availability of sources of financing, reviews the foreign
exchange risk of the Company, and oversees the liquidity and interest rate
sensitivity of the Company's asset and liability position. The Firm Risk
Manager heads the Firm Risk Management Group (described below) and assists
senior management and the Finance and Risk Committee in establishing,
monitoring and controlling the Company's overall risk profile. With respect to
the Company's major trading divisions (fixed income, equity, commodities and
foreign exchange), division risk managers monitor and manage positions and set
the overall division risk profile on a worldwide basis within established
market risk limits, review major trading positions and strategies, and report
major market and position events to the Firm Risk Manager. Desk risk managers
perform similar functions with respect to a product area or particular product
at the business unit and trading desk level.
The Firm Risk Management Group has operational responsibility for
identifying, monitoring and reporting to senior management on the Company's
exposure to risk. The Firm Risk Management Group includes three departments
that are all independent of the Company's business areas: the Market Risk
Department monitors the Company's market risk profile on a worldwide basis,
which includes all divisional, geographic and product-line market risks; the
Credit Department manages and monitors counterparty exposure limits on a
worldwide basis; the Internal Audit Department, which also reports to the
Audit Committee of the Board of Directors, assesses the Company's operations
and control environment through periodic examinations of business and
operational areas.
During fiscal 1996, the Company established a Risk Management Advisory Board
which advises the Firm Risk Management Group on risk measurement
methodologies, models and systems and establishes review procedures for models
used by the Company for valuation and risk measurement. Other departments
within the Company that are independent of the Company's business areas and
also are actively involved in monitoring the Company's risk profile include:
Controllers, Corporate Treasury, Information Technology, Legal and Compliance,
Tax and Operations.
In addition, the Company has certain commitment committees that are involved
in managing and monitoring the risks associated with the Company's diverse
businesses. These committees are composed of a cross section of the Company's
senior officers from various disciplines. The High-Yield Commitment Committee
and Equity Commitment Committee determine whether the Company should
participate in a transaction involving the underwriting or placement of high-
yield or equity securities, respectively, where the Company's capital and
reputation may be at risk, and evaluate the potential revenues and risks
involved with respect to a particular transaction.
Securities Market Risk
Market risk refers to the risk that a change in the level of one or more
market prices, rates, indices, volatilities, correlations or other market
factors, such as liquidity, will result in losses for a specified position or
portfolio.
21
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Company manages the market risk associated with its trading activities
Company-wide, on a divisional level worldwide and on an individual product
basis. Specific market risk guidelines and limits have been approved for the
Company and each trading division of the Company worldwide by the Finance and
Risk Committee. Discrete market risk limits are assigned to business units and
trading desks within trading areas which are compatible with the trading
division limits. Division risk managers, desk risk managers and the Market
Risk Department all monitor market risk measures against limits.
The Market Risk Department independently reviews the Company's trading
portfolios on a regular basis from a market risk perspective which includes
value at risk and other quantitative and qualitative risk measurements and
analyses. The Company may use measures, such as rate sensitivity, convexity,
volatility and time decay measurements, to estimate market risk and to assess
the sensitivity of positions to changes in market conditions. Stress testing,
which measures the impact on the value of existing portfolios of specified
changes in market factors, for certain products is performed periodically and
is reviewed by division risk managers, desk risk managers and the Market Risk
Department.
Securities Credit Risk
The Company's exposure to credit risk arises from the possibility that a
counterparty to a transaction might fail to perform under its contractual
commitment, resulting in the Company incurring losses. The Finance and Risk
Committee has approved Company-wide credit guidelines which limit the
Company's credit exposure to any one counterparty. Specific credit risk limits
based on the credit guidelines also have been approved by the Finance and Risk
Committee for each type of counterparty (by rating category) as well as
secondary positions of high-yield and emerging market debt.
The Credit Department administers and monitors the credit limits among
trading divisions on a worldwide basis. In addition to monitoring credit
limits, the Company manages the credit exposure relating to its trading
activities by reviewing counterparty financial soundness periodically, by
entering into master netting agreements and collateral arrangements with
counterparties in appropriate circumstances and by limiting the duration of
exposure. In certain cases, the Company also may close out transactions or
assign them to other counterparties to mitigate credit risk.
Securities Concentration Risk
The Company is subject to concentration risk by holding large positions in
certain types of securities or commitments to purchase securities of a single
issuer, including sovereign governments and other entities, issuers located in
a particular country or geographic area, public and private issuers involving
developing countries or issuers engaged in a particular industry. Financial
instruments owned by the Company include U.S. government and agency securities
and securities issued by other sovereign governments (principally Japan,
Germany and Italy), which, in the aggregate, represented approximately 13% of
the Company's total assets at fiscal year end 1996. In addition, substantially
all of the collateral held by the Company for resale agreements or bonds
borrowed, which together represented approximately 30% of the Company's total
assets at fiscal year end 1996, consists of securities issued by the U.S.
government, federal agencies or other sovereign government obligations.
Positions taken and commitments made by the Company, including positions taken
and underwriting and financing commitments made in connection with its
merchant banking and principal investment activities, often involve
substantial amounts and significant exposure to individual issuers and
businesses, including non-investment grade issuers. The Company seeks to limit
concentration risk through the use of the systems and procedures described in
the preceding discussions of market and credit risk.
Securities Customer Activities
The Company's customer activities involve the execution, settlement, custody
and financing of various securities and commodities transactions on behalf of
customers. Customer securities activities are transacted on
22
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
either a cash or margin basis. Customer commodities activities, which include
the execution of customer transactions in commodity futures transactions
(including options on futures), are transacted on a margin basis.
The Company's customer activities may expose it to off-balance sheet credit
risk. The Company may have to purchase or sell financial instruments at
prevailing market prices in the event of the failure of a customer to settle a
trade on its original terms or in the event cash and securities in customer
margin accounts are not sufficient to fully cover customer losses. The Company
seeks to control the risks associated with customer activities by requiring
customers to maintain margin collateral in compliance with various regulations
and Company policies.
Notional/Contract Amounts and Fair Values of Derivatives
The gross notional or contract amounts of derivative instruments and fair
value (carrying amount) of the related assets and liabilities at fiscal year
end 1996 and 1995, as well as the average fair value of those assets and
liabilities for fiscal year 1996 and 1995, are presented in the table which
follows. Fair value represents the cost of replacing these instruments and is
further described in Note 2. Future changes in interest rates, foreign
currency exchange rates or the fair values of the financial instruments,
commodities or indices underlying these contracts may ultimately result in
cash settlements exceeding fair value amounts recognized in the consolidated
statements of financial condition. Assets represent unrealized gains on
purchased exchange traded and OTC options and other contracts (including
interest rate, foreign exchange and other forward contracts and swaps) in gain
positions net of any unrealized losses owed to these counterparties on
offsetting positions in situations where netting is consistent with FASB
Interpretation No. 39. Similarly, liabilities represent net amounts owed to
counterparties. These amounts will vary based on changes in the fair values of
underlying financial instruments and/or the volatility of such underlying
instruments:
--------
(1) The notional amounts of derivatives have been adjusted to reflect the
effects of leverage, where applicable.
(2) Notional amounts include purchased and written options of $247 billion and
$193 billion, respectively, at fiscal year end 1996, and $139 billion and
$100 billion, respectively, at fiscal year end 1995.
(3) These amounts represent carrying value (exclusive of collateral) at fiscal
year end 1996 and 1995, respectively, and do not include receivables or
payables related to exchange traded futures contracts.
(4) Amounts are calculated using a monthly average.
23
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The gross notional or contract amounts of these instruments are indicative
of the Company's degree of use of derivatives for trading purposes but do not
represent the Company's exposure to market or credit risk. Credit risk 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 fair value of the contracts reported as assets. These amounts
are presented on a net-by-counterparty basis consistent with FASB
Interpretation No. 39 but are not reported net of collateral, which the
Company obtains with respect to certain of these transactions to reduce its
exposure to credit losses. The Company monitors the creditworthiness of
counterparties to these transactions on an ongoing basis and requests
additional collateral when deemed necessary. The Company believes that the
ultimate settlement of the transactions outstanding at fiscal year end 1996
will not have a material effect on the Company's financial condition.
The remaining maturities of the Company's swaps and other derivative
products at fiscal year end 1996 and 1995 are summarized in the following
table, showing notional values by year of expected maturity:
24
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The credit quality of the Company's trading-related derivatives at fiscal
year end 1996 and 1995 is summarized in the table below, showing the fair
value of the related assets by counterparty credit rating. The actual credit
ratings are determined by external rating agencies or by equivalent ratings
used by the Company's Credit Department:
The Company has also obtained assets posted as collateral by investment
grade counterparties amounting to $948 million and $883 million at fiscal year
end 1996 and fiscal year end 1995, respectively.
25
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
9. PREFERRED STOCK AND CAPITAL UNITS
Preferred stock is composed of the following issues:
Each issue of outstanding preferred stock ranks in parity with all other
outstanding preferred stock of the Company.
During fiscal 1996, the Company redeemed all 5,500,000 shares of its 9.36%
Cumulative Preferred Stock at a redemption price of $25.156 per share, which
reflected the stated value of $25 per share together with an amount equal to
all dividends accrued and unpaid to, but excluding, the redemption date.
During fiscal 1996, the Company issued 4,000,000 Depositary Shares,
representing 1,000,000 shares of 7 -3/4% Cumulative Preferred Stock, in an
aggregate amount of $200 million. Each Depositary Share represents 1/4 of a
share of such preferred stock.
During fiscal 1996, the Company issued 6,900,000 Depositary Shares,
representing 1,725,000 shares of Series A Fixed/Adjustable Rate Cumulative
Preferred Stock ("FRAPS"), in the aggregate amount of $345 million. The FRAPS
will pay a fixed dividend rate of 5.91% through 2001, after which it will pay
a floating rate based upon certain U.S. Treasury securities. Each Depositary
Share represents 1/4 of a share of such preferred stock.
Subsequent to fiscal year end 1996, the Company redeemed all 975,000 shares
of its 8.88% Cumulative Preferred Stock at a redemption price of $201.632 per
share, which reflects the stated value of $200 per share together with an
amount equal to all dividends accrued and unpaid to, but excluding, the
redemption date. In addition, the Company announced that it had called for
redemption, on May 30, 1997, all 750,000 shares of its 8- 3/4% Cumulative
Preferred Stock at a redemption price of $200 per share.
The Company has Capital Units outstanding which were issued by the Company
and Morgan Stanley Finance plc ("MS plc"), a U.K. subsidiary. A Capital Unit
consists of (a) a Subordinated Debenture of MS plc guaranteed by the Company
and having maturities from 2013 to 2015 and (b) a related Purchase Contract
issued by the Company, which may be accelerated by the Company beginning
approximately one year after the issuance of each Capital Unit, requiring the
holder to purchase one Depositary Share representing shares (or fractional
shares) of the Company's Cumulative Preferred Stock. The aggregate amount of
Capital Units outstanding was $865 million at fiscal year end 1996 and 1995.
Subsequent to fiscal year end 1996, the Company and MS plc issued 8.03%
Capital Units in the aggregate amount of $134 million which mature in 2017.
The estimated fair value of the Capital Units was $866 million and $872
million at fiscal year end 1996 and fiscal year end 1995, respectively.
26
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10. COMMON STOCK AND SHAREHOLDERS' EQUITY
In conjunction with the Merger, the Company increased the number of
authorized common shares to 1,750 million and changed the number of authorized
preferred shares to 30 million.
During the fiscal year 1996, the Company repurchased or acquired shares of
its common stock at an aggregate cost of $1,133 million and an average cost
per share of $26.96. Prior to the consummation of the Merger, both Morgan
Stanley and Dean Witter Discover rescinded their respective outstanding share
repurchase authorizations. At the time of the Merger, Morgan Stanley common
stock which had been held in treasury was retired.
DWR, a registered broker-dealer and a registered futures commission
merchant, is subject to the uniform net capital rule under the Securities
Exchange Act of 1934. Under the alternative method permitted by this Rule, the
required net capital, as defined, shall not be less than the greater of (a)
one million dollars, (b) 2% of aggregate debit balances arising from client
transactions pursuant to the Securities Exchange Act of 1934 Rule 15c3-3, or
(c) 4% of the funds required to be segregated pursuant to the Commodity
Exchange Act. The New York Stock Exchange, Inc. may also require a member
organization to reduce its business if its net capital is less than the
greater of (a) 4% of aggregate debit balances or (b) 6% of the funds required
to be segregated and may prohibit a member organization from expanding its
business and declaring cash dividends if its net capital is less than the
greater of (a) 5% of aggregate debit balances or (b) 7% of the funds required
to be segregated. At fiscal year end 1996, DWR's net capital was $589 million
and net capital in excess of the minimum required was $475 million. DWR's net
capital was 19.7% of aggregate debit balances and 20.6% of funds required to
be segregated.
MS&Co. is a registered broker-dealer and a registered futures commission
merchant and, accordingly, is subject to the minimum net capital requirements
discussed above. MS&Co. has consistently operated in excess of these
requirements with aggregate net capital, as defined, totaling $1,357 million
at fiscal year end 1996, which exceeded the amount required by $1,055 million.
MSIL, a London-based broker-dealer subsidiary, is subject to the capital
requirements of the Securities and Futures Authority, and MSJL, a Tokyo-based
broker-dealer, is subject to the capital requirements of the Japanese Ministry
of Finance. MSIL and MSJL have consistently operated in excess of their
respective regulatory capital requirements.
Under regulatory net capital requirements adopted by the Federal Deposit
Insurance Corporation ("FDIC") and other regulatory capital guidelines, FDIC
insured financial institutions must maintain (a) 3% to 5% of Tier 1 capital,
as defined, to total assets ("leverage ratio") and (b) 8% combined Tier 1 and
Tier 2 capital, as defined, to risk weighted assets ("risk-weighted capital
ratio"). At fiscal year end 1996, the leverage ratio and risk-weighed capital
ratio of each of the Company's FDIC insured financial institutions exceeded
these and all other regulatory minimums.
Certain other U.S. and non-U.S. subsidiaries are subject to various
securities, commodities and banking regulations, and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. These subsidiaries have consistently operated
in excess of their local capital adequacy requirements. Morgan Stanley
Derivative Products Inc., the Company's triple-A rated derivative products
subsidiary, also has established certain operating restrictions which have
been reviewed by various rating agencies.
The regulatory capital requirements referred to above, and certain covenants
contained in various agreements governing indebtedness of the Company, may
restrict the Company's ability to withdraw capital from its subsidiaries. At
fiscal year end 1996, approximately $4.0 billion of net assets of consolidated
subsidiaries may be restricted as to the payment of cash dividends and
advances to the Company.
27
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Cumulative translation adjustments include gains or losses resulting from
translating foreign currency financial statements from their respective
functional currencies to U.S. dollars, net of hedge gains or losses and
related tax effects. The Company uses foreign currency contracts and
designates certain non-U.S. dollar currency debt as hedges to manage the
currency exposure relating to its net monetary investments in non-U.S. dollar
functional currency subsidiaries. Increases or decreases in the value of the
Company's net foreign investments generally are tax-deferred for U.S.
purposes, but the related hedge gains and losses are taxable currently.
Therefore, the gross notional amounts of the contracts and debt designated as
hedges exceed the Company's net foreign investments to result in effective
hedging on an after-tax basis. The Company attempts to protect its net book
value from the effects of fluctuations in currency exchange rates on its net
monetary investments in non-U.S. dollar subsidiaries by selling the
appropriate non-U.S. dollar currency in the forward market. However, under
some circumstances, the Company may elect not to hedge its net monetary
investments in certain foreign operations due to market conditions, including
the availability of various currency contracts at acceptable costs.
Information relating to the hedging of the Company's net monetary investments
in non-U.S. dollar functional currency subsidiaries and their effects on
cumulative translation adjustments is summarized below:
--------
(1) Notional amounts represent the contractual currency amount translated at
respective fiscal year-end spot rates.
11. EMPLOYEE COMPENSATION PLANS
The Company has adopted a variety of compensation plans for certain of its
employees. These plans are designed to facilitate a pay-for-performance
policy, provide compensation commensurate with other leading financial
services companies and provide for internal ownership in order to align the
interests of employees with the long-term interests of the Company's
shareholders.
The Company's employee compensation plans currently consist of the
continuation of Dean Witter Discover's and Morgan Stanley's respective plans
that were in effect prior to the Merger. Accordingly, the following
information summarizes the Dean Witter Discover and Morgan Stanley predecessor
plans.
DEAN WITTER DISCOVER PREDECESSOR PLANS
Equity-Based Employee Incentive Awards
The Company is authorized to issue up to 38.2 million shares of its common
stock in connection with awards under several Dean Witter Discover equity-
based employee incentive plans.
28
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Stock option activity under these Dean Witter Discover plans was as follows
(share data in millions).
At fiscal year end 1996, 12.5 million shares were available for future grant
under these Dean Witter Discover plans.
These Dean Witter Discover plans are "non-compensatory" under APB No. 25,
and, accordingly, no charge to earnings has been recorded.
Employee Stock Purchase Plan
Under the Dean Witter Discover Employee Stock Purchase Plan, employees may
purchase shares of the Company's common stock at not less than 85% of the fair
value on the date of purchase. The Company is authorized to issue up to 2.2
million shares of common stock under this plan. Employees of the Company
purchased 1 million shares of common stock in each of fiscal years 1996 and
1995.
The discount to fair value was $2 million for fiscal 1996 and $1 million for
fiscal 1995. The plan is "non-compensatory" under APB No. 25, and,
accordingly, no charge to earnings has been recorded for the amount of the
discount to fair value.
Deferred Compensation Awards
The Company is authorized to issue up to 16.3 million shares of its common
stock under the terms of its Dean Witter Discover deferred compensation plans.
These plans provide for the deferral of a portion of certain employees'
compensation with payment made in the form of shares of the Company's common
stock. In fiscal 1996 and 1995, the Company recorded compensation expense of
$87 million and $57 million and unearned compensation of $8 million and $6
million in connection with the award of approximately 3.0 million and 2.4
29
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
million shares of common stock under these plans in fiscal 1996 and 1995.
These shares were issued in fiscal 1997 and 1996, and are held in custodial or
trust accounts pending employee eligibility to receive the shares. Unearned
compensation is recognized over the related plan vesting periods.
Non-Employee Director Awards
The Company sponsors stock plans for non-employee directors under which 0.4
million shares of the Company's common stock have been authorized for issuance
in the form of option grants, stock awards or deferred compensation. The fair
value of awards granted under this plan is charged to expense over the vesting
period of the related grant. The effect of these grants on results of
operations was not material.
401(k) Plan
Employees of Dean Witter Discover are eligible to participate in the Dean
Witter Discover 401(k) plan upon meeting certain eligibility requirements. The
Company matches a portion of each participant's contribution based upon the
performance of the Company. The Company's contributions to the Dean Witter
Discover 401(k) plan were $42 million, $37 million and $34 million in fiscal
1996, 1995 and 1994.
Employees Equity Accumulation Plan
The Dean Witter Discover shareholders approved the Dean Witter Discover &
Co. Employees' Equity Accumulation Plan on May 28, 1997. This plan is intended
to align key employees' interest with shareholders' through equity-based
compensation and to permit the granting of awards that will constitute
performance-based compensation for certain executive officers. Under this
plan, the Company will issue an aggregate of not more than 30 million shares
of common stock.
MORGAN STANLEY PREDECESSOR PLANS
Equity Incentive Compensation Plan
Stock units representing Morgan Stanley's employees' rights to receive
unrestricted common shares ("Stock Units") are awarded annually to key
employees; compensation expense for all such awards (including those subject
to forfeiture) amounted to $447 million, $178 million and $171 million for
fiscal 1996, fiscal 1995 and fiscal 1994. Compensation expense for such awards
was determined based on the fair value of the Company's common stock (as
defined in the plan). Stock Units had been awarded pursuant to the Morgan
Stanley 1988 Equity Incentive Compensation Plan. On April 3, 1996, Morgan
Stanley shareholders approved the Morgan Stanley 1995 Equity Incentive
Compensation Plan, and Stock Unit awards are now granted under this plan only.
For purposes of this footnote, the term "EICP" shall refer collectively to the
Morgan Stanley 1988 Equity Incentive Compensation Plan and the Morgan Stanley
1995 Equity Incentive Compensation Plan.
Stock Units generally will convert to shares of the Company's common stock
within five or 10 years from grant (or earlier in the event of the holder's
death or retirement, as defined). Holders of Stock Units generally have all
the rights of a common shareholder, subject to restrictions on transfer of
ownership of the units for the five- or 10-year period. Holders of the Stock
Units generally will forfeit ownership only in certain limited situations,
including termination for cause during the restriction period. In addition,
holders of the Stock Units having a 10-year restriction period, which were
awarded in respect of services for fiscal years 1992 to 1995, and holders of
Stock Units which were awarded in respect of services for fiscal 1996, will
generally forfeit ownership of a portion of their Stock Units if their
employment is terminated before the end of the relevant restriction period.
30
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
On April 3, 1996, the Company's shareholders approved the reservation of
144,319,699 million shares of common stock for awards under the Morgan Stanley
EICP (including stock options). At fiscal year end 1996, approximately
130,350,000 million shares reserved for future awards under the Morgan Stanley
EICP remain (net of fiscal 1996 awards).
Stock Option Awards
Prior to fiscal 1989, stock options had been awarded pursuant to the Morgan
Stanley's 1986 Stock Option Plan which provided for the granting of stock
options having an exercise price not less than the fair value of the Company's
common stock (as defined in the plan) on the date of grant. Such options
generally became exercisable over a three-year period and expire 10 years from
the date of the grant. Since fiscal 1989, stock options have been awarded
pursuant to the Morgan Stanley EICP. Options awarded under the Morgan Stanley
EICP are exercisable at a price equal to the fair value of the Company's
common stock (as defined in the plan) and will generally expire seven or 10
years (depending on the year awarded) from grant.
The following table sets forth activity relating to the Morgan Stanley stock
option awards:
The following table presents information relating to Morgan Stanley stock
options outstanding at fiscal year end 1996.
Capital Accumulation Plan
Under the Morgan Stanley Capital Accumulation Plan ("CAP"), vested units
consisting of unsecured rights to receive payments based on notional interests
in existing and future risk-capital investments made directly or indirectly by
the Company ("CAP Units") are granted to key employees. The value of the CAP
Units awarded for services rendered in fiscal 1996, 1995 and 1994 was
approximately $7 million, $12 million and $14 million, respectively, all of
which relate to vested units.
31
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Carried Interest Plans
Under the Morgan Stanley Carried Interest Plans, certain key employees
effectively participate in a portion of the Company's realized gains from
certain of its equity investments in merchant banking transactions.
Compensation expense for fiscal 1996, 1995 and 1994 related to these plans
aggregated $0.2 million, $14 million and $25 million, respectively.
Real Estate Fund Plans
On September 26, 1995, the Morgan Stanley Board of Directors approved the
adoption of the Morgan Stanley Real Estate Compensation Plan and the Morgan
Stanley Real Estate Profits Participation Plan. Under these plans, select
employees and consultants may participate in certain gains realized by the
Company's real estate funds. Compensation expense relating to these plans
aggregated $13 million and $9 million for fiscal 1996 and fiscal 1995,
respectively.
The Company also has established a worldwide profit sharing plan and an
employee stock ownership plan for the benefit of substantially all Morgan
Stanley U.S. employees. The following summarizes these plans:
Profit Sharing Plan
The Company sponsors a qualified non-contributory profit sharing plan
covering substantially all Morgan Stanley's U.S. employees and also provides
cash payment of profit sharing to employees of its international subsidiaries.
Contributions are made at the discretion of management based upon the
financial performance of the Company. Total profit sharing expense for fiscal
1996, fiscal 1995 and fiscal 1994 (excluding Company contributions to the
Morgan Stanley Employee Stock Ownership Plan, which increased in fiscal 1995)
was $30 million, $14 million and $23 million, respectively.
Employee Stock Ownership Plan
The Company has a $140 million leveraged employee stock ownership plan,
funded through an independently managed trust. The Morgan Stanley Group Inc.
and Subsidiaries Employee Stock Ownership Plan ("ESOP") was established to
broaden internal ownership of the Company and to provide benefits to its
employees in a cost-effective manner. Each of the 3.7 million preferred shares
outstanding at fiscal year end 1996, is held by the ESOP trust and is
convertible into 3.3 shares of the Company's common stock and is entitled to
annual dividends of $2.78 per preferred share. The ESOP trust funded its stock
purchase through a loan of $140 million from Morgan Stanley. The ESOP trust
note, due September 19, 2010 (extendable at the option of the ESOP trust to
September 19, 2015), bears a 10- 3/8% interest rate per annum with principal
payable without penalty on or before the due date. The ESOP trust expects to
make principal and interest payments on the note from funds provided by
dividends on the shares of convertible preferred stock and contributions from
the Company. The note receivable from the ESOP trust is reflected as a
reduction in the Company's shareholders' equity. Shares allocated to employees
generally may not be withdrawn until the employee's death, disability,
retirement or termination. Upon withdrawal, each share of ESOP preferred stock
generally will be converted into 3.3 shares of the Company's common stock. If
the fair value of such 3.3 common shares at conversion is less than the $35.88
liquidation value of an ESOP preferred share, the Company will pay the
withdrawing employee the difference in additional common shares or cash.
Contributions to the ESOP by the Company and allocation of ESOP shares to
employees are made annually at the discretion of the Board of Directors. The
cost of shares allocated to participants' accounts amounted to $9 million in
fiscal 1996, $13 million in fiscal 1995 and $10 million in fiscal 1994. The
ESOP debt service costs for fiscal 1996, fiscal 1995 and fiscal 1994 were paid
from dividends received on preferred stock held by the plan and from Company
contributions.
32
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Pro forma Effect of SFAS No. 123
Had the Company elected to recognize compensation cost pursuant to SFAS No.
123 for the Morgan Stanley and the Dean Witter Discover stock option plans and
the Dean Witter Discover Employee Stock Purchase Plan, net income would have
been reduced by $60 million and $111 million for fiscal year 1996 and 1995.
Primary and fully diluted earnings per common share would have been reduced by
$0.10 and $0.18 for fiscal year 1996 and 1995.
The weighted average fair value at date of grant for Morgan Stanley options
granted during fiscal 1996 and 1995 was $9.08 and $7.57 per option,
respectively. The fair value of Morgan Stanley options at date of grant was
estimated using the Black-Scholes option pricing model utilizing the following
weighted average assumptions.
The weighted average fair value at date of grant for Dean Witter Discover
options granted during fiscal 1996 and 1995 was $6.68 and $5.46 per option,
respectively. The fair value of Dean Witter Discover options at date of grant
was estimated using a binomial option pricing model utilizing the following
weighted average assumptions.
12. EMPLOYEE BENEFIT PLANS
The Company sponsors various pension plans for the majority of its worldwide
employees. It provides certain other postretirement benefits, primarily health
care and life insurance, to eligible employees. The Company also provides
certain benefits to former or inactive employees prior to retirement. The
following summarizes these plans:
Pension Plans
Substantially all of the U.S. employees of the Company and its U.S.
affiliates are covered by a non-contributory pension plan that is qualified
under Section 401(a) of the Internal Revenue Code (the "Qualified Plan").
Unfunded supplementary plans (the "Supplemental Plans") cover certain
executives. In addition to the Qualified Plan and the Supplemental Plans
(collectively, the "U.S. Plans"), the Company maintains a separate pension
plan which covers substantially all employees of the Company's U.K.
subsidiaries (the "U.K. Plan"). Eight other international subsidiaries also
have pension plans covering substantially all of their employees. These
pension plans generally provide pension benefits that are based on each
employee's years of credited service and compensation during the final years
of employment. The Company's policy is to fund the accrued cost of the
Qualified Plan, the U.K. Plan and the other international plans currently.
Liabilities for benefits payable under the Supplemental Plans are accrued by
the Company and are funded when paid to the beneficiaries.
33
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
During fiscal 1996, the benefit structure of the U.K. Plan was changed from
a defined benefit plan to a defined contribution plan. Under the defined
contribution plan, benefits are determined by the purchasing power of the
accumulated value of contributions paid. Under the defined benefit plan,
benefits were expressed as a proportion of earnings at or near retirement
based on years of service. In fiscal 1996, the Company's expense related to
the defined contribution U.K. Plan was $3 million.
The following tables present information for the Dean Witter Discover
predecessor pension plans and Morgan Stanley predecessor pension plans on an
aggregate basis.
Pension expense includes the following components:
The following table provides the assumptions used in determining the
projected benefit obligation for the U.S. Plans and the U.K. Plan:
34
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The following table sets forth the funded status of the U.S. Plans and the
U.K. Plan.
Postretirement Benefits
The Company has unfunded postretirement benefit plans that provide medical
and life insurance for eligible retirees, employees and dependents. At fiscal
year end 1996 and 1995, the Company's obligation for these benefits was $67
million and $61 million.
Postemployment Benefits
Postemployment benefits include, but are not limited to, salary
continuation, supplemental unemployment benefits, severance benefits,
disability-related benefits, and continuation of benefits such as health care
benefits and life insurance coverage for benefits provided to former or
inactive employees after employment but before retirement. These benefits were
not material to the consolidated financial statements in fiscal 1996, 1995 and
1994.
35
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
13. INCOME TAXES
The provision for income taxes consists of:
Lower tax rates applicable to non-U.S. earnings include the benefit of
foreign tax credits utilized against U.S. federal income taxes. The Company
intends to permanently reinvest earnings of international subsidiaries or
repatriate such earnings only when it is tax effective to do so. U.S. federal
income taxes that would be payable upon repatriation are estimated to be $487
million. Under SFAS No. 109, "Accounting for Income Taxes," deferred income
taxes reflect the net tax effects of temporary differences between the
financial reporting and tax bases of assets and liabilities and are measured
using the enacted tax rates and laws that will be in effect when such
differences are expected to reverse. Significant components of the Company's
deferred tax assets and liabilities at fiscal year end 1996 and 1995 are as
follows:
36
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
14. GEOGRAPHIC AREA DATA
Total revenues, net revenues, income before taxes and identifiable assets of
the Company's operations by geographic area are as follows:
Because of the international nature of the financial markets and the
resulting geographic integration of the Company's business, the Company
manages its business with a view to the profitability of the enterprise as a
whole, and, as such, profitability by geographic area is not necessarily
meaningful.
15. SEGMENT INFORMATION
The Company is in the business of providing financial services, and operates
in two business segments--Securities and Credit Services. Securities engages
in delivering a broad range of financial products and services, including
asset management, to individual and institutional investors. Credit Services
is engaged in the issuance and servicing of general purpose credit cards,
consumer lending and electronic transaction processing services.
The following table presents certain information regarding these business
segments.
--------
(1) Corporate assets have been fully allocated to the Company's business
segments.
37
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
16. ACQUISITIONS
In the first quarter of fiscal 1996, the Company completed its purchase of
MAS, an institutional investment manager, for $350 million, payable in a
combination of cash, notes and common stock of the Company. The Company's
fiscal 1996 results include the results of MAS since January 3, 1996, the date
of acquisition.
In the fourth quarter of fiscal 1996, the Company completed its purchase of
VKAC for $1.175 billion. The consideration for the purchase of the equity of
VKAC consisted of cash and approximately $26 million of preferred securities
issued by one of the Company's subsidiaries and exchangeable into common stock
of the Company. The Company's fiscal 1996 results include the results of VKAC
since October 31, 1996, the date of acquisition.
On April 3, 1997, the Company announced the acquisition of the institutional
global custody business of Barclays PLC ("Barclays"). The amount of
consideration for this business is to be fixed over a period of time based on
account retention. The transaction involves approximately $250 billion of
assets currently administered by Barclays, and the combination of Barclays
with the Company's global custody business would have increased the Company's
assets under administration at fiscal year end 1996 to approximately $394
billion on a pro forma basis (assuming that current clients of Barclays agree
to become clients of the Company). Barclays has agreed to provide global
subcustodial services to the Company for a period of time after completion of
the acquisition.
38
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
17. QUARTERLY RESULTS (UNAUDITED)
--------
(1) Amounts shown are used to calculate primary earnings per share.
(2) Per share and share data have been restated to reflect the Company's two-
for-one stock splits.
(3) Summation of the quarters' earnings per common share may not equal the
annual amounts due to the averaging effect of the number of shares and share
equivalents throughout the year.
39
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
17. QUARTERLY RESULTS (UNAUDITED)--CONTINUED
--------
(1) Amounts shown are used to calculate primary earnings per share.
(2) Per share and share data have been restated to reflect the Company's two-
for-one stock splits.
(3) Summation of the quarters' earnings per common share may not equal the
annual amounts due to the averaging effect of the number of shares and share
equivalents throughout the year.
40
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
FIVE YEAR SUMMARY OF FINANCIAL DATA
1
--------
(1) Amounts shown are used to calculate primary earnings per common share.
(2) Per share data have been restated to reflect the Company's two-for-one
stock splits.
(3) Prior to 1993, Dean Witter Discover was not a public company and
therefore, per share data was not meaningful.
(4) These amounts exclude the current portion of long-term borrowings and
include Capital Units.
(5) Return on average shareholders' equity for 1992 excludes the effects of a
$37 million charge for the cumulative effect of a change in the method of
accounting for postretirement benefits other than pensions, a non-
recurring gain of $32 million from the initial public offering of SPS
Transaction Services, Inc. common stock and a $133 million capital
contribution from Sears, Roebuck and Co. on December 31, 1992.
2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
INTRODUCTION
The Company
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged
with and into Dean Witter, Discover & Co. ("Dean Witter Discover") (the
"Merger"). At that time Dean Witter Discover changed its corporate name to
Morgan Stanley, Dean Witter, Discover & Co. (the "Company"). In conjunction
with the Merger, each share of Morgan Stanley common stock then outstanding
was converted into the right to receive 1.65 shares of the Company's common
stock (the "Exchange Ratio"), and each share of Morgan Stanley preferred stock
was converted into the right to receive one share of a corresponding series of
preferred stock of the Company. The Merger was treated as a tax free exchange.
The Company is a preeminent global financial services firm that maintains
leading market positions in each of its business segments--securities, which
includes asset management, and credit services. The Company combines three
well recognized brands in the financial services industry: Discover(R) Card,
Morgan Stanley and Dean Witter. The Company combines Morgan Stanley's global
strengths in investment banking, including the origination of quality
underwritten public offerings, mergers and acquisitions and other financial
advisory services, institutional sales and trading and global asset management
with Dean Witter Discover's strengths in providing investment and asset
management services to its customers and in providing quality consumer credit
products to its customers, primarily through its Discover Card brand. At
fiscal year end 1996, the Company had the third largest account executive
sales organization in the United States, with approximately 9,100 professional
account executives and 371 branches, and one of the largest global asset
management operations with total assets under management and administration of
$271 billion. In addition, based on its approximately 39 million general
purpose credit card accounts at fiscal year end 1996, the Company is the
nation's largest credit card issuer as measured by number of accounts and
cardmembers.
Basis of Financial Information
The supplemental consolidated financial statements give retroactive effect
to the merger of Dean Witter Discover and Morgan Stanley in a transaction
accounted for as a pooling of interests. The pooling of interests method of
accounting requires the restatement of all periods presented as if Dean Witter
Discover and Morgan Stanley had always been combined. Generally accepted
accounting principles proscribe giving effect to a consummated business
combination accounted for by the pooling of interests method in financial
statements that do not include the date of consummation. The supplemental
consolidated financial statements do not extend through the date of
consummation. However, they will become the historical consolidated financial
statements of the Company and its subsidiaries after financial statements
covering the date of consummation of the business combination are issued. The
supplemental consolidated statement of changes in shareholders' equity
reflects the accounts of the Company as if the additional preferred and common
stock had been issued during all the periods presented. The supplemental
consolidated financial statements, including the notes thereto, should be read
in conjunction with the historical consolidated financial statements of Dean
Witter Discover and Morgan Stanley, included in their Annual Reports on Form
10-K for the fiscal years ended December 31, 1996 and November 30, 1996,
respectively.
Prior to the consummation of the merger, Dean Witter Discover's fiscal year
ended on December 31 and Morgan Stanley's fiscal year ended on November 30. In
recording the pooling of interests combination, Dean Witter Discover's
financial statements for the fiscal years ended December 31, 1996, 1995 and
1994 were combined with Morgan Stanley's financial statements for the fiscal
years ended November 30, 1996, 1995 and 1994 (on a combined basis, "fiscal
year 1996," "fiscal year 1995," and "fiscal year 1994," respectively).
Certain reclassifications have been made to prior year amounts to conform to
the current presentation. All material intercompany balances and transactions
have been eliminated.
3
RESULTS OF OPERATIONS
The Company's results of operations may be materially affected by market
fluctuations and by economic factors. The Company's securities business,
particularly its involvement in primary and secondary markets for all types of
financial products, including derivatives, is subject to substantial positive
and negative fluctuations due to a variety of factors that cannot be predicted
with great certainty, including variations in the fair value of securities and
other financial products and the volatility and liquidity of trading markets.
Fluctuations also occur due to the level of market activity, which, among
other things, affects the flow of investment dollars into mutual funds, and
the size, number and timing of transactions or assignments (including
realization of returns from the Company's principal and merchant banking
investments). In the Company's credit services business, changes in economic
variables may substantially affect consumer loan growth and credit quality. In
addition, results of operations in the past have been and in the future may
continue to be materially affected by many factors of a national and
international nature, including economic and market conditions; the
availability of capital; the level and volatility of interest rates; currency
values and other market indices; the availability of credit; inflation; and
legislative and regulatory developments. Such factors may also have an impact
on the Company's ability to achieve its strategic objectives, including
(without limitation) profitable global expansion.
The Company's results of operations also may be materially affected by
competitive factors. In addition to competition from firms traditionally
engaged in the securities business, there has been increased competition from
other sources, such as commercial banks, insurance companies, mutual fund
groups and other companies offering financial services. As a result of recent
or pending legislative and regulatory initiatives in the U.S. to remove or
relieve certain restrictions on commercial banks, competition in some markets
which have traditionally been dominated by investment banks and retail
securities firms has increased and may continue to increase in the near
future. Such competition, among other things, affects the Company's ability to
attract and retain highly skilled individuals. Competitive factors also affect
the Company's success in attracting and retaining clients and assets through
its ability to meet investors' saving and investment needs through consistency
of investment performance and accessibility to financial products and advice.
In the credit services industry, competition centers on merchant acceptance of
credit cards, credit card account acquisition and customer utilization of
credit cards. Merchant acceptance is based on both competitive transaction
pricing and the volume of credit cards in circulation. Credit card account
acquisition and customer utilization are driven by the offering of credit
cards with competitive and appealing features such as no annual fees, low
introductory interest rates and other customized features targeting specific
consumer groups.
As a result of the above economic and competitive factors, net income and
revenues in any particular period may not be representative of full year
results and may vary significantly from year to year and from quarter to
quarter. The Company intends to manage its business for the long term and help
mitigate the potential effects of market downturns by strengthening its
competitive position in the global financial services industry through
diversification of its revenue sources and enhancement of its global
franchise. Maintaining high levels of profitable business activities,
emphasizing fee-based assets that are designed to generate a continuing stream
of revenues, managing risks, evaluating credit product pricing and monitoring
costs will continue to affect the overall financial results of the Company. In
addition, the two complementary trends in the financial services industry of
consolidation and globalization present, among other things, technological,
risk management and other infrastructure challenges that will require
effective resource allocation in order for the Company to remain competitive.
In an effort to create the platform to support the Company's long-term
strategic goal of expanding recurring fee-based revenues, on January 3, 1996
the Company acquired Miller Anderson & Sherrerd, LLP ("MAS"), a premier
Philadelphia-based institutional asset management firm, and on October 31,
1996 completed its acquisition of VK/AC Holding, Inc., the parent of Van
Kampen American Capital, Inc. ("VKAC"), the country's fourth largest non-
proprietary mutual fund provider with approximately $61 billion in assets
under management or supervision at fiscal year end. These acquisitions, along
with the Merger, combine the well-developed distribution and customer
servicing strengths of Dean Witter InterCapital Inc. ("ICAP") and VKAC with
the well-regarded investment performance record of Morgan Stanley Asset
Management and MAS. In
4
addition, in April 1997, the Company announced the acquisition of Barclays
PLC's institutional global custody business, which will also strengthen the
Company's global franchise, particularly in Europe, and increase fee-based
revenues.
The favorable market and economic conditions which characterized fiscal 1995
continued throughout fiscal 1996, contributing to higher industry wide
securities revenues and to record levels of earnings and net revenues for the
Company's securities business. The Company's performance in fiscal 1996
reflected the balanced mix of its global securities business coupled with
these favorable market conditions. All of the Company's core businesses
generated record earnings. In addition, the Company's securities business
ended the fiscal year with record levels of account executives, customer
accounts and assets, and assets under management and administration.
Throughout the year, the U.S. economy deviated little from its course of
moderate growth with low inflation. Bond markets, however, were unsettled as
the U.S. economy alternately slowed and accelerated, albeit within a
relatively narrow range, leaving the markets off balance and making forecasts
related to inflation more difficult. After faltering briefly in July due to
concerns of higher inflation and interest rates, the equity markets, in
particular, rebounded to record levels amid renewed signs of moderate economic
growth, which kept the Federal Reserve from altering interest rates from
January, 1996 through fiscal year end 1996. In addition, U.S. equity markets
were positively impacted by record levels of cash inflows into mutual funds,
which facilitated increased demand for new issues and propelled numerous
domestic stock indices to record levels. The potential for higher rates of
return in the U.S. as compared with other countries also contributed to higher
inflows of funds from foreign investors into the U.S. markets.
In European markets, the first half of fiscal 1996 experienced less robust
market conditions as compared with the U.S., as economic performance remained
relatively stable in many European countries. In general, European markets
became more buoyant in the latter half of the fiscal year, partly driven by a
stronger than expected performance in the U.K. economy and lower interest
rates in Germany. Japanese markets were relatively weak throughout the year,
reflecting a lackluster economic outlook, as wells as concerns regarding the
nation's banking industry, particularly its vulnerability to non-performing
real estate loans. Markets in Southeast Asia generally experienced slower
economic growth with the exception of Hong Kong, which had a year of solid
growth in anticipation of the impending change in its sovereignty.
The worldwide market for mergers and acquisitions continued to be strong
during fiscal 1996, resulting in overall improved investment banking
conditions. The need for economies of scale, location, financial capacity and
the ability to compete globally contributed to an aggressive acquisition
marketplace which was further stimulated by relatively low interest rates and
the high level of stock prices.
In fiscal 1996, consumer demand and retail sales continued to increase,
favorably impacting credit card transaction volume and consumer loan growth.
In fiscal 1996, the Company continued to invest in growth through the
expansion of its NOVUS Network and by increasing its marketing and
solicitation activities. The NOVUS Network is the third largest credit card
network in the United States and consists of merchant and cash access
locations that accept the Discover Card and other cards that carry the NOVUS
logo. In fiscal 1996, the Company launched its first NOVUS affinity credit
card program--the National Alliance for Species SurvivalSM Card. Credit
Services ended the year with record levels of NOVUS Network merchant
locations, general purpose credit card accounts and transaction volume, and
consumer loans.
The Company achieved net income of $1,980 million in fiscal 1996, a 35%
increase from fiscal 1995. In fiscal 1995, net income increased 17% to $1,465
million. Primary earnings per common shares increased 40% to $3.22 in fiscal
1996 and 17% to $2.30 in fiscal 1995. Fully diluted earnings per common share
increased 40% to $3.14 in fiscal 1996 and 17% to $2.25 in fiscal 1995. The
Company's return on average shareholders' equity was 20% in fiscal 1996 and
16% in fiscal 1995 and fiscal 1994.
The remainder of Management's Discussion and Analysis is presented on a
business segment basis. Substantially all of the operating revenues and
operating expenses of the Company can be directly attributed to its two
business segments, securities, which includes asset management, and credit
services. Certain reclassifications have been made to prior period amounts to
conform to the current presentation.
5
SECURITIES STATEMENTS OF INCOME
(DOLLARS IN MILLIONS)
SECURITIES
Securities provides a wide range of financial products, services and
investment advice to individual and institutional investors. Securities
business activities are conducted in the United States and in 19 other
countries and include investment banking, research, institutional sales and
trading and global asset management, and investment and asset management
products and services for individual clients. At fiscal year end 1996, the
Company served the needs of over 3.2 million individual and institutional
clients with assets of $478 billion. The Company had the third largest account
executive sales organizations in the United States with approximately 9,100
professional account executives and 371 branches at fiscal year end 1996. With
well-recognized brand names, including those associated with ICAP, VKAC,
Morgan Stanley Asset Management and MAS, the Company has one of the largest
global asset management operations with total assets under management and
administration of $271 billion at fiscal year end 1996.
6
Securities achieved record net revenues and net income of $9,165 million and
$1,531 million in fiscal 1996, increases of 27% and 50%, respectively, from
fiscal 1995. In fiscal 1995, Securities net revenues and net income increased
13% and 21%, respectively, from fiscal 1994. The Company's fiscal 1996 and
1995 levels of net revenues and net income in its securities businesses
reflect a strong global market for mergers and acquisitions, as well as
improved sales and trading results primarily driven by favorable economic
conditions and increased customer trading volume. These results were partially
offset in both years by increased costs for incentive-based compensation, as
well as increased non-compensation expenses associated with the Company's
higher level of global business activities. The growth in net income in both
years was impacted by favorable business environments, the Company's focus on
accumulating client assets and building fee-based assets under management and
administration.
INVESTMENT BANKING
Investment banking revenues are derived from the underwriting of securities
offerings and fees from advisory services. Investment banking revenues were as
follows:
Investment banking revenues attained record levels in fiscal 1996 due to
increased revenues from merger, acquisition and restructuring transactions, as
well as increased levels of equity and debt underwriting activities.
Investment banking revenues increased in fiscal 1995 due to significantly
higher levels of merger and acquisition revenues and increased debt and equity
underwriting revenues, reflecting a higher level of debt and equity financing
activity as well as a stronger market share resulting from strategic
investments made in personnel during 1994 to strengthen client service
capabilities.
The worldwide merger and acquisition markets remained robust for the second
consecutive year with more than $1 trillion of transactions (per Securities Data
Company) announced during the year, including record volume in the U.S. The
improved advisory revenues in fiscal 1996 were attributable to this increased
transaction volume and historically high stock prices, as well as the Company's
strong global presence and broad client base in industries such as health care,
banking and other financial services, telecommunications, media and
entertainment and utilities. Advisory revenues also were positively affected by
strategic advisory services provided to clients in some of the year's largest
transactions. Advisory fees increased in fiscal 1995, benefiting from an active
worldwide market and the broad range of strategic advisory services provided to
clients in many of the year's most active industry sectors, including banking
and financial services, media, telecommunications, health care and technology.
Equity underwriting revenues increased in fiscal 1996, resulting from a
strong primary calendar as new issuances were readily absorbed by the
increased flows of money into the equity markets. Additionally, reduced
concerns regarding inflation and lower interest rates positively affected the
demand for new equity issuances. Equity underwriting revenues in fiscal 1995
were positively affected by favorable market conditions in both the U.S. and
Europe, which included continued strong demand for initial public offerings,
increased corporate restructuring, diminished concerns about inflation and
lower interest rates. The Company increased its market share for worldwide
equity underwriting in fiscal 1995 and lead-managed a number of innovative and
notable transactions.
In fiscal 1996, revenues from debt financing activity were positively
affected by a relatively stable interest rate environment as the Federal
Reserve Board maintained short-term interest rates at a constant level
subsequent
7
to a modest decrease in the Federal Funds rate in January 1996. Debt
underwriting revenues increased, reflecting in part a continued demand for
corporate new issues as interest rates remained relatively low, an increased
level of high-yield issuance activity and increased revenues from securitized
debt transactions. Debt underwriting revenues increased in fiscal 1995,
reflecting favorable market conditions and a more stable interest rate
environment as the Federal Reserve Board held short-term interest rates
constant in the first half of the year and subsequently reduced short-term
interest rates in July 1995 as economic growth and inflation remained stable.
PRINCIPAL TRANSACTIONS
Principal transactions include revenues from customers' purchases and sales
of securities in which the Company acts as principal, and gains and losses on
securities held for resale. Principal trading revenues were as follows:
Equity trading revenues reached record levels in fiscal 1996, reflecting
increased customer trading activity, particularly in the U.S., as the
continuing strong market was driven by low inflation, a moderately growing
economy and relatively low interest rates. Equity cash products were
positively affected as individual investors infused money into mutual funds at
a record level. Revenues from equity derivative products increased as the
Company expanded its proprietary trading activities to capitalize on increased
levels of volatility, particularly in the U.S. options and futures markets.
Equity trading revenues in fiscal 1995 increased reflecting increased
customer-driven activity as most major global equity markets rallied,
positively impacting revenues from virtually all types of cash and derivative
products. Options and futures benefited from relatively higher volatilities
and increased trading volumes.
Fixed income trading revenues increased in fiscal 1996, primarily due to
higher revenues from high-yield, emerging market, swaps and securitized debt
trading. High-yield trading revenues benefited from increased volumes as
positive corporate earnings increased investor demand for high-yield issues.
Emerging market revenues increased, in part, due to higher levels of
volatility in Russian securities, as well as the strengthening of Latin
American markets, specifically in developing countries such as Mexico,
Argentina and Brazil. Swaps trading revenue increased significantly,
benefiting from an increased customer base, significant increases in volume,
and a favorable interest rate environment. Securitized debt trading revenues
increased substantially as the Company increased its focus on this market
segment by expanding its level of activity in securitized debt products.
Revenues from trading in mortgage-backed securities and commercial whole loans
contributed significantly to the overall revenue increases as securitizations
increased and innovative structures were created.
Fixed income trading revenues increased in fiscal 1995. The Company's global
corporate, emerging market and high-yield activities produced substantially
higher revenue levels in fiscal 1995 as conditions stabilized globally,
specifically in Mexico and the emerging markets.
Revenues from foreign exchange trading in fiscal 1996 were affected by
decreased volatility, driven by the narrowing of inflation rates around the
world and the approaching European monetary union. Revenues from foreign
exchange trading improved in fiscal 1995, primarily attributable to periods of
increased volatility in the first half of fiscal 1995, most notably in U.S.
dollar/deutsche mark and U.S. dollar/yen, as well as the subsequent
strengthening of the U.S. dollar vs. the yen and the deutsche mark during the
latter half of fiscal 1995.
Commodities trading revenues reached record levels in fiscal 1996,
benefiting from volatile markets that have been buoyed by low inventories,
robust demand and the industry's expectation for much of fiscal 1996 that
8
Iraq would re-enter the world crude oil market. Revenues from energy-related
products increased significantly due to increased volatility as the prices of
natural gas, crude oil, and heating oil increased to their highest levels
since the early 1990s. In addition, higher revenues were attained from
commodity-related products, including derivatives, as the customer base for
these products and the use of such products for risk management purposes
expanded. Revenues from commodities trading declined in fiscal 1995, resulting
from difficult market conditions in most energy-related products.
Principal transaction investment revenues aggregating $86 million were
recognized in fiscal 1996 as compared with $121 million in fiscal 1995. The
lower levels of revenues in fiscal 1996 reflects decreases in the carrying
value of certain of the Company's merchant banking investments, partially
offset by higher revenues associated with the Company's other principal
investments, including real estate investments. Principal investment revenues
of $154 million in fiscal 1994 included revenues related to the increase in
the carrying value of the Company's merchant banking investment in Southern
Pacific Corporation and several real estate investments.
COMMISSIONS
Commission revenues increased in fiscal 1996, primarily reflecting increased
market participation by investors resulting from favorable market conditions
and a strong primary calendar, particularly in the U.S., and an increase in
sales of mutual fund and insurance products. In addition, commission revenues
improved as institutional investors purchased more foreign and emerging market
issuances. Commission revenues increased in fiscal 1995 primarily reflecting
higher levels of activity as market participation by investors increased.
Additionally, increased primary equity activities in fiscal 1995 contributed
toward higher volumes in secondary markets.
NET INTEREST
Interest and dividend revenues and expense are a function of the level and
mix of total assets, including financial instruments owned and resale and
repurchase agreements, customer margin loans and the prevailing level, term
structure and volatility of interest rates. Net interest revenues decreased in
fiscal 1996, partly attributable to changes in the mix of the Company's fixed
income inventory, coupled with the general trend in interest rates. In
addition, the decline in net interest revenues reflected increased financing
costs associated with higher average levels of balance sheet usage,
particularly in equity-related businesses. Net interest revenues increased in
fiscal 1995, primarily attributable to higher net interest income from margin
lending, partially offset by lower net interest revenues due to the continuing
effect of a flat yield curve in the U.S. Interest and dividend revenues and
expense should be viewed in the broader context of principal trading results.
Decisions relating to principal transactions in securities are based on an
overall review of aggregate revenues and costs associated with each
transaction or series of transactions. This review includes an assessment of
the potential gain or loss associated with a trade, the interest income or
expense associated with financing or hedging the Company's positions, and
potential underwriting, commission or other revenues associated with related
primary or secondary market sales.
ASSET MANAGEMENT AND ADMINISTRATION
Asset management and administration revenues include fees for asset
management services, including fees for investment management and for
promoting and distributing mutual funds ("12b-1 fees"), other administrative
fees and non-interest revenues earned from correspondent clearing and custody
services. Fund management fees arise from investment management services the
Company provides to registered investment companies (the "funds") pursuant to
various contractual arrangements. The Company receives management fees based
upon each fund's average daily net assets. The Company receives 12b-1 fees for
services it provides in promoting and distributing certain open-ended funds.
These fees are based on the lesser of average daily fund asset balances or
average daily aggregate net fund sales and are affected by changes in the
overall level and mix of assets under management and administration.
9
Asset management and administration revenues were as follows:
In fiscal 1996, asset management and administration revenues increased
reflecting growth in both asset management activities, including the
acquisition of MAS, and global clearing and custody services resulting from
the Company's continuing strategic emphasis on these businesses, as well as
higher revenues from 12b-1 fees. The increase in fiscal 1995 asset management
and administration revenues reflected higher levels of customer assets under
management and administration.
As of fiscal year end 1996, assets under management or supervision had
increased significantly, reflecting the addition of $40 billion of assets from
MAS and $61 billion of assets from VKAC during the year. The increase in
assets under management in both fiscal 1996 and fiscal 1995 reflected
appreciation in the value of customer portfolios, particularly in equity
funds, as well as continued growth in international and emerging market funds.
At fiscal year end 1996, approximately $120 billion of assets under management
were invested in
mutual funds primarily offered to individual customers and approximately $112
billion of assets under management (including approximately $36 billion
invested in international related products) were invested in products
primarily offered to institutional clients, composed of approximately $35
billion in institutional mutual funds and approximately $77 billion in
separate accounts, pooled vehicles and other arrangements. The remaining
amounts primarily include assets in fiduciary accounts, unit investment trusts
and the Company's Investment Consulting Services accounts. Among mutual funds
primarily offered to individual customers, at fiscal year end 1996,
approximately 43% of the Company's assets under management were invested in
equity securities, 36% in fixed income securities and 21% in short-term
investments. Among products primarily offered to institutional clients, at
fiscal year end 1996, 50% consisted of equity products, 43% consisted of fixed
income products and 7% consisted of balanced products.
Customer assets under administration also increased in fiscal 1996 and
fiscal 1995, reflecting in both years additional assets placed under custody
with the Company, as well as appreciation in the value of customer portfolios.
On April 3, 1997, the Company announced the acquisition of the institutional
global custody business of Barclays PLC ("Barclays"). The amount of
consideration for this business is to be fixed over a period of time based on
account retention. The transaction involves approximately $250 billion of
assets previously administered by Barclays, and the combination of Barclays
with the Company's global custody business would have increased the Company's
assets under administration at fiscal year end 1996, to approximately $394
billion on a pro forma basis (assuming that clients of Barclays agree to
become clients of the Company). Barclays has agreed to provide global
subcustodial services to the Company for a period of time after completion of
the acquisition.
10
EXPENSES EXCLUDING INTEREST
Fiscal 1996's total non-interest expenses increased significantly from prior
year levels. Total non-interest expenses increased $1,140 million over fiscal
1995 expenses. Within that category, employee compensation and benefits
expense increased $1,000 million, reflecting increased levels of incentive
compensation based on record fiscal 1996 revenues and earnings, the impact of
salaries and benefits relating to additional personnel hired during the year
or joining the Company as a result of the MAS and VKAC acquisitions, and
higher costs related to training new account executives. Other non-interest
costs increased $199 million (excluding the $59 million relocation charge
discussed below) over fiscal 1995 expenses, including $48 million of operating
costs related to MAS and VKAC. Occupancy and equipment expenses increased over
fiscal 1995 expenses, principally reflecting costs associated with the
relocation of Morgan Stanley's New York offices, new leased office space in
Tokyo, and the occupancy costs of MAS and VKAC. Brokerage, clearing and
exchange fees increased over fiscal 1995 expenses, reflecting increased trade
volumes, both in the U.S. and in Europe, and the continued growth in the
international component of the Company's sales and trading activities.
Information processing and communications costs increased in fiscal 1996 due
to continued emphasis on technology initiatives. Business development and
professional services expenses increased in fiscal 1996, reflecting
significantly higher travel and entertainment, consulting and advertising
costs as a result of the increased level of the Company's global business
activities. Other expenses decreased in fiscal 1996, which primarily reflects
a reduction in litigation expenses partially offset by the amortization of
goodwill related to the acquisitions of MAS and VKAC.
Fiscal 1995's total non-interest expenses increased $529 million from fiscal
1994. Within that category, employee compensation and benefits expense
increased $405 million, reflecting increased levels of incentive compensation
based on higher revenues and earnings as well as the impact of salaries and
benefits relating to additional personnel hired during 1994. Other non-
interest expenses increased $65 million (excluding the $59 million relocation
charge discussed below). Occupancy and equipment expenses increased,
reflecting costs associated with the relocation of Morgan Stanley's New York
offices. Brokerage, clearing and exchange fees increased, reflecting increased
trade volumes, business mix changes and the growth in international sales and
trading. Information processing and communications expenses increased due to
the expansion of the Company's global business activities and increased
spending on information technology equipment. Business development expense
decreased in fiscal 1995, reflecting significantly lower recruiting and travel
costs directly related to the Company's cost-containment initiatives. Fiscal
1995 expenses include a pretax relocation charge of $59 million relating to
the decision to vacate much of Morgan Stanley's New York City office space at
1251 Avenue of the Americas and to relocate staff formerly occupying that
space to a new headquarters building at 1585 Broadway. The relocation charge
also includes similar charges relating to Morgan Stanley's move of its Tokyo
office to newly leased space.
CREDIT SERVICES
Credit Services focuses on the delivery of financial products to consumers
through its four business units: NOVUS Services, Prime Option Services, SPS
and NOVUS Financial.
11
Credit Services is the largest single issuer of general purpose credit cards
in the United States as measured by number of accounts and cardmembers.
Consumers use general purpose credit cards to purchase goods and services and
obtain cash advances. Credit Services proprietary general purpose credit cards
are issued by NOVUS Services, which operates the NOVUS Network. These include
the Discover Card, the Private Issue(R) Card, the BRAVOSM Card and an affinity
program card. The Prime OptionSM MasterCard(R) is a co-branded general purpose
credit card issued by NationsBank of Delaware, N.A., and serviced by Prime
Option Services. SPS is a 74% owned, publicly held subsidiary. SPS services
include electronic transaction processing, consumer private label credit card
program administration, commercial accounts receivable processing and call
center teleservices. NOVUS Financial is a consumer finance business which
emphasizes real estate-secured lending. NOVUS Financial originates loans
through the DWR account executive sales organization, Allstate insurance
agents, other third-party sales forces and direct response marketing.
CREDIT SERVICES STATEMENTS OF INCOME
(DOLLARS IN MILLIONS)
In fiscal 1996, Credit Services net income of $449 million remained level
compared to fiscal 1995. Credit Services net income increased 8% in fiscal
1995 to $447 million. In fiscal 1996, the effects of higher levels of general
purpose credit card accounts, transaction volume and loans, and increased
credit card fee revenues were offset by a higher rate of credit losses. The
increase in fiscal 1995 was primarily due to higher levels of general purpose
credit card accounts, transaction volume and loans, partially offset by
increased investments in growth and a higher rate of credit losses.
12
Credit Services statistical data was as follows (dollars in billions).
MERCHANT AND CARDMEMBER FEES
Merchant and cardmember fees include revenues from fees charged to merchants
on credit card sales, late payment fees, credit insurance fees, overlimit
fees, cash advance fees, transaction processing services and the
administration of credit card programs.
Merchant and cardmember fees increased 33% in fiscal 1996 and 21% in fiscal
1995. The increase in fiscal 1996 was due to higher revenues from overlimit
fees, merchant fees, late payment fees and credit insurance fees. The increase
in fiscal 1995 was due to higher revenues from merchant fees, credit insurance
fees and late payment fees, partially offset by the absence of fees from
Income Tax Refund Anticipation Loans. Overlimit fees were implemented in March
1996 and the amount of the fee was increased in the fourth quarter of fiscal
1996. In both years, the increases in merchant fee revenues were due to
continued growth in general purpose credit card transaction volume. The
increase in late payment fee revenues in fiscal 1996 was due to an increase in
the amount of the late payment fee charged, an increase in the incidence of
late payments and a tightening, in the fourth quarter of fiscal 1996, of late
payment fee terms. The increased incidence of late payments was attributable
to a higher level of delinquent accounts and an increase in active credit card
accounts. The increase in late payment fee revenues in fiscal 1995 was due to
an increase in the incidence of late payments due to an increased number of
active credit card accounts and a higher incidence of delinquent accounts. In
both years, the increases in credit insurance fees were due to higher
enrollments and favorable loss experience rebates.
SERVICING FEES
Servicing fees are revenues derived from consumer loans which have been sold
through asset securitizations. Cash flows from the interest yield and
cardmember fees generated by securitized loans are used to pay investors in
these loans a predetermined fixed or floating rate of return on their
investment, to reimburse the investors for losses of principal through charged
off loans and to pay the Company a fee for servicing the loans. Any excess
cash flows remaining are paid to the Company. The servicing fees and excess
net cash flows paid to the Company are reported as servicing fees in the
consolidated statements of income. The sale of consumer loans through asset
securitizations therefore has the effect of converting portions of net credit
income and fee income to servicing fees.
The table below presents the components of servicing fees (dollars in
millions).
Servicing fees are affected by the level of securitized loans, the spread
between the interest yield on the securitized loans and the yield paid to the
investors, the rate of credit losses on securitized loans and the level of
cardmember fees earned from securitized loans. Servicing fees also include the
effects of interest rate contracts entered into by the Company as part of its
interest rate risk management program. Servicing fees increased 18% in fiscal
1996 and 19% in fiscal 1995. The increases in both years were due to higher
net interest cash flows and
13
cardmember fees from securitized loans partially offset by increased credit
losses from securitized loans. The increased net interest cash flows were due
to higher average levels of securitized loans. As discussed under merchant and
cardmember fees, the higher cardmember fees were due to increased late payment
fees and in fiscal 1996, overlimit fees. The increases in credit losses were
due to a higher rate of credit losses on securitized loans and an increase in
the average level of securitized loans. The higher rate of credit losses was
consistent with the industry-wide trend of increasing credit loss rates as
discussed under provision for loan losses.
NET INTEREST INCOME
Net interest income is equal to the difference between interest revenue
derived from Credit Services consumer loan and short-term investment assets
and interest expense incurred to finance those assets. Credit Services assets,
primarily consumer loans, earn interest revenue at both fixed rates and market
indexed variable rates. The Company incurs interest expense at fixed and
floating rates to finance Credit Services assets. Interest expense also
includes the effects of interest rate contracts entered into by the Company as
part of its interest rate risk management program. This program is designed to
reduce the volatility of earnings resulting from changes in interest rates and
is accomplished primarily through matched financing which entails matching the
repricing schedules of consumer loans and the related financing.
The following tables present analyses of Credit Services average balance
sheets and interest rates in fiscal 1996, fiscal 1995 and fiscal 1994, and
changes in net interest income during those years.
CREDIT SERVICES AVERAGE BALANCE SHEET ANALYSIS (DOLLARS IN MILLIONS)
--------
(1) Net interest margin represents net interest income as a percentage of
total interest earning assets.
(2) Interest rate spread represents the difference between the rate on total
interest earning assets and the rate on total interest bearing
liabilities.
14
CREDIT SERVICES RATE/VOLUME ANALYSIS (DOLLARS IN MILLIONS)
Net interest income increased 15% in fiscal 1996 and 21% in fiscal 1995. The
increases in both years were due to higher average levels of consumer loans
outstanding partially offset by a shift in the mix of general purpose credit
card loans from fixed rate loans to lower yielding variable rate loans and the
effect of higher charge-offs on interest revenue. In both years, the effects
of changes in market interest rates on the Company's variable rate consumer
loans were substantially offset by comparable changes in the Company's cost of
funds for the related financing. Variable rate consumer loans were
approximately 57%, 46% and 41% of the Company's consumer loan portfolio at
fiscal year end 1996, 1995 and 1994. The Company believes that the effect of
changes in market interest rates on net interest income were mitigated due to
its liquidity and interest rate risk policies.
The supplemental table below provides average managed loan balance and rate
information which takes into account both owned and securitized loans.
SUPPLEMENTAL CREDIT SERVICES AVERAGE MANAGED LOAN INFORMATION (DOLLARS IN
MILLIONS)
PROVISION FOR LOAN LOSSES
The provision for loan losses is the amount necessary to establish the
allowance for loan losses at a level that the Company believes is adequate to
absorb estimated losses in its consumer loan portfolio at the balance sheet
date. The Company's allowance for loan losses is regularly evaluated by
management for adequacy on a portfolio by portfolio basis and was $815
million, $722 million and $566 million at fiscal year end 1996, 1995 and 1994.
15
The provision for loan losses is affected by net charge-offs, loan volume
and changes in the amount of consumer loans estimated to be uncollectable. The
provision for loan losses increased 67% in fiscal 1996 and 36% in fiscal 1995.
The increase in fiscal 1996 was primarily due to higher net charge-offs which
resulted from an increase in the percentage of consumer loans charged off and
a higher level of consumer loans outstanding. The effect of an increase in the
Company's estimate of the allowance for loan losses, primarily in the fourth
quarter of fiscal 1996, was partially offset by a lower provision for losses
for consumer loans intended to be securitized. (See Note 2 to the consolidated
financial statements, "Summary of Significant Accounting Policies.") The
increase in fiscal 1995 was due to a higher level of consumer loans
outstanding and an increase in net charge-off rates partially offset by a
reduction in the allowance for loan losses for one of the Company's owned loan
portfolios in the fourth quarter of fiscal 1995. The increases in both years
in the Company's net charge-off rate were consistent with the industry-wide
trend of increasing credit loss rates that the Company believes is related, in
part, to increased consumer debt levels and bankruptcy rates. The Company
believes this trend may continue and the Company may experience a higher net
charge-off rate in fiscal 1997. In fiscal 1996, the Company took steps to
reduce the impact of this trend, including raising credit quality standards
for new accounts, selectively reducing credit limits and increasing collection
activity. The Company believes these credit quality improvements had a minimal
impact in fiscal 1996, but believes they may have an increased effect in
fiscal 1997. The Company's expectations about future charge-off rates and
credit quality improvements are subject to uncertainties that could cause
actual results to differ materially from what has been projected above.
Factors that influence the level and direction of consumer loan delinquencies
and charge-offs include changes in consumer loan payment patterns, bankruptcy
trends, the seasoning of the Company's loan portfolio, interest rate movements
and their impact on consumer behavior, and the rate and magnitude of changes
in the Company's consumer loan portfolio, including the overall mix of
accounts, products and loan balances within the portfolio.
Consumer loans are considered delinquent when interest or principal payments
become 30 days past due. Consumer loans are charged off when they become 180
days past due, except in the case of bankruptcies and fraudulent transactions
which are charged off earlier. Loan delinquencies and charge-offs are
primarily affected by changes in economic conditions and may vary throughout
the year due to seasonal consumer spending and payment behaviors. The Company
believes the increases in consumer loan delinquency rates in fiscal 1996 and
1995 were related to the industry-wide credit conditions discussed previously.
The following table presents delinquency and net charge-off rates with
supplemental managed loan information.
CREDIT SERVICES ASSET QUALITY (DOLLARS IN MILLIONS)
NON-INTEREST EXPENSES
Total non-interest expenses increased 13% to $2.1 billion in fiscal 1996 and
21% to $1.9 billion in fiscal 1995.
Employee compensation and benefits expense increased 15% in fiscal 1996 and
17% in fiscal 1995. The increases in both years were due to costs associated
with processing increased credit card transaction volume and servicing
additional NOVUS Network merchants and active credit card accounts.
16
Marketing and business development expense increased 14% in fiscal 1996 and
25% in fiscal 1995. The increase in fiscal 1996 was due to higher cardmember
rewards expense and increased costs associated with the growth of new and
existing credit card brands. The increase in fiscal 1995 was due to higher
mailing and promotional costs associated with the launch of new credit card
brands, higher cardmember rewards expense and continued investment in the
growth of existing credit card products. In both years cardmember rewards
expense, which includes the Cashback Bonus(R) award, increased due to
continued growth in credit card transaction volume and increased cardmember
qualification for higher award levels.
Information processing and communications expense increased 16% in fiscal
1996 and 23% in fiscal 1995. The increases in both years were due to higher
costs associated with processing increased transaction volume, servicing
additional NOVUS Network merchants and active credit card accounts and the
development of the systems supporting the multi-card strategy.
Facilities and equipment expense increased 25% in fiscal 1996 and 8% in
fiscal 1995. In fiscal 1996, the Company opened several new facilities to
accommodate the growth of its NOVUS Network and its multi-card strategy.
Other non-interest expenses remained level in fiscal 1996 and increased 17%
in fiscal 1995. These expenses include fraud losses, professional fees, credit
inquiry fees and other administrative costs. The increase in fiscal 1995 was
due to higher credit card fraud losses. In fiscal 1995, the Company began
implementing several measures designed to reduce fraud losses. Since the
Company began implementing these measures, fraud losses as a percentage of
transaction volume has declined.
SEASONAL FACTORS
The credit card lending activities of Credit Services are affected by
seasonal patterns of retail purchasing. A substantial percentage of credit
card loan growth occurs in the fourth quarter, followed by a flattening or
decline of consumer loans in the subsequent first quarter. Merchant fees
increase in the fourth quarter, reflecting higher sales activity.
Additionally, higher cardmember rewards expense is accrued in the fourth
quarter, reflecting seasonal growth in retail sales volume.
LIQUIDITY AND CAPITAL RESOURCES
THE BALANCE SHEET
The Company's total assets increased from $182.0 billion at fiscal year end
1995 to $238.9 billion at fiscal year end 1996, primarily reflecting growth in
financial instruments owned, resale and repurchase agreements, and securities
borrowed. Due to the favorable operating conditions throughout fiscal 1996,
the Company operated with a larger balance sheet as compared with fiscal 1995,
as well as higher levels of balance sheet leverage. The growth is primarily
attributable to the Company's fixed income activities, most notably foreign
sovereign government obligations, corporate debt and reverse repurchase
agreements used in both financing activities and the Company's fixed income
matched book activities. The Company was positioned to capitalize on favorable
conditions in the global fixed income markets, particularly in the global high
yield and sovereign debt markets. Corporate equities inventory, including
equity-related derivatives, increased due to continued client demand for such
securities, as well as from larger proprietary trading positions held by the
Company. Securities borrowed also rose during 1996, reflecting an increase in
collateralized lending to facilitate higher levels of customer activity, as
well as increases related to the Company's proprietary trading activities. The
increase in other assets was primarily due to the goodwill associated with the
acquisitions of MAS and VKAC in fiscal 1996. A substantial portion of the
Company's total assets consists of highly liquid marketable securities and
short-term receivables arising principally from securities transactions. The
highly liquid nature of these assets provides the Company with flexibility in
financing and managing its business.
FUNDING AND CAPITAL POLICIES
The Company's senior management and Finance and Risk Committee, which
includes senior officers from each of the major capital commitment areas,
among other things, establishes the overall funding and capital
17
policies of the Company, reviews the Company's performance relative to these
policies, allocates capital among business activities of the Company, monitors
the availability of sources of financing, reviews the foreign exchange risk of
the Company, and oversees the liquidity and interest rate sensitivity of the
Company's asset and liability position. See also "Risk Management" herein. The
primary goal of the Company's funding and liquidity activities is to ensure
the stability of the Company's funding base and provide adequate financing
sources over a wide range of potential credit ratings and market environments.
Many of the Company's businesses are capital-intensive. Capital is required
to finance, among other things, the Company's securities inventories,
underwriting, principal investments, merchant banking activities, consumer
loans and investments in fixed assets. As a policy, the Company attempts to
maintain sufficient capital and funding sources in order to have the capacity
to finance itself on a fully collateralized basis at all times, including
periods of financial stress. Currently, the Company believes that it has
sufficient capital to meet its needs. In addition, the Company attempts to
maintain total equity, on a consolidated basis, at least equal to the sum of
all its subsidiaries' equity. Subsidiary equity capital requirements are
determined by regulatory requirements (if applicable), asset mix, leverage
considerations and earnings volatility.
The Company's purchases of MAS and VKAC during fiscal 1996 were financed
with a combination of cash, debt, and newly issued equity totaling
approximately $1,525 million. The Company financed the cash portion of these
purchases with a combination of internally generated equity capital and the
proceeds of its debt and preferred equity issuances during fiscal 1996. The
Company was able to meet the capital and financing requirements for these
purchases while maintaining sufficient capital and liquidity resources to
provide continuing financial flexibility for its ongoing business and
operating needs.
The Company views return on equity to be an important measure of its
performance, in the context of both the particular business environment in
which the Company is operating as well as its peer group's results. In this
regard, the Company actively manages its consolidated capital position based
upon, among other things, business opportunities, capital availability and
rates of return together with internal capital policies, regulatory
requirements and rating agency guidelines and therefore may, in the future,
expand or contract its capital base to
address the changing needs of its businesses. The Company has also returned
internally generated equity capital which is in excess of the needs of its
businesses through common stock repurchases and dividends.
The Company's liquidity policies emphasize diversification of funding
sources. The Company also follows a funding strategy which is designed to
ensure that the tenor of the Company's liabilities equals or exceeds the
expected holding period of the assets being financed. Short-term funding
generally is obtained at rates related to U.S., Euro or Asian money market
rates for the currency borrowed. Repurchase transactions are effected at
negotiated rates. Other borrowing costs are negotiated depending upon
prevailing market conditions. (See Notes 5 and 6 to the consolidated financial
statements.) Maturities of both short-term and long-term financings are
designed to minimize exposure to refinancing risk in any one period.
The volume of the Company's borrowings generally fluctuates in response to
changes in the amount of resale transactions outstanding, the level of the
Company's securities inventories and consumer loans receivable and overall
market conditions. Availability and cost of financing to the Company can vary
depending upon market conditions, the volume of certain trading activities,
the Company's credit ratings and the overall availability of credit. The
Company therefore maintains a surplus of unused short-term funding sources at
all times to withstand any unforeseen contraction in credit capacity. In
addition, the Company attempts to maintain cash and unhypothecated marketable
securities equal to at least 110% of its outstanding short-term unsecured
borrowings. The Company has in place a contingency funding strategy which
provides a comprehensive one-year action plan in the event of a severe funding
disruption; the plan is updated annually.
The Company continually seeks to expand its secured borrowing capacity on a
global basis. In support of this strategy, Morgan Stanley & Co. Incorporated
("MS&Co."), one of the Company's U.S. broker-dealer subsidiaries, maintains a
master collateral facility. This facility enables MS&Co. to pledge certain
collateral to secure loan arrangements, letters of credit and other financial
accommodations. Morgan Stanley & Co.
18
International Limited ("MSIL"), the Company's U.K. broker-dealer subsidiary,
can secure committed funding from a syndicate of banks by providing a broad
range of collateral under repurchase agreements.
The Company views long-term debt as a stable source of funding for core
inventories, consumer loans and illiquid assets and therefore maintains a
long-term debt-to-capitalization ratio at a level appropriate for the current
composition of its balance sheet. In general, fixed assets are financed with
fixed rate long-term debt, and securities inventories and all current assets
are financed with a combination of short-term funding, floating rate long-term
debt, or fixed rate long-term debt swapped to a floating basis. Both fixed
rate and variable rate long-term debt (in addition to sources of funds
accessed directly by the Company's Credit Services businesses) are used to
finance the Company's consumer loan portfolio. Consumer loan financing is
targeted to match the repricing characteristics of the loans financed. The
Company uses derivative products (primarily interest rate and currency swaps)
to assist in asset and liability management, reduce borrowing costs and hedge
consumer loan interest rate spreads. (See Note 6 to the consolidated financial
statements.)
The Company's reliance on external sources to finance a significant portion
of its day-to-day operations makes access to global sources of financing
important. The cost and availability of financing generally are dependent on
the Company's short-term and long-term debt ratings. In addition, the
Company's debt ratings can have a significant impact on certain trading
revenues, particularly in those businesses where longer term counterparty
performance is critical, such as over-the-counter derivative transactions. The
Company does not expect that the Merger will have a material impact on the
Company's cost and availability of financing or business activities.
As the Company continues its global expansion and as revenues are
increasingly derived from various currencies, foreign currency management is a
key element of the Company's financial policies. The Company benefits from
operating in a number of different currencies because weakness in any
particular currency often is offset by strength in another currency. The
Company closely monitors its exposure to fluctuations in currencies
and, where cost-justified, adopts strategies to reduce the impact of these
fluctuations on the Company's financial
performance. These strategies include engaging in various hedging activities
to manage income and cash flows denominated in foreign currencies and using
foreign currency borrowings, when appropriate, to finance investments outside
the U.S.
PRINCIPAL SOURCES OF FUNDING
The Company funds its balance sheet on a global basis. The Company's funding
for its Securities segment is raised through diverse sources. These sources
include the Company's capital, including equity and long-term debt; medium-
term notes; internally generated funds; repurchase agreements; U.S., Canadian,
Euro and French commercial paper; letters of credit; unsecured bond borrows;
German Schuldschein loans; securities lending; buy/sell agreements; municipal
reinvestments; master notes; deposits; short-term bank notes; Fed Funds and
committed and uncommitted lines of credit. Repurchase transactions and a
portion of the Company's bank borrowings and securities lending are made on a
collateralized basis and therefore provide a more stable source of funding
than short-term unsecured borrowings.
The funding sources utilized for the Company's Credit Services segment
include asset securitizations, medium-term notes, long-term borrowings,
deposits, asset-backed commercial paper, Fed Funds and short-term bank notes.
The Company sells consumer loans through asset securitizations using several
transaction structures. Riverwoods Funding Corporation ("RFC"), an entity
included in the consolidated financial statements of the Company, issues
asset-backed commercial paper.
The Company's bank subsidiaries solicit deposits from consumers and purchase
federal funds. Interest bearing deposits are classified by type as savings,
brokered and other time deposits. Savings deposits consist primarily of money
market deposits and certificate of deposit accounts sold directly to
cardmembers and savings deposits from DWR clients. Brokered deposits consist
primarily of certificates of deposit issued by the Company's bank
subsidiaries, which are sold through the DWR account executive sales
organization and a
19
syndicate of firms managed by DWR. Other time deposits include institutional
certificates of deposit. The Company, through Greenwood Trust Company, an
indirect subsidiary of the Company, sells notes under a short-term bank note
program.
The Company maintains borrowing relationships with a broad range of banks,
financial institutions, counterparties and others from which it draws funds in
a variety of currencies.
The Company maintains a senior revolving credit agreement with a group of
banks to support general liquidity needs, including the issuance of commercial
paper (the "Morgan Stanley Facility"). Under the terms of the credit
agreement, the banks are committed to provide up to $2.5 billion. At fiscal
year end 1996, $365 million was outstanding under the Morgan Stanley Facility
which was repaid in full subsequent to fiscal year end 1996. The Company has
assumed the Morgan Stanley Facility as part of the Merger.
The Company also maintains a second senior revolving credit agreement with a
group of banks to support general liquidity needs, including the issuance of
commercial paper (the "DWD Facility"). Under the terms of the credit
agreement, the banks are committed to provide up to $4.0 billion. As of fiscal
year end 1996, the Company has never borrowed from the DWD Facility. In April
1997, DWD renewed this facility which expires in April of 1998.
The Morgan Stanley Facility and the DWD Facility both contain covenants that
require the Company to maintain minimum net worth requirements and specified
financial ratios. The Company believes that the covenant restrictions will not
impair the Company's ability to pay its current level of dividends. Prior to
the closing of the Merger, the Morgan Stanley Facility and the DWD Facility
were amended to conform such facilities to insure that they remain effective
subsequent to the closing of the Merger and to accommodate the Company's post-
Merger business activities and financing needs. After the consummation of the
Merger, the Company expects that a new credit facility of the Company will
replace the Morgan Stanley Facility and the DWD Facility.
The Company maintains a master collateral facility that enables MS&Co. to
pledge certain collateral to secure loan arrangements, letters of credit and
other financial accommodations (the "MS&Co. Facility"). As part of the MS&Co.
Facility, MS&Co. also maintains a secured committed credit agreement with a
group of banks that are parties to the master collateral facility under which
such banks are committed to provide up to $1.25 billion. The credit agreement
contains restrictive covenants which require, among other things, that MS&Co.
maintain specified levels of consolidated shareholders' equity and Net
Capital, as defined. In January 1997, the MS&Co. Facility was renewed and the
amount of the commitment of the credit agreement was increased to $1.5
billion. At fiscal year end 1996, no borrowings were outstanding under the
MS&Co. Facility.
The Company also maintains a revolving committed financing facility that
enables MSIL to secure committed funding from a syndicate of banks by
providing a broad range of collateral under repurchase agreements (the "MSIL
Facility"). Such banks are committed to provide up to an aggregate of $1.25
billion available in 12 major currencies. The facility agreements contain
restrictive covenants which require, among other things, that MSIL maintain
specified levels of Shareholders' Equity and Financial Resources, each as
defined. In December 1996, the MSIL Facility was renewed, and the amount of
the commitment was increased to $1.55 billion. At fiscal year end 1996, no
borrowings were outstanding under the MSIL Facility.
RFC maintains a senior bank credit facility to support the issuance of
asset-backed commercial paper. In fiscal 1996, RFC renewed this facility and
increased its amount to $2.1 billion from $1.75 billion. RFC currently plans
to renew or replace this facility prior to its expiration in October 1997.
Under the terms of the asset-backed commercial paper program, certain assets
of RFC were subject to a lien in the amount of $2.2 billion at fiscal year end
1996. RFC has never borrowed from its senior bank credit facility.
The Company anticipates that it will utilize the Morgan Stanley Facility,
the DWD Facility, the MS&Co. Facility or the MSIL Facility for short-term
funding from time to time. RFC anticipates that it will utilize its facility
for short-term funding from time to time. (See Note 5 to the consolidated
financial statements.)
20
FISCAL 1996 AND SUBSEQUENT ACTIVITY
During fiscal year 1996, the Company took several steps to extend the
maturity of its liabilities, reduce its reliance on unsecured short-term
funding and increase its capital. These steps resulted in a net increase in
capital of $6,508 million to $31,152 million at fiscal year end 1996. The
additions to capital included net issuances of senior notes and subordinated
debt aggregating $6,108 million.
Subsequent to fiscal year end 1996, the Company and Morgan Stanley Finance
plc, a U.K. subsidiary ("MS plc"), issued 8.03% Capital Units in an aggregate
amount of $134 million. Each Capital Unit consists of (a) a Subordinated
Debenture of MS plc guaranteed by the Company, and (b) a related Purchase
Contract issued by the Company requiring the holder to purchase one Depositary
Share representing shares (or fractional shares) of the Company's 8.03%
Cumulative Preferred Stock.
During fiscal 1996, the Company redeemed all 5,500,000 shares of its 9.36%
Cumulative Preferred Stock at a redemption price of $25.156 per share, which
reflects the stated value of $25 per share together with an amount equal to
all dividends accrued and unpaid to, but excluding, the redemption date.
Subsequent to fiscal year end 1996, the Company redeemed all 975,000 shares
of its 8.88% Cumulative Preferred Stock at a redemption price of $201.632 per
share, which reflects the stated value of $200 per share
together with an amount equal to all dividends accrued and unpaid to, but
excluding, the redemption date. In addition, the Company announced that it had
called for redemption on May 30, 1997, all 750,000 shares of its 8-3/4%
Cumulative Preferred Stock at a redemption price of $200 per share.
During fiscal 1996, the Company issued 4,000,000 Depositary Shares,
representing 1,000,000 shares of 7-3/4% Cumulative Preferred Stock, in an
aggregate amount of $200 million. Each Depositary Share represents 1/4 of a
share of such preferred stock.
During fiscal 1996, the Company issued 6,900,000 Depositary Shares,
representing 1,725,000 shares of Series A Fixed/Adjustable Rate Cumulative
Preferred Stock ("FRAPS"), in the aggregate amount of $345 million. The FRAPS
will pay a fixed dividend rate of 5.91% through 2001, after which it will pay
a floating rate based upon certain U.S. Treasury securities. Each Depositary
Share represents 1/4 of a share of such preferred stock.
During fiscal 1996, the Company repurchased shares of its common stock at an
aggregate cost of $1,133 million and an average cost per share of $26.96.
Prior to the consummation of the Merger, both Morgan Stanley and Dean Witter
Discover rescinded any outstanding share repurchase authorizations.
At fiscal year end 1996, certain assets of the Company, such as real
property, equipment and leasehold improvements of $1.7 billion, and goodwill
and other intangible assets of $1.5 billion, are illiquid. In addition,
certain equity investments made in connection with the Company's merchant
banking and other principal investment activities, high-yield debt securities,
emerging market debt, and certain collateralized mortgage obligations and
mortgage-related loan products are not highly liquid. In connection with its
merchant banking and other principal investment activities, the Company has
equity investments (directly or indirectly through funds managed by the
Company) in privately and publicly held companies. As of fiscal year end 1996,
the aggregate carrying value of the Company's equity investments in privately
held companies (including direct investments and partnership interests) was
$107 million, and its aggregate investment in publicly held companies was $267
million.
The Company acts as an underwriter of and as a market-maker in mortgage-
backed pass-through securities, collateralized mortgage obligations and
related instruments, and as a market-maker in commercial, residential and real
estate loan products. In this capacity, the Company takes positions in market
segments where liquidity can vary greatly from time to time. The carrying
value of the portion of the Company's mortgage-related portfolio at fiscal
year end 1996 traded in markets that the Company believed were experiencing
lower levels of liquidity approximated $1,544 million.
21
In addition, at fiscal year end 1996, the aggregate value of high-yield debt
securities and emerging market loans and securitized instruments held in
inventory was $1,635 million (a substantial portion of which was subordinated
debt) with not more than 4%, 15% and 10% of all such securities, loans and
instruments attributable to any one issuer, industry or geographic region,
respectively. Non-investment grade securities generally involve greater risk
than investment grade securities due to the lower credit ratings of the
issuers, which typically have relatively high levels of indebtedness and are,
therefore, more sensitive to adverse economic conditions. In addition, the
market for non-investment grade securities and emerging market loans and
securitized instruments has been, and may in the future be, characterized by
periods of volatility and illiquidity. The Company has in place credit and
other risk policies and procedures to control total inventory positions and
risk concentrations for non-investment grade securities and emerging market
loans and securitized instruments.
The Company also has commitments to fund certain fixed assets and other less
liquid investments, including at fiscal year end 1996 approximately $208
million in connection with its merchant banking and other principal investment
activities. Additionally, the Company has provided and will continue to
provide financing, including margin lending and other extensions of credit to
clients.
The Company may, from time to time, also provide financing or financing
commitments to companies in connection with its investment banking and
merchant banking activities. The Company may provide extensions
of credit to leveraged companies in the form of senior or subordinated debt,
as well as bridge financing on a select basis (which may be in connection with
the Company's commitment to the Morgan Stanley Bridge Fund, LLC).
The Company also engages in senior lending activities, including
origination, syndication and trading of senior secured loans of non-investment
grade companies. Such companies are more sensitive to adverse economic
conditions than investment grade issuers, but the loans are generally made on
a secured basis and are senior to the non-investment grade securities of these
issuers that trade in the capital markets. As of fiscal year end 1996, the
aggregate value of senior secured loans and positions held by the Company was
$178 million, and aggregate senior secured loan commitments were $42 million.
The gross notional and fair value amounts of derivatives used by the Company
for asset and liability management and as part of its trading activities are
summarized in Notes 6 and 8, respectively, to the consolidated financial
statements. See also "Derivative Financial Instruments" herein.
The widespread use of computer programs that rely on two-digit date programs
to perform computations and decision-making functions may cause computer
systems to malfunction in the year 2000 which could lead to business delays
and disruptions in the U.S. and internationally. The Company has been
modifying its computer systems to address this issue. However, due to the
interdependent nature of computer systems, the Company may be adversely
impacted in the year 2000 depending on whether it or other entities not
affiliated with the Company address this issue successfully.
REGULATORY CAPITAL REQUIREMENTS
DWR, a registered broker dealer and a registered futures commission
merchant, is subject to the minimum net capital requirements of the Securities
and Exchange Commission ("SEC"). MS&Co. is a registered broker-dealer and a
registered futures commission merchant and, accordingly, is subject to the
minimum net capital requirements of the SEC and the Commodity Futures Trading
Commission. MSIL, a London-based broker-dealer subsidiary, is regulated by the
Securities and Futures Authority ("SFA") in the United Kingdom and,
accordingly, is subject to the Financial Resources Requirements of the SFA.
Morgan Stanley Japan Limited ("MSJL"), a Tokyo-based broker-dealer, is
regulated by the Japanese Ministry of Finance. DWR, MS&Co., MSIL and MSJL have
consistently operated in excess of their respective regulatory requirements
(see Note 10 to the consolidated financial statements).
22
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 applicable local capital adequacy requirements. In
addition, Morgan Stanley Derivative Products Inc., a triple-A rated subsidiary
through which the Company conducts some of its derivative activities, has
established certain operating restrictions which have been reviewed by various
rating agencies.
EFFECTS OF INFLATION AND CHANGES IN FOREIGN EXCHANGE RATES
Because the Company's assets to a large extent are liquid in nature, they
are not significantly affected by inflation. However, inflation may result in
increases in the Company's expenses, which may not be readily recoverable in
the price of services offered. To the extent inflation results in rising
interest rates and has other adverse effects upon the securities markets, on
the value of financial instruments and the markets for consumer credit
services, it may adversely affect the Company's financial position and
profitability.
A portion of the Company's business is conducted in currencies other than
the U.S. dollar. Non-U.S. dollar assets typically are financed by direct
borrowing or swap-based funding in the same currency. Changes in foreign
exchange rates affect non-U.S. dollar revenues as well as non-U.S. dollar
expenses. Those foreign exchange exposures that arise and are not hedged by an
offsetting foreign currency exposure are actively managed by the Company to
minimize risk of loss due to currency fluctuations.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company actively offers to clients and trades for its own account a
variety of financial instruments described as "derivative products" or
"derivatives". These products generally take the form of futures, forwards,
options, swaps, caps, collars, floors, swap options and similar instruments
which derive their value from underlying interest rates, foreign exchange
rates or commodity or equity instruments and indices. All of the Company's
trading-related divisions use derivative products as an integral part of their
respective trading strategies, and such products are used extensively to
manage the market exposure that results from a variety of proprietary trading
activities (see Note 8 to the consolidated financial statements). In addition,
as a dealer in certain derivative products, most notably interest rate and
currency swaps, the Company enters into derivative contracts to meet a variety
of risk management and other financial needs of its clients. Given the highly
integrated nature of derivative products and related cash instruments in the
determination of overall trading division profitability and the context in
which the Company manages its trading areas, it is not meaningful to allocate
trading revenues between the derivative and underlying cash instrument
components. Moreover, the risks associated with the Company's derivative
activities, including market and credit risks, are managed on an integrated
basis with associated cash instruments in a manner consistent with the
Company's overall risk management policies and procedures (see "Risk
Management" herein). It should be noted that while particular risks may be
associated with the use of derivatives, in many cases derivatives serve to
reduce, rather than increase, the Company's exposure to losses from market,
credit and other risks.
The total notional value of derivative trading contracts outstanding at
fiscal year end 1996 was $1,317 billion (as compared with $985 billion at
fiscal year end 1995). While these amounts are an indication of the Company's
degree of use of derivatives for trading purposes, they do not represent the
Company's market or credit exposure and may be more indicative of customer
utilization of derivatives. The Company's exposure to market risk relates to
changes in interest rates, foreign currency exchange rates or the fair value
of the underlying financial instruments or commodities. The Company's exposure
to credit risk at any point in time is represented by the fair value of such
contracts reported as assets. Such total fair value outstanding as of fiscal
year end 1996 was $11.2 billion. Approximately $9.0 billion of that credit
risk exposure was with counterparties rated single-A or better (see Note 8 to
the consolidated financial statements).
23
The Company also uses derivative products (primarily interest rate, currency
and equity swaps) to assist in asset and liability management, reduce
borrowing costs and hedge consumer loan interest rate spreads. (See Notes 5
and 6 to the consolidated financial statements.)
The Company believes that derivatives are valuable tools that can provide
cost-effective solutions to complex financial problems and remains committed
to providing its clients with innovative financial products. The Company
established Morgan Stanley Derivative Products Inc. to offer derivative
products to clients who will enter into derivative transactions only with
triple-A rated counterparties. In addition, the Company, through its
continuing involvement with regulatory, self-regulatory and industry
activities such as the International Swaps and Derivatives Association Inc.
(ISDA), the Securities Industry Association, the Group of 30 and the U.S.
securities firms' Derivatives Policy Group, provides leadership in the
development of policies and practices in order to maintain confidence in the
markets for derivative products, which is critical to the Company's ability to
assist clients in meeting their overall financial needs.
The following discussion of risk management relates to the Company's
securities businesses.
SECURITIES RISK MANAGEMENT
Risk is an inherent part of the Company's businesses and activities. The
extent to which the Company properly and effectively identifies, assesses,
monitors and manages each of the various types of risks involved in
its activities is critical to its soundness and profitability. The Company's
broad-based portfolio of business activities helps reduce the impact that
volatility in any particular area or related areas may have on its net
revenues as a whole. From an operational perspective, the Company seeks to
identify, assess, monitor and manage, in accordance with defined policies and
procedures, the following principal risks involved in each area of business
activity: market risk, credit risk, operational risk, legal risk and funding
risk (discussed in "Liquidity and Capital Resources--Funding and Capital
Policies" herein).
Risk management at the Company is an integrated process with independent
oversight which requires constant communication, judgment and knowledge of
specialized products and markets. The Company's senior management takes an
active role in the risk management process and has developed policies and
procedures that require specific administrative and business functions to
assist in the identification, assessment and control of various risks. In
recognition of the increasingly varied and complex nature of the financial
services business, the Company's risk management policies and procedures are
evolutionary in nature and are subject to ongoing review, modification and
revision.
The Company has developed a multi-tiered approach for monitoring and
managing its risks. The Finance and Risk Committee, authorized by the
Company's Board of Directors, is chaired by the Company's Chief Financial
Officer and is composed of senior officers with familiarity and expertise in
dealing with risk management principles. It establishes the overall risk
management policies of the Company, reviews the Company's performance relative
to these policies, allocates capital among business activities of the Company,
monitors the availability of sources of financing, reviews the foreign
exchange risk of the Company, and oversees the liquidity and interest rate
sensitivity of the Company's asset and liability position (see also "Liquidity
and Capital Resources--Funding and Capital Policies" herein). The Firm Risk
Manager heads the Firm Risk Management Group (described below) which assists
senior management and the Finance and Risk Committee in establishing,
monitoring and controlling the Company's overall risk profile. With respect to
the Company's major trading divisions (fixed income, equity, commodities and
foreign exchange), division risk managers monitor and manage positions and set
the overall division risk profile on a worldwide basis within established
market risk limits, review major trading positions and strategies, and report
major market and position events to the Firm Risk Manager. Desk risk managers
perform similar functions with respect to a product area or particular product
at the business unit and trading desk level.
The Firm Risk Management Group, which has operational responsibility for
identifying, monitoring and reporting to senior management on the Company's
exposure to risk, consists of three departments that are all independent of
the Company's business areas: the Market Risk Department monitors the
Company's market risk
24
profile on a worldwide basis, which includes all divisional, geographic and
product-line market risks; the Credit Department manages and monitors
counterparty exposure limits on a worldwide basis; and the Internal Audit
Department, which also reports to the Audit Committee of the Board of
Directors, assesses the Company's operations and control environment through
periodic examinations of business and operational areas.
During fiscal 1996, the Company established a Risk Management Advisory Board
which advises the Firm Risk Management Group on risk measurement
methodologies, models and systems and establishes review procedures for models
used by the Company for valuation and risk measurement. Other departments
within the Company that also are independent of the Company's business areas
and are actively involved in monitoring the Company's risk profile include:
Controllers, Corporate Treasury, Information Technology, Legal and Compliance,
Tax and Operations.
The Company also has certain commitment committees, composed of a cross
section of the Company's senior officers from various disciplines, that are
involved in managing and monitoring the risks associated with the Company's
diverse businesses. The High-Yield Commitment Committee and Equity Commitment
Committee determine whether the Company should participate in a transaction
involving the underwriting or placement of high-yield or equity securities,
respectively, where the Company's capital and reputation may be at risk, and
evaluate the potential revenues and risks involved with respect to particular
transactions.
The Company manages the various risks associated with its activities on a
Company-wide basis, on a divisional level worldwide and on an individual
product basis. Specific market risk guidelines and limits have been approved
for the Company and each trading division of the Company worldwide by the
Finance and Risk Committee. Discrete market risk limits are assigned to
business units and trading desks within trading areas which are compatible
with the trading division limits. Division risk managers, desk risk managers
and the Market Risk Department all monitor market risk measures against
limits. The Market Risk Department independently reviews the Company's trading
portfolios on a regular basis from a market risk perspective which includes
value at risk and other quantitative and qualitative risk measurements and
analyses. The Company may use measures, such as rate sensitivity, convexity,
volatility and time decay measurements, to estimate market risk and to assess
the sensitivity of positions to changes in market conditions. Stress testing,
which measures the impact on the value of existing portfolios of specified
changes in market factors, for certain products is performed periodically and
reviewed by division risk managers, desk risk managers and the Market Risk
Department.
The Finance and Risk Committee has approved Company-wide credit guidelines
which limit the Company's credit exposure to any one counterparty. Specific
credit risk limits based on the credit guidelines also have been approved by
the Finance and Risk Committee for each type of counterparty (by rating
category) as well as secondary positions of high-yield and emerging market
debt, and the Credit Department administers and monitors the credit limits
among trading divisions on a worldwide basis. The Company manages the credit
exposure relating to its trading activities by reviewing counterparty
financial soundness periodically; entering into master netting agreements and
collateral arrangements with counterparties in appropriate circumstances; and
limiting the duration of exposure. In certain cases, the Company may also
close out transactions or assign them to other counterparties to mitigate
credit risk.
In addition, the Company's Controllers and Operations Departments monitor
position, profit/loss and balance sheet information through reconciliation
procedures, and analyze business unit profitability, position market prices
and aged positions. The Company also has established legal standards and
procedures on a worldwide basis that are designed to ensure compliance with
applicable statutory and regulatory requirements and that senior management's
policies relating to conduct, ethics and business practices are followed to
protect client interests and maintain the Company's reputation and business
franchise.
Many of the Company's risk management and control practices are subject to
periodic review by the Company's internal auditors and independent
accountants, as well as interactions with various regulatory authorities. The
Company continues to be committed to employing qualified personnel with
appropriate expertise in each of its various administrative and business areas
to implement effectively the Company's risk management and monitoring systems
and processes.
25
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
(PARENT COMPANY ONLY)
SUPPLEMENTAL CONDENSED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN MILLIONS, EXCEPT SHARE DATA)
--------
(1)Amounts have been restated to reflect the Company's two-for-one stock
splits.
See Notes to the Supplemental Condensed Financial Information.
1
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
(PARENT COMPANY ONLY)
SUPPLEMENTAL CONDENSED STATEMENTS OF INCOME
(DOLLARS IN MILLIONS)
See Notes to the Supplemental Condensed Financial Information.
2
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
(PARENT COMPANY ONLY)
SUPPLEMENTAL CONDENSED STATEMENTS OF CASH FLOWS
(DOLLARS IN MILLIONS)
See Notes to the Supplemental Condensed Financial Information.
3
MORGAN STANLEY, DEAN WITTER, DISCOVER & CO.
(PARENT COMPANY ONLY)
NOTES TO SUPPLEMENTAL CONDENSED FINANCIAL INFORMATION
1. INTRODUCTION AND BASIS OF PRESENTATION
The Merger
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged with
and into Dean Witter, Discover & Co. ("Dean Witter Discover") (the "Merger").
At that time, Dean Witter Discover changed its corporate name to Morgan
Stanley, Dean Witter, Discover & Co. (the "Company"). In conjunction with the
Merger, each share of Morgan Stanley common stock then outstanding was
converted into the right to receive 1.65 shares of the Company's common stock
(the "Exchange Ratio"), and each share of Morgan Stanley preferred stock was
converted into the right to receive one share of a corresponding series of
preferred stock of the Company. The Merger was treated as a tax free exchange.
Basis of Financial Information
The supplemental condensed financial statements of Morgan Stanley, Dean
Witter, Discover & Co. (the "Parent Company financial statements") give
retroactive effect to the merger of Dean Witter Discover and Morgan Stanley in
a transaction accounted for as a pooling of interests. The pooling of interests
method of accounting requires the restatement of all periods presented as if
Dean Witter Discover and Morgan Stanley had always been combined. Generally
accepted accounting principles proscribe giving effect to a consummated
business combination accounted for by the pooling of interests method in
financial statements that do not include the date of consummation. The Parent
Company financial statements do not extend through the date of consummation.
However, they will become the historical condensed financial statements of
Morgan Stanley, Dean Witter, Discover & Co. (the "Parent Company") after
financial statements covering the date of consummation of the business
combination are issued. The Parent Company financial statements, including the
notes thereto, should be read in conjunction with historical condensed
financial statements of Dean Witter Discover (Parent Company Only) and Morgan
Stanley (Parent Company Only), included in their Annual Reports on Form 10-K
for the fiscal years ended December 31, 1996 and November 30, 1996,
respectively, and should also be read in conjunction with the supplemental
consolidated financial statements of the Company and notes thereto found
elsewhere in this Current Report on Form 8-K.
Prior to the consummation of the Merger, Dean Witter Discover's fiscal year
ended on December 31 and Morgan Stanley's fiscal year ended on November 30. In
recording the pooling of interests combination, Dean Witter Discover's
financial statements for the fiscal years ended December 31, 1996, 1995 and
1994 were combined with Morgan Stanley's financial statements for the fiscal
years ended November 30, 1996, 1995 and 1994 (on a combined basis, "fiscal year
1996", "fiscal year 1995" and "fiscal year 1994", respectively.)
Certain reclassifications have been made to prior years amounts to conform to
the current presentation.
4
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders of
Morgan Stanley, Dean Witter, Discover & Co.
We have audited the accompanying supplemental consolidated statements of
financial condition of Morgan Stanley, Dean Witter, Discover & Co. and
subsidiaries at fiscal year end 1996 and 1995, and the related supplemental
consolidated statements of income, cash flows and changes in shareholders'
equity for fiscal year 1996, 1995 and 1994. These supplemental consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these supplemental consolidated
financial statements based on our audits. We did not audit the consolidated
statement of financial condition of Morgan Stanley Group Inc. and subsidiaries
as of November 30, 1996 and 1995, or the related statements of income, cash
flows and changes in shareholders' equity for the years ended November 30,
1996, 1995 and 1994, which statements reflect total assets of $196,446 million
and $143,753 million as of November 30, 1996 and 1995, respectively, and total
revenues of $13,144 million, $10,797 million and $9,255 million for the years
ended November 30, 1996, 1995 and 1994, respectively. Those statements were
audited by other auditors whose report has been furnished to us, and our
opinion, insofar as it relates to the amounts included for Morgan Stanley
Group Inc. and subsidiaries for such periods, is based solely on the report of
such other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits and the report of the other
auditors provide a reasonable basis for our opinion.
The supplemental consolidated financial statements give retroactive effect
to the merger of Dean Witter, Discover & Co. and Morgan Stanley Group Inc.,
which has been accounted for as a pooling of interests as described in Note 1
to the supplemental consolidated financial statements. Generally accepted
accounting principles proscribe giving effect to a consummated business
combination accounted for by the pooling of interests method in financial
statements that do not include the date of consummation. The supplemental
consolidated financial statements do not extend through the date of
consummation. However, they will become the historical consolidated financial
statements of Morgan Stanley, Dean Witter, Discover & Co. and subsidiaries
after financial statements covering the date of consummation of the business
combination are issued.
In our opinion, based on our audits and the report of the other auditors,
the accompanying supplemental consolidated financial statements present
fairly, in all material respects, the consolidated financial position of
Morgan Stanley, Dean Witter, Discover & Co. and subsidiaries at fiscal year
end 1996 and 1995, and the consolidated results of their operations and their
cash flows for fiscal year 1996, 1995 and 1994, in conformity with generally
accepted accounting principles applicable after financial statements are
issued for a period which includes the date of consummation of the business
combination.
Our audits also included the supplemental financial statement schedules
relating to Morgan Stanley, Dean Witter, Discover & Co. (Parent Company Only).
These supplemental financial statement schedules are the responsibility of the
Company's management. Our responsibility is to express an opinion based on our
audits. In our opinion, based on our audits and the report of the other
auditors, such supplemental financial statement schedules, when considered in
relation to the supplemental consolidated financial statements taken as a
whole, present fairly in all material respects the information set forth
herein.
/s/ Deloitte & Touche LLP
New York, New York
May 31, 1997
Report of Independent Auditors
The Stockholders and
Board of Directors of
Morgan Stanley Group Inc.
We have audited the Consolidated Statement of Financial Condition of Morgan
Stanley Group Inc. as of November 30, 1996 and 1995 and the related
Consolidated Statements of Income, Cash Flows and Changes in Stockholders'
Equity for each of the three years in the period ended November 30, 1996 (not
presented separately herein). Our audits also included the schedule of parent
company stand alone financial statements of Morgan Stanley Group Inc. These
financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Morgan
Stanley Group Inc. at November 30, 1996 and 1995, and the consolidated results
of operations and cash flows for each of the three years in the period ended
November 30, 1996, in conformity with generally accepted accounting
principles. Also, in our opinion, the related schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly,
in all material respects, the information set forth therein.
/s/ Ernst & Young LLP
New York, New York
May 27, 1997
EXHIBIT 11
Morgan Stanley, Dean Witter, Discover & Co.
Computation of Earnings Per Share
(In millions, except share and per share data)
/(1)/ Historical share and per share amounts have been restated to reflect the
Company's two-for-one stock splits.
EXHIBIT 12
MORGAN STANLEY, DEAN WITTER DISCOVER & CO.
COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES
"Earnings" consist of income before income taxes and fixed charges. "Fixed
charges" consist of interest costs, including interest on deposits, and that
portion of rent expense estimated to be representative of the interest factor.