EXHIBIT 13.3
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
INTRODUCTION
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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
1.65 shares of the Company's common stock (the "Exchange Ratio"), and each share
of Morgan Stanley preferred stock was converted into 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 pre-eminent global financial services firm that maintains
leading market positions in each of its businesses--Securities and Asset
Management, and Credit and Transaction Services. The Company combines three
well-recognized brands in the financial services industry: Morgan Stanley, Dean
Witter and Discover(R) Card. The Company also combines global strengths in
investment banking (including in the origination of quality underwritten public
offerings and mergers and acquisitions advice) and institutional sales and
trading, with strengths in providing investment and global asset management
services to its customers and in providing quality consumer credit products
primarily through its Discover(R) Card brand.
BASIS OF FINANCIAL INFORMATION
The Company's consolidated financial statements give retroactive effect to the
Merger 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 always had been combined. The
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 of the periods presented.
Prior to the consummation of the Merger, Dean Witter Discover's year ended
on December 31 and Morgan Stanley's fiscal year ended on November 30. Subsequent
to the Merger, the Company adopted a fiscal year-end of November 30. In
recording the pooling of interests combination, Dean Witter Discover's financial
statements for the years ended December 31, 1996 and 1995 were combined with
Morgan Stanley's financial statements for the fiscal years ended November 30,
1996 and 1995 (on a combined basis, "fiscal 1996" and "fiscal 1995,"
respectively). The Company's results for the twelve months ended November 30,
1997 ("fiscal 1997") include the results of Dean Witter Discover that were
restated to conform to the new fiscal year-end date. The Company's results of
operations for fiscal 1997 and fiscal 1996 include the month of December 1996
for Dean Witter Discover.
Certain reclassifications have been made to prior-year amounts to conform
to the current presentation. All material intercompany balances and transactions
have been eliminated.
RESULTS OF OPERATIONS
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CERTAIN FACTORS AFFECTING RESULTS OF OPERATIONS*
The Company's results of operations may be materially affected by market
fluctuations and by economic factors. In addition, results of operations in the
past have been and in the future may continue to be materially affected by many
factors of a global nature, including 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 also may have an impact on
the Company's ability to achieve its strategic objectives, including (without
limitation) continued profitable global expansion.
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* This Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements, as well as a
discussion of some of the risks and uncertainties involved in the Company's
businesses that could affect the matters referred to in such statements.
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The Company's Securities and Asset Management 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 client assignments (including realization
of returns from the Company's principal and merchant banking investments). In
the Company's Credit and Transaction Services business, changes in economic
variables may substantially affect consumer loan growth and credit quality. Such
variables include the number of personal bankruptcy filings, the rate of
unemployment and the level of consumer debt to income ratios.
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 both in the U.S. and globally. As a
result of recent and pending legislative and regulatory initiatives in the U.S.
to remove or relieve certain restrictions on commercial banks, competition in
some markets that have traditionally been dominated by investment banks and
retail securities firms has increased and may continue to increase in the near
future. In addition, recent convergence and consolidation in the financial
services industry will lead to increased competition from larger diversified
financial services organizations. Fiscal 1997 was characterized by a record
level of strategic alliances in the financial services industry which focused on
expanding asset management capabilities and combining institutional and retail
businesses, including product origination and distribution capabilities.
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 by consistency of
investment performance and accessibility to a broad array of 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 number 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 and by having broad merchant acceptance.
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. The Company's ability and
success in maintaining high levels of profitable business activities,
emphasizing fee-based assets that are designed to generate a continuing stream
of revenues, managing risks in both the Securities and Asset Management and
Credit and Transaction Services businesses, evaluating credit product pricing
and monitoring costs will continue to affect its overall financial results. In
addition, the 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.
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MARKET AND ECONOMIC CONDITIONS IN FISCAL 1997
The favorable market and economic conditions which characterized fiscal 1996
continued throughout much of fiscal 1997, contributing to higher industry-wide
securities revenues and to record levels of net income and net revenues for the
Company's Securities and Asset Management business. In addition, the Company's
Securities and Asset Management business ended the fiscal year with record
levels of account executives, customer accounts and assets, and assets under
management and administration. The Company's Credit and Transaction Services
business also recorded record levels of net income, net revenues, managed
consumer loans and customer accounts despite difficult conditions in the
industry which resulted in higher rates of credit card loan charge-offs.
Market conditions in the U.S. were favorable for much of fiscal 1997, as
moderate economic growth, low levels of unemployment and continued growth in
corporate profits generally prevailed. Despite these conditions, the level of
inflation has remained relatively low. U.S. financial markets also experienced
periods of increased volatility during fiscal 1997. In the first half of the
year, bond markets were affected by fears of inflationary pressures due to
consistently strong indicators of economic growth, which prompted the Federal
Reserve Board to raise the overnight lending rate by .25% in March 1997. The
bond markets rallied later in the year as interest rates fell across the yield
curve. This decline in interest rates reflected the continuing stability of
inflation and the Federal Reserve Board's interest rate policy. The market for
U.S. government securities was particularly strong during the latter part of the
year, as market instability in certain Asian markets increased investor demand
for less risky investments. The performance of U.S. equity markets also was very
positive in fiscal 1997, primarily resulting from strong corporate earnings,
high levels of cash inflows into mutual funds, and a high volume of equity
issuances. U.S. equity markets also experienced periods of increased volatility,
particularly during the second and fourth fiscal quarters. During both of these
periods, equity markets experienced sharp selloffs that were subsequently
followed by strong recoveries.
In fiscal 1997, European financial markets provided investors with solid
returns despite a slight downturn during the fourth quarter. The robust
performance of these markets reflected strong corporate earnings and optimism
that economic growth in the region will continue to remain solid. European
financial markets also were impacted by the prospects of the approaching
European Economic and Monetary Union ("EMU"). The EMU is scheduled to commence
on January 1, 1999 when the European Currency Unit (the "ECU") will be replaced
by the "Euro" at a conversion rate of 1:1. Those national currencies which are
to participate in the EMU will ultimately cease to exist as separate currencies
and will be replaced by the Euro. Throughout fiscal 1997, varying expectations
regarding the probability and timing of the EMU often caused volatility in
certain interest rates and currencies.
In the Far East, the conditions in Japanese financial markets were
generally weak during the fiscal year, as the nation's rate of economic growth
remained sluggish. Investors also have been concerned with the strength of
Japan's financial system. The Japanese banking sector has been burdened by
underperforming real estate loans, rising unemployment, an anemic stock market
and fears regarding the potential impact of the economic crisis that began in
fiscal 1997 in much of Asia. Financial markets in Southeast Asia also
experienced difficult conditions, including the currency crisis that impacted
the region, which impaired creditworthiness and undermined investor confidence
in the region's highly leveraged banking sector. Conditions in these markets
were particularly volatile in the third and fourth fiscal quarters, as increased
investor concerns resulted in significant declines in certain Asian equity
markets. The currencies of certain nations in the region also experienced
sizable depreciation during this period.
The worldwide market for mergers and acquisitions continued to be robust
during fiscal 1997, resulting in record levels of revenues by the Company's
investment banking business. The need for economies of scale, loca-
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tion, 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 buoyant equity markets. The markets for the
underwriting of securities also were robust, as corporations, like consumers,
were capitalizing on low interest rates to refinance debt obligations. Primary
markets also benefited from the continued flow of funds into the equity markets
from mutual funds, asset allocation adjustments, the continued cross border
flows of capital and a significant number of privatizations.
In fiscal 1997, consumer demand and retail sales continued to increase
although at a slower rate than the prior year, favorably impacting credit card
transaction volume and consumer loan growth. In fiscal 1997, the Company
continued to invest in growth through the expansion of its NOVUS(R) Network and
by increasing its marketing and solicitation activities. However, credit quality
issues have continued to be a challenge for the credit services industry and the
Company, as levels of consumer debt and personal bankruptcies continued to
increase during fiscal 1997 with resulting continued increases in industry-wide
credit card loan losses.
FISCAL 1997 AND 1996 RESULTS FOR THE COMPANY
The Company achieved net income of $2,586 million in fiscal 1997, a 31% increase
from fiscal 1996. In fiscal 1996, net income increased 35% to $1,980 million
from fiscal 1995. Primary earnings per common share increased 32% to $4.25 in
fiscal 1997 and 40% to $3.22 in fiscal 1996. Fully diluted earnings per common
share increased 32% to $4.15 in fiscal 1997 and 40% to $3.14 in fiscal 1996. The
Company's return on average shareholders' equity was 22%, 20% and 16% in fiscal
1997, fiscal 1996 and fiscal 1995, respectively. The Company's fiscal 1997 net
income includes $63 million of costs related to the Merger. These costs, which
consisted primarily of proxy solicitation costs, severance costs, financial
advisory and accounting fees, and legal and regulatory filing fees, were
recorded by the Company during the second fiscal quarter.
The remainder of Results of Operations is presented on a business segment
basis. With the exception of fiscal 1997's merger-related expenses,
substantially all of the operating revenues and operating expenses of the
Company can be directly attributed to its two business segments: Securities and
Asset Management, and Credit and Transaction Services. Certain reclassifications
have been made to prior-period amounts to conform to the current year's
presentation.
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SECURITIES AND ASSET MANAGEMENT
Securities and Asset Management provides a wide range of financial products,
services and investment advice to individual and institutional investors.
Securities and Asset Management business activities are conducted in the U.S.
and throughout the world and include investment banking, research, institutional
sales and trading, global asset management, and investment and asset management
products and services for individual clients. At November 30, 1997, the
Company's Dean Witter Reynolds Inc. ("DWR") account executives provided
investment services to more than 3.5 million client accounts with assets of $302
billion. The Company had the third largest account executive sales organization
in the U.S. with 9,946 professional account executives and 399 branches at
November 30, 1997. With well-recognized brand names, including those associated
with Dean Witter InterCapital Inc. ("ICAP"), Van Kampen American Capital, Inc.
("VKAC"), Morgan Stanley Asset Management and Miller Anderson & Sherrerd, LLP
("MAS"), the Company has one of the largest global asset management operations
of any full-service securities firm, with total assets under management or
supervision of $338 billion at November 30, 1997.
Securities and Asset Management achieved record net revenues and net income
of $11,866 million and $2,181 million in fiscal 1997, increases of 29% and 41%,
respectively, from fiscal 1996. In fiscal 1996, Securities and Asset Management
net revenues and net income increased 27% and 50%, respectively, from fiscal
1995. The Company's fiscal 1997 and 1996 levels of net revenues and net income
in its Securities and Asset Management business 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 and the positive accumulation and management of client assets. 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 and 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 increased 23% and attained record levels in fiscal
1997, surpassing the Company's previous level of record revenues that were
recorded in fiscal 1996. Revenues in both fiscal 1997 and fiscal 1996 benefited
from increased advisory fees from merger, acquisition and restructuring
transactions, as well as increased revenues from underwriting debt and equity
securities.
The worldwide merger and acquisition markets remained robust for the third
consecutive year with more than $1.6 trillion of transactions (per Securities
Data Company) announced during calendar year, 1997, including record volume in
the U.S. The sustained growth of the merger and acquisition markets, coupled
with the Company's global presence and strong market share, had a positive
impact on advisory fees, which increased 8% in fiscal 1997. As was the case in
fiscal 1996, merger and acquisition activity was diversified across many
industries in the Company's client base. In fiscal 1997, the health care,
banking and other financial services, telecommunications, technology and energy
sectors contributed the greatest level of activity. Advisory fees from real
estate
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transactions were also higher as compared with the prior year, benefiting
from a stable financing environment, favorable economic conditions and a strong
real estate market, including accelerated consolidation activity among real
estate investment trusts ("REITS"). The 36% increase in advisory fees in 1996
was primarily due to high transaction volumes that were propelled in part by
rising stock prices, as well as the Company's strong global presence and broad
client base.
Equity underwriting revenues increased 23% in fiscal 1997, primarily due to
a higher volume of equity offerings and an increased market share, particularly
in Europe, as compared with the prior year. The primary market for equity
issuances continued to benefit from the high volume of cash inflows into equity
mutual funds, as well as from a favorable economic environment. Equity
underwriting revenues increased 44% in fiscal 1996 and were positively affected
by 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.
Revenues from debt underwriting increased 43% in fiscal 1997. The increase
was primarily attributable to higher revenues from high-yield debt issuances, as
the favorable market conditions which existed for much of fiscal 1997 enabled
certain high-yield issuers to obtain attractive rates of financing. Issuers in
the telecommunications sector were particularly active in the high-yield debt
market. Debt financing revenues also were impacted by higher revenues from
securitized debt issuances, resulting from the Company's continued focus on this
business sector and an increase in the number of asset-backed transactions. In
fiscal 1996, revenues from debt financing activity increased 44% and 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 to a modest decrease in the Federal Funds rate in January 1996.
Fiscal 1996 debt underwriting revenues reflected 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.
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 increased 11% to record levels in fiscal 1997,
reflecting favorable market conditions that contributed to strong customer
demand and high trading volumes. The increased revenues were primarily from
trading in equity cash products, as the strong rates of return generated by many
global equity markets contributed to higher customer trading volumes and the
continuance of high levels of cash inflows into mutual funds. Revenues also
benefited from the strong performance of many foreign equity markets,
particularly in Europe, which led to higher trading volumes as U.S. investors
sought to increase their positions in these markets. Equity trading revenues
increased 62% in fiscal 1996, reflecting increased customer trading activity,
particularly in the U.S., as the 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
equity mutual funds at a high level. Revenues from equity derivative
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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.
Fixed income trading revenues increased 1% in fiscal 1997. Revenues from
trading in fixed income products were positively affected by high levels of
customer trading volumes, a large amount of new debt issuances and increased
demand for credit sensitive fixed income products. Revenues from trading in
high-yield debt securities and fixed income derivative products were
particularly favorably impacted by these developments. Securitized debt trading
revenues also increased, as the Company continued to focus on this market
segment by expanding its level of activity in several key areas. Trading
revenues benefited from higher revenues from trading in commercial whole loans
and mortgage swaps, coupled with increased securitization volumes and innovative
structures. These increases were offset by lower revenues from trading in
government and investment grade corporate securities. Fixed income trading
revenues increased 65% 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 increase as securitizations
increased and innovative structures were created.
Revenues from foreign exchange trading increased 196% to record levels in
fiscal 1997, primarily resulting from the Company's increased client market
share and from high levels of volatility in the foreign exchange markets. The
U.S. dollar appreciated against many currencies throughout the year due to the
strong growth of the U.S. economy and continued low levels of inflation. In
addition, many European currencies experienced periods of increased volatility
due to uncertainty regarding the timing of the EMU and the strength of the Euro,
while the performance of the yen was affected by sluggish economic growth in
Japan. Other Asian currencies were particularly volatile during the latter half
of fiscal 1997, primarily due to the depreciation of certain currencies,
including Thailand's baht. Higher trading volumes and an increasing customer
base also contributed to the increase in revenues. Foreign exchange trading
revenues declined 5% in fiscal 1996, primarily due to decreased volatility in
the foreign exchange markets due to the narrowing of the differences in
inflation rates among certain European nations.
Commodities trading revenues increased 42% and reached record levels in
fiscal 1997, benefiting from higher revenues from trading in energy products,
including the Company's increased presence in the electricity markets, precious
metals and natural gas. Volatility in these products was high during most of the
year due to fluctuating levels of customer demand and inventory. In both fiscal
1997 and fiscal 1996, commodities trading revenues benefited from the expansion
of the customer base for commodity-related products, including derivatives, and
the use of such products for risk management purposes. Revenues from commodities
trading increased 96% in fiscal 1996, benefiting from volatile markets that were
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buoyed by low inventories, robust demand and the industry's expectation for much
of fiscal 1996 that Iraq would re-enter the world crude oil market. In fiscal
1996, 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.
Principal transaction investment revenues aggregating $463 million were
recognized in fiscal 1997 as compared with $86 million in fiscal 1996. Fiscal
1997 revenues reflect a record level of revenues from the Company's merchant
banking business. The higher revenues primarily reflect increases in the
carrying value of certain of the Company's merchant banking investments,
including an increase related to the Company's holdings of Fort James
Corporation, the entity created from the merger of Fort Howard Corporation and
James River Corporation of Virginia, as well as realized gains on certain
positions that were sold during the year. Higher revenues from certain real
estate and venture capital investment gains also contributed to the increase.
Fiscal 1996 revenues also reflect increases in the carrying value of certain of
the Company's merchant banking investments, as well as revenues from other
principal investments, including real estate investments.
Commissions
Commission revenues primarily arise from agency transactions in listed and
over-the-counter equity securities and sales of mutual funds, futures, insurance
products and options. Commission revenues increased 16% in fiscal 1997,
primarily reflecting high customer trading volumes, particularly in the third
and fourth fiscal quarters when the New York Stock Exchange experienced some of
the highest trading volume in its history. The strong returns posted by many
global equity markets encouraged an increased investor demand for equity
securities and resulted in high levels of cash inflows into mutual funds.
Commission revenues also benefited from an increase in the Company's market
share and from the continued strength in the market for equity issuances. In
fiscal 1996, the 16% increase in commission revenues primarily reflected
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.
Net Interest
Interest and dividend revenues and expense are a function of the level and mix
of total assets and liabilities, including financial instruments owned, reverse
repurchase and repurchase agreements, customer margin loans and the prevailing
level, term structure and volatility of interest rates. 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. Net interest revenues increased 23% in fiscal 1997,
reflecting higher levels of trading activities and retail customer financing
activity, including margin interest. Net interest revenues decreased 23% 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 both
fiscal 1997 and fiscal 1996, net interest revenues reflected increased financing
costs associated with higher average levels of balance sheet usage, particularly
in equity-related businesses.
Asset Management, Distribution and Administration Fees
Asset management, distribution and administration fees include revenues from
asset management services, including fund management fees which are received for
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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 either the
average daily Fund net 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. The Company also receives fees from investment
management services provided to segregated customer accounts pursuant to various
contractual arrangements.
Asset management, distribution and administration fees were as follows:
The Company's customer assets under management or supervision and global assets
under custody were as follows:
In fiscal 1997, asset management, distribution and administration fees increased
45%, reflecting the Company's continuing strategic emphasis on the asset
management business. The increase also reflects revenues from VKAC, which was
acquired by the Company on October 31, 1996. Fiscal 1997 revenues benefited from
higher levels of fund management fees and increased revenues from international
equity, emerging market and U.S. domestic equity and fixed income products and
continued growth in customer assets under management or supervision. Revenues
also were positively impacted by the Company's acquisition of the institutional
global custody business of Barclays Bank PLC ("Barclays") on April 3, 1997. In
fiscal 1996, the 26% increase in asset management, distribution and
administration fees reflected growth in both asset management activities,
including the acquisition of MAS, and global clearing and custody services.
Higher revenues from 12b-1 fees also contributed to the increase in fiscal 1996.
As of November 30, 1997, assets under management or supervision had
increased significantly as compared with fiscal year-end 1996. The increase in
assets under management or supervision in both fiscal 1997 and fiscal 1996
reflected continued inflows of customer assets as well as appreciation in the
value of customer portfolios, particularly in equity funds, and growth in
international equity and domestic fixed income funds. In fiscal 1997,
approximately 50% of the increase in assets under management or supervision was
attributable to the acquisition of net new assets, while the remaining 50%
reflected market appreciation.
Global assets under custody also increased significantly in fiscal 1997.
Approximately $204 billion of the increase is attributable to the Company's
acquisition of Barclays, and approximately $150 billion of these assets remain
subject to current clients of Barclays agreeing to become clients of the
Company. In both fiscal 1997 and fiscal 1996, global assets under custody also
increased due to additional assets placed under custody with the Company, as
well as appreciation in the value of customer portfolios.
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Non-Interest Expenses
Fiscal 1997's total non-interest expenses increased 21% to $8,269 million.
Within that category, employee compensation and benefits expense increased 19%,
reflecting increased levels of incentive compensation based on record fiscal
1997 revenues and earnings. Excluding compensation and benefits expense,
non-interest expenses increased $571 million, including $266 million of
operating costs related to VKAC and the global institutional custody business of
Barclays. Occupancy and equipment expenses increased 7%, principally reflecting
the occupancy costs of VKAC and increased office space in London and Hong Kong.
Brokerage, clearing and exchange fees increased 41%, primarily reflecting the
acquisitions of VKAC and the institutional global custody business of Barclays,
as well as higher levels of trading volume in the global securities markets.
Information processing and communications costs increased 17% due to higher data
services costs related to an increased number of employees, incremental costs
related to VKAC and continued enhancements to the Company's information
technology infrastructure. Marketing and business development expenses increased
33%, reflecting higher travel and entertainment costs relating to increased
levels of business activity associated with active financial markets. Additional
advertising costs associated with VKAC's retail mutual funds also contributed to
the increase. Professional services expenses increased 34%, reflecting higher
consulting costs as a result of information technology initiatives and the
increased level of overall business activity. Other expenses increased 34%,
which includes goodwill amortization of $43 million associated with the
acquisitions of VKAC and Barclays, as well as the impact of a higher level of
business activity on various operating expenses.
Fiscal 1996's total non-interest expenses increased 20% to $6,808 million.
Within that category, employee compensation and benefits expense increased 28%,
reflecting increased levels of incentive compensation based on higher fiscal
1996 revenues and earnings, the impact of salaries and benefits relating to
additional personnel hired during the year or joining the Company as the result
of the MAS and VKAC acquisitions, and higher costs related to training new
account executives. Excluding compensation and benefits expense, non-interest
expenses increased $199 million (excluding fiscal 1995's relocation charge),
including $48 million of operating costs related to MAS and VKAC. Occupancy and
equipment expenses increased 6%, 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 10%, 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 8% in fiscal 1996 due to continued emphasis on technology initiatives.
Marketing and business development and professional services expenses increased
32% in fiscal 1996, reflecting significantly higher travel and entertainment,
consulting
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and advertising costs as a result of the increased level of the Company's global
business activities. Other expenses decreased 8% in fiscal 1996, which primarily
reflects a reduction in legal expenses partially offset by the amortization of
goodwill related to the acquisitions of MAS and VKAC.
CREDIT AND TRANSACTION SERVICES
Credit and Transaction Services, which had approximately 40 million general
purpose credit card accounts at November 30, 1997, was 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 and Transaction Services
proprietary general purpose credit cards are offered principally by the
Company's NOVUS Services business unit, which operates the NOVUS(R) Network.
These include the Discover Card, the Private Issue(R) Card, and co-branded and
affinity program cards. The Prime Option(SM) MasterCard(R) is a co-branded
general purpose credit card issued by NationsBank of Delaware, N.A., and
serviced by Prime Option Services. SPS Transaction Services, Inc. ("SPS") is a
74% owned, publicly held subsidiary. Services provided by SPS include electronic
transaction processing, consumer private label credit card program
administration, commercial accounts receivable processing and call center
teleservices. Discover Brokerage Direct offers discount trading services,
principally to individual investors, through its Internet site, an automated
telephone system and a core group of registered representatives, and is an
example of the Company's efforts to satisfy the demand for financial services
outside the traditional full-service brokerage channel.
In fiscal 1997, Credit and Transaction Services net income increased 8% to $468
million. Fiscal 1997 net income was positively impacted by higher average levels
of consumer loans, credit card fees and interest revenue enhancements introduced
in fiscal 1996 and higher general purpose credit card transaction volume,
partially offset by increased consumer credit losses and higher non-interest
expenses. In fiscal 1996, Credit and Transaction Services net income of $434
million remained level compared with fiscal 1995, as revenues from higher levels
of transaction
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volume and average loans and increased credit card fees were offset by a higher
rate of consumer credit losses.
Due to the Company's recent adoption of a November 30 fiscal year-end and
the seasonality of the credit card business, certain information for November
30, 1996 is presented in order to provide a more meaningful comparison with the
November 30, 1997 balances (see also "Seasonal Factors" herein).
Credit and Transaction Services statistical data was as follows:
Merchant and Cardmember Fees
Merchant and cardmember fees include revenues from fees charged to merchants on
credit card sales, late payment fees, overlimit fees, insurance fees, cash
advance fees, the administration of credit card programs and transaction
processing services.
Merchant and cardmember fees increased 13% in fiscal 1997 and 33% in fiscal
1996. The increase in both fiscal years was primarily the result of higher
revenues from overlimit fees, late payment fees and merchant fees. Overlimit
fees were implemented in March 1996, and the amount of the fee was increased in
the fourth quarter of fiscal 1996. The increase in overlimit fees in fiscal 1997
was due to a higher incidence of overlimit occurrences. The increase in late
payment fee revenues in both fiscal years was due to an increase in the
incidence of late payments and higher levels of delinquent accounts. In both
fiscal years, higher merchant fee revenues were primarily the result of
continued growth in the level of general purpose credit card transaction volume.
Fiscal 1996 revenues also benefited from increases in credit insurance fees,
primarily due to higher enrollments and favorable loss experience rebates.
Servicing Fees
Servicing fees are revenues derived from consumer loans which have been sold to
investors 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:
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 decreased 6% in fiscal
1997 and
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increased 19% in fiscal 1996. The decline in fiscal 1997 servicing fees was
attributable to higher credit losses, partially offset by higher merchant and
cardmember fees and net interest revenues. The increased revenues in fiscal 1996
were primarily due to higher net interest cash flows and cardmember fees from
securitized loans, partially offset by increased credit losses from securitized
loans. The increased net interest cash flows in fiscal 1996 were due to higher
average levels of securitized loans.
Net Interest Income
Net interest income is equal to the difference between interest revenue derived
from Credit and Transaction Services consumer loans and short-term investment
assets and interest expense incurred to finance those assets. Credit and
Transaction Services assets, consisting primarily of consumer loans, earn
interest revenue at both fixed rates and market indexed variable rates. The
Company incurs interest expense at fixed and floating rates. 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 and Transaction Services
average balance sheets and interest rates in fiscal 1997, fiscal 1996 and fiscal
1995 and changes in net interest income during those fiscal years:
AVERAGE BALANCE SHEET ANALYSIS
(1) Net interest margin represents net interest income as a percentage of total
interest earning assets.
(2) Interest rate spread represents the difference between the rate on total
interest earning assets and the rate on total interest bearing liabilities.
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RATE/VOLUME ANALYSIS
Net interest income increased 16% in fiscal 1997 and 15% in fiscal 1996. The
increases in both years were due to higher average levels of consumer loans
outstanding, partially offset by the effects of higher charge-offs on interest
revenue. The impact of higher charge-offs in fiscal 1997 was mitigated by
pricing actions implemented in the fourth quarter of fiscal 1996. In both years,
the effects of changes in interest rates on the Company's variable rate loan
portfolio were substantially offset by comparable changes in the Company's cost
of funds for the related financing. Fiscal 1997's revenues also were impacted by
the pricing actions implemented in the fourth quarter of fiscal 1996. The
Company believes that the effect of changes in market interest rates on net
interest income were mitigated as a result of 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 AVERAGE MANAGED LOAN INFORMATION
Provision for Consumer Loan Losses
The provision for consumer 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 $884 million
at fiscal year-end 1997 and $802 million at fiscal year-end 1996.
The provision for consumer loan losses, which is affected by net
charge-offs, loan volume and changes in the amount of consumer loans estimated
to be uncollectable,
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increased 23% in fiscal 1997 and 68% in fiscal 1996. In both fiscal 1997 and
fiscal 1996, the increase 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 average consumer loans outstanding. In fiscal 1996, 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. 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 1998. 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 continued to implement similar
measures in fiscal 1997, including a more stringent screening of new
cardmembers, tightened overlimit authorization procedures, and the closing of
certain high risk accounts. The Company believes these measures, designed to
improve credit quality, had a minimal impact in fiscal 1997 due to the period of
time necessary for such measures to have a meaningful effect on portfolio credit
quality, but believes they may have an increased effect in fiscal 1998. The
Company's expectations about future charge-off rates and credit quality are
subject to uncertainties that could cause actual results to differ materially
from what has been discussed above. Factors that influence the level and
direction of consumer loan delinquencies and charge-offs include changes in
consumer spending and payment behaviors, 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, where loans 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 that changes in its consumer loan delinquency
rates in fiscal 1997 and 1996 were related to the industry-wide credit
conditions discussed previously.
From time to time, the Company has offered and may continue to offer
cardmembers with accounts in good standing the opportunity to skip the minimum
monthly payment, while continuing to accrue periodic finance charges, without
being considered to be past due ("skip-a-payment"). The comparison of
delinquency rates at any particular point in time may be affected depending on
the timing of the "skip-a-payment" program. The delinquency rate for consumer
loans 30-89 days past due at November 30, 1997 was favorably impacted by a
skip-a-payment offer allowing certain cardmembers to skip their October 1997
monthly payment. The following table presents delinquency and net charge-off
rates with supplemental managed loan information:
ASSET QUALITY
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Non-Interest Expenses
Total non-interest expenses increased 6% to $2,216 million in fiscal 1997 and
13% to $2,098 million in fiscal 1996.
Employee compensation and benefits expense increased 12% in fiscal 1997 and
15% in fiscal 1996. The increases in both years were due to higher headcount and
employment costs associated with processing increased credit card transaction
volume and servicing additional NOVUS Network merchants and active credit card
accounts, including collection activities.
Brokerage, clearing and exchange fees of $12 million were recorded in
fiscal 1997. These expenses relate to the trading volume recorded by Discover
Brokerage Direct, the Company's provider of electronic brokerage services that
was acquired in January 1997.
Information processing and communications expense decreased 1% in fiscal
1997 and increased 16% in fiscal 1996. In both fiscal years, there were higher
costs associated with processing increased transaction volume, servicing
additional NOVUS Network merchants and active credit card accounts, and
developing the systems supporting the Company's multi-card strategy. In fiscal
1997, such increases were offset by an adjustment resulting from the sale of the
Company's indirect interest in one of the Company's transaction processing
vendors.
Marketing and business development expense increased 8% in fiscal 1997 and
14% in fiscal 1996. In both years, the increase was primarily attributable to
higher cardmember rewards expense. Cardmember rewards expense includes the
Cashback Bonus(R) award, pursuant to which the Company annually pays Discover
cardmembers and Private Issue cardmembers electing this feature a percentage of
their purchase amounts ranging up to one percent (up to 2% for the Private Issue
card) based upon a cardmember's level of annual purchases. Cardmember rewards
expense increased due to continued growth in credit card transaction volume and
increased cardmember qualification for higher award levels. Both years' expenses
also were impacted by higher marketing and promotional costs associated with the
growth of new and existing credit card brands.
Professional services expense increased 40% in fiscal 1997 and remained
relatively level in fiscal 1996. The increase in fiscal 1997 was primarily due
to higher expenditures for consumer credit counseling and collections services.
Other non-interest expenses decreased 9% in fiscal 1997 and remained
relatively level in fiscal 1996. Other expenses primarily include fraud losses,
credit inquiry fees and other administrative costs. The decrease in fiscal 1997
was due to a continuing decline in the level of 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 have declined.
Seasonal Factors
The credit card lending activities of Credit and Transaction Services are
affected by seasonal patterns of retail purchasing. Historically, a substantial
percentage of credit card loan growth occurs in the fourth calendar quarter,
followed by a flattening or decline of consumer loans in the subsequent first
calendar quarter. Merchant fees, therefore, have historically tended to increase
in the first fiscal quarter, reflecting higher sales activity in the month of
December. Additionally, higher cardmember rewards expense is accrued in the
fiscal first quarter, reflecting seasonal growth in retail sales volume.
LIQUIDITY AND CAPITAL RESOURCES
The Balance Sheet
The Company's total assets increased to $302.3 billion at November 30, 1997 from
$238.9 billion at fiscal year-end 1996, primarily reflecting growth in financial
instruments owned, reverse repurchase agreements, and securities borrowed. Due
to the favorable operating conditions throughout fiscal 1997, the Company
operated with a larger balance sheet as compared with fiscal 1996, as well as
higher levels of balance sheet leverage. The growth is
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primarily attributable to the Company's fixed income activities, most notably
corporate debt, foreign sovereign government obligations 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. Securities borrowed also rose during
fiscal 1997, 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. 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 establishes the overall funding and capital
policies of the Company, reviews the Company's performance relative to these
policies, 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 primary goal of
the Company's funding and liquidity activities is to ensure adequate financing
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 of its subsidiaries'
equity. Subsidiary equity capital requirements are determined by regulatory
requirements (if applicable), asset mix, leverage considerations and earnings
volatility.
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 and 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 also
had returned internally generated equity capital which was 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 repurchase 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
MSDWD 52
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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 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 and Transaction Services business) 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 interest rate
risk (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.
As of January 31, 1998, the Company's credit ratings were as follows:
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 several
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 and Asset Management business is raised through diverse sources.
These sources include the Company's capital, including equity and long-term
debt; 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; and
committed and uncommitted lines of credit. Repurchase agreement transactions,
securities lending and a portion of the Company's bank
MSDWD 53
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borrowings 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 and Transaction
Services business include the Company's capital, including equity and long-term
debt, asset securitizations, commercial paper, 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, purchase
Fed Funds and issue short-term bank notes. 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. 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.
In November 1997, the Company replaced the predecessor Dean Witter Discover
and Morgan Stanley holding company senior revolving credit agreements with a
senior revolving credit agreement with a group of banks to support general
liquidity needs, including the issuance of commercial paper (the "MSDWD
Facility"). Under the terms of the MSDWD Facility, the banks are committed to
provide up to $6.0 billion. The MSDWD Facility contains restrictive covenants
which require, among other things, that the Company maintain shareholders'
equity of at least $8.3 billion at all times. The Company believes that the
covenant restrictions will not impair the Company's ability to pay its current
level of dividends. At November 30, 1997, no borrowings were outstanding under
the MSDWD Facility.
The Company maintains a master collateral facility that enables Morgan
Stanley & Co. Incorporated ("MS&Co."), one of the Company's U.S. broker-dealer
subsidiaries, 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 $1.5 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, each as defined. In January 1998, this facility was renewed, and the
amount of the commitment was increased to $1.875 billion. At November 30, 1997,
no borrowings were outstanding under the MS&Co. Facility.
The Company also maintains a revolving committed financing facility that
enables Morgan Stanley & Co. International Limited ("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 $1.85 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. At November 30, 1997, no borrowings were
outstanding under the MSIL Facility.
RFC maintains a senior bank credit facility which supports the issuance of
asset-backed commercial paper. In fiscal 1997, RFC renewed this facility and
increased its amount to $2.55 billion from $2.1 billion. Under the terms of the
asset-backed commercial paper program, certain
MSDWD 54
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assets of RFC were subject to a lien in the amount of $2.6 billion at November
30, 1997. RFC has never borrowed from its senior bank credit facility.
The Company anticipates that it will utilize the MSDWD Facility, the
MS&Co. Facility or the MSIL Facility for short-term funding from time to time
(see Note 5 to the consolidated financial statements).
Fiscal 1997 and Subsequent Activity
During fiscal 1997, 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 contributed to a net increase in capital of $2,425
million to $33,577 million at November 30, 1997. The additions to capital
included net issuances of senior notes and subordinated debt aggregating $2,655
million.
During fiscal 1997, 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 1997, 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. During
fiscal 1997, the Company also redeemed all 750,000 shares of its 8-3/4%
Cumulative Preferred Stock at a redemption price of $200 per share, which was
equal to the stated value of $200 per share.
During fiscal 1997, the Company repurchased shares of its common stock at
an aggregate cost of $124 million and an average cost per share of $34.22. Prior
to the consummation of the Merger, both Morgan Stanley and Dean Witter Discover
rescinded any outstanding share repurchase authorizations.
Between November 30, 1997 and January 31, 1998, additional debt obligations
aggregating approximately $1,659 million were issued. These notes have
maturities from 1998 to 2004.
At November 30, 1997, certain assets of the Company, such as real property,
equipment and leasehold improvements of $1.7 billion, and goodwill and other
intangible assets of $1.4 billion, were 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 November 30, 1997, the aggregate carrying value
of the Company's equity investments in privately held companies (including
direct investments and partnership interests) was $128 million, and its
aggregate investment in publicly held companies was $547 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 in which liquidity can vary greatly from time to time. The carrying
value of the portion of the Company's mortgage-related portfolio at November 30,
1997 traded in markets that the Company believed were experiencing lower levels
of liquidity than traditional mortgage-backed pass-through securities
approximated $2,697 million.
In addition, at November 30, 1997, the aggregate value of high-yield debt
securities and emerging market loans and securitized instruments held in
inventory was $2,188 million (a substantial portion of which was subordinated
debt) with not more than 4%, 14% and 16% of all such securities, loans and
instruments attributable to any
MSDWD 55
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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 November 30, 1997 approximately $150
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 selective basis (which may be in connection with the Company's
commitment to the Morgan Stanley Bridge Fund, LLC). At November 30, 1997, the
Company had one such loan of $355 million outstanding in connection with its
securitized debt underwriting activities.
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. At November 30, 1997, the aggregate
value of senior secured loans and positions held by the Company was $738
million, and aggregate senior secured loan commitments were $325 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).
Year 2000 and EMU
Many of the world's computer systems currently record years in a two-digit
format. Such computer systems will be unable to properly interpret dates beyond
the year 1999, which could lead to business disruptions in the U.S. and
internationally (the "Year 2000" issue). The potential costs and uncertainties
associated with the Year 2000 issue will depend on a number of factors,
including software, hardware and the nature of the industry in which a company
operates. Additionally, companies must coordinate with other entities with which
they electronically interact, such as customers, creditors and borrowers.
To ensure that the Company's computer systems are Year 2000 compliant, a
team of information technology professionals began preparing for the Year 2000
issue in 1995. Since then, the Company has been reviewing each of its systems
and programs to identify those that contain two-digit year codes. The Company is
assessing the amount of programming required to upgrade or replace each of the
affected programs with the goal of completing all relevant internal software
remediation and testing by the end of 1998 with continuing Year 2000 compliance
efforts through 1999. In addition, the Company is actively working with all of
its major external counterparties and suppliers to assess their compliance
efforts and the Company's exposure to them.
Based upon current information, the Company believes that its Year 2000
expenditures for 1998 and through the project's completion will be approximately
$125 million. Costs incurred relating to this project are being expensed by the
Company during the period in which they are incurred. The Company's expectations
MSDWD 56
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about future costs associated with the Year 2000 issue are subject to
uncertainties that could cause actual results to differ materially from what has
been discussed above. Factors that could influence the amount and timing of
future costs include the success of the Company in identifying systems and
programs that contain two-digit year codes, the nature and amount of programming
required to upgrade or replace each of the affected programs, the rate and
magnitude of related labor and consulting costs, and the success of the
Company's external counterparties and suppliers in addressing the Year 2000
issue.
Modifications to the Company's computer systems and programs are also being
made in order to prepare for the upcoming EMU. The EMU, which will ultimately
result in the replacement of certain European currencies with the "Euro," will
primarily impact the Company's Securities and Asset Management business. Costs
associated with the modifications necessary to prepare for the EMU are also
being expensed by the Company during the period in which they are incurred.
Preparation relating to the Year 2000 issue and the EMU transition will
also create additional resource allocation challenges that the Company and other
international financial institutions will need to address.
Regulatory Capital Requirements
DWR and MS&Co. are registered broker-dealers and registered futures commission
merchants and, accordingly, are subject to the minimum net capital requirements
of the Securities and Exchange Commission ("SEC"), the New York Stock Exchange
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 with respect to
regulatory capital requirements. DWR, MS&Co., MSIL and MSJL have consistently
operated in excess of their respective regulatory requirements (see Note 10 to
the consolidated financial statements).
Certain of the Company's subsidiaries are Federal Deposit Insurance
Corporation ("FDIC") insured financial institutions. Such subsidiaries are
therefore subject to the regulatory capital requirements adopted by the FDIC.
These subsidiaries have consistently operated in excess of these and other
regulatory requirements.
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 upon 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.
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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" following Management's Discussion and Analysis of
Financial Condition and Results of Operations). 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
market, credit and other risks.
The total notional value of derivative trading contracts outstanding at
November 30, 1997 was $2,529 billion (as compared with $1,317 billion at fiscal
year-end 1996). While these amounts are an indication of the degree of the
Company's 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 November
30, 1997 was $17.1 billion. Approximately $14.2 billion of that credit risk
exposure was with counterparties rated single-A or better (see Note 8 to the
consolidated financial statements).
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 interest rate risk (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.
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