EXHIBIT 13.5
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Shareholders of
Morgan Stanley, Dean Witter,
Discover & Co.
We have audited the accompanying consolidated statements of financial condition
of Morgan Stanley, Dean Witter, Discover & Co. and subsidiaries at fiscal years
ended November 30, 1997 and 1996, and the related consolidated statements of
income, cash flows and changes in shareholders' equity for each of the three
fiscal years in the period ended November 30, 1997. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits. The consolidated financial statements give
retroactive effect to the merger of Morgan Stanley Group Inc. and Dean Witter,
Discover & Co., which has been accounted for as a pooling of interests as
described in Note 1 to the consolidated financial statements. We did not audit
the consolidated statement of financial condition of Morgan Stanley Group Inc.
and subsidiaries as of November 30, 1996, or the related statements of income,
cash flows and changes in shareholders' equity for the fiscal years ended
November 30, 1996 and 1995, which statements reflect total assets of $196,446
million as of November 30, 1996 and total revenues of $13,144 million and
$10,797 million for the fiscal years ended November 30, 1996 and 1995,
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.
In our opinion, based on our audits and the report of the other auditors,
the accompanying consolidated financial statements present fairly, in all
material respects, the consolidated financial position of Morgan Stanley, Dean
Witter, Discover & Co. and subsidiaries at fiscal years ended November 30, 1997
and 1996, and the consolidated results of their operations and their cash flows
for each of the three fiscal years in the period ended November 30, 1997, in
conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
New York, New York
January 23, 1998
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(1) Amounts have been restated to reflect the Company's two-for-one stock split.
See Notes to Consolidated Financial Statements.
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(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 split.
See Notes to Consolidated Financial Statements.
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See Notes to Consolidated Financial Statements.
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1. INTRODUCTION AND BASIS OF PRESENTATION
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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, the
Company issued 260,861,078 shares of its common stock, as each share of Morgan
Stanley common stock then outstanding was converted into 1.65 shares of the
Company's common stock (the "Exchange Ratio"). In addition, 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
The Company's consolidated financial statements include the accounts of Morgan
Stanley, Dean Witter, Discover & Co. and its 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
and securities services on a global basis and provides credit and transaction
services nationally. Its securities and asset management 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 and transaction services businesses include the
operation of the NOVUS Network, a proprietary network of merchant and cash
access locations, and the issuance of the Discover(R) Card and other 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 individuals.
BASIS OF FINANCIAL INFORMATION
The consolidated financial statements give retroactive effect to the Merger,
which was 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. The fiscal
year end 1996, 1995 and 1994 shareholders' equity data reflects the accounts of
the Company as if the preferred and additional 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 12 months ended November 30, 1997
("fiscal 1997") include the results of Dean Witter Discover that were restated
to conform with 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.
The separate results of operations for Dean Witter Discover and Morgan
Stanley during the periods preceding the Merger that are included in the
Company's Consolidated Statements of Income were as follows:
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In connection with the Merger, the Company incurred pre-tax expenses of $74
million ($63 million after tax) in the second fiscal quarter of 1997. These
expenses consisted primarily of proxy solicitation costs, severance costs,
financial advisory and accounting fees, legal costs and regulatory filing fees.
The 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 consolidated
financial statements are prudent and reasonable. Actual results could differ
materially 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.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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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 fiscal 1997 purchase of Lombard Brokerage, Inc.
("Lombard"), the Company issued 1.9 million shares of common stock having a fair
value on the date of acquisition of approximately $63 million. In connection
with the purchase of Miller Anderson & Sherrerd, LLP ("MAS") in fiscal 1996, 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 in
fiscal 1996 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 and other consumer
installment loans, are reported at their principal amounts outstanding, less
applicable allowances. 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 12 months.
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, 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.
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
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securitization market and the 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.
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 are not 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, when appropriate.
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. 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 swaps, foreign exchange forwards, foreign currency swaps and cost
of funds 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 repricing characteristics of consumer loans with those of 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
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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
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 on a net-by-counterparty basis, when appropriate. 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 collateral on a daily basis. Additional collateral is obtained as necessary
to ensure such transactions are adequately collateralized.
INVESTMENT BANKING
Underwriting revenues and fees for mergers and acquisitions and advisory
assignments are recorded when services for the transaction are substantially
completed. Transaction-related expenses are deferred and later expensed to match
revenue recognition.
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 depreciation and
amortization of furniture, fixtures and equipment are 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 give effect to
preferred stock dividend requirements. All per share and share amounts reflect
stock splits effected 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
Cardmember rewards, primarily the Cashback Bonus award, pursuant to which the
Company annually pays Discover cardmembers and Private Issue cardmembers a
percentage of their purchase amounts ranging up to one percent (up to two
percent for the Private Issue Card), are based upon a cardmember's level of
annual purchases. 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.
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STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation" 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 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 five to 40 years, generally not exceeding 25 years, and are
periodically evaluated for impairment. At November 30, 1997, goodwill of
approximately $1.4 billion was included in the Company's consolidated statements
of financial condition as a component of Other Assets (see Note 16).
NEW ACCOUNTING PRONOUNCEMENTS
As of January 1, 1997, the Company adopted SFAS No. 125, which was 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. The adoption of the
enacted provisions of SFAS No. 125 had no material effect on the Company's
financial condition or results of operations. With respect to the provisions of
SFAS No. 125 which became effective in 1998, the Company does not expect the
impact of the adoption of the deferred provisions to be material to the
Company's financial condition or results of operations.
In February 1997, the FASB issued SFAS No. 128, "Earnings per Share"
("EPS"), effective for periods ending after December 15, 1997, with restatement
required for all prior periods. SFAS No. 128 replaces the current EPS categories
of primary and fully diluted with "basic EPS," which reflects no dilution from
common stock equivalents, and "diluted EPS," which reflects dilution from common
stock equivalents and other dilutive securities based on the average price per
share of the Company's common stock during the period. The adoption of SFAS No.
128 would not have had, and is not expected to have, a material effect on the
Company's EPS calculations.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information." These statements, which are effective for fiscal years
beginning after December 15, 1997, establish standards for the reporting and
display of comprehensive income and the disclosure requirements related to
segments.
3. CONSUMER LOANS
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Consumer loans were as follows:
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Activity in the allowance for consumer loan losses was as follows:
(1) Primarily reflects net transfers related to asset securitizations.
(2) Beginning balance differs from the fiscal 1996 end of period balance due to
the Company's change in fiscal year-end.
Interest accrued on loans subsequently charged off, recorded as a reduction of
interest revenue, was $301 million, $181 million and $115 million in fiscal
1997, 1996 and 1995.
At fiscal year-end 1997 and 1996, $5,385 million and $5,695 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, this amount may not necessarily be indicative of the Company's actual
consumer loan repayments.
At fiscal year-end 1997, the Company had commitments to extend credit in
the amount of $178.5 billion. Commitments to extend credit arise from agreements
to extend to customers unused lines of credit on certain credit cards provided
there is no violation of conditions established in the related agreement. These
commitments, substantially all of which the Company can terminate at any time
and which do not necessarily represent future cash requirements, are
periodically reviewed based on account usage and customer creditworthiness.
The Company received proceeds from asset securitizations of $2,783 million,
$4,528 million, and $1,827 million in fiscal 1997, 1996 and 1995. The
uncollected balances of consumer loans sold through asset securitizations were
$15,033 million and $13,197 million at fiscal year-end 1997 and 1996.
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). Gains and losses from these
agreements are recognized as adjustments to servicing fees. 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 $303 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
1997 and 1996, the fair values of these agreements were not material. No
payments have been made by the Company under these agreements, which expire
through 2000.
The estimated fair value of the Company's consumer loans approximated
carrying value at fiscal year end 1997 and 1996. 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
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Deposits were as follows:
The weighted average interest rates of interest-bearing deposits outstanding
during fiscal 1997 and 1996 were 6.2% and 6.3%.
At fiscal year-end 1997 and 1996, the notional amounts of interest rate
exchange agreements that hedged deposits outstanding were $535 million and $495
million and had fair values of $7 million and $5 million. Under these interest
rate exchange agreements the Company primarily pays floating rates and receives
fixed
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rates. At November 30, 1997, the weighted average interest rate of the Company's
deposits including the effect of interest rate exchange agreements was 6.16%.
At November 30, 1997, certificate accounts maturing over the next five
years were as follows:
The estimated fair value of the Company's deposits, using current rates for
deposits with similar maturities, approximated carrying value at fiscal year-end
1997 and 1996.
5. SHORT-TERM BORROWINGS
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At fiscal year-end 1997 and 1996, commercial paper in the amount of $15,447
million and $18,890 million, with weighted average interest rates of 5.5% and
5.4%, was outstanding.
At fiscal year-end 1997 and 1996, the notional amounts of interest rate
contracts that hedged commercial paper outstanding were $732 million and $808
million and had fair values of $(5) million and $(7) 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 1997 and 1996, other short-term borrowings of $7,167
million and $7,436 million were outstanding. These borrowings included bank
loans, federal funds and bank notes.
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.
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
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 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 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 $1.5 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,
as defined. In January 1998, the MS&Co. Facility was renewed and the amount of
the commitment of the credit agreement 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 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.
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.
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6. LONG-TERM BORROWINGS
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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.
MEDIUM-TERM NOTES
Included in the table above are medium-term notes of $14,049 million and $13,272
million at fiscal year-end 1997 and 1996. The effective weighted average
interest rate on all medium-term notes was 5.9% in fiscal 1997 and 5.8% in
fiscal 1996. Maturities of these notes range from fiscal 1998 through fiscal
2023.
STRUCTURED BORROWINGS
U.S. dollar index/equity linked borrowings include 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 1997 and 1996.
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
$1,302 million and $1,325 million at fiscal year-end 1997 and 1996 respectively.
The effective weighted average interest rate on these subordinated notes was
7.2% in fiscal 1997 and 7.0% in fiscal 1996. 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 1998 through
fiscal 1999. The stated maturities of these notes, which aggregate $1,495
million, are from fiscal 1998 to fiscal 2004.
MS&Co., a registered U.S. broker-dealer subsidiary of the Company, has
outstanding approximately $313 million of 6.81% fixed rate subordinated Series C
notes,
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$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.
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 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 5.7% and 5.6% in
fiscal 1997 and fiscal 1996, 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 1997. 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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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:
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 $1.8 billion and $1.1 billion at fiscal year end 1997 and 1996,
and unrecognized gains of approximately $13 million and $14 million as of fiscal
year end 1997 and 1996, 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 1997, 1996 and 1995.
7. COMMITMENTS AND CONTINGENCIES
--------------------------------
The Company has non-cancelable operating leases covering office space and
equipment. At fiscal year-end 1997, future minimum rental commitments under such
leases (net of subleases, principally on office rentals) were as follows:
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 $262 million, $264 million and $271 million in fiscal 1997, 1996 and
1995, respectively.
The Company has an agreement with 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.
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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 $5.5 billion of letters of credit outstanding
at November 30, 1997 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 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
(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.
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.
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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.
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 by purchasing or
selling additional 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 mort-
MSDWD 83
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gage-backed security without purchasing the cash position. The Company 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 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 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, Italian 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-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, precious and base metals, 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
prof-
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its 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 relate to the Company's trading
activities.
RISK MANAGEMENT
Risk management at the Company is a multi-faceted 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 and modification. Many of the
Company's risk management and control practices are subject to periodic review
by the Company's internal auditors as well as to interactions with various
regulatory authorities.
The Management Committee, composed of the Company's most senior officers,
establishes the overall risk management policies for the Company and reviews the
Company's performance relative to these policies. The Management Committee has
created several Risk Committees to assist it in monitoring and reviewing the
Company's risk management practices. These Risk Committees, among other things,
review the general framework, levels and monitoring procedures relating to the
Company's market and credit risk profile, general sales practice policies, legal
enforceability and operational and systems risks. The Controllers, Treasury,
Law, Compliance and Governmental Affairs and Market Risk Departments, which are
all independent of the Company's business units, assist senior management and
the Risk Committees in monitoring and controlling the Company's risk profile. In
addition, the Internal Audit Department, which also reports to senior
management, evaluates the Company's operations and control environment through
periodic examinations of business operational areas. 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.
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.
The Company manages the market risk associated with its trading activities
Company-wide, on a trading division level worldwide and on an individual product
basis. Market risk guidelines and limits have been approved for the Company and
each trading division of the Company worldwide. Discrete market risk limits are
assigned to trading divisions and trading desks within trading areas which are
compatible with the trading division limits. Trading division risk managers,
desk risk managers and the Market Risk Department all monitor market risk
measures against limits and report major market and position events to senior
management.
The Market Risk Department independently reviews the Company's trading
portfolios on a regular basis from a market risk perspective utilizing
Value-at-Risk and other quantitative and qualitative risk measurements and
analyses. The Company may use measures,
MSDWD 85
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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 trading division risk managers,
desk risk managers and the Market Risk Department.
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 Company has credit
guidelines which limit the Company's credit exposure to any one counterparty.
Specific credit risk limits based on the credit guidelines are also in place for
each type of counterparty (by rating category) as well as for 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 the Company's 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.
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 and
Italy), which, in the aggregate, represented approximately 12% of the Company's
total assets at fiscal year end 1997. In addition, substantially all of the
collateral held by the Company for resale agreements or bonds borrowed, which
together represented approximately 34% of the Company's total assets at fiscal
year end 1997, 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.
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 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 1997
and 1996, as
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well as the average fair value of those assets and liabilities for fiscal year
1997 and 1996, 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) net of any unrealized losses owed to these counterparties
on offsetting positions in situations where netting is appropriate. 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 $572 billion and
$549 billion, respectively, at fiscal year-end 1997, and $247 billion and
$193 billion, respectively, at fiscal year-end 1996.
(3) These amounts represent carrying value (exclusive of collateral) at fiscal
year-end 1997 and 1996, respectively, and do not include receivables or
payables related to exchange traded futures contracts.
(4) Amounts are calculated using a monthly average.
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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 the fair value of the contracts reported as assets. These amounts
are presented on a net-by-counterparty basis when appropriate, 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
1997 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 1997 and 1996 are summarized in the following table,
showing notional values by year of expected maturity:
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The credit quality of the Company's trading-related derivatives at fiscal
year-end 1997 and 1996 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 $1,219 million and $948 million at fiscal year-end
1997 and fiscal year-end 1996, respectively.
9. PREFERRED STOCK AND CAPITAL UNITS
------------------------------------
Preferred stock is composed of the following issues:
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Each issue of outstanding preferred stock ranks in parity with all other
outstanding preferred stock of the Company.
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.
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 2017 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 $999 million at fiscal year end 1997 and $865 million at fiscal
year end 1996.
During fiscal 1997, 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 approximated carrying value
at fiscal year-end 1997 and fiscal year-end 1996.
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.
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, 5,902,751 shares of Morgan Stanley
common stock which had been held in treasury were retired.
MS&Co. and DWR are registered broker-dealers and registered futures
commission merchants and, accordingly, subject to the minimum net capital
requirements of the Securities Exchange Commission, the New York Stock Exchange
and the Commodity Futures Trading Commission. MS&Co. and DWR have consistently
operated in excess of these requirements. MS&Co.'s net capital totaled $2,186
million at November 30, 1997 which exceeded the amount required by $1,753
million. DWR's net capital totaled $764 million at November 30, 1997 which
exceeded the amount required by $643 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 November 30, 1997, the leverage ratio and risk-weighted
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
MSDWD 90
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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
November 30, 1997, approximately $4,303 million of net assets of consolidated
subsidiaries may be restricted as to the payment of cash dividends and advances
to the Company.
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 as well as the Company's non-employee directors. 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. These plans are summarized
below.
EQUITY-BASED COMPENSATION PLANS
The Company is authorized to issue up to approximately 260 million shares of its
common stock in connection with awards under its equity-based compensation
plans. At November 30, 1997, approximately 164 million shares were available for
future grant under these plans.
Stock Option Awards
Stock option awards have been granted pursuant to several equity-based
compensation plans. Each plan provides 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 become
exercisable over a one to five year period and expire seven to 10 years from the
date of grant.
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The following table sets forth activity relating to the Company's stock
option awards (share data in millions):
The following table presents information relating to the Company's stock options
outstanding at November 30, 1997 (share data in millions):
Deferred Compensation Awards
The Company has made deferred compensation awards under a number of equity-based
compensation plans. These plans provide for the deferral of a portion of certain
key employees' compensation with payments made in the form of the Company's
common stock or in the right to receive unrestricted shares (collectively,
"Restricted Stock"). Compensation expense for all such awards (including those
subject to forfeiture) amounted to $347 million, $534 million and $235 million
in fiscal 1997, fiscal 1996 and fiscal 1995. Compensation expense for Restricted
Stock awards was determined based on the fair value of the Company's common
stock (as defined in the plans). The number of Restricted Stock shares
outstanding were 62 million at fiscal year-end 1997, 65 million at fiscal
year-end 1996, and 56 million at fiscal year-end 1995.
Restricted Stock awarded under these plans are subject to restrictions on
sale, transfer or assignment until the end of a specified restriction period,
generally 5 to 10 years from the date of grant. Holders of Restricted Stock
generally may forfeit ownership of a portion of their award if employment is
terminated before the end of the relevant restriction period. Holders of vested
Restricted Stock generally will forfeit ownership only in certain limited
situations, including termination for cause during the restriction period.
Employees Equity Accumulation Plan
Shareholders approved the 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, as calculated in accordance with the plan.
Employee Stock Purchase Plan
Under the 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. Employees of the Company purchased 0.5 million shares of common stock
in fiscal 1997, 0.7 million shares in fiscal 1996 and 0.8 million shares in
fiscal 1995.
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The discount to fair value was $2 million for both fiscal 1997 and fiscal
1996 and $1 million in 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.
Non-Employee Director Awards
The Company sponsors a stock plan for non-employee directors under which shares
of the Company's common stock have been authorized for issuance in the form of
option grants, stock awards or deferred compensation. The effect of these grants
on results of operations was not material.
OTHER COMPENSATION PLANS
Capital Accumulation Plan
Under the 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 1997, 1996 and 1995 was approximately $14 million,
$7 million and $12 million, respectively, all of which relate to vested units.
Carried Interest Plans
Under various 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 1997, 1996 and 1995 related to these plans aggregated $38 million, $0.2
million and $14 million, respectively.
Real Estate Fund Plans
Under the Real Estate Compensation Plan and the Real Estate Profits
Participation Plan, select employees and consultants may participate in certain
gains realized by the Company's real estate funds. Compensation expense relating
to these plans aggregated $8 million, $13 million and $9 million for fiscal
1997, fiscal 1996 and fiscal 1995, respectively.
Profit Sharing Plans
The Company sponsors qualified profit sharing plans covering substantially all
U.S. employees and also provides cash payment of profit sharing to employees of
its international subsidiaries. Contributions are made to eligible employees at
the discretion of management based upon the financial performance of the
Company. Total profit sharing expense for fiscal 1997, fiscal 1996 and fiscal
1995 (excluding Company contributions to the Employee Stock Ownership Plan,
which increased in fiscal 1995) was $113 million, $72 million and $51 million,
respectively.
Employee Stock Ownership Plan
The Company has a $140 million leveraged employee stock ownership plan, funded
through an independently managed trust. The 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
3,646,664 preferred shares outstanding at fiscal year end 1997 is held by the
ESOP trust, 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 the Company. 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.
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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 $8 million in
fiscal 1997, $9 million in fiscal 1996 and $13 million in fiscal 1995. The ESOP
debt service costs for fiscal 1997, fiscal 1996 and fiscal 1995 were paid from
dividends received on preferred stock held by the plan and from Company
contributions.
PRO FORMA EFFECT OF SFAS NO. 123
Had the Company elected to recognize compensation cost pursuant to SFAS No. 123
for its stock option plans and the Employee Stock Purchase Plan, net income
would have been reduced by $196 million, $41 million and $147 million for fiscal
1997, 1996 and 1995. Primary and fully diluted earnings per common share would
have been reduced by $0.36, $0.08 and $0.25 for fiscal 1997, 1996 and 1995.
The weighted average fair value at date of grant for stock options granted
during fiscal 1997, 1996 and 1995 was $16.76, $9.08 and $7.27 per option,
respectively. The fair value of stock options at date of grant was estimated
using the Black-Scholes 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. The Company 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 non-contributory pension plans that are qualified under Section
401(a) of the Internal Revenue Code (the "Qualified Plans"). Unfunded
supplementary plans (the "Supplemental Plans") cover certain executives. In
addition to the Qualified Plans and the Supplemental Plans (collectively, the
"U.S. Plans"), ten of the Company's 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 on compensation levels specified in the plans. For the
Qualified Plans and the other international plans, the Company's policy is to
fund at least the amounts sufficient to meet minimum funding requirements under
applicable employee benefit and tax regulations. Liabilities for benefits
payable under the Supplemental Plans are accrued by the Company and are funded
when paid to the beneficiaries.
The Company also maintains a separate pension plan which covers
substantially all employees of the Company's U.K. subsidiaries (the "U.K.
Plan"). 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 1997 and 1996, the Company's expense related to
the defined contribution U.K. Plan was $15 million and $3 million, respectively.
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:
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The following table provides the assumptions used in determining the projected
benefit obligation for the U.S. Plans:
The following table sets forth the funded status of the U.S. Plans:
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 1997 and 1996, the Company's accrued postretirement benefit costs were $91
million and $85 million.
POSTEMPLOYMENT BENEFITS
Postemployment benefits include, but are not limited to, salary continuation,
supplemental unemployment benefits, severance benefits, disability-related
benefits, and continuation of health care and life insurance coverage provided
to former or inactive employees after employment but before retirement. These
benefits were not material to the consolidated financial statements in fiscal
1997, 1996 and 1995.
13. INCOME TAXES
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The provision for income taxes consists of:
The following table reconciles the provision to the U.S. federal statutory
income tax rate:
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As of November 30, 1997 the Company had approximately $2.2 billion of earnings
attributable to foreign subsidiaries for which no tax provisions have been
recorded for income tax that could occur upon repatriation. Except to the extent
such earnings can be repatriated tax efficiently, they are permanently invested
abroad. It is not practicable to determine the amount of income taxes payable in
the event all such foreign earnings are repatriated. 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 1997 and 1996 are as follows:
Cash paid for income taxes were $1,251 million, $1,190 million and $887
million in fiscal 1997, 1996 and 1995.
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.
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15. SEGMENT INFORMATION
-----------------------
The Company is in the business of providing financial services, and operates in
two business segments -- Securities and Asset Management and Credit and
Transaction Services. Securities and Asset Management engages in delivering a
broad range of financial products and services, including asset management, to
individual and institutional investors. Credit and Transaction 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) Excludes merger-related expenses of $74 million.
(2) Corporate assets have been fully allocated to the Company's business
segments.
16. ACQUISITIONS AND DISPOSITION
--------------------------------
In January 1997, the Company acquired Lombard, a company which provides discount
trading services, principally to individual investors, through its Internet
site, an automated telephone system, and a core group of registered
representatives. Subsequent to the date of acquisition, Lombard's corporate name
was changed to Discover Brokerage Direct, Inc.
In April 1997, the Company acquired 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.
Barclays has agreed to provide global subcustodial services to the Company for a
period of time after completion of the acquisition.
In July 1997, the Company sold the DWR institutional futures business to
Carr Futures, Inc., a subsidiary of Credit Agricole Indosuez. This sale did not
have a material effect on the Company's results of operations or financial
position.
In 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 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.
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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 split.
(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.
(4) Prices represent the range of sales per share on the New York Stock
Exchange for the periods indicated. The number of stockholders of record at
November 30, 1997 approximated 192,440. The number of beneficial owners of
common stock is believed to exceed this number.
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