EXHIBIT 13.3
Morgan Stanley Dean Witter * 1998 Annual Report
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. ("MSDWD"). In conjunction with the
Merger, each share of Morgan Stanley common stock then outstanding was converted
into 1.65 shares of MSDWD'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 MSDWD. The Merger was treated as a
tax-free exchange.
On March 24, 1998, MSDWD changed its corporate name to Morgan Stanley Dean
Witter & Co. (the "Company").
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 global
strengths in investment banking (including underwriting public offerings of
securities 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
BASIS OF FINANCIAL INFORMATION AND CHANGE IN FISCAL YEAR-END
The Company's 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 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 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 year
ended December 31, 1996 were combined with Morgan Stanley's financial statements
for the fiscal year ended November 30, 1996 (on a combined basis, "fiscal
1996"). The Company's results for the 12 months ended November 30, 1998 ("fiscal
1998") and November 30, 1997 ("fiscal 1997") reflect the change in fiscal
year-end. Fiscal 1997 includes 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 equity prices and interest
rates; currency values and other market indices; technological changes and
events (such as the increased use of the Internet and the Year 2000 issue); 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 on a global basis, including (without limitation) continued
increased market share in its securities activities, growth in assets under
management and the expansion of its Discover Card brand.
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
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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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Morgan Stanley Dean Witter * 1998 Annual Report
products and the volatility and liquidity of global 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 the
realization of returns from the Company's private equity investments).
In the Company's Credit and Transaction Services business, changes in
economic variables may substantially affect consumer loan levels and credit
quality. Such variables include the number and size of personal bankruptcy
filings, the rate of unemployment and the level of consumer debt as a percentage
of income.
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 and asset management business, there has been increased
competition from other sources, such as commercial banks, insurance companies,
mutual fund groups, online service providers 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
historically been dominated by investment banks and retail securities firms has
increased and may continue to increase in the near future. In addition, recent
and continuing global convergence and consolidation in the financial services
industry will lead to increased competition from larger diversified financial
services organizations.
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 offering 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.
GLOBAL MARKET AND ECONOMIC CONDITIONS IN FISCAL 1998
Conditions in the global financial markets were extremely turbulent during
fiscal 1998. While the favorable market and economic conditions which
characterized fiscal 1997 continued through much of the first and second
quarters of fiscal 1998, periods of extreme volatility in the latter half of the
year created difficult conditions in many global financial markets.
Nevertheless, the Company's Securities and Asset Management business generated
record levels of net income and net revenues and ended the fiscal year with
record levels of financial advisors, customer accounts and assets, and assets
under management and administration. The Company's Credit and Transaction
Services business also achieved record operating results in fiscal 1998,
reflecting an improvement in the credit quality of customer receivables.
In the U.S., market conditions continued to benefit from the overall
strength of the domestic economy. Throughout fis-
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Morgan Stanley Dean Witter * 1998 Annual Report
cal 1998, the U.S. economy was characterized by moderate levels of growth, a
stable level of inflation, low unemployment, and high levels of consumer
confidence and spending. However, U.S. financial markets also experienced
periods of volatility. In the first half of the year, investors were concerned
with the potential impact of the ongoing economic downturn in the Far East and
with domestic wage inflation. Later in the year, U.S. markets were adversely
affected by investor reaction to the severe economic turmoil in the Far East,
Russia and other emerging market nations. Investor preferences shifted toward
less-risky investments, resulting in unprecedented widening of credit spreads,
reduced liquidity in the marketplace and dramatic declines in U.S. Treasury
yields. In addition, equity prices declined significantly as a result of these
developments. During the fourth quarter, these conditions prompted the Federal
Reserve Board to lower the overnight lending rate by 0.25% on three separate
occasions in an effort to increase liquidity, to minimize the risk of recession
in the U.S. due to the weaknesses in foreign economies and to avert a continued
global economic slowdown. The actions of the Federal Reserve Board, coupled with
the continued resilience of the U.S. economy, contributed to improved conditions
in the financial markets in late 1998, and both equity and bond prices
rebounded.
Conditions in European financial markets were generally favorable in fiscal
1998. Many European stock exchanges reached record levels during the year as the
result of strong corporate earnings, merger and consolidation activity, and
stable economic conditions in the first half of fiscal 1998. European financial
markets also benefited from positive investor sentiment relating to the European
Economic and Monetary Union ("EMU"). EMU commenced on January 1, 1999 when the
European Central Bank assumed control of monetary policy for the 11 European
Union countries participating in the EMU. Those national currencies of the
participating countries have become fixed denominations of the euro and
ultimately will cease to exist as separate currencies and will be replaced by
the euro. European markets also experienced periods of extreme volatility during
the year, particularly during the third quarter as investors reacted to the
severe economic and financial difficulties which developed in Russia. The
Russian economy was adversely affected by the difficult conditions in the Far
East, declining oil prices and an unstable political infrastructure. The Russian
government's decision to reschedule its domestic debt obligations and some of
its external Soviet debt obligations and to devalue the ruble severely reduced
investor confidence and resulted in significant levels of volatility in Russian
and other financial markets. Toward the end of fiscal 1998, conditions in Europe
recovered due to, among other things, lower interest rates and increased
stability in the global financial markets.
Market conditions in the Far East continued to be sluggish due to the
ongoing financial and economic difficulties that have existed in that region
since the latter half of fiscal 1997. The Japanese economy continued to be
adversely affected by shrinking consumer demand, declining corporate profits,
deflation and rising unemployment. These conditions contributed to the
resignation of Japan's Prime Minister during the year, as well as the
announcement of more aggressive fiscal, monetary and financial sector policies
designed to improve the nation's rate of economic growth. However, due to the
weakness of the Japanese banking system and the difficult economic conditions
existing throughout the Far East, many investors were concerned that the length
of time necessary for economic recovery would be longer than expected. Financial
markets elsewhere in the Far East also were weak during fiscal 1998. The poor
economic performance of Japan, outbreaks of political and social unrest, and
crises in other emerging markets adversely affected the financial markets of
many nations within the region.
The worldwide market for mergers and acquisitions continued to be robust
during fiscal 1998, contributing to record levels of revenues by the Company's
investment banking business. The merger and acquisition market reflected ongoing
consolidation and globalization across many industry sectors, as well as an
increased level of deregulation and privatization. As a result, fiscal 1998
included some of the largest merger and acquisition transactions ever completed.
The markets for the underwriting of securities were positively impacted by the
generally favorable market and economic conditions which existed during the
first half of fiscal 1998. Activity in the primary markets virtually came to a
standstill in the latter part of the third quarter and the beginning of the
fourth quarter. However, toward the end of fiscal 1998, activity in the primary
markets, par-
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Morgan Stanley Dean Witter * 1998 Annual Report
ticularly for fixed income securities, began to strengthen as conditions in the
global financial markets stabilized.
In fiscal 1998, U.S. consumer demand and retail sales continued to increase
at a moderate pace, despite an earlier consensus that a slowdown may have been
imminent. The favorable interest rate environment that existed in the U.S.
during fiscal 1998 enabled consumers to manage finances advantageously while
still allowing for steady growth in consumer credit. During fiscal 1998, loan
losses and personal bankruptcies appeared to level off from the record growth of
industry-wide loan losses set in 1997. The Company continued to invest in the
growth of its credit card business through the expansion of its
Discover/NOVUS
activities with respect to the Discover Card brand.
FISCAL 1998 AND 1997 RESULTS FOR THE COMPANY
The Company achieved net income of $3,276 million in fiscal 1998, a 27% increase
from fiscal 1997. Fiscal 1998's net income included a net gain of $345 million
from the sale of the Company's Global Custody business, its interest in the
operations of SPS Transaction Services, Inc. ("SPS"), and certain BRAVO
receivables ("BRAVO") (see "Results of Operations -- Business Dispositions"
herein). Fiscal 1998 net income also included a charge of $117 million resulting
from the cumulative effect of an accounting change. This charge represents the
effect of an accounting change adopted in the fourth quarter (effective December
1, 1997) with respect to the accounting for offering costs paid by investment
advisors of closed-end mutual funds, where such costs are not specifically
reimbursed through separate advisory contracts (see Note 2 to the consolidated
financial statements).
Excluding the net gain from the sale of the businesses noted above and the
charge resulting from the cumulative effect of an accounting change, fiscal 1998
income was $3,048 million, an increase of 18% from fiscal 1997. In fiscal 1997,
net income was $2,586 million, an increase of 31% from fiscal 1996. Basic
earnings per common share increased 28% to $5.60 in fiscal 1998 and 31% to $4.38
in fiscal 1997. Excluding the net gain from the sale of the businesses noted
above and the impact of the cumulative effect of an accounting change, basic
earnings per common share was $5.20 in fiscal 1998, an increase of 19% from
fiscal 1997. Diluted earnings per common share increased 28% to $5.33 in fiscal
1998 and 32% to $4.16 in fiscal 1997. Excluding the net gain from the sale of
the businesses noted above and the impact of the cumulative effect of an
accounting change, diluted earnings per common share was $4.95 in fiscal 1998,
an increase of 19% from fiscal 1997. The Company's return on average
shareholders' equity was 25%, 22% and 20% in fiscal 1998, fiscal 1997 and fiscal
1996, respectively. Excluding the net gain from the sale of the businesses noted
above and the impact of the cumulative effect of an accounting change, fiscal
1998's return on average shareholders' equity was 23%.
BUSINESS DISPOSITIONS
In fiscal 1998, the Company entered into several transactions reflecting
its strategic decision to focus on growing its core Securities and Asset
Management and Credit and Transaction Services businesses.
In the fourth quarter of fiscal 1998, the Company completed the sale of its
Global Custody business. The Company also sold its interest in the operations of
SPS, a 73%-owned, publicly held subsidiary of the Company. In addition, the
Company sold certain credit card receivables relating to its discontinued BRAVO
Card. The Company's aggregate net pre-tax gain resulting from these transactions
was $685 million.
In addition, during fiscal 1998 the Company sold its Prime Option(SM)
MasterCard(R) portfolio ("Prime Option"), a business it had operated with
NationsBank of Delaware, N.A., and its Correspondent Clearing business. The
gains resulting from the sale of these businesses were not material to the
Company's results of operations or financial condition.
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. This discussion excludes
the cumulative effect of the accounting change in references to fiscal 1998 net
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Morgan Stanley Dean Witter * 1998 Annual Report
income. Certain reclassifications have been made to prior-period amounts to
conform to the current year's presentation.
SECURITIES AND ASSET MANAGEMENT
STATEMENTS OF INCOME
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, and investment and asset management products and services for
institutional and individual clients. At November 30, 1998, the Company's
financial advisors provided investment services to more than 3.9 million client
accounts with assets of $438 billion. The Company had the second largest
financial advisor sales organization in the U.S. with 11,238 professional
financial advisors and 438 branches at November 30, 1998. With several brands,
including those associated with Morgan Stanley Dean Witter Advisors (formerly
known as Dean Witter InterCapital), Van Kampen Investments ("VK"), Morgan
Stanley Dean Witter Investment Management and Miller Anderson & Sherrerd, 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 $376 billion at November 30, 1998.
Securities and Asset Management achieved record net revenues and income of
$13,244 million and $2,705 million in fiscal 1998, increases of 12% and 24%,
respectively, from fiscal 1997. Fiscal 1998's net income includes a net gain of
$182 million resulting from the sale of the Company's Global Custody business.
Excluding the net gain from the sale of this business, income increased 16% to
$2,523 million. Fiscal 1998's net income also reflects a decline in the
effective income tax rate, primarily resulting from lower tax rates applicable
to non-U.S. earnings. In fiscal 1997, Securities and Asset Management net
revenues and net income increased 29% and 41%, respectively, from fiscal 1996.
The Company's fiscal 1998 and 1997 levels of net revenues and net income in its
Securities and Asset Management business reflected a strong global market for
mergers and acquisitions, higher principal trading and commission revenues
primarily driven by generally favorable economic conditions, increased customer
trading volume, and the positive accumulation and management of client assets.
In fiscal 1998, record levels of net revenues were partially offset by losses
from an institutional leveraged emerging markets debt portfolio that occurred
during the third quarter. The results of both years were partially offset 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.
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Morgan Stanley Dean Witter * 1998 Annual Report
The operating results of both years were favorably impacted by 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 24% and attained record levels in
fiscal 1998, surpassing the Company's previous record in fiscal 1997. Revenues
in fiscal 1998 benefited from increased advisory fees from merger, acquisition
and restructuring transactions, as well as increased revenues from underwriting
fixed income securities. Fiscal 1997's revenues reflect higher advisory fees
from merger, acquisition and restructuring transactions, as well as increased
revenues from underwriting both equity and fixed income securities.
The worldwide merger and acquisition markets remained robust for the fourth
consecutive year with more than $2.5 trillion of transactions (per Securities
Data Company) announced during calendar year 1998, including record volume in
the U.S. During calendar year 1998, the Company's dollar volume of announced
merger and acquisition transactions increased by more than 80% over the
comparable period of 1997. The high level of transaction activity reflected the
continuing trend of consolidation and globalization across many industry
sectors, as companies attempted to expand into new markets and businesses
through strategic combinations. 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 44% in
fiscal 1998. Advisory fees from real estate transactions also were higher as
compared with the prior year, driven by strong levels of market consolidation
activities in the U.S. and by recovering real estate markets in Europe. The 8%
increase in advisory fees in fiscal 1997 was primarily due to high transaction
volumes resulting from the strong global market for merger, acquisition and
restructuring activities, as well as increased revenues from real estate
advisory transactions.
Equity underwriting revenues decreased 8% in fiscal 1998 although
continuing to reflect a high volume of equity offerings and the Company's strong
market share. During the first half of fiscal 1998, the primary market for
equity issuances benefited from a high volume of cash inflows into equity mutual
funds, as well as from a generally favorable economic environment. Equity
underwriting revenues were adversely affected by the reduced activity in the
primary market in the second half of the fiscal year due to the significant
uncertainty and volatility in global financial markets. 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. In fiscal 1997, the primary market for equity
issuances also benefited from a high volume of cash inflows into equity mutual
funds and from a favorable economic environment.
Revenues from fixed income underwriting increased 36% in fiscal 1998,
primarily driven by higher revenues from issuances of global high-yield and
investment grade fixed income securities. The primary market for these
securities benefited from relatively low nominal interest rates which existed
throughout the year and attracted many issuers to the market, as well as from
periods of strong investor demand. During the latter part of fiscal 1998, the
primary market was less active as increased volatility in global financial
markets caused an unprecedented widening of credit spreads and a shift of
investor preferences toward financial instruments with higher credit ratings.
Revenues from fixed income 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.
Fiscal 1997's fixed income underwriting 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.
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Morgan Stanley Dean Witter * 1998 Annual Report
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 transaction trading revenues were as follows:
Principal transaction trading revenues increased 3% in fiscal 1998,
primarily due to higher equities and foreign exchange trading revenues,
partially offset by a decline in fixed income trading revenues. In fiscal 1997,
principal trading revenues increased 20%, primarily reflecting higher equities
and foreign exchange trading revenues.
Equity trading revenues increased 57% to a record level in fiscal 1998,
primarily reflecting higher revenues from equity cash and derivative products.
The increase in revenues from equity cash products was primarily attributable to
higher trading volumes in European markets, which benefited from the Company's
increased sales and research coverage of the region that began in mid-1997.
European equity trading revenues also benefited from generally favorable market
conditions and positive investor sentiment regarding EMU. Revenues from trading
equity derivative products also increased, primarily due to increased
transaction volume and the high levels of market volatility that existed
throughout the year, particularly in technology-related issues. Equity trading
revenues increased 11% 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.
Fixed income trading revenues decreased 62% in fiscal 1998, reflecting
significantly lower revenues from investment grade, high-yield and securitized
fixed income securities. Revenues from investment grade fixed income securities
were adversely affected by the severe economic and financial turmoil in the Far
East, Russia and emerging markets that occurred during the year. These difficult
conditions caused investor preferences to shift toward higher quality financial
instruments, principally to U.S. treasury securities. This negatively affected
the trading of credit-sensitive fixed income securities by widening credit
spreads, reducing market liquidity and de-coupling the historical price
relationships between credit-sensitive securities and government securities.
Revenues from high-yield fixed income securities also were impacted by the
turbulent conditions in the global financial markets due to investors' concerns
about the impact of a prolonged economic downturn on high-yield issuers.
Revenues from securitized fixed income securities also declined, as the
relatively low interest rate environment in the U.S. increased prepayment
concerns and resulted in increased spreads. 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.
Revenues from foreign exchange trading increased 17% to record levels in
fiscal 1998. The increase was primarily attributable to high levels of customer
trading volume and volatility in the foreign exchange markets. During fiscal
1998, the U.S. dollar fluctuated against major currencies due to concerns about
the U.S. economy's exposure to the financial crises in the Far East and emerging
markets, as well as from the Federal Reserve Board's decision to lower the
overnight lending rate on three occasions during the fourth
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Morgan Stanley Dean Witter * 1998 Annual Report
quarter. Certain European currencies also experienced periods of volatility,
resulting from expectations of interest rate fluctuations in anticipation of EMU
and the collapse of the Russian ruble. Difficult political and economic
conditions in certain Asian nations, coupled with the continued recession in
Japan, also contributed to periods of high volatility in the currency markets.
Foreign exchange trading revenues increased 196% in fiscal 1997, primarily
resulting from the Company's increased client market share and from high levels
of volatility in the foreign exchange markets. During fiscal 1997, 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 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.
Commodities trading revenues were comparable to prior-year levels, as
higher revenues from crude oil, refined energy products and electricity were
partially offset by lower revenues from natural gas trading. Revenues from
trading crude oil and refined energy products were impacted by energy prices
that fell during much of fiscal 1998. Diminished demand for these products,
partially due to the ongoing economic crisis in the Far East, coupled with high
inventory levels, contributed to the decline in prices. Electricity trading
revenues benefited from higher electricity prices, primarily during the summer
months when the demand for electric power increased. The Company's continued
presence in the electricity market and the ongoing deregulation of the industry
also had a favorable impact on electricity trading revenues. Revenues from
natural gas trading decreased as unseasonably warm weather in certain regions of
the U.S. during the winter months reduced the demand for home heating oil,
leading to a decline in prices. 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 1998 and fiscal 1997, 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.
Principal transaction investment revenues aggregating $89 million were
recognized in fiscal 1998 as compared with $463 million in fiscal 1997. Fiscal
1998 revenues reflected the second highest level of revenues from the Company's
private equity business, which primarily resulted from gains on certain
positions that were sold during the year and increases in the carrying value of
certain of the Company's private equity investments. Such increases included
gains from the initial public offering of Equant and gains from the sale of
positions in Fort James Corporation and Jefferson Smurfit Corporation. These
gains were substantially offset by losses from an institutional leveraged
emerging markets debt portfolio that occurred during the third quarter. Fiscal
1997 revenues primarily reflect increases in the carrying value of certain of
the Company's private equity investments, including an increase related to the
Company's holdings of Fort James Corporation, 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 fiscal
1997's revenues.
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 13% in fiscal 1998,
reflecting higher revenues from equity cash products, primarily from markets in
the U.S. and Europe, as well as higher revenues from derivative products.
Revenues from U.S. markets benefited from high levels of market volatility,
which contributed to increased customer trading volumes. Revenues from European
markets also benefited from strong customer trading volumes, which were
positively impacted by the generally favorable performances of certain European
equity markets and from the Company's increased sales and research activities in
the region. Commissions on derivative products increased as the high levels of
market volatility contributed to increased customer hedging activities and
trading volumes. Higher commissions from the sale of mutual funds and the
Company's addition of more than 1,000 financial advisors during fiscal 1998 also
contributed to the increase. 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 expe-
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Morgan Stanley Dean Witter * 1998 Annual Report
rienced 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.
Net Interest
Interest and dividend revenues and interest expense are a function of the level
and mix of total assets and liabilities, including financial instruments owned,
reverse repurchase and repurchase agreements, trading strategies associated with
the Company's institutional securities activities, customer margin loans and the
prevailing level, term structure and volatility of interest rates. Interest and
dividend revenues and interest 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
43% in fiscal 1998, primarily attributable to higher levels of revenues from net
interest earning assets, including financial instruments owned and customer
margin receivable balances. Higher levels of securities lending transactions
also had a positive impact on net interest revenues. Net interest revenues
increased 23% in fiscal 1997, reflecting higher levels of trading activities and
retail customer financing activity, including margin interest. In fiscal 1997,
net interest revenues also 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
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:
FISCAL FISCAL FISCAL
(dollars in millions) 1998 1997 1996
================================================================================
Asset management, distribution
and administration fees $2,848 $2,505 $1,732
--------------------------------------------------------------------------------
The Company's customer assets under management or supervision were as
follows:
FISCAL FISCAL FISCAL
(dollars in billions) 1998 1997 1996
================================================================================
Customer assets under
management or supervision
(at fiscal year-end) $376 $338 $278
--------------------------------------------------------------------------------
In fiscal 1998, asset management, distribution and administration fees increased
14%, reflecting the Company's continuing strategic emphasis on the asset
management business. The increase in revenues primarily reflects higher fund
management and 12b-1 fees as well as other revenues resulting from a higher
level of assets under management or supervision, including revenues from
developed country global equity and fixed income products. Such increases were
partially offset by the impact of market depreciation in certain of the
Company's products resulting from the downturn in certain global financial
markets which occurred during the latter half of the year. Fiscal 1998's
revenues also were negatively impacted by the Company's sale of its
Correspondent Clearing and Global Custody businesses which occurred during
fiscal 1998. In fiscal 1997, asset management, distribution and administration
fees increased 45%. This increase reflects revenues from VK, which was acquired
by the Company on October 31, 1996. Fiscal 1997 revenues also benefited from
higher levels of fund management fees and increased
31
Morgan Stanley Dean Witter * 1998 Annual Report
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.
As of November 30, 1998, assets under management or supervision increased
$38 billion from fiscal year-end 1997. The increase in assets under management
or supervision in both fiscal 1998 and fiscal 1997 reflected continued inflows
of customer assets as well as appreciation in the value of customer portfolios.
In both fiscal 1998 and 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.
Non-Interest Expenses
FISCAL FISCAL FISCAL
(dollars in millions) 1998 1997 1996
================================================================================
Compensation and benefits $6,071 $5,475 $4,585
Occupancy and equipment 510 462 432
Brokerage, clearing and
exchange fees 538 448 317
Information processing and
communications 666 602 514
Marketing and business
development 487 393 296
Professional services 579 378 282
Other 529 511 382
--------------------------------------------------------------------------------
Total non-interest expenses $9,380 $8,269 $6,808
--------------------------------------------------------------------------------
Fiscal 1998's total non-interest expenses increased 13% to $9,380 million.
Within the non-interest expense category, employee compensation and benefits
expense increased 11%, reflecting increased levels of incentive compensation
based on record fiscal 1998 revenues and earnings, as well as an increase in the
number of employees. Excluding compensation and benefits expense, non-interest
expenses increased $515 million. Occupancy and equipment expense increased 10%,
principally reflecting additional office space and higher occupancy costs in New
York and Hong Kong, as well as incremental rent attributable to the opening of
27 securities branch locations. Brokerage, clearing and exchange fees increased
20%, primarily reflecting increased expenses related to higher levels of trading
volume in the global securities markets. Commissions paid in connection with the
Company's launch of The Van Kampen Senior Income Trust mutual fund also
contributed to the increase. Information processing and communications costs
increased 11% due to higher data services and communications costs related to an
increased number of employees and continued enhancements and maintenance
associated with the Company's information technology infrastructure. Marketing
and business development expense increased 24%, reflecting higher travel and
entertainment costs relating to increased levels of business activity associated
with active financial markets. Higher advertising and promotional costs also
contributed to the increase. Professional services expense increased 53%,
primarily reflecting higher consulting costs as a result of certain information
technology initiatives, including the Company's preparations for EMU and Year
2000 (see also "Year 2000 and EMU" herein). Higher levels of temporary staff and
employment fees due to the increased level of overall business activity also
contributed to the increase. Other expenses increased 4%, which reflects the
impact of a higher level of business activity on various operating expenses.
Fiscal 1997's total non-interest expenses increased 21% to $8,269 million.
Within the non-interest expense category, employee compensation and benefits
expense increased 19%, reflecting increased levels of incentive compensation
based on then-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 VK and the global institutional
custody business of Barclays. Occupancy and equipment expense increased 7%,
principally reflecting the occupancy costs of VK and increased office space in
London and Hong Kong. Brokerage, clearing and exchange fees increased 41%,
primarily reflecting the acquisitions of VK 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 VK and continued enhancements to the
Company's information technology infrastructure. Marketing and business
development expense 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 VK's retail
mutual funds also contributed to the increase. Professional services expense
increased 34%, reflecting higher consulting costs as a result of information
technology ini-
32
Morgan Stanley Dean Witter * 1998 Annual Report
tiatives and the increased level of overall business activity. Other expenses
increased 34%, which includes goodwill amortization of $43 million associated
with the acquisitions of VK and Barclays, as well as the impact of a higher
level of business activity on various operating expenses.
CREDIT AND TRANSACTION SERVICES
STATEMENTS OF INCOME
FISCAL FISCAL FISCAL
(dollars in millions) 1998 1997 1996
================================================================================
Fees:
Merchant and cardmember $1,647 $1,704 $1,505
Servicing 928 762 809
Commissions 36 27 --
Asset management, distribution
and administration fees 1 -- --
Other 16 12 4
................................................................................
Total non-interest revenues 2,628 2,505 2,318
................................................................................
Interest revenue 2,740 3,128 2,717
Interest expense 995 1,173 1,032
................................................................................
Net interest income 1,745 1,955 1,685
Provision for consumer
loan losses 1,173 1,493 1,214
................................................................................
Net credit income 572 462 471
................................................................................
Net revenues 3,200 2,967 2,789
................................................................................
Compensation and benefits 565 544 486
Occupancy and equipment 73 64 61
Brokerage, clearing and
exchange fees 14 12 --
Information processing and
communications 474 478 482
Marketing and business
development 924 786 731
Professional services 98 73 52
Other 216 259 286
................................................................................
Total non-interest expenses 2,364 2,216 2,098
................................................................................
Gain on sale of businesses 362 -- --
................................................................................
Income before income taxes 1,198 751 691
Provision for income taxes 510 283 257
................................................................................
Net income $ 688 $ 468 $ 434
................................................................................
CREDIT AND TRANSACTION SERVICES
In fiscal 1998, Credit and Transaction Services net income increased 47% to $688
million, including a net after-tax gain of $163 million related to the sale of
the Company's interest in the operations of SPS and certain BRAVO receivables.
Excluding this gain, net income increased 12%. The increase in net income in
fiscal 1998 was primarily attributable to the gain on the above-mentioned sales
and a lower provision for loan losses primarily resulting from the sale of Prime
Option and the operations of SPS. This increase was partially offset by
increases in marketing and business development expense and incremental taxes
associated with the sale of the operations of SPS. In fiscal 1997, 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.
The sale of Prime Option, the operations of SPS and certain BRAVO
receivables reflect the Company's strategic decision to focus on the growth of
its existing Discover Card brand and Discover/NOVUS Network. Reflecting this
renewed focus, the Company introduced the Discover(R) Platinum Card in December
1998 and plans to launch the Discover Card in a major foreign market during
fiscal 1999.
As a result of enhancements made to certain of the Company's operating
systems in the fourth quarter of fiscal 1997, the Company began recording
charged-off cardmember fees and interest revenue directly against the income
statement line items to which they were originally recorded. Prior to the
enhancements, charged-off cardmember fees and interest revenue both were
recorded as a reduction of interest revenue. While this change had no impact on
net revenues, the Company believes the revised presentation better reflects the
manner in which charge-offs affect the Credit and Transaction Services
statements of income. However, since prior periods have not been restated to
reflect this change, the comparability of merchant and cardmember fees and
interest revenue between fiscal 1998 and fiscal 1997 has been affected.
Accordingly, the following sections also will discuss the changes in these
income statement categories excluding the impact of this reclassification.
Credit and Transaction Services statistical data were as follows:
FISCAL FISCAL FISCAL
(dollars in billions) 1998 1997 1996
================================================================================
Consumer loans at fiscal year-end:
Owned $16.0 $20.9 $22.1
Managed $32.5 $36.0 $35.3
General Purpose Credit Card
transaction volume $58.0 $55.8 $53.6
--------------------------------------------------------------------------------
33
The lower level of consumer loans at November 30, 1998 reflects the Company's
sale of Prime Option, the operations of SPS and certain BRAVO receivables during
fiscal 1998.
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, and fees for the administration of credit card programs and
transaction processing services.
Merchant and cardmember fees decreased 3% in fiscal 1998 and increased 13%
in fiscal 1997. Excluding the effect of the reclassification of charged-off
cardmember fees discussed above, merchant and cardmember fees would have
increased 2% in fiscal 1998. This increase in fiscal 1998 was attributable to
higher merchant discount revenue primarily associated with increased growth of
general purpose credit card transaction volume related to the Discover Card
offset by lower revenues due to the sale of the operations of SPS in October
1998. In addition, merchant and cardmember fees benefited from higher overlimit
and late fees attributable to a fee increase introduced during fiscal 1998 and
an increase in occurrences of delinquent and overlimit accounts. Partially
offsetting these increases was a decrease in cash advance fees as a result of
lower cash advance transaction volume primarily attributable to limits on cash
advances imposed by the Company in an effort to improve credit quality. The
increase in fiscal 1997 was due to an increase in merchant discount revenue
associated with increased growth of general purpose credit card transaction
volume and increased late payment fees and overlimit fees. The increase in
overlimit fees was due to a higher incidence of overlimit occurrences. The
increase in late payment fee revenues was due to an increase in the incidence of
late payments and higher levels of delinquent accounts.
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 resulting from
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 Company completed asset
securitizations of $4.5 billion in fiscal 1998 and $2.8 billion in fiscal 1997.
The asset securitizations in fiscal 1998 and 1997 have expected maturities
ranging from three to 10 years from the date of issuance.
The table below presents the components of servicing fees:
FISCAL fiscal fiscal
(dollars in millions) 1998 1997 1996
============================================================================
Merchant and cardmember fees $ 505 $ 436 $ 307
Interest revenue 2,598 2,116 2,025
Interest expense (1,010) (829) (792)
Provision for consumer
loan losses (1,165) (961) (731)
----------------------------------------------------------------------------
Servicing fees $ 928 $ 762 $ 809
----------------------------------------------------------------------------
Servicing fees are affected by the level of securitized loans, the spread
between the interest yield on the securitized loans and the yield paid to the
investors, the rate of credit losses on securitized loans and the level of
cardmember fees earned from securitized loans. Servicing fees also include the
effects of interest rate contracts entered into by the Company as part of its
interest rate risk management program. Servicing fees increased 22% in fiscal
1998 and decreased 6% in fiscal 1997. The increase in fiscal 1998 was due to
higher levels of net interest cash flows and increased fee revenue, partially
offset by increased credit losses from securitized consumer loans which were
primarily a result of higher levels of average securitized loans. The decline in
fiscal 1997 servicing fees was attributable to higher credit losses, partially
offset by higher cardmember fees and net interest revenues.
Commission Revenues
Commission revenues arise from customer securities transactions associated with
Discover Brokerage Direct, Inc. ("DBD"), the Company's provider of electronic
brokerage services acquired in January 1997. Commission revenues increased 33%
in fiscal 1998 resulting from an increase in the level of customer trading
activity, partially offset by lower revenue per trade due to an increase in
Internet trades as a percentage of total trades. In addition, fiscal 1998
contained a full year of commissions for DBD, while fiscal 1997 reflected only
10 months.
34
Morgan Stanley Dean Witter * 1998 Annual Report
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 by
DBD for promoting and distributing mutual funds.
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 1998, fiscal 1997 and fiscal
1996 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.
(3) Certain prior-year information has been reclassified to conform to the
current year's presentation.
35
Morgan Stanley Dean Witter * 1998 Annual Report
RATE/VOLUME ANALYSIS
Net interest income decreased 11% in fiscal 1998 and increased 16% in fiscal
1997. Excluding the effect of the reclassification of charged-off cardmember
fees discussed previously, net interest income would have decreased 15% in
fiscal 1998. The decrease in fiscal 1998 was due to lower average levels of
owned consumer loans and a lower yield on general purpose credit card loans. The
decrease in owned consumer loans was primarily due to an increase in securitized
loans and the sale of the Prime Option and SPS portfolios. The lower yield on
general purpose credit card loans in fiscal 1998 was due to a larger number of
cardmembers taking advantage of promotional rates. 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. The Company believes that the effect of changes in market
interest rates on net interest income was mitigated as a result of its liquidity
and interest rate risk management policies. The increase in net interest income
in fiscal 1997 was 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.
The Company anticipates the repricing of a substantial portion of its
existing credit card receivables to a fixed interest rate during fiscal 1999.
The Company does not believe this repricing will have a material impact on its
interest rate sensitivity due to the Company's matched financing objectives.
36
Morgan Stanley Dean Witter * 1998 Annual Report
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 $787 million
at November 30, 1998 and $884 million at November 30, 1997.
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, decreased 21% in fiscal 1998 and increased 23% in fiscal
1997. The decrease in fiscal 1998 was due to a decrease in net charge-offs
resulting from lower average levels of owned consumer loans, primarily
attributable to an increased level of securitized loans and reduced levels of
charge-offs associated with the sale of Prime Option and SPS receivables,
partially offset by a small increase in the net charge-off rate of the Discover
Card portfolio. The provision for loan losses also was positively impacted by a
decline in the loan loss allowance in connection with securitization
transactions entered into prior to the third quarter of 1996. The Company
expects this loan loss allowance will be fully amortized over fiscal 1999. In
fiscal 1997, the increase in consumer loan losses 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. 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 provision for
consumer loan losses include the level and direction of consumer loan
delinquencies and charge-offs, 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. Delinquency rates decreased in fiscal 1998 as a reflection of the
Company's increased focus on credit quality and account collections, as well as
the sale of Prime Option, SPS and BRAVO.
From time to time, the Company has offered and may continue to offer
cardmembers with accounts in good standing the
37
Morgan Stanley Dean Witter * 1998 Annual Report
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
as compared with November 30, 1996 was favorably impacted by a September 1997
skip-a-payment offer allowing certain cardmembers to skip their next monthly
payment. The following table presents delinquency and net charge-off rates with
supplemental managed loan information:
Non-Interest Expenses
Total non-interest expenses increased 7% to $2,364 million in fiscal 1998 and 6%
to $2,216 million in fiscal 1997.
Employee compensation and benefits expense increased 4% in fiscal 1998 and
12% in fiscal 1997. The increase in fiscal 1998 was due to an increased number
of employees and higher executive compensation costs associated with Discover
Card operations and DBD, offset by lower compensation costs associated with the
sale of Prime Option and the operations of SPS. The increase in fiscal 1997 was
due to an increased number of employees and employment costs associated with
processing increased credit card transaction volume and servicing additional
Discover/NOVUS Network merchants and active credit card accounts, including
collection activities.
Occupancy and equipment expense increased 14% in fiscal 1998 and 5% in
fiscal 1997. The increases in both years were due to higher rent and other
occupancy costs at certain of the Company's facilities, including payment
processing centers.
Brokerage, clearing and exchange fees increased 17% from fiscal 1997. The
increase is attributable to higher levels of DBD customer trading volume,
partially offset by lower costs per trade resulting from DBD's implementation of
self-clearing operations in October 1998.
Information processing and communications expense decreased 1% in fiscal
1998 and 1997. In fiscal 1998, lower transaction processing costs resulting from
the sale of the operations of SPS were partially offset by higher external data
processing costs related to the Year 2000 project and increased cardmember data
analysis associated with credit risk management activity. In fiscal 1997,
information processing and communications expense increased due to higher levels
of transaction volume, additional Discover/NOVUS Network servicing costs and the
development of the systems supporting the Company's multi-card strategy. In
fiscal 1997, the 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 18% in fiscal 1998 and
8% in fiscal 1997. The increase in fiscal 1998 was attributed to higher
advertising and promotional expenses associated with increased direct mail and
other promotional activities related to the Discover Card, Private Issue(R)
Card, partnership programs and DBD, as well as higher cardmember rewards
expense. The Company increased marketing and promotional spending significantly
in the third and fourth quarters of fiscal 1998 in an effort to renew and
increase growth in the Discover Card brand. In the past several years, the
Company focused its attention on improving and maintaining credit quality. In
fiscal 1999, the Company expects to continue to invest in the growth of its
credit card business, including the introduction of a Discover Platinum Card and
the launch of the Discover Card into a major foreign market.
38
Morgan Stanley Dean Witter * 1998 Annual Report
The increase in fiscal 1997 was primarily attributable to higher cardmember
rewards expense and marketing and promotional costs. Higher marketing and
promotional costs were associated with the growth of new and existing credit
card brands. 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 1% (up to 2% for the Private Issue Card) based upon a cardmember's
level of annual purchases. Higher cardmember rewards expense in both years was
associated with growth in credit card transaction volume and increased credit
cardmember qualification for higher award levels. Commencing March 1, 1998, the
terms of the Private Issue Cashback Bonus program were amended by limiting the
maximum annual bonus amount to $500 and by increasing the amount of purchases
required to receive this bonus amount. Cardmember rewards expense was not
materially impacted by these changes.
Professional services expense increased 34% in fiscal 1998 and 40% in
fiscal 1997. The increase in fiscal 1998 was due to services related to
increased partnership program activity, higher expenditures for consumer credit
counseling and collections services and consulting fees. The increase in fiscal
1997 was primarily due to higher expenditures for consumer credit counseling and
collections services.
Other non-interest expenses decreased 17% in fiscal 1998 and 9% in fiscal
1997. Other expenses primarily include fraud losses, credit inquiry fees and
other administrative costs. The decrease in both years was due to a continuing
decline in the level of fraud losses. Fiscal 1998 also reflects a lower level of
expenses resulting from the sale of Prime Option and the operations of SPS.
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 following 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 first fiscal
quarter, reflecting seasonal growth in retail sales volume.
LIQUIDITY AND CAPITAL RESOURCES
The Balance Sheet
The Company's total assets increased to $317.6 billion at November 30, 1998 from
$302.3 billion at November 30, 1997, primarily reflecting growth in cash and
cash equivalents, cash and securities deposited with clearing organizations or
segregated under federal and other regulations, and securities borrowed. 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, private equity 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 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
39
Morgan Stanley Dean Witter * 1998 Annual Report
things, business opportunities, capital availability and rates of return
together with internal capital policies, regulatory requirements and rating
agency guidelines and therefore, in the future, may expand or contract its
capital base to address the changing needs of its businesses. The Company also
has returned to shareholders 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 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
floating 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 and duration characteristics of the loans financed. The
Company 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 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 unsecured 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, 1999, the Company's credit ratings were as follows:
Commercial Senior
Paper Debt
========================================================================
Dominion Bond Rating Service R-1 n/a
Duff & Phelps Credit Rating Co. D-1+ AA
Fitch IBCA, Inc. F1+ AA-
Japan Rating & Investment Information, Inc. A-1+ AA-
Moody's Investors Service P-1 Aa3
Standard & Poor's A-1 A+
Thomson BankWatch, Inc. TBW-1 AA
------------------------------------------------------------------------
During fiscal 1998, Moody's Investors Service upgraded the Company's senior debt
rating from A1 to Aa3. In January 1999, Duff & Phelps Credit Rating Co. upgraded
the Company's senior debt rating from AA- to AA.
As the Company continues its global expansion and derives revenues
increasingly 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 engag-
40
Morgan Stanley Dean Witter * 1998 Annual Report
ing 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 Japanese commercial paper;
letters of credit; unsecured bond borrows; 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 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, Federal 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
Federal 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 individual
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.
The Company maintains a senior revolving credit agreement with a group of
banks to support general liquidity needs, including the issuance of commercial
paper (the "MSDW Facility"). Under the terms of the MSDW Facility, the banks are
committed to provide up to $6.0 billion. The MSDW Facility contains restrictive
covenants which require, among other things, that the Company maintain
shareholders' equity of at least $9.1 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, 1998, no borrowings were outstanding
under the MSDW 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 $1.875 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 1999, the MS&Co. Facility was renewed. At
November 30, 1998, 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"), the Company's
London-based broker-dealer subsidiary, 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 and, effective
January 1, 1999, the euro. 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,
1998, no borrowings were outstanding under the MSIL Facility.
RFC maintains a senior bank credit facility to support the issuance of
asset-backed commercial paper in the amount of $2.6 billion. Under the terms of
the asset-backed commercial paper program, certain assets of RFC were subject to
a lien in the amount of
41
Morgan Stanley Dean Witter * 1998 Annual Report
$2.6 billion at November 30, 1998. RFC has never borrowed from its senior bank
credit facility.
The Company anticipates that it will utilize the MSDW 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 1998 and Subsequent Activity
During fiscal 1998, 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 $4,345
million to $37,922 million at November 30, 1998.
During fiscal 1998, the Company issued senior notes aggregating $9,800
million, including non-U.S. dollar currency notes aggregating $1,640 million,
primarily pursuant to its public debt shelf registration statements. These notes
have maturities from 1999 to 2028 and a weighted average coupon interest rate of
5.6% at November 30, 1998; the Company has entered into certain transactions to
obtain floating interest rates based primarily on short-term LIBOR trading
levels. At November 30, 1998, the aggregate outstanding principal amount of the
Company's Senior Indebtedness (as defined in the Company's public debt shelf
registration statements) was approximately $45.3 billion. Between November 30,
1998 and January 31, 1999, the Company issued additional debt obligations
aggregating approximately $2,298 million. These notes have maturities from 2000
to 2013.
Effective January 1999, the Company's Board of Directors authorized the
Company to purchase, subject to market conditions and certain other factors, up
to $1 billion of the Company's common stock. The Board of Directors also
approved a separate ongoing repurchase authorization in connection with awards
granted under the Company's equity-based compensation plans. During fiscal 1998,
the Company purchased $2,925 million of its common stock. Subsequent to November
30, 1998 and through January 31, 1999, the Company purchased an additional $110
million of its common stock.
On March 5, 1998, MSDW Capital Trust I, a Delaware statutory business trust
(the "Capital Trust"), all of the common securities of which are owned by the
Company, issued $400 million of 7.10% Capital Securities (the "Capital
Securities") that are guaranteed by the Company. The Capital Trust issued the
Capital Securities and invested the proceeds in 7.10% Junior Subordinated
Deferrable Interest Debentures issued by the Company, which are due February 28,
2038.
On March 12, 1998, the Company's shelf registration statement for an
additional $8 billion of debt securities, warrants, preferred stock or purchase
contracts, or any combination thereof in the form of units, became effective.
On August 31, 1998, the Company redeemed all 1,000,000 outstanding shares
of its 7-3/8% Cumulative Preferred Stock at a redemption price of $200 per
share. The Company also simultaneously redeemed all corresponding Depositary
Shares at a redemption price of $25 per Depositary Share. Each Depositary Share
represented 1/8 of a share of the Company's 7-3/8% Cumulative Preferred Stock.
On January 28, 1999, the Company and Morgan Stanley Finance, plc, a U.K.
subsidiary, called for redemption all of the outstanding 7.82% Capital Units and
7.80% Capital Units on February 28, 1999. The aggregate principal amount of the
Capital Units to be redeemed is $352 million.
At November 30, 1998, certain assets of the Company, such as real property,
equipment and leasehold improvements of $1.8 billion, and goodwill and other
intangible assets of $1.2 billion, were illiquid. In addition, certain equity
investments made in connection with the Company's private equity 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 private equity 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, 1998, the aggregate carrying value of the Company's equity
investments in privately held companies (including direct investments and
partnership interests) was $185 million, and its aggregate investment in
publicly held companies was $320 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
42
Morgan Stanley Dean Witter * 1998 Annual Report
of the portion of the Company's mortgage-related portfolio at November 30, 1998
traded in markets that the Company believed were experiencing lower levels of
liquidity than traditional mortgage-backed pass-through securities approximated
$1,369 million.
In addition, at November 30, 1998, the aggregate value of high-yield debt
securities and emerging market loans and securitized instruments held in
inventory was $2,395 million (a substantial portion of which was subordinated
debt). These securities, loans and instruments were not attributable to more
than 6% to any one issuer, 22% to any one industry or 18% to any one geographic
region. 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, therefore, are
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 that are administered 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").
The Company also has commitments to fund certain fixed assets and other
less liquid investments, including at November 30, 1998 approximately $181
million in connection with its private equity 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.
In November 1998, the Company announced that it had entered into an
agreement that will result in the development of an office tower in New York
City. Pursuant to this agreement, the Company has entered into a 99-year lease
for the land at the proposed development site.
The Company may, from time to time, also provide financing or financing
commitments to companies in connection with its investment banking and private
equity 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. At November 30, 1998, the Company had two
commitments to provide an aggregate of $82 million and had one loan in the
amount of $8 million outstanding in connection with its high-yield underwriting
activities. Between November 30, 1998 and January 31, 1999, the Company's
aggregate commitments increased to $89 million and had two loans in the amount
of $112 million outstanding.
In September 1998, the Company made an investment of $300 million in the
Long-Term Capital Portfolio, L.P. ("LTCP"). The Company is a member of a
consortium of 14 financial institutions participating in an equity
recapitalization of LTCP. The objectives of this investment, the term of which
is three years, are to continue active management of its positions and, over
time, reduce excessive risk exposures and leverage, return capital to the
participants and ultimately realize the potential value of the LTCP portfolio.
At November 30, 1998, the carrying value of the Company's investment in LTCP
approximated fair value.
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 generally are 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, 1998, the aggregate
value of senior secured loans and positions held by the Company was $1,259
million, and aggregate senior secured loan commitments were $447 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 9, respectively, to the consolidated financial
statements (see also "Derivative Financial Instruments" herein).
YEAR 2000 AND EMU
Year 2000 Readiness Disclosure
Many of the world's computer systems (including those in non-information
technology equipment and systems) currently record years in a two-digit format.
If not addressed, such computer systems may 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,
43
Morgan Stanley Dean Witter * 1998 Annual Report
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.
The Company has established a firm-wide initiative to address issues
associated with the Year 2000. Each of the Company's business areas has taken
responsibility for the identification and remediation of Year 2000 issues within
its own areas of operations and for addressing all interdependencies. A
corporate team of internal and external professionals supports the business
teams by providing direction and company-wide coordination as needed. The Year
2000 and EMU (discussed below) projects have been designated as the highest
priority activities of the Company's Information Technology Department. 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 its systems and programs to
identify those that contain two-digit year codes and is in the process of
upgrading its global infrastructure and corporate facilities to achieve Year
2000 compliance. In addition, the Company is actively working with its major
external counterparties and suppliers to assess their compliance and remediation
efforts and the Company's exposure to them.
In addressing the Year 2000 issue, the Company has identified the following
phases. In the Awareness phase, the Company defined the Year 2000 issue and
obtained executive level support and funding. In the Inventory phase, the
Company collected a comprehensive list of items that may be affected by Year
2000 compliance issues. Such items include facilities and related
non-information technology systems (embedded technology), computer systems,
hardware, and services and products provided by third parties. In the Assessment
phase, the Company evaluated the items identified in the Inventory phase to
determine which will function properly with the change to the new century and
ranked items which will need to be remediated based on their potential impact to
the Company. The Remediation phase includes an analysis of the items that are
affected by Year 2000, the identification of problem areas and the repair of
non-compliant items. The Testing phase includes a thorough testing of all
proposed repairs, including present and forward date testing which simulates
dates in the Year 2000. The Implementation phase consists of placing all items
that have been remediated and successfully tested into production. Finally, the
Integration and External Testing phase includes exercising business-critical
production systems in a future time environment and testing with external
entities.
The Company has completed the Awareness, Inventory and Assessment phases.
As of November 30, 1998, the Remediation, Testing and Implementation phases were
substantially complete. Due to resource allocations between the Year 2000 and
EMU projects, as well as late vendor delivery of third-party products, the
Company expects that the remaining portions of the Remediation, Testing and
Implementation phases of substantially all mission-critical systems will be
complete by March 31, 1999 as compared with the original expected completion
date of December 31, 1998. The Integration and External Testing phase commenced
in the second quarter of 1998 and will continue through 1999. In addition, the
major business relationships of the Company have been identified, and the most
critical of them have been or are scheduled to be tested.
In addition, the Company is closely monitoring the Year 2000 compliance
status of its most critical business relationships. The Company continues to
survey and communicate with counterparties, intermediaries and vendors with whom
it has important financial and operational relationships to determine the extent
to which they are vulnerable to Year 2000 issues. As of November 30, 1998, the
Company had not yet received sufficient information from all parties about their
remediation plans to predict the outcomes of their efforts. In particular, in
some international markets in which the Company conducts business, the level of
awareness and remediation efforts relating to the Year 2000 issue is thought to
be less advanced than in the United States.
During the third quarter of fiscal 1998, the Company participated in the
Securities Industry Association's Beta test and a test sponsored by the Bank of
England's Central Gilts Office. These tests were run in "future time," using a
portion of the Company's production system, and employed test scripts to check
functionality. The Company has achieved successful results in each of the
industry-wide tests in which it participated. The Company will continue to
participate in industry-wide and vendor-specific tests throughout 1999.
There are many risks associated with the Year 2000 issue, including the
possibility of a failure of the Company's computer and non-information
technology systems. Such failures could have a material adverse effect on the
Company and may cause systems malfunctions; incorrect or incomplete transaction
processing resulting in failed trade settlements; the inability to reconcile
accounting books and records; the inability to reconcile credit card
transactions and
44
Morgan Stanley Dean Witter * 1998 Annual Report
balances; the inability to reconcile trading positions and balances with
counterparties; and inaccurate information to manage the Company's exposure to
trading risks and disruptions of funding requirements. In addition, even if the
Company successfully remediates its Year 2000 issues, it can be materially and
adversely affected by failures of third parties to remediate their own Year 2000
issues. The Company recognizes the uncertainty of such external dependencies
since it cannot directly control the remediation efforts of third parties. The
failure of third parties with which the Company has financial or operational
relationships, such as securities exchanges, clearing organizations,
depositories, regulatory agencies, banks, clients, counterparties, vendors
(including data center, data network and voice service providers) and utilities,
to remediate their computer and non-information technology systems issues in a
timely manner could result in a material financial risk to the Company.
If the above-mentioned risks are not remedied, the Company may experience
business interruption or shutdown, financial loss, regulatory actions, damage to
the Company's global franchise and legal liability.
The Company has business continuity plans in place for its critical
business functions on a worldwide basis. The Company also has in place a
contingency funding strategy (see "Liquidity and Capital Resources"). The
Company has begun Year 2000 contingency planning. The Company is currently
reviewing responses from its major external counterparties and suppliers with
respect to Year 2000 preparation, assessing the results of various internal and
external systems tests and analyzing possible Year 2000 scenarios to determine a
range of likely outcomes. The Company intends to document and test Year 2000
specific contingency plans during fiscal 1999 as part of its Year 2000
mitigation efforts.
Based upon current information, the Company estimates that the total cost
of implementing its Year 2000 initiative will be between $200 million and $225
million. The decrease in these estimates from amounts previously reported is
associated with the Company's sale of its interest in the operations of SPS and
with revised internal estimates. The Year 2000 costs include all activities
undertaken on Year 2000 related matters across the Company, including, but not
limited to, remediation, testing (internal and external), third- party review,
risk mitigation and contingency planning. Through November 30, 1998, the Company
expended approximately $110 million on the Year 2000 project. The Company
expects the majority of the remaining costs to be directed primarily toward
testing activities. These costs have been and will continue to be funded through
operating cash flow and are expensed in the period in which they are incurred.
The Company's expectations about future costs, the timely completion and
the potential risks of its Year 2000 modifications are subject to uncertainties
that could cause actual results to differ materially from what has been
discussed above. Factors that could influence the amount of future costs and the
effective timing of remediation efforts include the success of the Company in
identifying computer programs and non-information technology systems that
contain two-digit year codes; the nature and amount of programming and testing
required to upgrade or replace each of the affected programs and systems; the
nature and amount of testing, verification and reporting required by the
Company's regulators around the world, including securities exchanges, central
banks and various governmental regulatory bodies; the rate and magnitude of
related labor and consulting costs; and the success of the Company's external
counterparties and suppliers, as well as worldwide exchanges, clearing
organizations and depositories, in addressing the Year 2000 issue.
EMU
EMU replaces the national currencies of 11 participating European Union
countries with a single European currency -- the euro. The euro was launched on
January 1, 1999, when the European Central Bank assumed control of monetary
policy for the participating nations. During the transition period until the
national currencies are withdrawn from circulation (July 2002 at the latest),
such currencies will continue to exist but only as fixed denominations of the
euro. EMU will primarily impact the Company's Securities and Asset Management
business.
The introduction of the euro presents major business opportunities for
financial market participants such as the Company. The Company expects that the
introduction of the euro will lead to greater cross-border price transparency
and will have a significant impact on the markets in which the Company operates.
The Company prepared actively for the introduction of the euro and
implemented significant modifications to its information technology systems and
programs in order to prepare for transition to the euro. The Company engaged in
extensive testing of the
45
Morgan Stanley Dean Witter * 1998 Annual Report
systems and processes affected by EMU and also communicated extensively with its
clients and counterparties regarding the implications of EMU. The Company
considers that the initial redenomination exercise that took place between
January 1 and January 3, 1999 was successful from the perspective of its
internal systems and books and records. Despite certain initial issues with the
settlement of euro payments, as of January 31, 1999 it appears that the
changeover to the euro has been successful across Europe.
Based upon current information, the Company estimates that the costs
associated with reviewing, amending and testing its information technology
systems to prepare for EMU for fiscal 1998 and through the project's completion
will be approximately $76 million. Substantially all of such costs were incurred
by the end of fiscal 1998. These costs have been and will continue to be funded
through operating cash flow and are expensed in the period in which they are
incurred.
REGULATORY CAPITAL REQUIREMENTS
Dean Witter Reynolds Inc. ("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 11 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.
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 9 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
46
Morgan Stanley Dean Witter * 1998 Annual Report
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, 1998 was $2,860 billion (as compared with $2,529 billion at
November 30, 1997). 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, 1998 was $21.4 billion. Approximately $16.2 billion of that credit risk
exposure was with counterparties rated single-A or better (see Note 9 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 Note 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.
47