EXHIBIT 13.5
Morgan Stanley Dean Witter * 1998 Annual Report
REPORT OF INDEPENDENT AUDITORS
TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF
MORGAN STANLEY DEAN WITTER & CO.
We have audited the accompanying consolidated statements of financial condition
of Morgan Stanley Dean Witter & Co. and subsidiaries as of fiscal years ended
November 30, 1998 and 1997, and the related consolidated statements of income,
cash flows and changes in shareholders' equity for each of the three fiscal
years in the period ended November 30, 1998. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits. The consolidated financial statements give
retroactive effect to the merger of Morgan Stanley Group Inc. and Dean Witter,
Discover & Co., which has been accounted for as a pooling of interests as
described in Note 1 to the consolidated financial statements. We did not audit
the consolidated statements of income, cash flows and changes in shareholders'
equity of Morgan Stanley Group Inc. and subsidiaries for the fiscal year ended
November 30, 1996, which statements reflect total revenues of $13,144 million
for the fiscal year then ended. Those statements were audited by other auditors
whose report has been furnished to us, and our opinion, insofar as it relates to
the amounts included for Morgan Stanley Group Inc. and subsidiaries for such
period, is based solely on the report of such other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of the other auditors provide a
reasonable basis for our opinion.
In our opinion, based on our audits and the report of the other auditors,
the accompanying consolidated financial statements present fairly, in all
material respects, the consolidated financial position of Morgan Stanley Dean
Witter & Co. and subsidiaries at fiscal years ended November 30, 1998 and 1997,
and the consolidated results of their operations and their cash flows for each
of the three fiscal years in the period ended November 30, 1998, in conformity
with generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, in fiscal
1998, Morgan Stanley Dean Witter & Co. changed its method of accounting for
certain offering costs of closed-end funds.
/s/ Deloitte & Touche LLP
New York, New York
January 22, 1999
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Morgan Stanley Dean Witter * 1998 Annual Report
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
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Morgan Stanley Dean Witter * 1998 Annual Report
(1) These amounts relate to the Company's adoption of SFAS No. 127.
See Notes to Consolidated Financial Statements.
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Morgan Stanley Dean Witter * 1998 Annual Report
CONSOLIDATED STATEMENTS OF INCOME
(1) Amounts shown are used to calculate basic earnings per common share.
(2) Per share and share data for fiscal 1997 and 1996 have been restated to
reflect the Company's adoption of SFAS No. 128.
See Notes to Consolidated Financial Statements.
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Morgan Stanley Dean Witter * 1998 Annual Report
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
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Morgan Stanley Dean Witter * 1998 Annual Report
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
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Morgan Stanley Dean Witter * 1998 Annual Report
See Notes to Consolidated Financial Statements.
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Morgan Stanley Dean Witter * 1998 Annual Report
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. INTRODUCTION AND BASIS OF PRESENTATION
--------------------------------------------------------------------------------
THE MERGER
On May 31, 1997, Morgan Stanley Group Inc. ("Morgan Stanley") was merged with
and into Dean Witter, Discover & Co. ("Dean Witter Discover") (the "Merger"). At
that time, Dean Witter Discover changed its corporate name to Morgan Stanley,
Dean Witter, Discover & Co. ("MSDWD"). In conjunction with the Merger, MSDWD
issued 260,861,078 shares of its common stock, as each share of Morgan Stanley
common stock then outstanding was converted into 1.65 shares of 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
The consolidated financial statements include the accounts of the Company
and its U.S. and international subsidiaries, including Morgan Stanley & Co.
Incorporated ("MS&Co."), Morgan Stanley & Co. International Limited ("MSIL"),
Morgan Stanley Japan Limited ("MSJL"), Dean Witter Reynolds Inc. ("DWR"), Morgan
Stanley Dean Witter Advisors Inc. (formerly known as Dean Witter InterCapital
Inc.) and NOVUS Credit Services Inc.
The Company, through its subsidiaries, provides a wide range of financial
and securities services on a global basis and provides credit and transaction
services nationally. Its Securities and Asset Management businesses include
securities underwriting, distribution and trading; merger, acquisition,
restructuring, real estate, project finance and other corporate finance advisory
activities; asset management; private equity and other principal investment
activities; brokerage and research services; the trading of foreign exchange and
commodities as well as derivatives on a broad range of asset categories, rates
and indices; and securities lending. The Company's Credit and Transaction
Services businesses include the issuance of the Discover(R) Card and other
proprietary general purpose credit cards, the operation of the Discover/NOVUS(R)
Network, a proprietary network of merchant and cash access locations, and
direct-marketed activities such as the online securities services offered by
Discover Brokerage Direct, Inc. The Company's services are provided to a large
and diversified group of clients and customers, including corporations,
governments, financial institutions and individuals.
BASIS OF FINANCIAL INFORMATION
The consolidated financial statements give retroactive effect to the Merger,
which was accounted for as a pooling of interests. The pooling of interests
method of accounting requires the restatement of all periods presented as if
Dean Witter Discover and Morgan Stanley had always been combined. The
consolidated statement of changes in shareholders' equity reflects the accounts
of the Company as if the preferred and additional common stock had been issued
during all of the periods presented.
Prior to the consummation of the Merger, Dean Witter Discover's year ended
on December 31 and Morgan Stanley's fiscal year ended on November 30. Subsequent
to the Merger, the Company adopted a fiscal year-end of November 30. In
recording the pooling of interests combination, Dean Witter Discover's financial
statements for the 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 with the new fiscal year-end date. The
Company's results of operations for fiscal 1997 and fiscal 1996 include the
month of December 1996 for Dean Witter Discover.
The consolidated financial statements are prepared in accordance with
generally accepted accounting principles, which require management to make
estimates and assumptions regarding certain trading inventory valuations,
consumer loan loss levels, the potential outcome of litigation and other matters
that affect the consolidated financial statements and related disclosures.
Management believes that the estimates utilized in the preparation of the con-
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Morgan Stanley Dean Witter * 1998 Annual Report
solidated financial statements are prudent and reasonable. Actual results could
differ materially from these estimates.
Certain reclassifications have been made to prior-year amounts to conform
to the current presentation. All material intercompany balances and transactions
have been eliminated.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
--------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
For purposes of these statements, cash and cash equivalents consist of cash and
highly liquid investments not held for resale with maturities, when purchased,
of three months or less.
In connection with the fiscal 1997 purchase of Discover Brokerage Direct,
Inc. (formerly Lombard Brokerage, Inc.), the Company issued 1.9 million shares
of common stock having a fair value on the date of acquisition of approximately
$63 million. In connection with the purchase of Miller Anderson & Sherrerd, LLP
("MAS") in fiscal 1996, the Company issued approximately $66 million of notes
payable, as well as 3.3 million shares of common stock having a fair value on
the date of acquisition of approximately $83 million. In addition, in connection
with the purchase in fiscal 1996 of VK/AC Holding, Inc., the parent of Van
Kampen American Capital, Inc., the Company assumed approximately $162 million of
long-term debt.
CONSUMER LOANS
Consumer loans, which consist primarily of credit card and other consumer
installment loans, are reported at their principal amounts outstanding, less
applicable allowances. Interest on consumer loans is credited to income as
earned.
Interest is accrued on credit card loans until the date of charge-off,
which generally occurs at the end of the month during which an account becomes
180 days past due, except in the case of bankruptcies and fraudulent
transactions, which are charged off earlier. The interest portion of charged-off
credit card loans is written off against interest revenue. Origination costs
related to the issuance of credit cards are charged to earnings over periods not
exceeding 12 months.
ALLOWANCE FOR CONSUMER LOAN LOSSES
The allowance for consumer loan losses is a significant estimate that is
regularly evaluated by management for adequacy on a portfolio-by-portfolio basis
and is established through a charge to the provision for loan losses. The
evaluations take into consideration factors such as changes in the nature and
volume of the loan portfolio, overall portfolio quality, review of specific
problem loans and current economic conditions that may affect the borrower's
ability to pay.
The Company uses the results of these evaluations to provide an allowance
for loan losses. The exposure for credit losses for owned loans is influenced by
the performance of the portfolio and other factors discussed above, with the
Company absorbing all related losses. The exposure for credit losses for
securitized loans is represented by the Company retaining a contingent risk
based on the amount of credit enhancement provided.
SECURITIZATION OF CONSUMER LOANS
The Company periodically sells consumer loans through asset securitizations and
continues to service these loans. In accordance with Statement of Financial
Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities" ("SFAS No. 125"), the
present value of the future net servicing revenues which the Company estimates
that it will receive over the term of the securitized loans is recognized in
income as the loans are securitized. A corresponding asset also is recorded and
then amortized as a charge to income over the term of the securitized loans,
with actual net servicing revenues continuing to be recognized in income as they
are earned. The impact of recognizing the present value of estimated future net
servicing revenues as loans are securitized has not been material to the
consolidated statements of income.
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Morgan Stanley Dean Witter * 1998 Annual Report
FINANCIAL INSTRUMENTS USED FOR TRADING AND INVESTMENT
Financial instruments, including derivatives, used in the Company's trading
activities are recorded at fair value, and unrealized gains and losses are
reflected in trading revenues. Interest and dividend revenue and interest
expense arising from financial instruments used in trading activities are
reflected in the consolidated statements of income as interest and dividend
revenue or interest expense. The fair values of the trading positions generally
are based on listed market prices. If listed market prices are not available or
if liquidating the Company's positions would reasonably be expected to impact
market prices, fair value is determined based on other relevant factors,
including dealer price quotations and price quotations for similar instruments
traded in different markets, including markets located in different geographic
areas. Fair values for certain derivative contracts are derived from pricing
models which consider current market and contractual prices for the underlying
financial instruments or commodities, as well as time value and yield curve or
volatility factors underlying the positions. Purchases and sales of financial
instruments are recorded in the accounts on trade date. Unrealized gains and
losses arising from the Company's dealings in over-the-counter ("OTC") financial
instruments, including derivative contracts related to financial instruments and
commodities, are presented in the accompanying consolidated statements of
financial condition on a net-by-counterparty basis, when appropriate.
Equity securities purchased in connection with private equity and other
principal investment activities initially are carried in the consolidated
financial statements at their original costs. The carrying value of such equity
securities is adjusted when changes in the underlying fair values are readily
ascertainable, generally as evidenced by listed market prices or transactions
which directly affect the value of such equity securities. Downward adjustments
relating to such equity securities are made in the event that the Company
determines that the eventual realizable value is less than the carrying value.
The carrying value of investments made in connection with principal real estate
activities which do not involve equity securities are adjusted periodically
based on independent appraisals, estimates prepared by the Company of discounted
future cash flows of the underlying real estate assets or other indicators of
fair value.
Loans made in connection with private equity and investment banking
activities are carried at cost plus accrued interest less reserves, if deemed
necessary, for estimated losses.
FINANCIAL INSTRUMENTS USED FOR ASSET AND LIABILITY MANAGEMENT
The Company has entered into various contracts as hedges against specific
assets, liabilities or anticipated transactions. These contracts include
interest rate swaps, foreign exchange forwards and foreign currency swaps. The
Company uses interest rate and currency swaps to manage the interest rate and
currency exposure arising from certain borrowings and to match the repricing
characteristics of consumer loans with those of the borrowings that fund these
loans. For contracts that are designated as hedges of the Company's assets and
liabilities, gains and losses are deferred and recognized as adjustments to
interest revenue or expense over the remaining life of the underlying assets or
liabilities. For contracts that are hedges of asset securitizations, gains and
losses are recognized as adjustments to servicing fees. Gains and losses
resulting from the termination of hedge contracts prior to their stated maturity
are recognized ratably over the remaining life of the instrument being hedged.
The Company also uses foreign exchange forward contracts to manage the currency
exposure relating to its net monetary investment in non-U.S. dollar functional
currency operations. The gain or loss from revaluing these contracts is deferred
and reported within cumulative translation adjustments in shareholders' equity,
net of tax effects, with the related unrealized amounts due from or to
counterparties included in receivables from or payables to brokers, dealers and
clearing organizations.
SECURITIES TRANSACTIONS
Clients' securities transactions are recorded on a settlement date basis with
related commission revenues and expenses recorded on trade date. Securities
purchased under agreements to resell (reverse repurchase agreements) and
securities sold under agreements to repurchase (repurchase agreements),
principally government and
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Morgan Stanley Dean Witter * 1998 Annual Report
agency securities, are treated as financing transactions and are carried at the
amounts at which the securities subsequently will be resold or reacquired as
specified in the respective agreements; such amounts include accrued interest.
Reverse repurchase and repurchase agreements are presented on a
net-by-counterparty basis, when appropriate. It is the Company's policy to take
possession of securities purchased under agreements to resell. The Company
monitors the fair value of the underlying securities as compared with the
related receivable or payable, including accrued interest, and, as necessary,
requests additional collateral. Where deemed appropriate, the Company's
agreements with third parties specify its rights to request additional
collateral.
Securities borrowed and securities loaned are carried at the amounts of
cash collateral advanced and received in connection with the transactions. The
Company measures the fair value of the securities borrowed and loaned against
the collateral on a daily basis. Additional collateral is obtained as necessary
to ensure such transactions are adequately collateralized.
INVESTMENT BANKING
Underwriting revenues and fees for mergers and acquisitions and advisory
assignments are recorded when services for the transaction are substantially
completed. Transaction-related expenses are deferred and later expensed to match
revenue recognition.
OFFICE FACILITIES
Office facilities are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization of buildings and leasehold
improvements are provided principally by the straight-line method, while
depreciation and amortization of furniture, fixtures and equipment are provided
by both straight-line and accelerated methods. Property and equipment are
depreciated over the estimated useful lives of the related assets, while
leasehold improvements are amortized over the lesser of the economic useful life
of the asset or, where applicable, the remaining term of the lease.
INCOME TAXES
Income tax expense is provided for using the asset and liability method, under
which deferred tax assets and liabilities are determined based upon the
temporary differences between the financial statement and income tax bases of
assets and liabilities, using currently enacted tax rates.
EARNINGS PER SHARE
The calculations of earnings per common share are based on the weighted average
number of common shares and share equivalents outstanding and give effect to
preferred stock dividend requirements. All per share and share amounts reflect
stock splits effected by Dean Witter Discover and Morgan Stanley prior to the
Merger, as well as the additional shares issued to Morgan Stanley shareholders
pursuant to the Exchange Ratio.
As of December 1, 1997, the Company adopted SFAS No. 128, "Earnings per
Share" ("SFAS No. 128"). SFAS No. 128 replaces the previous earnings per share
("EPS") categories of primary and fully diluted with "basic EPS," which reflects
no dilution from common stock equivalents, and "diluted EPS," which reflects
dilution from common stock equivalents and other dilutive securities based on
the average price per share of the Company's common stock during the period. The
EPS amounts of prior periods have been restated in accordance with SFAS No. 128.
The adoption of SFAS No. 128 has not had a material effect on the Company's EPS
calculations.
CARDMEMBER REWARDS
Cardmember rewards, primarily the Cashback Bonus(R) award, pursuant to which the
Company annually pays Discover Cardmembers and Private Issue(R) Cardmembers a
percentage of their purchase amounts ranging up to 1% (up to 2% for the Private
Issue Card), are based upon a cardmember's level of annual purchases. The
liability for cardmember rewards expense, included in other liabilities and
accrued expenses, is accrued at the time that qualified cardmember transactions
occur and is calculated on an individual cardmember basis.
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Morgan Stanley Dean Witter * 1998 Annual Report
STOCK-BASED COMPENSATION
SFAS No. 123, "Accounting for Stock-Based Compensation" encourages, but does not
require, companies to record compensation cost for stock-based employee
compensation plans at fair value. The Company has elected to continue to account
for its stock-based compensation plans using the intrinsic value method
prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB No. 25"). Under the provisions of APB No. 25,
compensation cost for stock options is measured as the excess, if any, of the
quoted market price of the Company's common stock at the date of grant over the
amount an employee must pay to acquire the stock.
TRANSLATION OF FOREIGN CURRENCIES
Assets and liabilities of operations having non-U.S. dollar functional
currencies are translated at year-end rates of exchange, and the income
statements are translated at weighted average rates of exchange for the year. In
accordance with SFAS No. 52, "Foreign Currency Translation," gains or losses
resulting from translating foreign currency financial statements, net of hedge
gains or losses and related tax effects, are reflected in cumulative translation
adjustments, a separate component of shareholders' equity. Gains or losses
resulting from foreign currency transactions are included in net income.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets are amortized on a straight-line basis over
periods from five to 40 years, generally not exceeding 25 years, and are
periodically evaluated for impairment. At November 30, 1998, goodwill of
approximately $1.2 billion was included in the Company's consolidated statements
of financial condition as a component of Other Assets.
ACCOUNTING CHANGE
In the fourth quarter of fiscal 1998, the Company adopted American Institute of
Certified Public Accountants ("AICPA") Statement of Position 98-5, "Reporting on
the Costs of Start-Up Activities" ("SOP 98-5"), with respect to the accounting
for offering costs paid by investment advisors of closed-end funds where such
costs are not specifically reimbursed through separate advisory contracts. In
accordance with SOP 98-5 and per an announcement by the Financial Accounting
Standards Board ("FASB") staff in September 1998, such costs are to be
considered start-up costs and expensed as incurred. Prior to the adoption of SOP
98-5, the Company deferred such costs and amortized them over the life of the
fund. The Company recorded a charge to earnings for the cumulative effect of the
accounting change as of December 1, 1997, of $117 million, net of taxes of $79
million. The first three quarters of fiscal 1998 have been retroactively
restated to reflect this change (see Note 18). The effect of adopting these
provisions on the Company's income before the cumulative effect of the
accounting change for fiscal year 1998 was a decrease of $24 million, net of
taxes. The effect on diluted and basic earnings per share was $0.04. The pro
forma effect on net income for fiscal years 1997 and 1996 would not have been
material.
NEW ACCOUNTING PRONOUNCEMENTS
As of January 1, 1998, the Company adopted SFAS No. 127, "Deferral of the
Effective Date of Certain Provisions of FASB Statement No. 125," which was
effective for transfers and pledges of certain financial assets and collateral
made after December 31, 1997. The adoption of SFAS No. 127 required the
recognition of assets and liabilities on the Company's consolidated statement of
financial condition related to certain securities provided and received as
collateral. At November 30, 1998, the Company recorded an obligation to return
securities received as collateral of $6,636 million. The related collateral
assets were recorded among various captions included in the Company's
consolidated statement of financial condition. After giving effect to
reclassifications, the net increase in total assets and total liabilities was
$2,089 million.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income" and SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information." These statements, which are effective for fiscal years
beginning after
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Morgan Stanley Dean Witter * 1998 Annual Report
December 15, 1997, establish standards for the reporting and presentation of
comprehensive income and the disclosure requirements related to segments.
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits," which revises and
standardizes pension and other postretirement benefit plan disclosures that are
to be included in the employers' financial statements. SFAS No. 132 does not
change the measurement or recognition rules for pensions and other
postretirement benefit plans and is effective for fiscal years beginning after
December 15, 1997.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. The statement is
effective for fiscal years beginning after June 15, 1999. The Company is in the
process of evaluating the impact of adopting SFAS No. 133.
In July 1998, the Emerging Issues Task Force ("EITF") reached a consensus
on EITF Issue 97-14, "Accounting for Deferred Compensation Arrangements Where
Amounts Earned Are Held in a Rabbi Trust and Invested" ("EITF 97-14"). Under
EITF 97-14, assets of the rabbi trust are to be consolidated with those of the
employer, and the value of the employer's stock held in the rabbi trust should
be classified in shareholders' equity and generally accounted for in a manner
similar to treasury stock. The Company therefore has included its obligations
under certain deferred compensation plans in employee stock trust. Shares that
the Company has issued to the rabbi trusts are recorded in common stock issued
to employee trust. Both employee stock trust and common stock issued to employee
trust are components of shareholders' equity. The adoption of EITF 97-14 did not
result in any change to the Company's consolidated statement of income, total
assets, total liabilities or total shareholders' equity.
3. CONSUMER LOANS
--------------------------------------------------------------------------------
Consumer loans were as follows:
Nov. 30, Nov. 30,
(dollars in millions) 1998 1997
=====================================================================
Credit card $15,993 $20,914
Other consumer installment 3 3
---------------------------------------------------------------------
15,996 20,917
Less:
Allowance for loan losses 787 884
---------------------------------------------------------------------
Consumer loans, net $15,209 $20,033
---------------------------------------------------------------------
Activity in the allowance for consumer loan losses was as follows:
fiscal fiscal fiscal
(dollars in millions) 1998 1997 1996
=====================================================================
Balance beginning of period $ 884 $ 781(2) $ 709
Additions:
Provision for loan losses 1,173 1,493 1,214
Purchase of loan portfolios 1 -- 4
---------------------------------------------------------------------
Total additions 1,174 1,493 1,218
---------------------------------------------------------------------
Deductions:
Charge-offs 1,423 1,639 1,182
Recoveries (170) (196) (155)
---------------------------------------------------------------------
Net charge-offs 1,253 1,443 1,027
---------------------------------------------------------------------
Other(1) (18) 53 (98)
---------------------------------------------------------------------
Balance end of period $ 787 $ 884 $ 802
=====================================================================
(1) These amounts primarily reflect net transfers related to asset
securitizations and the sale of consumer loans associated with
SPS, Prime Option and BRAVO (see Note 17).
(2) Beginning balance differs from the fiscal 1996 end-of-period balance
due to the Company's change in fiscal year-end.
Interest accrued on loans subsequently charged off, recorded as a reduction
of interest revenue, was $199 million, $301 million and $181 million in fiscal
1998, 1997 and 1996, respectively. The amounts charged off in fiscal 1998
include only interest, whereas amounts in fiscal 1997 and 1996 also include
cardmember fees.
At November 30, 1998 and 1997, $3,999 million and $5,385 million of the
Company's consumer loans had minimum contractual maturities of less than one
year. Because of the uncertainty
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Morgan Stanley Dean Witter * 1998 Annual Report
regarding consumer loan repayment patterns, which historically have been higher
than contractually required minimum payments, this amount may not necessarily be
indicative of the Company's actual consumer loan repayments.
At November 30, 1998, the Company had commitments to extend credit in the
amount of $170.5 billion. Commitments to extend credit arise from agreements to
extend to customers unused lines of credit on certain credit cards provided
there is no violation of conditions established in the related agreement. These
commitments, substantially all of which the Company can terminate at any time
and which do not necessarily represent future cash requirements, are
periodically reviewed based on account usage and customer creditworthiness.
The Company received proceeds from asset securitizations of $4,466 million,
$2,783 million and $4,528 million in fiscal 1998, 1997 and 1996, respectively.
The uncollected balances of consumer loans sold through asset securitizations
were $16,506 million and $15,033 million at November 30, 1998 and 1997.
The Company uses interest rate exchange agreements to hedge the risk from
changes in interest rates on servicing fee revenues (which are derived from
loans sold through asset securitizations). Gains and losses from these
agreements are recognized as adjustments to servicing fees.
The estimated fair value of the Company's consumer loans approximated
carrying value at November 30, 1998 and 1997. The Company's consumer loan
portfolio, including securitized loans, is geographically diverse, with a
distribution approximating that of the population of the United States.
4. Deposits
--------------------------------------------------------------------------------
Deposits were as follows:
Nov. 30, Nov. 30,
(dollars in millions) 1998 1997
==============================================================
Demand, passbook and
money market accounts $1,355 $1,210
Consumer certificate accounts 1,635 1,498
$100,000 minimum
certificate accounts 5,207 6,285
-------------------------------------------------------------
Total $8,197 $8,993
-------------------------------------------------------------
The weighted average interest rates of interest bearing deposits outstanding
during fiscal 1998 and 1997 were 6.2%.
At November 30, 1998 and 1997, the notional amounts of interest rate
exchange agreements that hedged deposits outstanding were $650 million and $535
million and had fair values of $15 million and $7 million. Under these interest
rate exchange agreements, the Company primarily pays floating rates and receives
fixed rates. At November 30, 1998, the weighted average interest rate of the
Company's deposits, including the effect of interest rate exchange agreements,
was 6.1%.
At November 30, 1998, certificate accounts maturing over the next five
years were as follows:
(dollars in millions)
==================================================
1999 $2,448
2000 1,502
2001 1,261
2002 592
2003 620
--------------------------------------------------
The estimated fair value of the Company's deposits, using current rates for
deposits with similar maturities, approximated carrying value at November 30,
1998 and 1997.
5. Short-Term Borrowings
--------------------------------------------------------------------------------
At November 30, 1998 and 1997, commercial paper in the amount of $19,643
million and $15,447 million, with weighted average interest rates of 5.3% and
5.5%, was outstanding.
At November 30, 1998 and 1997, the notional amounts of interest rate
contracts that hedged commercial paper outstanding were $208 million and $732
million and had fair values of $(6) million and $(5) million. These interest
rate contracts effectively converted the commercial paper to fixed rates. These
contracts had no material effect on the weighted average interest rates of
commercial paper.
At November 30, 1998 and 1997, other short-term borrowings of $8,494
million and $7,167 million were outstanding. These borrowings included bank
loans, Federal Funds and bank notes.
The Company maintains a senior revolving credit agreement with a group of
banks to support general liquidity needs, including the issuance of commercial
paper (the "MSDW Facility").
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Morgan Stanley Dean Witter * 1998 Annual Report
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.
Riverwoods Funding Corporation ("RFC"), an entity included in the
consolidated financial statements of the Company, maintains a senior bank credit
facility to support the issuance of asset-backed commercial paper in 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 $2.6 billion at
November 30, 1998. RFC has never borrowed from its senior bank credit facility.
The Company maintains a master collateral facility that enables MS&Co. to
pledge certain collateral to secure loan arrangements, letters of credit and
other financial accommodations (the "MS&Co. Facility"). As part of the MS&Co.
Facility, MS&Co. also maintains a secured committed credit agreement with a
group of banks that are parties to the master collateral facility under which
such banks are committed to provide up to $1.875 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 MSIL to secure committed funding from a syndicate of banks by providing
a broad range of collateral under repurchase agreements (the "MSIL Facility").
Such banks are committed to provide up to an aggregate of $1.85 billion
available in 12 major currencies 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.
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.
6 LONG-TERM BORROWINGS
------------------------------------------------------------------------------
MATURITIES AND TERMS
Long-term borrowings at fiscal year-end consist of the following:
(1) Weighted average coupon was calculated utilizing non-U.S. dollar interest
rates.
(2) U.S. dollar contractual floating rate borrowings bear interest based on a
variety of money market indices, including London Interbank Offered Rates
("LIBOR") and Federal Funds rates. Non-U.S. dollar contractual floating
rate borrowings bear interest based on Euro floating rates.
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Morgan Stanley Dean Witter * 1998 Annual Report
MEDIUM-TERM NOTES
Included in the table above are medium-term notes of $17,011 million and $14,049
million at November 30, 1998 and 1997. The effective weighted average interest
rate on all medium-term notes was 5.7% in fiscal 1998 and 5.9% in fiscal 1997.
Maturities of these notes range from fiscal 1999 through fiscal 2028.
STRUCTURED BORROWINGS
U.S. dollar index/equity linked borrowings include various structured
instruments whose payments and redemption values are linked to the performance
of a specific index (i.e., Standard & Poor's 500), a basket of stocks or a
specific equity security. To minimize the exposure resulting from movements in
the underlying equity position or index, the Company has entered into various
equity swap contracts and purchased options which effectively convert the
borrowing costs into floating rates based upon LIBOR. These instruments are
included in the preceding table at their redemption values based on the
performance of the underlying indices, baskets of stocks or specific equity
securities at November 30, 1998 and 1997.
OTHER BORROWINGS
Included in the Company's long-term borrowings are subordinated notes of $1,309
million and $1,302 million at November 30, 1998 and 1997, respectively. The
effective weighted average interest rate on these subordinated notes was 7.1% in
fiscal 1998 and 7.2% in fiscal 1997. Maturities of the subordinated notes range
from fiscal 1999 to fiscal 2016.
Certain of the Company's long-term borrowings are redeemable prior to
maturity at the option of the holder. These notes contain certain provisions
which effectively enable noteholders to put the notes back to the Company and
therefore are scheduled in the foregoing table to mature in fiscal 1999 through
fiscal 2001. The stated maturities of these notes, which aggregate $1,933
million, are from fiscal 2000 to fiscal 2011.
MS&Co., a registered U.S. broker-dealer subsidiary of the Company, has
outstanding $357 million of 8.22% fixed rate subordinated Series A notes, $243
million of 8.51% fixed rate subordinated Series B Notes, $313 million of 6.81%
fixed rate subordinated Series C notes, $96 million of 7.03% fixed rate
subordinated Series D notes, $82 million of 7.28% fixed rate subordinated Series
E notes and $25 million of 7.82% fixed rate subordinated Series F notes. These
notes have maturities from 2001 to 2016. The terms of such notes contain
restrictive covenants which require, among other things, that MS&Co. maintain
specified levels of Consolidated Tangible Net Worth and Net Capital, each as
defined.
ASSET AND LIABILITY MANAGEMENT
A portion of the Company's fixed rate long-term borrowings is used to fund
highly liquid marketable securities, short-term receivables arising from
securities transactions and consumer loans. The Company uses interest rate swaps
to more closely match the duration of these borrowings to the duration of the
assets being funded and to minimize interest rate risk. These swaps effectively
convert certain of the Company's fixed rate borrowings into floating rate
obligations. In addition, for non-U.S. dollar currency borrowings that are not
used to fund assets in the same currency, the Company has entered into currency
swaps which effectively convert the borrowings into U.S. dollar obligations. The
Company's use of swaps for asset and liability management reduced its interest
expense and effective average borrowing rate as follows:
fiscal fiscal fiscal
(dollars in millions) 1998 1997 1996
========================================================= ====== ======
Net reduction in interest expense from
swaps for the fiscal year $48 $21 $29
---------------------------------------------------------------------------
Weighted average coupon of
long-term borrowings at fiscal year-end(1) 6.1% 6.1% 6.2%
---------------------------------------------------------------------------
Effective average borrowing rate for long-term
borrowings after swaps at fiscal year-end(1) 5.9% 6.0% 6.1%
---------------------------------------------------------------------------
(1) Included in the weighted average and effective average calculations are
non-U.S. dollar interest rates.
The effective weighted average interest rate on the Company's index/equity
linked notes, which is not included in the table above, was 5.2% and 5.7% in
fiscal 1998 and fiscal 1997, respectively, after giving effect to the related
hedges.
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Morgan Stanley Dean Witter * 1998 Annual Report
The table below summarizes the notional or contract amounts of these
swaps by maturity and weighted average interest rates to be received and paid at
fiscal year-end 1998. Swaps utilized to hedge the Company's structured
borrowings are presented at their redemption values:
(1) The differences between the receive rate and the pay rate may reflect
differences in the rate of interest associated with the underlying
currency.
(2) These amounts include currency swaps used to effectively convert borrowings
denominated in one currency into obligations denominated in another
currency.
(3) The table was prepared under the assumption that interest rates remain
constant at year-end levels. The variable interest rates to be received or
paid will change to the extent that rates fluctuate. Such changes may be
substantial. Variable rates presented generally are based on LIBOR or
Treasury bill rates.
As noted above, the Company uses interest rate and currency swaps to modify the
terms of its existing borrowings. Activity during the periods in the notional
value of the swap contracts used by the Company for asset and liability
management (and the unrecognized gain at fiscal year-end) is summarized in the
table below:
fiscal fiscal
(dollars in millions) 1998 1997
==========================================================================
Notional value at beginning of period $11,707 $10,189
Additions 4,520 3,567
Matured (2,305) (1,657)
Terminated (868) (216)
Effect of foreign currency translation on
non-U.S. dollar notional values and
changes in redemption values on
structured borrowings 47 (176)
--------------------------------------------------------------------------
Notional value at fiscal year-end $13,101 $ 11,707
--------------------------------------------------------------------------
Unrecognized gain at fiscal year-end $ 279 $ 104
--------------------------------------------------------------------------
The Company also uses interest rate swaps to modify certain of its repurchase
financing agreements. The Company had interest rate swaps with notional values
of approximately $1.3 billion and $1.8 billion at November 30, 1998 and 1997,
and unrecognized gains of approximately $28 million and $13 million at November
30, 1998 and 1997, for such purpose. The unrecognized gains on these swaps were
offset by unrecognized losses on certain of the Company's repurchase financing
agreements.
The estimated fair value of the Company's long-term borrowings
approximated carrying value based on rates available to the Company at year-end
for borrowings with similar terms and maturities.
Cash paid for interest for the Company's borrowings and deposits
approximated interest expense in fiscal 1998, 1997 and 1996.
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Morgan Stanley Dean Witter * 1998 Annual Report
7 COMMITMENTS AND CONTINGENCIES
-------------------------------------------------------------------------------
The Company has non-cancelable operating leases covering office space and
equipment. At November 30, 1998, future minimum rental commitments under such
leases (net of subleases, principally on office rentals) were as follows:
(dollars in millions)
================================================================================
1999 $363
2000 324
2001 286
2002 238
2003 193
Thereafter 959
--------------------------------------------------------------------------------
Occupancy lease agreements, in addition to base rentals, generally provide for
rent and operating expense escalations resulting from increased assessments for
real estate taxes and other charges. Total rent expense, net of sublease rental
income, was $274 million, $262 million and $264 million in fiscal 1998, 1997 and
1996, respectively.
The Company has an agreement with IBM, under which the Company receives
information processing, data networking and related services. Under the terms of
the agreement, the Company has an aggregate minimum annual commitment of $166
million subject to annual cost-of-living adjustments.
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.
In the normal course of business, the Company has been named as a defendant
in various lawsuits and has been involved in certain investigations and
proceedings. Some of these matters involve claims for substantial amounts.
Although the ultimate outcome of these matters cannot be ascertained at this
time, it is the opinion of management, after consultation with outside counsel,
that the resolution of such matters will not have a material adverse effect on
the consolidated financial condition of the Company, but may be material to the
Company's operating results for any particular period, depending upon the level
of the Company's income for such period.
The Company had approximately $5.7 billion of letters of credit outstanding
at November 30, 1998 to satisfy various collateral requirements.
Financial instruments sold, not yet purchased represent obligations of the
Company to deliver specified financial instruments at contracted prices, thereby
creating commitments to purchase the financial instruments in the market at
prevailing prices. Consequently, the Company's ultimate obligation to satisfy
the sale of financial instruments sold, not yet purchased may exceed the amounts
recognized in the consolidated statements of financial condition.
The Company also has commitments to fund certain fixed assets and other
less liquid investments, including at November 30, 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
(including subordinated loans on an interim basis to leveraged companies
associated with its investment banking and its private equity and other
principal investment activities), that may subject the Company to increased
credit and liquidity risks.
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Morgan Stanley Dean Witter * 1998 Annual Report
8 EARNINGS PER SHARE
--------------------------------------------------------------------------------
Earnings per share was calculated as follows (in millions, except for per share
data):
fiscal fiscal fiscal
Basic EPS: 1998 1997 1996
================================================================================
Income before cumulative effect
of accounting change $ 3,393 $ 2,586 $ 1,980
Cumulative effect of accounting
change (117) -- --
Preferred stock dividend
requirements (55) (66) (66)
--------------------------------------------------------------------------------
Net income available to common
shareholders $ 3,221 $ 2,520 $ 1,914
--------------------------------------------------------------------------------
Weighted average common shares
outstanding 576 575 573
Basic EPS before cumulative
effect of accounting change $ 5.80 $ 4.38 $ 3.34
Cumulative effect of accounting
change $ (0.20) -- --
--------------------------------------------------------------------------------
Basic EPS $ 5.60 $ 4.38 $ 3.34
--------------------------------------------------------------------------------
fiscal fiscal fiscal
Diluted EPS: 1998 1997 1996
================================================================================
Income before cumulative effect
of accounting change $ 3,393 $ 2,586 $ 1,980
Cumulative effect of accounting
change (117) -- --
Preferred stock dividend
requirements (47) (61) (62)
--------------------------------------------------------------------------------
Net income available to common
shareholders $ 3,229 $ 2,525 $ 1,918
--------------------------------------------------------------------------------
Weighted average common shares
outstanding 576 575 573
Effect of dilutive securities:
Stock options 18 19 21
ESOP convertible preferred stock 12 12 13
--------------------------------------------------------------------------------
Weighted average common shares
outstanding and common stock
equivalents 606 606 607
--------------------------------------------------------------------------------
Diluted EPS before cumulative
effect of accounting change $ 5.52 $ 4.16 $ 3.16
Cumulative effect of accounting
change $ (0.19) -- --
--------------------------------------------------------------------------------
Diluted EPS $ 5.33 $ 4.16 $ 3.16
-------------------------------------------------------------------------------
9. TRADING ACTIVITIES
--------------------------------------------------------------------------------
TRADING REVENUES
The Company's trading activities include providing securities brokerage,
derivatives dealing and underwriting services to clients. While trading
activities are generated by client order flow, the Company also takes
proprietary positions based on expectations of future market movements and
conditions. The Company's trading strategies rely on the integrated management
of its client-driven and proprietary transactions, along with the hedging and
financing of these positions.
The Company manages its trading businesses by product groupings and
therefore has established distinct, worldwide trading divisions having
responsibility for equity, fixed income, foreign exchange and commodities
products. Because of the integrated nature of the markets for such products,
each product area trades cash instruments as well as related derivative products
(i.e., options, swaps, futures, forwards and other contracts with respect to
such underlying instruments or commodities). Revenues related to principal
trading are summarized below by trading division:
fiscal fiscal fiscal
(dollars in millions) 1998 1997 1996
============================================================
Equities $2,056 $1,310 $1,181
Fixed Income 455 1,187 1,172
Foreign Exchange 587 500 169
Commodities 193 194 137
------------------------------------------------------------
Total principal trading revenues $3,291 $3,191 $2,659
============================================================
Interest revenue and expense are integral components of trading activities. In
assessing the profitability of trading activities, the Company views net
interest and principal trading revenues in the aggregate.
The Company's trading portfolios are managed with a view toward the risk
and profitability of the portfolios to the Company. The nature of the equities,
fixed income, foreign exchange and commodities activities conducted by the
Company, including the use of derivative products in these businesses, and the
market, credit and concentration risk management policies and procedures
covering these activities are discussed below.
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Morgan Stanley Dean Witter * 1998 Annual Report
EQUITIES
The Company makes markets and trades in the global secondary markets for
equities and convertible debt and is a dealer in equity warrants, exchange
traded and OTC equity options, index futures, equity swaps and other
sophisticated equity derivatives. The Company's activities as a dealer primarily
are client-driven, with the objective of meeting clients' needs while earning a
spread between the premiums paid or received on its contracts with clients and
the cost of hedging such transactions in the cash or forward market or with
other derivative transactions. The Company limits its market risk related to
these contracts, which stems primarily from underlying equity/index price and
volatility movements, by employing a variety of hedging strategies, such as
delta hedging (delta is a measure of a derivative contract's price movement
based on the movement of the price of the security or index underlying the
contract). The Company also takes proprietary positions in the global equity
markets by using derivatives, most commonly futures and options, in addition to
cash positions, intending to profit from market price and volatility movements
in the underlying equities or indices positioned.
Equity option contracts give the purchaser of the contract the right to buy
(call) or sell (put) the equity security or index underlying the contract at an
agreed-upon price (strike price) during or at the conclusion of a specified
period of time. The seller (writer) of the contract is subject to market risk,
and the purchaser is subject to market risk (to the extent of the premium paid)
and credit risk. Equity swap contracts are contractual agreements whereby one
counterparty receives the appreciation (or pays the depreciation) on an equity
investment in return for paying another rate, often based upon equity index
movements or interest rates. The counterparties to the Company's equity
transactions include commercial banks, investment banks, broker-dealers,
investment funds and industrial companies.
FIXED INCOME
The Company is a market-maker for U.S. and non-U.S. government securities,
corporate bonds, money market instruments, medium-term notes and Eurobonds,
high-yield securities, emerging market securities, mortgage and other
asset-backed securities, preferred stock and tax-exempt securities. In addition,
the Company is a dealer in interest rate and currency swaps and other related
derivative products, OTC options on U.S. and non-U.S. government bonds and
mortgage-backed forward agreements ("TBA"), options and swaps. In this capacity,
the Company facilitates asset and liability management for its customers in
interest rate and currency swaps and related products and OTC government bond
options.
Swaps used in fixed income trading are, for the most part, contractual
agreements to exchange interest payment streams (i.e., an interest rate swap may
involve exchanging fixed for floating interest payments) or currencies (i.e., a
currency swap may involve exchanging yen for U.S. dollars in one year at an
agreed-upon exchange rate). The Company profits by earning a spread between the
premium paid or received for these contracts and the cost of hedging such
contracts. The Company seeks to manage the market risk of its swap portfolio,
which stems from interest rate and currency movements and volatility, by using
modeling that quantifies the sensitivity of its portfolio to movements in
interest rates and currencies and by adding positions to or selling positions
from its portfolio as needed to minimize such sensitivity. Typically, the
Company adjusts its positions by entering into additional swaps or interest rate
and foreign currency futures or foreign currency forwards and by purchasing or
selling additional underlying government bonds. The Company manages the risk
related to its option portfolio by using a variety of hedging strategies such as
delta hedging, which includes the use of futures and forward contracts to hedge
market risk. The Company also is involved in using debt securities to structure
products with multiple risk/return factors designed to suit investor objectives.
The Company is an underwriter of and a market-maker in mortgage-backed
securities and collateralized mortgage obligations ("CMO") as well as
commercial, residential and real estate loan products. The Company also
structures mortgage-backed swaps for its clients, enabling them to derive the
cash flows from an underlying mortgage-backed security without purchasing the
cash position. The Company earns the spread between the premium inherent in the
swap and the cost of hedging the swap contract through the use of cash positions
or TBA contracts. The Company also uses TBAs in its
72
Morgan Stanley Dean Witter * 1998 Annual Report
role as a dealer in mortgage-backed securities and facilitates customer trades
by taking positions in the TBA market. Typically, these positions are hedged by
offsetting TBA contracts or underlying cash positions. The Company profits by
earning the bid-offer spread on such transactions. Further, the Company uses
TBAs to ensure delivery of underlying mortgage-backed securities in its CMO
issuance business. As is the case with all mortgage-backed products, market risk
associated with these instruments results from interest rate fluctuations and
changes in mortgage prepayment speeds. The counterparties to the Company's fixed
income transactions include investment advisors, commercial banks, insurance
companies, investment funds and industrial companies.
FOREIGN EXCHANGE
The Company is a market-maker in a number of foreign currencies. In this
business, it actively trades currencies in the spot and forward markets earning
a dealer spread. The Company seeks to manage its market risk by entering into
offsetting positions. The Company conducts an arbitrage business in which it
seeks to profit from inefficiencies between the futures, spot and forward
markets. The Company also makes a market in foreign currency options. This
business largely is client-driven and involves the purchasing and writing of
European and American style options and certain sophisticated products to meet
specific client needs. The Company profits in this business by earning spreads
between the options' premiums and the cost of the hedging of such positions. The
Company limits its market risk by using a variety of hedging strategies,
including the buying and selling of the currencies underlying the options based
upon the options' delta equivalent. Foreign exchange option contracts give the
purchaser of the contract the right to buy (call) or sell (put) the currency
underlying the contract at an agreed-upon strike price at or over a specified
period of time. Forward contracts and futures represent commitments to purchase
or sell the underlying currencies at a specified future date at a specified
price. The Company also takes proprietary positions in currencies to profit from
market price and volatility movements in the currencies positioned.
The majority of the Company's foreign exchange business relates to major
foreign currencies such as deutsche marks, yen, pound sterling, French francs,
Swiss francs, Italian lire, Canadian dollars and, effective January 1, 1999, the
euro. The balance of the business covers a broad range of other currencies. The
counterparties to the Company's foreign exchange transactions include commercial
banks, investment banks, broker-dealers, investment funds and industrial
companies.
COMMODITIES
The Company, as a major participant in the world commodities markets, trades in
physical precious, base and platinum group metals, electricity, energy products
(principally oil, refined oil products and natural gas) as well as a variety of
derivatives related to these commodities such as futures, forwards and exchange
traded and OTC options and swaps. Through these activities, the Company provides
clients with a ready market to satisfy end users' current raw material needs and
facilitates their ability to hedge price fluctuations related to future
inventory needs. The former activity at times requires the positioning of
physical commodities. Derivatives on those commodities, such as futures,
forwards and options, often are used to hedge price movements in the underlying
physical inventory. The Company profits as a market-maker in physical
commodities by capturing the bid-offer spread inherent in the physical markets.
To facilitate hedging for its clients, the Company often is required to
take positions in the commodity markets in the form of forward, option and swap
contracts involving oil, natural gas, precious and base metals, and electricity.
The Company generally hedges these positions by using a variety of hedging
techniques such as delta hedging, whereby the Company takes positions in the
physical markets and/or positions in other commodity derivatives such as futures
and forwards to offset the market risk in the underlying derivative. The Company
profits from this business by earning a spread between the premiums paid or
received for these derivatives and the cost of hedging such derivatives.
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Morgan Stanley Dean Witter * 1998 Annual Report
The Company also maintains proprietary trading positions in commodity
derivatives, including futures, forwards and options in addition to physical
commodities, to profit from price and volatility movements in the underlying
commodities markets.
Forward, option and swap contracts on commodities are structured similarly
to like-kind derivative contracts for cash financial instruments. The
counterparties to OTC commodity contracts include precious metals producers,
refiners and consumers as well as shippers, central banks, and oil, gas and
electricity producers.
The following discussions of risk management, market risk, credit risk,
concentration risk and customer activities relate to the Company's trading
activities.
RISK MANAGEMENT
Risk management at the Company is a multi-faceted process with independent
oversight which requires constant communication, judgment and knowledge of
specialized products and markets. The Company's senior management takes an
active role in the risk management process and has developed policies and
procedures that require specific administrative and business functions to assist
in the identification, assessment and control of various risks. In recognition
of the increasingly varied and complex nature of the global financial services
business, the Company's risk management policies and procedures are evolutionary
in nature and are subject to ongoing review and modification. Many of the
Company's risk management and control practices are subject to periodic review
by the Company's internal auditors as well as to interactions with various
regulatory authorities.
The Management Committee, composed of the Company's most senior officers,
establishes the overall risk management policies for the Company and reviews the
Company's performance relative to these policies. The Management Committee has
created several Risk Committees to assist it in monitoring and reviewing the
Company's risk management practices. These Risk Committees, among other matters,
review the general framework, levels and monitoring procedures relating to the
Company's market and credit risk profile, sales practices, legal enforceability
and operational and systems risks. The Controllers, Treasury, Law, Compliance
and Governmental Affairs and Firm Risk Management Departments, which are all
independent of the Company's business units, assist senior management and the
Risk Committees in monitoring and controlling the Company's risk profile. In
addition, the Internal Audit Department, which also reports to senior
management, periodically examines and evaluates the Company's operations and
control environment. The Company continues to be committed to employing
qualified personnel with appropriate expertise in each of its various
administrative and business areas to implement effectively the Company's risk
management and monitoring systems and processes.
MARKET RISK
Market risk refers to the risk that a change in the level of one or more market
prices, rates, indices, volatilities, correlations or other market factors, such
as liquidity, will result in losses for a specified position or portfolio.
The Company manages the market risk associated with its trading activities
on a Company-wide basis, on a trading division level worldwide and on an
individual product basis. Market risk limits have been approved for the Company
and each trading division of the Company worldwide. Discrete market risk limits
are assigned to trading divisions and trading desks and, as appropriate,
products and regions, that are compatible with the trading division limits.
Trading division risk managers, desk risk managers and the Firm Risk Management
Department all monitor market risk measures against limits and report major
market and position events to senior management.
The Firm Risk Management Department independently reviews the Company's
trading portfolios on a regular basis from a market risk perspective utilizing
Value-at-Risk and other quantitative and qualitative risk measurements and
analyses. The Company may use measures, such as rate sensitivity, convexity,
volatility and time decay measurements, to estimate market risk and to assess
the sensitivity of positions to changes in market conditions. Stress testing,
which measures the impact on the value of existing portfolios
74
Morgan Stanley Dean Witter * 1998 Annual Report
of specified changes in market factors, for certain products is performed
periodically and is reviewed by trading division risk managers, desk risk
managers and the Firm Risk Management Department.
CREDIT RISK
The Company's exposure to credit risk arises from the possibility that a
counterparty to a transaction might fail to perform under its contractual
commitment, which could result in the Company incurring losses. The Company has
credit guidelines which limit the Company's credit exposure to any one
counterparty. Specific credit risk limits based on the credit guidelines also
are in place for each type of counterparty (by rating category) as well as for
secondary positions of high-yield and emerging market debt.
The Credit Department administers and monitors the credit limits among
trading divisions on a worldwide basis. In addition to monitoring credit limits,
the Company manages the credit exposure relating to the Company's trading
activities by reviewing counterparty financial soundness periodically, by
entering into master netting agreements and collateral arrangements with
counterparties in appropriate circumstances and by limiting the duration of
exposure. In certain cases, the Company also may close out transactions or
assign them to other counterparties to mitigate credit risk.
CONCENTRATION RISK
The Company is subject to concentration risk by holding large positions in
certain types of securities or commitments to purchase securities of a single
issuer, including sovereign governments and other entities, issuers located in a
particular country or geographic area, public and private issuers involving
developing countries or issuers engaged in a particular industry. Financial
instruments owned by the Company include U.S. government and agency securities
and securities issued by other sovereign governments (principally Japan, Germany
and Italy), which, in the aggregate, represented approximately 9% of the
Company's total assets at November 30, 1998. In addition, substantially all of
the collateral held by the Company for resale agreements or bonds borrowed,
which together represented approximately 33% of the Company's total assets at
November 30, 1998, consists of securities issued by the U.S. government, federal
agencies or other sovereign government obligations. Positions taken and
commitments made by the Company, including positions taken and underwriting and
financing commitments made in connection with its private equity and principal
investment activities, often involve substantial amounts and significant
exposure to individual issuers and businesses, including non-investment grade
issuers. The Company seeks to limit concentration risk through the use of the
systems and procedures described in the preceding discussions of market and
credit risk.
CUSTOMER ACTIVITIES
The Company's customer activities involve the execution, settlement and
financing of various securities and commodities transactions on behalf of
customers. Customer securities activities are transacted on either a cash or
margin basis. Customer commodities activities, which include the execution of
customer transactions in commodity futures transactions (including options on
futures), are transacted on margin basis.
The Company's customer activities may expose it to off-balance sheet credit
risk. The Company may have to purchase or sell financial instruments at
prevailing market prices in the event of the failure of a customer to settle a
trade on its original terms or in the event cash and securities in customer
margin accounts are not sufficient to fully cover customer loses. The Company
seeks to control the risks associated with customer activities by requiring
customers to maintain margin collateral in compliance with various regulations
and Company policies.
NATIONAL/CONTRACT AMOUNTS AND FAIR MARKET VALUES OF DERIVATIVES
The gross notinal or contract amounts of derivative instruments and fair value
(carrying amount) of the related assets and liabilities at November 30, 1998 and
1997, as well as the average fair value of those assets and liabilities for
fiscal 1998 and 1997, are presented in the table which follows. Fair value
represents the cost of replacing these instruments and is further described in
Note 2. Future
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Morgan Stanley Dean Witter * 1998 Annual Report
changes in interest rates, foreign currency exchange rates of the fair values of
the financial instruments, commodities or indices underlying these contracts
may ultimately result in cash settlements exceeding fair value amounts
recognized in the consolidated statements of financial condition. Assets
represent unrealized gains on purchased exchange traded and OTC options and
other contracts (including interest rate, foreign exchange and other forward
contracts and swaps) net of any unrealized losses owed to the counterparties on
offsetting positions in situations where netting is appropriate. Similarly,
liabilities represent net amounts owed to counterparties. These amounts will
vary based on changes in the fair values of underlying financial instruments
and/or the volatility of such underlying instruments:
(1) The notional amounts of derivatives have been adjusted to reflect the
effects of leverage, where applicable.
(2) Notional amounts include purchased and written options of $485 billion and
$442 billion, respectively, at November 30, 1998, and $572 billion and $549
billion, respectively, at November 30, 1997.
(3) These amounts represent carrying value (exclusive of collateral) at
November 30, 1998 and 1997, respectively, and do not include receivables or
payables related to exchange traded futures contracts.
(4) Amounts are calculated using a monthly average.
The gross notional or contract amounts of these instruments are indicative of
the Company's degree of use of derivatives for trading purposes but do not
represent the Company's exposure to market or credit risk. Credit risk arises
from the failure of a counterparty to perform according to the terms of the
contract. The Company's exposure to credit risk at any point in time is
represented by the fair value of the contracts reported as assets. These amounts
are presented on a net-by-counterparty basis when appropriate, but are not
reported net of collateral, which the Company obtains with respect to certain of
these transactions to reduce its exposure to credit losses. The Company monitors
the creditworthiness of counterparties to these transactions on an ongoing basis
and requests additional collateral when deemed necessary. The Company believes
the ultimate settlement of the transactions outstanding at November 30, 1998
will not have a material effect on the Company's financial condition.
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Morgan Stanley Dean Witter * 1998 Annual Report
The remaining maturities of the Company's swaps and other derivative products at
November 30, 1998 and 1997 are summarized in the following table, showing
notional values by year of expected maturity:
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Morgan Stanley Dean Witter * 1998 Annual Report
The credit quality of the Company's trading-related derivatives at November 30,
1998 and 1997 is summarized in the table below, showing the fair value of the
related assets by counterparty credit rating. The actual credit ratings are
determined by external rating agencies or by equivalent ratings used by the
Company's Credit Department:
The Company also has obtained assets posted as collateral by investment grade
counterparties amounting to $2.5 billion and $1.2 billion at November 30, 1998
and November 30, 1997, respectively.
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Morgan Stanley Dean Witter * 1998 Annual report
10 PREFERRED STOCK, CAPITAL UNITS AND
PREFERRED SECURITIES ISSUED BY SUBSIDIARIES
----------------------------------------------
Preferred stock of the Company is composed of the following issues:
Each issue of outstanding preferred stock ranks in parity with all other
outstanding preferred stock of the Company.
During fiscal 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.
During fiscal 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.
The Company has Capital Units outstanding which were issued by the Company
and Morgan Stanley Finance plc ("MS plc"), a U.K. subsidiary. A Capital Unit
consists of (a) a Subordinated Debenture of MS plc guaranteed by the Company and
having maturities from 2013 to 2017 and (b) a related Purchase Contract issued
by the Company, which may be accelerated by the Company beginning approximately
one year after the issuance of each Capital Unit, requiring the holder to
purchase one Depositary Share representing shares (or fractional shares) of the
Company's Cumulative Preferred Stock. The aggregate amount of Capital Units
outstanding was $999 million at November 30, 1998 and 1997.
In January 1999, the Company and MS plc 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.
The estimated fair value of the Capital Units approximated carrying value
at November 30, 1998 and November 30, 1997.
11 SHAREHOLDERS' EQUITY
--------------------------------------------------------------------------------
MS&Co. and DWR 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, the New York Stock Exchange and the
Commodity Futures Trading Commission. MS&Co. and DWR have consistently operated
in excess of these requirements. MS&Co.'s net capital totaled $3,205 million at
November 30, 1998, which exceeded the amount required by $2,699 million. DWR's
net capital totaled $752 million at November 30, 1998, which exceeded the amount
required by $668 million. MSIL, a London-based broker-dealer subsidiary, is
subject to the capital requirements of the Securities and Futures Authority, and
MSJL, a Tokyo-based broker-dealer, is subject to the capital requirements of the
Japanese Ministry of Finance. MSIL and MSJL have consistently operated in excess
of their respective regulatory capital requirements.
Under regulatory net capital requirements adopted by the Federal Deposit
Insurance Corporation ("FDIC") and other regulatory capital guidelines,
FDIC-insured financial institutions must
79
Morgan Stanley Dean Witter * 1998 Annual Report
maintain (a) 3% to 5% of Tier 1 capital, as defined, to total assets ("leverage
ratio") and (b) 8% combined Tier 1 and Tier 2 capital, as defined, to
risk-weighted assets ("risk-weighted capital ratio"). At November 30, 1998, the
leverage ratio and risk-weighted capital ratio of each of the Company's
FDIC-insured financial institutions exceeded these and all other regulatory
minimums.
Certain other U.S. and non-U.S. subsidiaries are subject to various
securities, commodities and banking regulations, and capital adequacy
requirements promulgated by the regulatory and exchange authorities of the
countries in which they operate. These subsidiaries have consistently operated
in excess of their local capital adequacy requirements. Morgan Stanley
Derivative Products Inc., the Company's triple-A rated derivative products
subsidiary, also has established certain operating restrictions which have been
reviewed by various rating agencies.
The regulatory capital requirements referred to above, and certain
covenants contained in various agreements governing indebtedness of the Company,
may restrict the Company's ability to withdraw capital from its subsidiaries. At
November 30, 1998, approximately $4.9 billion of net assets of consolidated
subsidiaries may be restricted as to the payment of cash dividends and advances
to the Company.
Cumulative translation adjustments include gains or losses resulting from
translating foreign currency financial statements from their respective
functional currencies to U.S. dollars, net of hedge gains or losses and related
tax effects. The Company uses foreign currency contracts and designates certain
non-U.S. dollar currency debt as hedges to manage the currency exposure relating
to its net monetary investments in non-U.S. dollar functional currency
subsidiaries. Increases or decreases in the value of the Company's net foreign
investments generally are tax-deferred for U.S. purposes, but the related hedge
gains and losses are taxable currently. Therefore, the gross notional amounts of
the contracts and debt designated as hedges exceed the Company's net foreign
investments to result in effective hedging on an after-tax basis. The Company
attempts to protect its net book value from the effects of fluctuations in
currency exchange rates on its net monetary investments in non-U.S. dollar
subsidiaries by selling the appropriate non-U.S. dollar currency in the forward
market. However, under some circumstances, the Company may elect not to hedge
its net monetary investments in certain foreign operations due to market
conditions, including the availability of various currency contracts at
acceptable costs. Information relating to the hedging of the Company's net
monetary investments in non-U.S. dollar functional currency subsidiaries and
their effects on cumulative translation adjustments is summarized below:
At November 30
(dollars in millions) 1998 1997
===========================================================================
Net monetary investments in non-U.S.
dollar functional currency subsidiaries $ 1,364 $ 1,128
---------------------------------------------------------------------------
Gross notional amounts of foreign exchange
contracts and non-U.S. dollar debt
designated as hedges(1) $ 2,239 $ 1,881
---------------------------------------------------------------------------
Cumulative translation adjustments
resulting from net investments in
subsidiaries with a non-U.S. dollar
functional currency $ 29 $ 6
Cumulative translation adjustments
resulting from realized or unrealized
gains or losses on hedges, net of tax $ (41) $ (15)
---------------------------------------------------------------------------
Total cumulative translation adjustments $ (12) $ (9)
---------------------------------------------------------------------------
(1) Notional amounts represent the contractual currency amount translated at
respective fiscal year-end spot rates.
12 EMPLOYEE COMPENSATION PLANS
--------------------------------------------------------------------------------
The Company has adopted a variety of compensation plans for certain of its
employees as well as the Company's non-employee directors. These plans are
designed to facilitate a pay-for-performance policy, provide compensation
commensurate with other leading financial services companies and provide for
internal ownership in order to align the interests of employees with the
long-term interests of the Company's shareholders. These plans are summarized
below.
EQUITY-BASED COMPENSATION PLANS
The Company is authorized to issue up to approximately 270 million shares of its
common stock in connection with awards under its equity-
80
Morgan Stanley Dean Witter * 1998 Annual Report
based compensation plans. At November 30, 1998, approximately 150 million shares
were available for future grant under these plans.
STOCK OPTION AWARDS
Stock option awards have been granted pursuant to several equity-based
compensation plans. Historically, these plans have generally provided for the
granting of stock options having an exercise price not less than the fair value
of the Company's common stock (as defined in the plan) on the date of grant.
Such options generally become exercisable over a one-to-five year period and
expire seven to 10 years from the date of grant.
The following table sets forth activity relating to the Company's stock option
awards (share data in millions):
The following table presents information relating to the Company's stock options
outstanding at November 30, 1998 (share data in millions):
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------------------
Weighted Average Weighted
Average Remaining Average
Range of Number Exercise Life Number Exercise
Exercise Prices Outstanding Price (Years) Exercisable Price
================================================================================
$ 8.00 - $19.99 22.7 $17.29 5.9 17.9 $17.09
$20.00 - $29.99 2.0 24.02 3.3 1.0 23.35
$30.00 - $39.99 7.9 32.13 5.5 1.3 32.42
$40.00 - $49.99 4.4 43.47 8.6 3.8 43.47
$50.00 - $59.99 15.0 54.90 8.1 9.2 55.64
$60.00 - $69.99 0.5 63.08 7.1 0.5 62.88
$70.00 - $79.99 9.5 71.56 9.8 5.7 71.73
$80.00 - $96.00 1.3 89.90 7.1 1.2 90.00
--------------------------------------------------------------------------------
Total 63.3 7.1 40.6
--------------------------------------------------------------------------------
Deferred Compensation Awards
The Company has made deferred compensation awards pursuant to several equity-
based compensation plans. These plans provide for the deferral of a portion of
certain key employees' compensation with payments made in the form of the
Company's common stock or in the right to receive unrestricted shares
(collectively, "Restricted Stock"). Compensation expense for all such awards
(including those subject to forfeiture) amounted to $415 million, $347 million
and $534 million in fiscal 1998, fiscal 1997 and fiscal 1996, respectively.
Compensation expense for Restricted Stock awards was determined based on the
fair value of the Company's common stock (as defined in the plans). The number
of Restricted Stock shares outstanding were 59 million at fiscal year-end 1998,
62 million at fiscal year-end 1997, and 65 million at fiscal year-end 1996.
Restricted Stock awarded under these plans are subject to restrictions on
sale, transfer or assignment until the end of a specified restriction period,
generally 5 to 10 years from the date of grant. Holders of Restricted Stock
generally may forfeit ownership of a portion of their award if employment is
terminated before the end of the relevant restriction period. Holders of vested
Restricted Stock generally will forfeit ownership only in certain limited
situations, including termination for cause during the restriction period.
Employee Stock Purchase Plan
Under the Employee Stock Purchase Plan, eligible employees may purchase shares
of the Company's common stock at not less than
81
Morgan Stanley Dean Witter * 1998 Annual Report
85% of the fair value on the date of purchase. Employees of the Company
purchased 0.6 million shares of common stock in fiscal 1998, 0.5 million shares
in fiscal 1997 and 0.7 million shares in fiscal 1996.
The discount to fair value was $6 million for fiscal 1998 and $3 million
for both fiscal 1997 and fiscal 1996. The plan is "non-compensatory" under APB
No. 25, and, accordingly, no charge to earnings has been recorded for the amount
of the discount to fair value.
Non-Employee Director Awards
The Company sponsors an equity-based plan for non-employee directors under which
shares of the Company's common stock have been authorized for issuance in the
form of option grants, stock awards or deferred compensation. The effect of
these grants on results of operations was not material.
OTHER COMPENSATION PLANS
Capital Accumulation Plan
Under the Capital Accumulation Plan ("CAP"), vested units consisting of
unsecured rights to receive payments based on notional interests in existing and
future risk-capital investments made directly or indirectly by the Company ("CAP
Units") are granted to key employees. The value of the CAP Units awarded for
services rendered in fiscal 1998, 1997 and 1996 was approximately $15 million,
$14 million and $7 million, respectively, all of which relate to vested units.
Carried Interest Plans
Under various Carried Interest Plans, certain key employees effectively
participate in a portion of the Company's realized gains from certain of its
equity investments in private equity transactions. Compensation expense for
fiscal 1998, 1997 and 1996 related to these plans aggregated $33 million, $38
million and $0.2 million, respectively.
Real Estate Fund Plans
Under various plans, select employees and consultants to certain partnerships
may participate in certain gains realized by the Company's real estate funds.
Compensation expense relating to these plans aggregated $3 million, $8 million
and $13 million for fiscal 1998, fiscal 1997 and fiscal 1996, respectively.
Profit Sharing Plans
The Company sponsors qualified profit sharing plans covering substantially all
U.S. employees and also provides cash payment of profit sharing to employees of
its international subsidiaries. Contributions are made to eligible employees at
the discretion of management based upon the financial performance of the
Company. Total profit sharing expense for fiscal 1998, fiscal 1997 and fiscal
1996 was $115 million, $113 million and $72 million, respectively.
Employee Stock Ownership Plan
The Company has a $140 million leveraged employee stock ownership plan, funded
through an independently managed trust. The Employee Stock Ownership Plan
("ESOP") was established to broaden internal ownership of the Company and to
provide benefits to its employees in a cost-effective manner. Each of the
3,581,964 preferred shares outstanding at November 30, 1998 is held by the ESOP
trust, is convertible into 3.3 shares of the Company's common stock and is
entitled to annual dividends of $2.78 per preferred share. The ESOP trust funded
its stock purchase through a loan of $140 million from the Company. The ESOP
trust note, due September 19, 2005 (extendible at the option of the ESOP trust
to September 19, 2010), bears a 10-3/8% interest rate per annum with principal
payable without penalty on or before the due date. The ESOP trust expects to
make principal and interest payments on the note from funds provided by
dividends on the shares of convertible preferred stock and contributions from
the Company. The note receivable
82
Morgan Stanley Dean Witter * 1998 Annual Report
from the ESOP trust is reflected as a reduction in the Company's shareholders'
equity. Shares allocated to employees generally may not be withdrawn until the
employee's death, disability, retirement or termination. Upon withdrawal, each
share of ESOP preferred stock generally will be converted into 3.3 shares of the
Company's common stock. If the fair value of such 3.3 common shares at
conversion is less than the $35.88 liquidation value of an ESOP preferred share,
the Company will pay the withdrawing employee the difference in additional
common shares or cash.
Contributions to the ESOP by the Company and allocation of ESOP shares to
employees are made annually at the discretion of the Board of Directors. The
cost of shares allocated to participants' accounts amounted to $8 million in
both fiscal 1998 and fiscal 1997, and $9 million in fiscal 1996. The ESOP debt
service costs for fiscal 1998, fiscal 1997 and fiscal 1996 were paid from
dividends received on preferred stock held by the plan and from Company
contributions.
PRO FORMA EFFECT OF SFAS NO. 123
Had the Company elected to recognize compensation cost pursuant to SFAS No. 123
for its stock option plans and the Employee Stock Purchase Plan, net income
would have been reduced by $214 million, $196 million and $41 million for fiscal
1998, 1997 and 1996, respectively. Basic and diluted earnings per common share
would have been reduced by $0.38, $0.34 and $0.07 for fiscal 1998, 1997 and
1996, respectively.
The weighted average fair value at date of grant for stock options granted
during fiscal 1998, 1997 and 1996 was $22.37, $16.76 and $9.08 per option,
respectively. The fair value of stock options at date of grant was estimated
using the Black-Scholes option pricing model utilizing the following weighted
average assumptions:
FISCAL fiscal fiscal
1998 1997 1996
============================================================================
Risk-free interest rate 4.9% 6.0% 5.5%
Expected option life in years 4.8 6.0 5.3
Expected stock price volatility 33.2% 28.0% 27.5%
Expected dividend yield 1.3% 1.3% 1.6%
----------------------------------------------------------------------------
13 EMPLOYEE BENEFIT PLANS
The Company sponsors various pension plans for the majority of its worldwide
employees. The Company provides certain other postretirement benefits, primarily
health care and life insurance, to eligible employees. The Company also provides
certain benefits to former or inactive employees prior to retirement. The
following summarizes these plans:
PENSION PLANS
Substantially all of the U.S. employees of the Company and its U.S. affiliates
are covered by non-contributory pension plans that are qualified under Section
401(a) of the Internal Revenue Code (the "Qualified Plans"). Unfunded
supplementary plans (the "Supplemental Plans") cover certain executives. In
addition to the Qualified Plans and the Supplemental Plans (collectively, the
"U.S. Plans"), nine of the Company's international subsidiaries also have
pension plans covering substantially all of their employees. These pension plans
generally provide pension benefits that are based on each employee's years of
credited service and on compensation levels specified in the plans. For the
Qualified Plans and the other international plans, the Company's policy is to
fund at least the amounts sufficient to meet minimum funding requirements under
applicable employee benefit and tax regulations. Liabilities for benefits
payable under the Supplemental Plans are accrued by the Company and are funded
when paid to the beneficiaries.
83
Morgan Stanley Dean Witter * 1998 Annual Report
The following tables present information for the Company's pension plans on
an aggregate basis.
Pension expense includes the following components:
FISCAL fiscal fiscal
(dollars in millions) 1998 1997 1996
=============================================================================
U.S. Plans:
Service cost, benefits earned
during the period $ 72 $ 54 $ 48
Interest cost on projected
benefit obligation 78 67 58
Return on plan assets (7) (170) (111)
Difference between actual and
expected return on assets (80) 104 53
Net amortization 1 1 2
-----------------------------------------------------------------------------
Total U.S. plans 64 56 50
International plans 12 9 12
-----------------------------------------------------------------------------
Total pension expense $ 76 $ 65 $ 62
-----------------------------------------------------------------------------
The following table provides the assumptions used in determining the projected
benefit obligation for the U.S. Plans:
FISCAL fiscal
1998 1997
=============================================================================
Weighted average discount rate 6.75% 7.25%
Rate of increase in future compensation levels 5.00% 5.00%
Expected long-term rate of return on plan assets 9.00% 9.00%
-----------------------------------------------------------------------------
The following table sets forth the funded status of the U.S. Plans:
NOVEMBER 30, 1998 November 30, 1997
ACCUMULATED Accumulated
ASSETS EXCEED BENEFITS Assets Exceed Benefits
ACCUMULATED EXCEED Accumulated Exceed
(dollars in millions) BENEFITS ASSETS Benefits Assets
============================================================================
Actuarial present
value of vested
benefit obligation $ (269) $ (616) $ (735) $ (34)
----------------------------------------------------------------------------
Accumulated
benefit obligation $ (314) $ (693) $ (807) $ (71)
Effect of future
salary increases (114) (93) (181) (30)
----------------------------------------------------------------------------
Projected benefit
obligation (428) (786) (988) (101)
Plan assets at fair
value (primarily listed
stocks and bonds) 384 597 1,006 --
----------------------------------------------------------------------------
Projected benefit
obligation (in
excess of) or less
than plan assets (44) (189) 18 (101)
Unrecognized net
loss or (gain) 53 83 (4) 27
Unrecognized prior
service cost 1 28 31 (4)
Unrecognized net
transition obligation -- 8 3 5
----------------------------------------------------------------------------
Prepaid (accrued)
pension cost at
fiscal year-end $ 10 $ (70) $ 48 $ (73)
Additional liability
for unfunded
accumulated
benefit obligation -- (30) -- --
----------------------------------------------------------------------------
Pension asset
(liability) $ 10 $ (100) $ 48 $ (73)
----------------------------------------------------------------------------
The Company also maintains a separate defined contribution pension plan
which covers substantially all employees of the Company's U.K. subsidiaries (the
"U.K. Plan"). Under the U.K. Plan, benefits are determined by the purchasing
power of the accumulated value of contributions paid. In fiscal 1998 and 1997,
the Company's expense related to the U.K. Plan was $17 million and $15 million,
respectively.
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Morgan Stanley Dean Witter * 1998 Annual Report
POSTRETIREMENT BENEFITS
The Company has unfunded postretirement benefit plans that provide medical and
life insurance for eligible retirees, employees and dependents. At November 30,
1998 and 1997, the Company's accrued postretirement benefit costs were $95
million and $91 million, respectively.
POSTEMPLOYMENT BENEFITS
Postemployment benefits include, but are not limited to, salary continuation,
supplemental unemployment benefits, severance benefits, disability-related
benefits, and continuation of health care and life insurance coverage provided
to former or inactive employees after employment but before retirement. These
benefits were not material to the consolidated financial statements in fiscal
1998, 1997 and 1996.
14 INCOME TAXES
-----------------------------------------------------------------------------
The provision for income taxes consists of:
FISCAL fiscal fiscal
(dollars in millions) 1998 1997 1996
===========================================================================
Current
U.S. federal $ 1,199 $ 1,079 $ 1,096
U.S. state and local 372 348 290
Non-U.S 476 338 177
---------------------------------------------------------------------------
2,047 1,765 1,563
---------------------------------------------------------------------------
Deferred
U.S. federal (26) (45) (326)
U.S. state and local 1 (17) (74)
Non-U.S (30) (15) (26)
---------------------------------------------------------------------------
(55) (77) (426)
---------------------------------------------------------------------------
Provision for income taxes $ 1,992 $ 1,688 $ 1,137
---------------------------------------------------------------------------
The following table reconciles the provision to the U.S. federal statutory
income tax rate:
FISCAL fiscal fiscal
1998 1997 1996
============================================================================
U.S. federal statutory income
tax rate 35.0% 35.0% 35.0%
U.S. state and local income taxes,
net of U.S. federal income tax
benefits 4.6 5.1 4.6
Lower tax rates applicable to
non-U.S. earnings (2.4) (1.1) (1.7)
Reduced tax rate applied to
dividends (0.1) (0.1) (0.1)
Other (0.1) 0.6 (1.3)
----------------------------------------------------------------------------
Effective income tax rate 37.0% 39.5% 36.5%
----------------------------------------------------------------------------
As of November 30, 1998, the Company had approximately $2.6 billion of earnings
attributable to foreign subsidiaries for which no provisions have been recorded
for income tax that could occur upon repatriation. Except to the extent such
earnings can be repatriated tax efficiently, they are permanently invested
abroad. It is not practicable to determine the amount of income taxes payable in
the event all such foreign earnings are repatriated.
Deferred income taxes reflect the net tax effects of temporary differences
between the financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when such
differences are expected to reverse. Significant components of the Company's
deferred tax assets and liabilities at November 30, 1998 and 1997 are as
follows:
NOV. 30, NOV. 30,
(dollars in millions) 1998 1997
=========================================================================
Deferred tax assets
Employee compensation and benefit plans $1,289 $1,168
Loan loss allowance 371 459
Other valuation and liability allowances 604 545
Other 167 180
-------------------------------------------------------------------------
Total deferred tax assets 2,431 2,352
-------------------------------------------------------------------------
Deferred tax liabilities
Prepaid commissions 239 233
Valuation of inventory, investments
and receivables 127 298
Other 237 265
-------------------------------------------------------------------------
Total deferred tax liabilities 603 796
-------------------------------------------------------------------------
Net deferred tax assets $1,828 $1,556
-------------------------------------------------------------------------
Cash paid for income taxes was $1,591 million, $1,251 million and $1,190 million
in fiscal 1998, 1997 and 1996, respectively.
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Morgan Stanley Dean Witter * 1998 Annual Report
15 GEOGRAPHIC AREA DATA
-----------------------------------------------------------------------------
Total revenues, net revenues, income before taxes and identifiable assets of the
Company's operations by geographic area are as follows:
Because of the international nature of the financial markets and the resulting
geographic integration of the Company's business, the Company manages its
business with a view to the profitability of the enterprise as a whole, and, as
such, profitability by geographic area is not necessarily meaningful.
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Morgan Stanley Dean Witter * 1998 Annual Report
16 SEGMENT INFORMATION
-----------------------------------------------------------------------------
The Company is in the business of providing financial services, and operates in
two business segments -- Securities and Asset Management and Credit and
Transaction Services. Securities and Asset Management engages in delivering a
broad range of financial products and services, including asset management, to
individual and institutional investors. Credit and Transaction Services is
engaged in the issuance and servicing of general purpose credit cards, consumer
lending and electronic transaction processing services.
The following table presents certain information regarding these business
segments:
FISCAL fiscal fiscal
(dollars in millions) 1998 1997 1996
============================================================================
Total revenues:
Securities and Asset
Management $ 25,763 $ 21,499 $ 17,136
Credit and Transaction
Services 5,368 5,633 5,035
Income before income
taxes(1):
Securities and Asset
Management 4,187 3,597 2,426
Credit and Transaction
Services 1,198 751 691
Identifiable assets at end
of period(2):
Securities and Asset
Management 297,054 277,878 213,967
Credit and Transaction
Services 20,536 24,409 24,893
----------------------------------------------------------------------------
(1) Excludes merger-related expenses of $74 million in fiscal 1997.
(2) Corporate assets have been fully allocated to the Company's business
segments.
17 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 Transaction Services, Inc., 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, 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.
87
Morgan Stanley Dean Witter * 1998 Annual report
18 QUARTERLY RESULTS (UNAUDITED)
----------------------------------------------------------------------------
(1) The quarterly results for the first, second and third quarters of fiscal
1998 have been restated to reflect the effects of the accounting change
adopted in the fourth quarter, effective December 1, 1997. As a result of
this restatement, net income has been decreased by $117 million, $2 million
and $21 million for the first, second and third quarters of fiscal 1998,
respectively. For further information regarding the change in accounting,
see Note 2.
(2) Amounts shown are used to calculate basic earnings per share.
(3) Summation of the quarters' earnings per common share may not equal the
annual amounts due to the averaging effect of the number of shares and share
equivalents throughout the year.
(4) Prices represent the range of sales per share on the New York Stock Exchange
for the periods indicated. The number of stockholders of record at November
30, 1998 approximated 186,000. The number of beneficial owners of common
stock is believed to exceed this number.
88