MS

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended August 31, 2007, for Morgan Stanley, a global financial services firm. The Company operates through three primary segments: Institutional Securities, Global Wealth Management Group, and Asset Management. A significant corporate event during this period was the completion of the spin-off of Discover Financial Services (DFS) on June 30, 2007, with DFS results reported as discontinued operations. The Company also sold its Quilter Holdings Ltd. business in February 2007, which is also reported as discontinued.

Key Financial Metrics

Segment Performance (Nine Months 2007):

• Institutional Securities: Net revenues of $19,574 million; Income from continuing operations of $4,938 million.
• Global Wealth Management Group: Net revenues of $4,836 million; Income from continuing operations of $469 million.
• Asset Management: Net revenues of $4,241 million; Income from continuing operations of $745 million.

Material Changes vs. Prior Period

• Revenue Growth: Consolidated net revenues increased 13% for the quarter and 29% for the nine-month period compared to the prior year. This was driven by higher investment banking fees, increased asset management fees, and higher net interest revenue.
• Profitability: Net income for the quarter decreased 17% to $1.543 billion, primarily due to lower gains from discontinued operations (Quilter sale in 2006 vs. DFS spin-off in 2007) and higher compensation expenses. However, income from continuing operations for the nine-month period increased 41% to $6.151 billion.
• Expense Increases: Non-interest expenses rose 18% for the quarter and 24% for the nine-month period, largely due to higher compensation and benefits accruals linked to revenue growth and business investments.
• Balance Sheet: Total assets increased to $1.185 trillion from $1.121 trillion at the end of the prior fiscal year, driven by growth in financial instruments owned and securities received as collateral, partially offset by the Discover spin-off.

Guidance, Outlook, Risks, and Unusual Items

Market Conditions and Risks: Management highlighted deteriorating conditions in the credit markets during the third quarter, characterized by increased volatility, spread widening, and lower liquidity, particularly in sub-prime mortgage and leveraged lending sectors. These conditions led to mark-to-market losses on certain loan commitments and credit products.

Unusual Items:

• Corporate Lending Losses: Other sales and trading revenues included losses of approximately $940 million in the quarter due to mark-to-market valuations on loans and loan commitments, including $726 million in markdowns on leveraged loan commitments for acquisition financing that had not yet closed.
• Discontinued Operations: The quarter included a $69 million gain from discontinued operations (primarily DFS results through June 30). The nine-month period included a $646 million gain, driven by the sale of Quilter ($168 million pre-tax gain) and DFS results.
• Legal Proceedings: The Company maintains a $360 million reserve for the Coleman litigation. While an appellate court reversed a previous $1.578 billion judgment in the Company's favor, the plaintiff has petitioned the Florida Supreme Court for review. The Company believes the reserve is adequate but acknowledges potential additional exposure if the judgment is reinstated.

Outlook: The Company announced a restructuring of its residential mortgage business in October 2007 to reduce origination capacity in response to market conditions, resulting in a net reduction-in-force of approximately 600 employees. Costs are not expected to be material.

Investor Verification Checklist

• Credit Exposure: Verify the extent of exposure to sub-prime mortgages and leveraged loan commitments, specifically the $31.3 billion in "pipeline" commitments to non-investment grade borrowers that were accepted but not closed.
• Legal Reserves: Monitor the status of the Coleman litigation appeal at the Florida Supreme Court and the adequacy of the $360 million reserve against potential reinstatement of the $1.578 billion judgment.
• Discontinued Operations: Confirm the separation of DFS results and the impact of the spin-off on future earnings and capital structure.
• Liquidity Position: Review the increase in liquidity reserves to $125 billion (as of August 31, 2007) and the Company's ability to fund loan commitments in a stressed credit environment.
• Compensation Trends: Assess the sustainability of rising compensation expenses, which increased significantly due to incentive accruals and deferred compensation plan adjustments.