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Morgan Stanley. (NYSE:MS)

F1Q07 Earnings Call

March 21, 2007, 11:00 AM ET

Executives

David Sidwell - Executive Vice President and Chief Financial Officer

Analysts

Glenn Schorr - UBS

Guy Moszkowski - Merrill Lynch

William Tanona - Goldman Sachs

Douglas Sipkin - Wachovia Securities

James Mitchell - Buckingham Research Group

Meredith Whitney - CIBC World Markets

Ron Mendell - DIC

Mike Hecht - Banc of America Securities

Presentation

Operator

Good day, ladies and gentlemen, welcome to the Morgan Stanley conference call. The following is a live broadcast by Morgan Stanley and is provided as a courtesy. Please note that this call is being broadcast on the Internet through the Company’s website at www.morganstanley.com. A replay of the call and Web cast will be available through the company’s website and by phone until April 20, 2007. This presentation may contain forward-looking statements. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the day on which they are made, which reflects management’s current estimates, projections, expectations, or beliefs and which are subject to risks and uncertainties that may cause actual results to differ materially.

For a discussion of additional risks and uncertainties that may affect the future results of the company, please see forward-looking statements immediately proceeding part 1 item 1 competition and regulation and part 1 item 1 risk factors and part 1 item 1A, legal proceedings in part 1, item 3, management’s discussion and analysis of financial condition and results of operations in part 2, item 7, and quantitative and qualitative disclosures about market risk in part 2, item 7A of the company’s annual report on form 10-K for the fiscal year ended November 30, 2006 and other items throughout the form 10-K and the Company’s 2007 current reports on form 8-K.

The information provided today may also include certain non-GAAP financial measures. The reconciliations of such measures for the comparable GAAP figures are included in our annual reports on form 10-K, our quarterly reports on form 10-Q, and our current reports on 8-K, which are available on our website www.morganstanley.com. Any recording, rebroadcast, or other use of this presentation in whole or in part is strictly prohibited without prior written consent of Morgan Stanley. This presentation is copyrighted and proprietary to Morgan Stanley. At this time I would like to turn the program over to David Sidwell for today’s call.

David Sidwell

Thanks very much, operator, and thanks everyone for joining us today. As you’ve seen from our press release, Morgan Stanley had a tremendous first quarter with record results across the board including record revenues, income from continuing operations, net income and earnings per share. These outstanding results reflect continued execution of our plan for growth and strong trading performance and client execution in very favorable markets across our businesses. We increased the firm’s risk-taking this quarter in a disciplined and balanced way to take advantage of the market opportunities, which together with robust client flows helped us deliver record sales and trading numbers across our equities and fixed income businesses. We continue to make significant progress in executing on our plans to improve performance in our Asset Management and Global Wealth Management businesses.

Let me begin with an overview of our firm-wide results, which are included in the pages, 1 and 2 of the financial supplement. First quarter income from continuing operations was $2.6 billion, our highest quarter ever. Earnings per share from continuing operations was $2.40 per share versus $2.08 per share in the fourth quarter of last year, which included a $0.27 per share tax benefit related to finalizing a federal audit. Diluted earnings per share were $2.51, which includes $0.11 per share in our discontinued operations line related to the sale of Quilter. This compares to $2.08 of share in the fourth quarter of 2006. Return on equity from continuing operations was 28.8% and 29.9% including discontinued ops.

Net revenues for the quarter were $11 billion, up 25% from the fourth quarter, our highest quarter ever and ahead of the second quarter of last year, the previous record. Total non-interest expenses were $7.1 billion, up 21%. The largest component, compensation and benefits expense was $5 billion, up from $3.5 billion for compensation to net revenue ratio of 45%. The ratio for full-year 2006 was 43%. On our last call, I said that the 2007 ratio would be 1 to 2 percentage point higher than the 43% we reported last year. In addition, in the first quarter we’ve changed to a growth presentation so an employee-deferred compensation and current investment plan to reflect the returns on such plans as both revenue and compensation expense. While this growth had negligible impact on profit before tax and net income, it increased the compensation to net revenue ratio by approximately 1.5 percentage points. We have reclassified amounts for previous periods to conform this presentation.

Non-compensation expense in the fist quarter was $2.1 billion, down 11% from last quarter driven by lower professional services and marketing and business development in-line with the usual seasonal trend for these expenses. For example, Discover’s marketing spend is down $56 million, following its seasonal pattern of spend. And non-compensation to net revenue ratio was 19% this quarter, down from the full-year 2006 level of 25%, reflecting both strong revenues, but also this seasonal trend that we see each year. Our tax rate for continuing operations was 33%, the same as last year’s normalized full-year rates.

Now let me look at the business specifics. Turning to Institutional Securities detailed on page 5 of the supplement, we were very pleased with our results for the quarter. Record net revenues of $7.6 billion were up 34% from our previous record in the fourth quarter of last year. Profit before tax of $3 billion also a record, was up 32%. And the margin of 40% was flat with last quarter. We achieved return on equity of 40%. Non-interest expenses of $4.6 billion increased 35%, compensation expense was up on higher revenues while non-compensation expenses decreased slightly, reflecting the seasonal decline in Professional Services, including legal, consulting, and recruiting costs, marketing and business development. Looking at page 6 of the supplement investment banking revenues were $1 billion, a 22% decline from our extremely strong fourth quarter last year. All categories were higher than one year ago, up 16%.

Advisory revenues decreased 39% to $390 million from a near record fourth quarter 2006. Our M&A backlog is up significantly versus both this time last year and versus the end of the fourth quarter. Equity underwriting revenues were up 18% to $300 million. Our equity backlog is up from the fourth quarter and last year’s first quarter with a strong pipeline of equity offerings across geographies expected in 2007. Fixed income underwriting revenues were down 21% to $359 million from a record fourth quarter of 2006, largely reflecting a decrease in industry volumes during the quarter. Our debt backlog is up quarter-over-quarter and year-over-year.

Lead table standings are not very meaningful this early in the year because they only reflect the first two months. However, we believe our pipelines indicate that we will capture our share of deals going forward and we continue to be optimistic about the prospects for investment banking. Also on page 6 of the supplement, you can see that we had a record sales and trading quarter, with total revenues of $5.8 billion, up 57% from the strong fourth quarter. Equity sales and trading revenues of $2.2 billion were a record quarter, ahead of our previous record high in the second quarter of 2000 and up 57% from the fourth quarter of 2006, reflecting robust market conditions for much of the quarter and strong revenue growth across businesses and regions, including in our principal and process-driven trading strategies.

Cash equities revenues were up 27% with rising stock market indices, strong client volume, and growth across all regions, including record results in Europe and Asia. Derivatives researches nearly tripled, driven by increased risk, higher client flows, and new deal activity across all regions. We continue to see results from our derivative expansion plan. For example, we recently launched a European retail structure product for high net worth and ultrahigh net worth individuals that being sold through multiple distribution channels, including our own Wealth Management business.

Financing products also contributed to the overall increase in revenues. This was a record quarter in prime brokerage, with revenues up substantially on both new accounts and growth in global client balances for the 16th consecutive quarter. In fixed income sales and trading, $3.6 billion in revenues was our best quarter ever, up 57% driven by broad-based strength across credit products, interest rate, and currency products and commodities. We sold very strong trading performance and good levels of client activity across our fixed income businesses. Looking at the results by product area, credit products rose 110% to a new record, with the largest increase in securitized products driven by favorable positioning in the Subprime Mortgage Markets, strong customer flows, and robust growth in our Global Commercial Mortgage business.

In corporate credit revenues increased substantially with tightening spreads and strong liquidity, driving good client flow and positioning opportunities. Interest rate and currencies increased 10%, driven by strong results in emerging markets. Where there were strong rallies in most countries and good customer flow. Commodities increased 56% in volatile market conditions, with strength across the board in our oil liquids, electricity, and natural gas, and metals businesses. All of which benefited from strong client flows and positioning opportunities. Our results were also enhanced by our recent acquisitions of TransMontaigne and Heidmar.

Principal transaction’s investment revenues were $801 million, a $298 million increase from the fourth quarter of 2006. The growths were up for certain differed compensation plans, which I mentioned earlier, largely impact this revenue line. The impact in the current quarter is $237 million compared with $93 million in the fourth quarter of 2006. Outside of this factor, the increase was primarily driven by higher unrealized gains in the real estate portfolio and fixed income investments, including ICE.

Turning to risk, we assumed more risk this quarter to take advantage of market opportunities across our institutional businesses. This increased risk is visible in our value at risk, as well as the increase in capital allocated to the Institutional Securities segment. Looking at value at risk for the quarter, aggregate average trading and non-trading value at risk is up $25 million to $92 million with increases in equities and commodities risk, as well as a decrease in the diversification benefit because of high correlation, given the size and mix of the portfolio.

Period end accretive trading and non-trading risk was $78 million as we decreased risk exposure during the latter part of the quarter to balance the level of risk with our view of potential market changes. Stress testing scenarios, which help us manage less liquid risk showed a similar trend over the quarter. In the quarter, total loans and commitments rose by $4.3 billion. Compared to where we were last year at this time, total loans and commitments net of hedges have increased by $8.1 billion or 32%. Non-investment grade loans and commitments have increased by $19 billion or three-fold.

We continue to see considerable opportunities for event lending as we grow our leverage finance business, build off our strong client relationship, structuring capabilities, and distribution. Before I leave Institutional Securities, let me turn to a topic that’s been a focus in the market in the past several weeks, subprime mortgage. We participate in the subprime mortgage market in a number of ways. Through our securitized product groups we purchased loans from originators and originate loans, including through Saxon, which closed this quarter. We are active in the structuring, securitization, and distribution of subprime products, including CLOs and CDOs. Third, we manage our risk through a variety of hedging strategies and we also take proprietary risk positions. In the aggregate, these activities were a significant contributor to our results this quarter. In addition, we extend loans and lending commitments to clients that are secured by assets of the borrower such as loan pools. At the end of the quarter, whereas lending commitments to the subprime lenders totaled $5.2 billion, of which $2.3 billion was funded and fully collateralized. The largest component of this was the New Century. Our current funded balance with New Century is $2.5 billion. Finally, through our acquisition of Saxon, we have servicing capabilities.

Now turning to page 8 of the financial supplements, and our Global Wealth Management business, the sale of our U.K. stand-alone mass-affluent brokerage business Quilter to Citigroup was finalized this quarter and resulted in a $168 million pretax gain. Quilter is excluded from all periods and shown in the firm’s results as a discontinued operation. Global Wealth Management revenues reached $1.5 billion, the best quarterly revenue in six years, and up 4% from the fourth quarter of 2006, reflecting improved performance as well as increased market activity.

Non-interest expenses of $1.3 billion were flat, reflecting increased compensation because of higher revenues offset by a decrease in non-compensation expenses driven by lower legal services and other Professional Services costs. There were no significant expenses related to legal and regulatory matters this quarter. We achieved significant operating leverage in the quarter, with profit before tax of $220 million, a 33% increase from the fourth quarter of 2006. And we had a 15% PBT margin, the highest margin achieved since the second quarter of 2000.

ROE increased to 32%, reflecting the improved margin as well as the reduced capital required to support the business. The business continues to build on its momentum, showing improvement in many areas. On page 9, you can see this in a number of productivity metrics. Net new assets of $6.7 billion represented our fourth consecutive quarter of client inflows and highest since we started tracking the metric. Assets in the $1 million plus household sector increased $16 billion and are 70% of our total client asset base versus 65% at this point last year. Total client assets increased to $690 billion and fee-based assets represented 29% of the total. Average FA production grew to a record $748,000.

Our bank deposit program continues to grow, ending the quarter at $16.4 billion, well on track to achieve the high end of our goal of 18 to $20 billion by year end. Product launches during the quarter includes a closed end fund in advance, on which we reached highest sales for closed and fund of $1.5 billion. We continue to expand our product offerings to our clients to include more lending products. For example, we introduced a portfolio loan account which attracted over $400 million in credit lines.

Our FA headcount is up slightly from last quarter as we continue to attract high quality producers. We believe that we will end the year with approximately 8,000 FAs, slightly higher than we have today. This is our fourth consecutive quarter of progress, and while we do not expect progress to be linear, we are clearly building momentum in this business.

Let me turn to our Asset Management business. We continue to make good progress against our key initiatives. We delivered our second consecutive quarter of positive flow and for the first quarter in over two years, we reported positive net long-term flows driven impart from new products launched in 2006. Also, institutional money market flows continue to be strong. As you see on page 10 of the supplement, net revenues of $905 million were up 24% from the fourth quarter of 2006. Management and administration fees increased 15% to $732 million, largely driven by higher revenues in our alternatives business, including FrontPoint Partners and higher average assets under management. In the quarter, the acquisition of FrontPoint added $6 billion of assets under management.

Principal transaction investment revenues increased to $121 million in the quarter, primarily from net unrealized gains related to private equity investments and investments in our alternatives business. The increase in other revenue primarily reflects revenue recognized from our minority stake in Lansdowne and Avenue Capital. Expense of $669 million were up 24%, driven by higher compensation due to increased investment in the business and higher net revenues resulting in a higher payout ratio. Income before taxes was $236 million, up 24% and PBT margin was 26%, primarily driven by the private equity gains. We continue to believe the full-year margin will be closer to 20% as a result of continued business investment and products and people, for example, as we build our private equity business. Return on equity was 20%, up from the 18% reported last quarter. There was an increase in the economic capital required to support the business during the quarter, primarily related to goodwill from acquisition and additional fee capital.

Turning to page 11 of the supplement, you can see assets under management or supervision increased by $22 billion to end the quarter at $500 billion. This increase reflects the impact of positive flows in both long-term assets and institutional money markets. The acquired assets under management are associated with FrontPoint and strong market performance. We had $4.3 billion in total net inflows, which marks our second consecutive quarter of net asset inflows. Institutional liquidity inflows continued strong, at $2.5 billion. We also continued to see positive flows in our non-US and Americas Intermediary channels of $4.5 billion and $1 billion respectively. These were partially offset by $1.8 billion in retail money market outflows, primarily resulting from the build out of the deposit program in Global Wealth Management and our Morgan Stanley branded retail channel as $1.9 billion of outflows.

We continue to broaden our product offering and launched and incubated 21 new core products, including 12 in alternatives, five in equities, and four in fixed income. Recognizing a new products typically take anywhere from one year to several to establish a track record and attract meaningful assets, we feel good about the early success we have seen with flows into the new products that are being launched in 2006 and 2007. We are pleased with the traction we are getting with our investments for long-term growth, including product expansion and alternatives and the progress we are making in developing our private equity and infrastructure initiatives. Results for our Discover business are detailed on pages 13 and 14 of the supplement. Financial information and statistical data follow on page 15.

Net revenues for the quarter were $1 billion, up 6% sequentially and profit before tax increased 87% to $372 million, primarily driven by higher revenues, which included a lower provision for loan losses and lower expenses. Receivables grew for the fifth consecutive quarter, up 6% year-on-year and 1% sequentially with record transaction volume and stable payment rates. Fees were up slightly on a managed basis, primarily reflecting higher sequential sales volume due to normal seasonal trends and to higher Card member related fee revenue partially offset by higher Card member rewards. Interest income increased slightly due to higher average balances. The yield was up slightly from last quarter as well. The provision for losses was $482 million, down 9%, reflecting an improvement in the US, partially offset by deterioration in the UK, where bankruptcies have been increasing. Across the portfolio the net charge-off rate and 30-day delinquencies decreased.

Turning to expenses, non-interest expenses decreased 15% driven by lower seasonal advertising and marketing spend and lower legal fees related to the VISA/MasterCard litigation. For the year, we expect our marketing and business development spending to be at or slightly up from 2006 levels. Looking forward, consistent with the industry, our U.S. bankruptcies have not returned to higher level, as quickly as we have been expecting, although there has been deterioration in the U.K. credit environment.

The consumer credit environment in the U.S. remains very favorable for our business, with bankruptcies remaining low throughout the quarter. As a result we’re revising slightly our outlook for the full year charge-off rate to a range of 4 to 4.5% versus the prior estimate of 4.5 to 5%. While there has been considerable media coverage regarding higher delinquencies in the subprime mortgage industry, we have not seen any impact on our Card portfolio. Nevertheless, we continue to monitor the situation closely. In summary, our U.S. business is performing well with growth in usage and receivables and strong credit performance. In the U.K., we’re working hard to limit the impact, we are facing due to the adverse credit environment.

Finally, regarding our spin-off of Discover, the various work streams are progressing as plan and we continue to expect to complete the spin in the third quarter. The next step is we expect to file the form-10 shortly. As we described in our recent 10-K, we’re now using Tier 1 regulatory capital as a definition of economic capital, this gives credit to Hybrid Capital instruments and certain preferred stock, but deducts deferred tax assets from capital. In making this change, we wanted to recognize that non-common equity Tier 1 instruments are a cost efficient source of equity.

In terms of share repurchase, we told you last quarter that our board had authorized a stock repurchase program of up to $6 billion, and then we would have actively managed our share repurchases to achieve this over the next 12 to 18 months. As of February 28, the company repurchased approximately 15 million shares of its common stock worth approximately $1.2 billion since the end of fiscal 2006. With respect to the pace of repurchases, we evaluate and balance the needs of our business for additional capital to reinvest in the organic growth and make attractive acquisitions with our objective over time of offsetting the dilutive impact of equity compensation to employees.

Finally, as a regard to outlook, the markets have been very volatile over the last few weeks with a decline in stock markets, widening credit spreads, higher interest rates, and higher volatility as well as concerns which have continued about the subprime market and whether it would spread to other markets. At this time we believe this could be a reasonably limited event, as we have not seen any signs that the subprime deterioration could spread to other parts of the market. At this early point in the second quarter, we remain reasonably optimistic. I mentioned earlier that our investment banking pipeline across advisory equities of fixed income are strong. The level of client activity in our sales and trading businesses remain strong, with the increase in volatility providing trading opportunities for our clients as well as for us. At Discover, charge-off rates remain relatively low and credit costs are expected to continue to rise at a slower rate. In the equity markets if they continue to see a downward trend, it will obviously have an impact on the retail investor’s transaction activity; however that revenue pressure would be mitigated somewhat by fee-based assets, the growing deposits on lending business, plus a pipeline of closed and fund offerings. Our Asset Management business will also be affected by equity market trends, but we’re building momentum from our build out in alternatives. So in sum we continue to invest in the long-term growth of our business, I fear we are well-positioned to deliver value to our shareholders. So, with that let me please hand it over to you all for any questions you may have.

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Question-and-Answer Session

Operator

In the line of Glenn Schorr of UBS. Please proceed.

Glenn Schorr - UBS

Hi, Dave.

David Sidwell

Good morning Glenn.

Glenn Schorr - UBS

Good morning, afternoon -- well, still morning. I’ve missed it in your prepared remarks. You had touched on the lower equity allocation of Global Wealth Management. Wasn’t sure what that was, as that business gets more full balance sheet focused. If you could elaborate, that would be cool.

David Sidwell

We obviously look at the capital we allocate to each of the businesses on a regular basis. The methodology has not changed in our assessment: however, of the capital required for both the market and credit risk in this business together with operational risk, those calculations showed a lower requirement in the quarter. In contrast, actually Asset Management has a higher capital allocation in the quarter because of the acquisitions.

Glenn Schorr - UBS

It just seemed down 40% in the quarter and 50% year-over-year it seemed like something changed in terms of feeling towards what it would chew up in regulatory capital. Did the deposit program housed within Global Wealth Management?

David Sidwell

The deposit program is within Global Wealth Management.

Glenn Schorr - UBS

It’s not that big of a deal. Maybe a more important question is, now what do you do with the $5.1 billion of capital surplus? I guess to your point, keep building your business to deploy risk capital and make your bolt-on acquisitions along the way?

David Sidwell

Yeah. And balance it obviously with -- we do want to make sure that we cover over time to the diluted impact of the stock awards to employees. So, it’s very much each quarter we look at the capital we’re going to need for all the factors you’ve said and balance that against our desire to cover the cost of the stock programs for our employees. That dynamic again, we set at each quarter.

Glenn Schorr - UBS

Right and I guess in the first quarter, the share count rose a little bit, but that’s a first quarter phenomenon for the most part?

David Sidwell

Yeah, it is. We make our equity awards to employees in the first quarter and that’s the big driver in the share count.

Glenn Schorr - UBS

Right and I noticed that sometime right before the conference call started, you were right and you got the Proman case overturned?

David Sidwell

Yeah, we just got the opinion and I haven’t been through it in detail, but I think our first read and that of our law team is that this is clearly a victory. Obviously we have to go through it in detail and work it out and obviously, there are additional steps that the other party can take, but this was very good news today, we are very pleased.

Glenn Schorr - UBS

Not bad, not bad. So eventually we could see a partial or all reversal of the reserves taken, if it holds?

David Sidwell

Yeah, the reserve is $360 million.

Glenn Schorr - UBS

Right, right. Okay. Thanks very much.

David Sidwell

Sure.

Operator

And our next question comes from the line of Guy Moszkowski of Merrill Lynch. Please proceed.

David Sidwell

Good morning, Guy.

Guy Moszkowski - Merrill Lynch

Thanks, good morning. On the VaR and the fact that you did bring it up quite a bit on average for the quarter but then down quite a bit by the end of the quarter, can you give us a sense for the asset classes that would have accounted for the end of quarter pullback from whatever the peak was during the quarter?

David Sidwell

Yeah, we -- just to give a bit of background on this and I think I talked about this at the last conference call that we did, we actually had increased the level of VaR that we were taking by the end of the fourth quarter, if you remember on average, just using trading VaR as an example, the fourth quarter average was 61, in fact, the period end was $85 million. That increase continued in the first quarter on average and most of the increase was in equities and in commodities and we then pulled that back down again by period end, so the trading VaR was reduced to $76 million over the last couple of weeks of the quarter. And the decreases, again, were primarily in equity.

Guy Moszkowski - Merrill Lynch

Primarily in equities, you said, right?

David Sidwell

Yeah.

Guy Moszkowski - Merrill Lynch

And I think when you were talking about the fixed income business revenue changes, you were actually referring relative not fourth quarter as supposed to in the press release, when you talked about relative to year-over-year; is that right?

David Sidwell

Basically the way we’ve done this call, the press release compared with a year, we always do the conference call compared with the last quarter.

Guy Moszkowski - Merrill Lynch

Right I just want to make sure that was the right. So then relative to last quarter, you were also saying that mortgage trading revenues were stronger relative to fourth quarter, despite all the subprime issues and everything and largely because of positioning. Is that appropriately interpreted?

David Sidwell

Yes. Our fixed income business was up and a big part of the increase in fixed income is in the credit marketed and a big driver of that was our residential mortgage business for the reasons that we talked about, we were well positioned for the market moves.

Guy Moszkowski - Merrill Lynch

And just a follow-up question on the capital management, first of all, with respect to the reduction of capital, I guess about half relative to what it was a year ago in Global Wealth Management, some of that presumably related to the sale of Quilter. Can you give us a sense for how much was that as opposed to…?

David Sidwell

We actually had moved Quilter and showed it in discontinued operations. So if you look at page 4 in the supplement, you’ll see a row, which is called discontinued operations, that’s the capital that was assigned to Quilter.

Guy Moszkowski - Merrill Lynch

Gotcha, okay. So really all we see above the line there, is just a reassessment of the legal and operating capital risks in the business?

David Sidwell

Yes, absolutely. As I said earlier to the question, we regularly evaluate the components of our capital calculation, which are our market risk, credit risk, operating risk, as well as obviously the capital to support acquisitions through the amount of goodwill and it was with consideration of all of those factors that we lowered the amount of capital to the retail business.

Guy Moszkowski - Merrill Lynch

Obviously as the previous question pointed out, the amount of capital that you’re now carrying at the corporate level, the excess capital at the corporate level raises the question of either buybacks or continued acquisitions and you’ve obviously made quite a number of those of the ladder in the last year. Would you at this point consider increasing the amount of subprime origination or alt A type origination, capability that you have, or is that appetite pretty much satisfied at this point with Saxon?

David Sidwell

Well, I would say that -- and obviously we’ve been talking about this for a little bit. We had felt as we looked at the firm and its strategy, we felt that we were underrepresented in the mortgage business that our fixed income business, which is a leader in many areas, that we did not have the scale of penetration in the mortgage markets that we should have had. It was with that, that we have said over the last couple of years that we wanted to increase our footprint in mortgages, Saxon was part of that as was some of the expansion that we’ve done overseas. Obviously, I think we will continue to look at opportunities in the marketplace, but it’s something that we have at this point made no definitive plans on or else I’d share them with you.

Guy Moszkowski - Merrill Lynch

Okay, great. Thanks very much, David.

David Sidwell

Sure.

Operator

Ladies and gentlemen, please stand by, your question-and-answer portion will resume momentarily.

David Sidwell

Great. When there are good results for fewer questions.

Operator

Our next question comes from the line of William Tanona with Goldman Sachs. Please proceed.

William Tanona - Goldman Sachs

Hey, David.

David Sidwell

Hey, good morning.

William Tanona - Goldman Sachs

So can we talk a little bit about the margins, obviously we saw some improvements there and I would say in particular in the Global Wealth Management and in Maxim, you had guided before in the Maxim side too probably the low 20s you came in at 26%. I’m guessing part of that is probably just seasonal, given the incentive fees and if you can just update us on how we shall think about that line going forward for Maxim and then on the Global Wealth Management side. There you had indicated that there were no legal fees or no legal expenses in this quarter, so that kind of abnormally high here for the first quarter or is that a good run rate we should use going forward?

David Sidwell

Let me start with the Asset Management business. We, as you say, we did have margin of 26% in the quarter. We’ve actually been signaling that a 20% margin was a much more realistic level for the full year, and that’s in large part as we continue to make the investment in people and specifically the investment in building the private equity business. So, I would still, just reinforce that that our expectation is the margin will be much closer to 20%. Obviously part of the driver in the first quarter and as you know, these tend to be lumpy; we had fairly high investment gains, both from seed capital and in private equity. And as I said, by definition, those tend to be lumpy. Wealth Management, one of our stated objectives here has obviously been to improve our margins to get to more industry-leading margins. If you remember for a lot of time in ‘05, we had barely single digit margins. We have over the last several quarters had margins much better than that in the low double digits, so 11, 12%. 15% is probably a little higher than we’ve seen, but I think over time we have said that we want to have our margins improve and this is a demonstration of that improvement.

William Tanona - Goldman Sachs

Okay, that’s helpful. And then in terms of mortgages, obviously you’ve highlighted that as an area of particular strength. Could you give us a sense as to kind of the contribution of mortgages relative to the fourth quarter as it related to the increased 1% of the increase in thick had been in mortgages? And then also, could you give us a sense as to what your residuals might look like across mortgage and specifically subprime as it ended the quarter?

David Sidwell

I think the major point I’ve been trying to make, actually, is that if you look at our institutional businesses across equities and fixed income, it was really the breadth of performance compared with the fourth quarter. So looking at equities, all areas of that business were up, if you look at our fixed income, it’s the same thing. Within fixed income, when going down a little bit, the largest driver of the increase compared with fourth quarter was in credit markets and the residential mortgage business was a big part of that driver. As I gave a rough sizing of it, but I’m not going to break it down further into the actual contribution from that one business.

William Tanona - Goldman Sachs

Okay, that’s fair and then just on the residuals?

David Sidwell

Again, that’s part of the overall evaluation of that residential mortgage business, so I’d rather not just address one of the types of instruments that are a part of that overall business strategy, which includes many instruments.

William Tanona - Goldman Sachs

Okay. Thank you.

Operator

And our next question comes from the line of Douglas Sipkin of Wachovia. Please proceed.

Douglas Sipkin - Wachovia Securities

David, how are you?

David Sidwell

Fine, thank you, good morning.

Douglas Sipkin - Wachovia Securities

Two questions, one, obviously a very strong quarter for mortgage trading. Is it fair to say that the fact that you guys have acquired and now are a bigger player in origination that you had more insight into the market, do you think that helped position you the right way for some of the turmoil in the market?

David Sidwell

I think that we, across all of our businesses try and make sure that we understand where the opportunities are and where the markets are going. So, clearly that insight is obviously key when you think about running the business.

Douglas Sipkin - Wachovia Securities

Okay and then just non-investment grade commitments up 35% sequentially. Is that an indication that the private equity markets are still going to remain very strong, or is there something else in there accounting for that big jump?

David Sidwell

Yeah. One of the -- and I think this is an interesting follow-up to the discussion about the mortgage business. We also identified when we reviewed the strategy about 18 months ago that we were also underway in the leverage finance business, that this is a very significant part of the market, a lot of transaction flow has been in the leverage finance business, it is also very much linked to the financial sponsors part of the business that we want to be a leader in, so we’ve been very committed to building the business and this is really part of the continued buildup in our saying that we have good capabilities in terms of structuring transactions to now taking on the risk and distributing the risk as part of that build out.

Douglas Sipkin - Wachovia Securities

So I guess we should interrupt the big jump then as an indication that -- at least from these numbers that the private equity markets are still going to remain fairly active in the months ahead.

David Sidwell

We continue to see a very good backlog in terms of the amount of financial business around leverage finance. It continues to be a very good market environment.

Douglas Sipkin - Wachovia Securities

Okay, great. Thanks.

Operator

And our next question comes from the line of James Mitchell of Buckingham Research Group. Please proceed.

James Mitchell - Buckingham Research Group

Hey, good morning.

David Sidwell

Good morning, James.

James Mitchell - Buckingham Research Group

Can we just go over on the Asset Management business, you had quite a bit of net inflows improving the non-US components? Can you talk a little bit and give me a little more detail around what you’re doing there to drive that growth?

David Sidwell

I think we’re ultimately trying to build our business globally. It’s something that we see the opportunities not just being based in the US, so we are very committed to continue to build out the right product offering to attract through that channel.

James Mitchell - Buckingham Research Group

Now, is that a combination of retail and institutional, or mostly …

David Sidwell

Primarily institutional.

James Mitchell - Buckingham Research Group

And another question on Discover, it seems that obviously you guys, your expectations for loss rates this year have come down. I assume that’s -- if I do the math correctly, you’ve released some reserves to reflect that, I assume. Is much of that reserve number now, or because credit continues to look good we should expect perhaps more reserve leases going forward?

David Sidwell

Well I think we feel the -- and we keep saying this, I know, in terms of -- I think we expect that the environment is going to lead to a higher level of charge-offs, which is a big driver of the allowance and the reserve for credit losses. As I said, we think that our outlook is probably better than it was when I talked about it in December. And it really is reflecting the fact that when you look compared for instance with the fourth quarter, the charge-off rate is down to 4.05%, it was 4.15% in the fourth quarter. If you look at delinquencies, over 30-day delinquencies are 3.45% down from 3.51% in the fourth quarter. So the underlying trends continue to be strong. It’s just that we really do believe these trends; you would expect them to increase.

James Mitchell - Buckingham Research Group

Right, now I understood, well I guess my point is that obviously reserves also reflect expectations of future losses, and since you’ve changed that thought process, I was wondering if most of that change in thought process reflected currently.

David Sidwell

Most of what you’re trying to do with the reserves will actually reflect what you thought the losses are that you already incurred. So you’re not trying to project future losses.

James Mitchell - Buckingham Research Group

Okay, fair enough. Thanks.

Operator

And our next question comes from the line of Meredith Whitney of CIBC. Please proceed.

Meredith Whitney - CIBC World Markets

Hi, David, I have two quick questions, please. The first is, given the fact that you have beaten your own internal expectations for the deposit sweep; why not revisit your targets on the $20 billion in deposits by year-end?

David Sidwell

I think it’s more just a limit to what we can do. There’s just an absolute size limit based on the amount that our clients have in the money market funds, so I think that we believe 20 is a reasonable number. Can it be $1 billion or $2 higher than that, absolutely, but at the moment $20 billion is our best estimate.

Meredith Whitney - CIBC World Markets

Okay.

David Sidwell

You’re not going to see it double, for instance.

Meredith Whitney - CIBC World Markets

Don’t get too excited about one quarter’s results. My second question is, on your corporate loan book which grew pretty aggressively this quarter year-on-year.

David Sidwell

Yeah.

Meredith Whitney - CIBC World Markets

Is that because of your willingness to commit capital, a change in your willingness to commit capital, or is that because clients are increasingly demanding to have you commit capital? And then finally, if I look at the change in deal flow, you see a disproportionate growth at the top end in terms of market share accumulation by the firms who are willing to commit capital and invest in deals. Can you just comment on all that, please?

David Sidwell

Well I think that using your capital is important to the leverage finance business. Most of this is non-investment grade. That’s where most of the increase has been, and most of it has been bridge financing. So our expectation is that while we use our balance sheet at some point you are able to take it off your balance sheet and on average that has been several months and not longer than that. And I don’t think there’s anything we see about the current balance sheet which would say at this point we would expect it to be any different than it’s been before. So the objective here is to help clients structure deals and then as quickly as we can to distribute the risk, obviously through our expertise.

Meredith Whitney - CIBC World Markets

Okay. Thanks, David.

Operator

Our next question comes from the line of Ron Mendell of DIC. Please proceed.

Ron Mendell - DIC

I had a couple of questions; one was on the principal investment gains, the $800 million in institutional securities. I know you’ve mentioned that in your remarks, but I was wondering if you could elaborate a little bit more on that as to what was in there, what the prospects are, and also I think you made some related compensation comments.

David Sidwell

Yeah, let me do that a little more slowly. I apologize, if I rushed it. In this quarter, we changed the way we present a number of deferred compensation and current investment plans for employees. We used to net the compensation expense against the revenues. What we are now doing from the first quarter and we’ve restated all of the history is that we are now showing the revenues growth and the expenses in compensation expense and using institutional securities as an example, that added $237 million in the revenue line and as I said, that was largely offset in the compensation line.

Ron Mendell - DIC

And the $237 million was in the principal investing line?

David Sidwell

Yes. It’s actually -- yes, principal investing, a fair amount of it relates actually to gains in the real estate business.

Ron Mendell - DIC

Right and but even so, as you said everything was restated, so the 800 -- or I think you said that, right.

David Sidwell

Yeah.

Ron Mendell - DIC

So everything -- so everything -- so that $800 million still looks large relative to prior quarters?

David Sidwell

It is. And I would reiterate that these tend to be very lumpy that this was a very good quarter in terms of the real estate gains, specifically. And it will continue to be lumpy.

Ron Mendell - DIC

Okay. Then in regard to fixed income sales and trading, one thing I was taking away from your comments on the contribution that mortgages made was you took advantage of the volatility and basically what I took away was that you were short subprime very successfully, and I guess that’s possibly going to be very hard to repeat going forward since so much of the activity, although not all of it took place in that quarter.

David Sidwell

I actually don’t really want to address specifically how we were positioned, but I think the thrust of what you said in terms of the trading and hedging activity, I don’t think you want to model that in.

Ron Mendell - DIC

Okay. Thanks.

Operator

Ladies and gentlemen, we do have time for one final question. Our last question comes from the line of Mike Hecht of Bank of America. Please proceed.

Mike Hecht - Banc of America Securities

Hey, David. How you doing?

David Sidwell

Fine, thanks, and you?

Mike Hecht - Banc of America Securities

Pretty good, glad to be last. Just -- actually, a couple questions. Wanted to just follow up on the principal investing gains question, just to understand. When you guys report like sales and trading, fixed income equities, principal investing gains are not embedded in those numbers; correct?

David Sidwell

That’s correct.

Mike Hecht - Banc of America Securities

So there’s no real kind of guidance or color on the size or the investments you’re making there? I know it’s a place you’ve been looking to allocate some incremental capital and just thoughts on the ability to kind of harvest gains over time?

David Sidwell

I think I would just say at this point that this was a very significant quarter and it’s lumpy and our expectation would not be that this is a new trend level at this point in time. We’re still obviously in the investment phase of building out our principal investing with institutional securities as well as what would sharpen the Asset Management sector in terms of building the private equity business. As you know, we have really just started that effort; we started probably the right way of saying.

Mike Hecht - Banc of America Securities

Right, that’s fair. And I just wanted to get a little more color on the very strong results in equities. It sounds like its pretty broad-based, but I also noticed that the equity VaR was up a fair amount. So I’m wondering how should we think about that increase, is it really more business mix in terms of facilitating more or large block trades or doing more principally priced business on the cash business or non-US business, or really just more prop trading?

David Sidwell

I would say all of above. Not wanting to be few too flip.

Mike Hecht - Banc of America Securities

That’s fine.

David Sidwell

It was well distributed across as I’ve said the cash business, the derivatives business, financing, prime brokerage as well as our own risk taking, and it was not just US, it was in Europe and Asia, and we saw very robust growth in all of these regions. So, it was just a very, very strong quarter.

Mike Hecht - Banc of America Securities

Okay. And then you have it in your remarks, you guys picked up the servicing platform as part of the Saxon deal. Do you think that gives you an advantage in, as you might look to become more active in evaluating whether to purchase, subprime assets at attractive evaluations?

David Sidwell

We think, and we had talked about this in terms of our strategy of extending our footprint from smaller origination and securitization activity to having a fuller, more virtually integrated mortgage business. And obviously servicing capabilities are a very important part of that and depending on what happens in the subprime market could be a very useful capability. Okay.

Mike Hecht - Banc of America Securities

Just one last question on Discover. Looks like you had pretty good growth in transaction volume or net sales and also post network transaction volumes up nicely year-over-year. Any color on what’s driving that on both counts? Any new promotions that are going particularly well or new clients signed up?

David Sidwell

I don’t think there’s anything specific, this is obviously, these are trends that take some time to emerge and as you know we’ve been very focused on building our network and building the capabilities and to bring people onboard to use our networks and that effort will continue.

Mike Hecht - Banc of America Securities

Okay, great. Thanks a lot.

David Sidwell

Thanks, everyone. I guess that was the last question. Thank you very much and obviously if you have further questions, please call our Bill Pike and the rest of his team. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference call. This does conclude the presentation and you may now disconnect. Have a great day.

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