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Executives

Colm Kelleher – Chief Financial Officer, Executive Vice President & Co-Head of Strategic Planning

Analysts

Guy Moszkowski - Merrill Lynch

Prashant Bhatia - Citigroup

Glenn Schorr - UBS

Mike Mayo – Deutsche Bank

Ron Mendel – GIC

Guy Moszkowski – Merrill Lynch

Douglas Sipkin – Wachovia Capital Markets, LLC

Roger Freeman – Lehman Brothers

Morgan Stanley (MS) F3Q08 Earnings Call September 16, 2008 5:00 PM ET

Operator

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 webcast will be available through the company’s website and by phone through October 16, 2008.

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 date on which they are made which reflect managements’ current estimates, projects, expectations or belief and which are subject to risks and uncertainties which 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 and Part 1 Item 3, managements’ discussion and analysis of financial condition and results of operations and Part 2 Item 7, quantitative and qualitative disclosures about market risks, and Part 2 Item 7A of the company’s annual report on Form 10K for the fiscal year ended November 30, 2007 and other items throughout the Form 10K, the company’s 2008 quarterly reports on Form 10Q and the company’s 2008 current reports on Form 8K.

The presentation may also include certain non-GAAP financial measures. The reconciliation of such measures to the comparable GAAP figures are included in our annual report on Form 10K, our quarterly reports on Form 10Q and our current reports on 8K 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’d like to turn the program over to Colm Kelleher for today’s call.

Colm Kelleher

What we are seeing is unprecedented in terms of turmoil in the financial services industry. This quarter in an environment marked by unprecedented ongoing challenges and serious dislocation, Morgan Stanley achieved a return on equity of 16.5%, diluted earnings per share of $1.32 and the third consecutive quarter of positive book value growth. As stated, we made further progress in reducing our balance sheet leverage and continue to run high levels of liquidity while maintaining surplus capital. Our Tier 1 ratio this quarter is expected to be approximately 12.7%.

The third quarter was extremely challenging with a macro environment characterized by continuing illiquid markets compounded by a distinct fall off in client flows. We have strength across many of our industry leading businesses including prime brokerage, equity derivatives, equity underwriting, foreign exchange and commodities. Therefore, we are very confident that Morgan Stanley with its global diversified business and client franchise is well equipped to deal with the environment we are in and the future environment as it unfolds.

Let me give you some examples of what we have done. When we realized we had a proprietary position gone wrong in the fourth quarter of last year we moved immediately to market appropriately, take our losses, execute trades and manage the position down. Since then we have disclosed our exposures and tried to give you as much granular information to understand our marks across areas of interest to you. We are confident with our marking policy calibrated in the first instance to executed trades and where that is not possible to other relevant factors we can point to.

As we have all learned, the best way to deal with troublesome assets is to reduce the growth size by sale where possible and again we will show continued progress in the reduction of exposures and overall leverage since the third quarter of last year and on an ongoing basis. The broker/dealer model is the subject of much debate and its viability has recently been most eloquently espoused. I will only add that we believe in the diversified business model of an investment bank and its ability to adapt to different environments. This has been proven over the cycles. Let me also add at this point very clearly that depository institutions do not necessarily better enable us to execute our business and in fact may bring with them their own set of complications.

Let me begin with an overview of our firm-wide results outlined on pages 1 and 2 of our financial supplement. I want to reiterate, we have a great deal of confidence in the Morgan Stanley business and brand, what we have accomplished and what we will do in the future. We generated net income of $1.4 billion, diluted earnings per share of $1.32, and a return on equity of 16.5%. Firm-wide net revenues were $8 billion and BVT margin was 24%.

Non-interest expenses were $6.1 billion up 20% from the second quarter largely driven by higher compensation. Non-compensation expenses were $2.4 billion up 14% from last quarter driven by an auction rate securities provision on the operating results at present, both of which are predominantly reflected in other expenses. We continue to accrue compensation based on our earnings level on assessment of the market. Our year-to-date compensation ratio is 47%.

I would like to highlight two items that affected our revenues this quarter and to point out that even without them we had solid revenue growth in our core business.

First, as you know this quarter we sold an additional portion of our investment in MSCI through a secondary offering that resulted in a $745 million gain. Second, institutional securities results included approximately $1.5 billion of revenue for the widening of credit spreads on firm issued structured notes of which $941 million were recorded in fixed income and $509 million in equity.

Exclusive of these items in both quarters and the gain from the sale of the Spanish wealth management business last quarter, our revenues increased 19%. That solid revenue growth even in these difficult markets clearly underscores the breadth and depth of Morgan Stanley’s underlying client franchise. This strong revenue growth included net losses of $1.3 billion related to trades and write-downs of legacy positions including mortgage-related assets, monolines and leverage lending.

In addition, last month we announced our intention to repurchase at par approximately $5 billion of auction rate securities held by retail accounts of the firm. This has resulted in a provision of $288 million for the estimated difference between the purchase price and the market value of these securities at the date of purchase and other losses. This amount was almost entirely recorded in global wealth management.

Now please let me turn to the businesses. Starting with institutional securities detailed on page 5 of the supplement, net revenues of $5.9 billion which included the revenue in all structured notes and gain from MSCI was 63% higher than the second quarter. Excluding these items from both quarters, revenues increased 34% of strong results in investment banking and equities and significantly improved results in fixed income. Non-interest expense of $3.7 billion increased 27% from the second quarter of 08 predominantly reflecting an increase in compensation. However, on a year-to-year date basis we are accruing at levels below last year. Pre-tax income was $2.2 billion. Our return in equity in this sector was 29%.

In our investment banking segment we increased revenues across all categories despite subdued market volumes. Looking at page 6 of the supplement, investment banking revenues were $1 billion up 18% from the last quarter driven by higher revenues in equity and fixed income underwriting. During the quarter we advised on several important transactions including Verizon Wireless’ acquisition of Alltel and Dow Chemicals’ acquisition of Rohm and Haas. Significant underwriting transactions included the European rights offering for UBS, [HBOS] and Imperial Tobacco as well as Rio Tinto’s issuance of investment grade debt, the largest ever investment grade issuance out of the metals and mining sector. We are also honored to be advising the US Treasury of strategic alternatives for Fannie Mae and Freddie Mac and view this as a testament to the strength of our investment banking franchise.

Our pipelines are broadly unchanged from last quarter and continue to be healthy. We are maintaining high levels of strategic dialogue with corporate clients and financial sponsors alike. We are well positioned to take advantage of client activity as it returns to the market.

Advisory revenues of $401 million increased 9% from the second quarter while it strengthened the US and Asia although overall M&A volumes remain subdued. Underwriting revenues increased 24% to $631 million. Driven by our participation in the majority of the European financial rights issuances, equity underwriting revenues of $379 million were up 27% from last quarter. Fixed income underwriting increased 20% to $252 million reflecting higher revenues from lower than non-investment grade issuance as well as improved results in securitized products which were partially offset by slowed investment grade issuance in the quarter.

Page 6 of the supplement shows total sales and trading revenues of $4.2 billion up significantly from last quarter across both equity and fixed income sales and trading. In equity sales and trading we had our second best quarter with revenues of $2.7 billion, 27% higher than the second quarter of 08. Results reflected continued strength in prime brokerage and derivatives partially offset by seasonally lower commissions. Prime brokerage reported record revenues this quarter with average customer balances essentially unchanged from last quarter. Derivative revenues were flat to last quarter as better trading opportunities driven by volatility were offset by the absence of seasonal revenues. Cash equity revenues declined 16% from last quarter on seasonally lower activity levels.

Total fixed income sales and trading revenues were $1.9 billion as revenues increased across nearly all major categories. Commodities increased 164% from last quarter and were near the solid results we reported in the first quarter. Strong customer flows and an increasing volatility throughout the sector led to broad based strength.

Interest rate, credit and currency trading revenues combined were up 29% from the second quarter on higher client flows. Interest rate products were up on strong volume and currencies had a strong quarter benefiting from increased customer flows and volatility with favorable positioning. Credit trading reported positive results compared to a loss in the second quarter. Better results reflected higher customer activity levels and favorable positioning as credit spreads widened during the quarter.

Losses related to monolines were $362 million this quarter. Now aggregate and net direct exposure to monolines remain close to last quarter at $2.7 billion. The net exposure includes $800 million of ABS wrap bonds held by our subsidiary banks, $1.5 billion of insured municipal bond securities, and $400 million of net counter-party exposure representing gross exposure of $5.5 billion net of hedges and cumulative credit valuation adjustments of $2 billion.

A significant increase in our gross counter-party exposure reflects the current credit environment impacting the monolines. We are managing this counter-party risk through a hedging program that utilizes both credit default swaps and transactions that effectively replace the potentially impaired component of underlying transactions as well as credit valuation adjustments.

Significant deterioration in European mortgage fundamentals and continued losses in the US ALTA residential mortgage market drove losses in mortgage proprietary trading of $640 million. We provide increased disclosure on pages 16 through 18 in our financial supplement.

On page 16 of the supplement our total ABS CDO subprime net exposure is now zero and net write-downs of $200 million. You’ll see on page 17 of the supplement that we reduced our net exposures to non-subprime residential mortgages to $6.5 billion from $6.7 billion. Our gross exposure was $10.9 billion at quarter end down from $12.4 billion last quarter. We continue to reduce our ALTA and UK loan exposures through a combination of executed trades and marks. Our ALTA exposure was reduced to $2.2 billion and our UK mortgage loans were reduced to $1.5 billion from $1.9 million during the quarter. Net losses in nonprime residential were $600 million.

Our CMBS commercial home loan portfolio is well positioned across the regions. On page 18 of the supplement you can see that we increased our net exposure to $7.7 billion from $6.4 billion while our gross exposure declined to $19.5 billion and $22.1 billion. Talking through this, this is driven by decreases in CMBS backed warehouse lines which was reduced in the supplement to $1.6 billion from $1.9 billion. Commercial loans which decreased to $4.6 billion from $6.3 billion and other secured financing which is reduced to $4.2 billion from $6.1 billion. These reductions were partially offset by an increase in our gross exposure to CMBS swaps which ended at the third quarter at $3.3 billion up from $2 billion last quarter.

Now whilst we continue to manage down our commercial loan and warehouse line exposures reducing this net exposure $2.1 billion this quarter, we are also acting on opportunities to take directional positions because of widening spreads and volatility. That is why we give this level of disclosure so you can follow these categories. We recorded a net gain of $200 million in this portfolio.

Other sales and trading revenues were -$410 million this quarter primarily driven by net losses of $272 million in our lending businesses which include leverage acquisition finance and relationship lending. These net losses reflect negative market movements and write-downs of $724 million offset by effective hedges. Our leverage acquisition portfolio is now $9.3 billion down from $12.7 billion last quarter as you can see in the footnote on page 7 of the financial supplement.

During the quarter we added $3.5 billion of new commitments and had $6.6 billion in reductions. Included in the reductions are $3.4 billion of sales to third parties where we provided senior secured funding of $2.6 billion. I committed to you that were we to provide financing under these trades, I would inform you of that.

The retained senior debt securities are included in our relationship lending portfolio. Also included in other sales and tradings are investment portfolio losses of $108 million from our subsidiary banks.

Total average trading and non-trading VaR increased $128 million from $112 million last quarter reflecting an increase in non-trading VaR. This was primarily driven by our lending book as we closed the remaining pipeline of deals early in the quarter. Non-trading VaR at year-end was lower than the average on the subsequent sale of the loans. Average trading VaR was flat to last quarter at $99 million as reductions in commodities and foreign exchange were offset by slight increases in equity and interest rate categories.

Turning to capital and liquidity. Obviously given the volatility of the markets we remain very focused on maintaining a strong capital position, high levels of liquidity and prudent leverage ratios. Page 4 of the financial supplement highlights our current capital position. We continue to be well capitalized with excess capital. Whilst we are still in the process of finalizing our Tier 1 ratio for August, we expect to report a ratio in our 10Q filing next month that will be approximately 12.7%. This increase was driven by retained earnings and stable risk-rated asset levels which we continue to maintain.

Looking ahead we are well positioned to continue investing in our businesses and take advantage of potential market opportunities.

We continue to strengthen our liquidity position in the quarter and actively managed down positions requiring significant cash funding and reallocated the balance sheet liquid assets with significant two-way cost in the flows. Total liquidity which includes liquidity at the parent company, bank and non-bank subsidiary levels was $179 billion at quarter end and averaged $175 billion in the quarter up 30% from the $135 billion average last quarter.

Parent company liquidity was $77 billion at quarter end and averaged $81 billion up from an average of $74 billion in the second quarter. Banks and non-bank subsidiaries liquidity position was $102 billion at quarter end and averaged $94 billion in the quarter versus an average of $61 billion last quarter.

Because of higher levels of liquidity we’ve further reduced our commercial paper outstanding to $7.8 billion for this quarter end down $4.5 billion from last quarter. Due to significant spread widening we chose not to issue long-term debt in the public markets, and as I mentioned last quarter we’d already covered our 2008 financing needs. However we did issue incremental non-public structured notes at attractive pricing levels.

Our overall liquidity planning and financing capabilities continued to work successfully. We are obtaining term, broadening the collateral categories that existing and new parties will accept, retaining stability and haircuts and collateral schedules as well as diversifying our regional scope.

The weighted average maturity across all asset classes in our repo and stock lending books was over 40 days at quarter end which is unchanged from last quarter. To be clear, when we provide you with weighted average maturity we include all secured financing mechanisms or trades; for example repos, security loans and collateral upgrades across all financial asset classes including fixed income products, equities, capital commitments and other receivables are structure products. In other words, the full spectrum of everything that is funded in our secured funding books. At the end of the third quarter the total notional amount of all secured financing was $311 billion and a relatively small portion 22% of this is overnight.

The most difficult to fund non-central bank eligible assets which includes capital commitments and other receivables represents roughly 10% of our funding needs and had a weighted average maturity of greater than 90 days.

We are managing our balance sheet prudently and further reducing both total and adjusted assets during the quarter. Our discipline in maintaining an appropriately sized balance sheet in today’s environment along with our strong capital position has brought our total leveraged ratio down to 23.5 times from 25.1 and our adjusted leveraged ratio down to 12.9 from 14.1 at the end of the second quarter. Our strong capital position, high levels of liquidity and lower leverage enables us to take advantage of market opportunities.

Given the current market dynamics coupled with the significant reduction in our balance sheet, our level three assets increased to approximately 8% of total assets at August 31.

Now turning to page 8 of the supplement and our global wealth management business. The Business supported a pre-tax loss of $34 million including a provision of $277 million relating to auction rate securities. Excluding the divestiture gain last quarter, revenues decreased 9% sequentially on lower new issuance activity but increased investment banking and principal trading revenues primarily in fixed income. Fees were flat despite lower market levels while commissions fell 6% on slowing transactions volumes. This business continues to provide us with a source of stable recurring revenues.

Non-interest expense increased 10% from last quarter including the provision related to auction rate securities. Away from the provision, non-interest expense decreased on lower compensation and professional services expenses. Without the auction rate securities provision, PBT for the quarter would have been $243 million and PBT margin was 16%.

On page 9 you can see the productivity metrics which continue to highlight the underlying strength of this business. Net new assets of $13.7 billion represented our 10th consecutive quarter of positive client inflows and our second highest ever. Total client assets decreased 4% from last quarter to $707 billion reflecting lower market levels partially offset by net new assets.

RFA headcount increased 2% from the second quarter to 8,500. RFA levels are now higher than they were before last quarter’s divestiture of our Spanish wealth management business. We continue to successfully recruit high-producing FAs and year-to-date we are seeing record recruiting volume and record low FA turnover. We are net positive both in the number of FA hires and trailing production of these hires across all our major competitors. Both revenues and assets per FA declined modestly driven by the greater number of financial advisors and lower revenue and asset levels.

Our bank deposits grew to $36 billion as clients continue to keep assets in cash due to the volatile markets.

Let me turn to asset management on page 10 of the supplement. The business reported a pre-tax loss of $204 million. Revenues were up 33% from last quarter to $647 million though this business continued to be negatively impacted by the difficult operating environment. Losses associated with negative marks in our merchant banking portfolios, private equity infrastructure and real estate namely were lower than last quarter. Losses of structured investment vehicles held in our balance sheet were significantly lower than last quarter and had minimal impact this quarter.

As we disclosed last quarter we now consolidate Crescent our real estate subsidiary within asset management which added $85 million in net revenues. These are the primary drivers of our revenue growth which were partially offset by slightly lower management and administration fees driven by less favorable asset mix at a lower average asset balances. Non-interest expenses of $850 million increased 19% for the second quarter primarily driven by the operating costs for Crescent partially offset by lower compensation.

Asset management continues to operate in difficult markets and our merchant banking business is clearly subject to market conditions. This year the primary driver of the decline in revenues is the negative marks of the real estate portfolio compared to the significant gains reported last year, the lower marks in seed investments, lower performance fees, and losses associated with [siffs].

Aside from Crescent our total real estate net exposure which includes direct investments in our real estate, private equity and infrastructure funds was $4.1 billion as of the end of the quarter. This exposure does not include the assets included in investments for the benefit of employee compensation or co-investment funds.

Turning to pages 11, 12 and 13 of the supplement, you can see the assets under management and asset flow data. Total assets under management decreased 6% to $570 billion primarily due to the market impact in equities. We did generate $1.6 billion in positive flows in the quarter. While flows continue to be positive in our non-US and US institutional channels, our retail in US institutional channels recorded outflows this quarter. The retail business continues to be a major focus and we are committed to improving our performance in this space.

From an asset class perspective, there were $1.2 billion of inflows into core with international money markets driving inflows into fixed income. Alternative products also recorded positive inflows. However we experienced outflows in equity products. Inflows into merchant banking products were $400 million in the quarter.

Despite our losses this quarter we are committed to investing in this business as we see many long-term growth opportunities in the asset management area. The turnaround for this business will take some time.

The issues we are facing are compounded by the current environment. We are keenly focused on improving performance and have hired new talent and made organizational management changes. We are also focused on enhancing and utilizing all our distribution channels. In merchant banking our strongest franchise real estate is at the weakest point in the cycle. However we continue to attract capital for new funds. In private equity and infrastructure we also continue to attract capital and these businesses are currently in investing mode.

The market environment continues to present many challenges for our asset management businesses but we are confident that we can drive this business to competitive advantage when markets improve.

On page 3 of the supplement you can see the regional revenue disclosures at the firm-wide levels. This quarter 42% of our revenues were international with 32% in Europe, the Middle East and Africa, 10% from Asia, and 58% came from the Americas.

As you know we suspended our buy-back program at the end of last year. We continue to evaluate this program in light of market conditions. As of August 31, 2008 we did not repurchase any shares of common stock this fiscal year as part of our capital management share repurchase program. On September 8, 2008 our outstanding share count was reduced by 24 million shares in connection with employee tax withholding obligations resulting from the conversion of certain restricted stock unit awards previously granted to employees to common stock. I am reserving the right to restart my share repurchase program.

Now a few words on the outlook, this is clearly the most challenging market environment we have seen. Whilst we expect severe cyclical challenges in the short term, we remain very positive on the secular story. As you know, we’ve been cautious of the markets and our view has not changed, and we believe the remainder of the year will be challenging especially in the light of recent events. This is why we have consistently focused on reducing our exposure and legacy assets and maintaining surplus capital.

We have been working with a consortium of commercial and investment banks on a series of initiatives to help stabilize financial markets and provide additional liquidity if needed. These include among other measures: Working cooperatively to ensure that Lehman’s positions and derivative exposures are unwound in an orderly and fair manner and establishing a collateralized borrowing facility of at least $70 billion that will be available to members of the consortium to provide additional liquidity. In addition, the Fed is also adding more liquidity to the market by expanding the primary dealer credit facility and making other rule changes, significant changes.

Investor sentiment remains negative which directly impacts trading volumes and client flows. While the US economy continues to be sluggish, the downturn is beginning to spread to other parts of the world. Macroeconomic uncertainty will continue to put pressure on emerging market economies. We do not expect the volatility in the market to subside until at the very least the mortgage market, ultimately the housing market, stabilizes.

We believe this environment provides us with the opportunity to invest in our core businesses. We are adding new talent, investing in technology and expanding internationally. We have a tremendous opportunity to gain clients and market share. Our pipelines remain healthy, and while monetizing them near term may be challenging, strategic dialogues continue at high levels. The drivers of secular growth, globalization, disintermediation and alternative asset pools are intact.

Morgan Stanley is well positioned to giving our leading client franchise global diversification and a strong balance sheet.

By way of summary so that you understand the Morgan Stanley view, our business and our brand, we are navigating through this unprecedented environment. We have done it and we will continue to do it in the future.

Thank you. I will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Guy Moszkowski - Merrill Lynch.

Guy Moszkowski - Merrill Lynch

I really just want to ask you about this issue that everybody’s so concerned about the funding viability of the independent broker dealers. Viability is probably too strong a word to use but obviously spreads have gapped a lot. You did allude to that in terms of executing your funding program just this quarter. How do you trade off the cost of funding that you’re seeing in the market relative to the desire to grow or not grow the balance sheet, and all of that obviously in the context of the fact that you’ve been bringing down your balance sheet pretty significantly over the last 12 months anyway?

Colm Kelleher

The good news Guy is that we pre-funded. So we don’t have to issue for the rest of this year and frankly I can delay issuance in 2009 by a significant amount too. The issue here is I don’t believe these unsecured funding levels are sustainable. Now I don’t know where they’re going to end up but I’m absolutely convinced that when the fear comes out of this market and confidence returns, you’ll get a much more sensible funding level. At that stage I think it’s about fundamental credit analyses of the institutions you’re buying into, which is why we are trying to disclose more so you understand the basis of our credit and the risk associated. So I do believe that unsecured funding returns. I do believe it will be at sensible levels. When we actually work out what those levels are that clearly will have an impact on how an innovative and let’s be honest responsive investment bank will respond in that environment.

Guy Moszkowski - Merrill Lynch

That’s fair. Maybe we can go to a more granular question. Maybe you can walk us through how the major hedges that you use in for example your commercial real estate activities and other areas where you have used hedges, how they performed for you during the quarter relative to what we saw last quarter?

Colm Kelleher

They performed relatively well. As you can see from the schedules we’ve given, we’ve not had any asynchronist behavior from the hedges. Obviously in some areas we find hedges are not effective and we manage the risk appropriately more often than not by selling the exposure, but I think the schedules will show that we haven’t had this. Clearly CDAs we’ve taken off significantly in the quarter and that’s the cost of doing the business, but I have no issues with the way our hedges have performed.

Guy Moszkowski - Merrill Lynch

And finally, just on the subprime disclosure where obviously it does net to zero at this point and it’s a little bit of a riff on the last question. We see that at zero and yet obviously that is the result of a netting. Can you give us a sense for plus or minus what you think is a reasonable expectation that we might see in further losses ahead?

Colm Kelleher

I think what you need to look at is we’ve clearly written down the residuals. They’ve thrown off some cash still. We’ve got the super senior subprime CDO which is there, which is significantly down from I think the $14.3 billion we originally showed. The valuation range, it’s all very much marked in the low teens. So frankly I think that that pretty much exhausted. We may get some recovery in the earlier vintages but my view is that it’s become a non-issue.

Operator

Our next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

Just on Lehman and AIG, any color on the exposures to those two?

Colm Kelleher

Sure. As you know we do collateralized dealing. On margin our exposure is not material in terms of income and it’s as simple as that.

Prashant Bhatia - Citigroup

So not really a big deal there?

Colm Kelleher

No big deal.

Prashant Bhatia - Citigroup

On the retail brokerage side, I guess we’ve never seen a situation where you have potentially 16,000 financial advisors in flux. Is there an offensive plan here to try and capitalize on the situation?

Colm Kelleher

There most definitely is and we’re clearly getting a lot of phone calls and we’re very comfortable about that given our even in these turbulent times, so we feel very optimistic and very positive about the outlook for the growth of that business.

Prashant Bhatia - Citigroup

On the prime brokerage side, it looks like the record revenues even coming off of seasonally strong last quarter, how much of that is share gain versus pricing? Can you shed any light on that?

Colm Kelleher

Pretty much pricing to be honest; not share gain. Frankly given our balance sheet and so on, I’m kind of comfortable with the size of our balances where they are. So I think as I said to you last quarter and indeed the quarter before, we’re looking to pricing power and we’re looking to good partners in that business and that’s the way we’re going to view it. It is certainly not a market share strategy.

Prashant Bhatia - Citigroup

The $1.4 million in write-ups on the debt side, is there any change in methodology there? It didn’t look like the spreads had gapped up that much more than the past.

Colm Kelleher

No. I think what you’ve done is you’ve underestimated the duration of that debt. We actually have a longer duration of that debt than the analysts have given, which is actually a good thing. To be honest with you I’d rather our debt wasn’t gapping out because it’s a distraction.

Prashant Bhatia - Citigroup

You touched on it a little bit on the need for bank deposits and the perception around the necessity to have these deposits. It doesn’t seem like you’re necessarily in that camp. Could you just talk about your $36 billion in deposits that you had?

Colm Kelleher

Sure. It’s a good thing to have. It’s a nice thing to have. It’s part of the service for our retail business. And obviously that is pretty much in proportion to the number of brokers you’re going to have. So I think it’s an alternative funding source which we like but I go back to my issue of depository institutions are not key to our strategy.

Operator

Our next question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

When you mentioned the Crescent and when you mentioned the revenue impact, did you mention any marks related to them in the quarter?

Colm Kelleher

No, if you remember we had accumulative marks up to the end of the second quarter, $300 million. At that point, we said we were consolidating it, as part of the consolidation we clearly had external valuations checked, brought it in and as you know it was fully consolidated. At August 31 we have real estate properties of $4.3 billion but against that we have secured financing of $3.3 billion so that’s the way you should think about present.

Glenn Schorr - UBS

You reduced your exposures, have a lot of liquidity, you have the highest Tier 1 in the group but there still is the 30 or 40, depending on which you count, of growth exposure come down some. I’m going to combine and make it a long question because they’re really interrelated. I wanted to get the average marks if you could on some of the bigger positions in commercial and residential and then [inaudible].

Colm Kelleher

Sure. I’m glad you asked that. Despite not liking to use averages due to the wide disparities of value across vintages and ratings, let me say the following regarding some of our key exposures. On average, a weighted average, CMBS bonds are marked to the low 70s, the US, the average is 66, the UK the average is 87. We continue to trade and observe marks through trading. Senior commercial loans are valued in the high 80s to low 90s, mezzanine commercial loans are marked in the mid 70s, ALTAs are marked in the mid 30s, US & UK residential loans are valued in the mid 80s. Just to let you know post quarter end, we continue to make sales and prove those marks. Subprime ABSCDO mezzanine positions are marked in the low teens and our leverage finance portfolio is valued in the mid 80s and as you know we did reduction trades there which valued our marks as well. Hopefully that’s helpful.

Glenn Schorr - UBS

Now, on Slide Four I think you mentioned you had $7.1 billion of unallocated capital. You took down the capital at the investment bank, just a little geography there but it’s interesting because people are obviously begging for deleveraging, you did some but you also dangled the carrot of potential buybacks. In this environment, with your CDS spreads hitting almost quadruple digits, do you use that unallocated capital and big Tier 1 ratio and big capital ratio to bring down leverage some more even though it’s an inefficient and inaccurate measure of [inaudible].

Colm Kelleher

Glen, I’ve got reserve optionality. I mean, frankly I clearly believe in my book value. There are some people out there who don’t so we’re going to manage in the benefit and interest of our shareholders accordingly. So, I have a number of options I can do and I will pursue those given the strength of our capital position not just on a regulatory capital which you see but also on our economic capital market model which, as you know, as we’ve gone through with you, is a pretty conservative model. I have a number of options.

Glenn Schorr - UBS

Last one, this is an easy one, do we care about really wide CDS spreads in the short term? I mean we care about much wider funding costs on the debt chart in the long term but as you said, you don’t need to fund now so in the short term –

Colm Kelleher

I mean I care that it could be contagion and you’ve got fear in the market and a lack of confidence. It is clearly – and certain peoples are focusing on CDS as an excuse to look at the equities and my view is look we need these markets to normalize, what we need is confidence. We are confident, the regulators are doing a lot and frankly I believe this nonsense will end.

Operator

Your next question will come from the line of Mike Mayo – Deutsche Bank.

Mike Mayo – Deutsche Bank

I think I know the answer to this but why did you report early tonight and what did you want to highlight the most?

Colm Kelleher

I wanted to highlight the strength and robustness of Morgan Stanley, its diversification and its strengths. I want to have a building block in a bridge to rebuilding confidence in this market where things are frankly getting out of hand and ridiculous rumors are being repeated, some of which if I wrote down today and reread tomorrow I would probably think I was dreaming. That is exactly why we’ve reported Mike, because I think it’s very important to get some sanity back in to the market.

Mike Mayo - Deutsche Bank

But let me go along those lines. So to the extend rating agencies say capital could be fine and liquidity could be fine but they could still downgrade based on market sentiment if it impacts funding. How can you protect yourself against that potential outcome?

Colm Kelleher

Look, it’s an interesting debate. It’s not an override. I think my issue is to reach out to our investors, our customers and explain what we’re about, right? At some stage, people are going to have to make that decision for themselves and so far we are getting a very strong vote from our customers and our real investors. So look, talk to the rating agencies.

Mike Mayo - Deutsche Bank

Well, I guess the, is 12.7% Tier One the right number? I know there’s no right number but does Morgan Stanley need to have significantly higher capital levels through the cycle as a result of current events?

Colm Kelleher

Look, I think when the dust settles, we’re going to look at what funding costs are, what the risk adjusted return is on certain businesses. Frankly, I think we need normalized markets to meet those decisions and the great thing about the investment banking model is that it is very adaptable to making those decisions. So we’ll deal with it then and I’ll have a better idea at the moment. I’m very much in the situation of maintaining strong capital, strong liquidity. I keep my leverage down.

Mike Mayo - Deutsche Bank

Let me get into the more mundane questions, at least relatively. Revenues, commodities had a great quarter. Proprietary trading and equities did really well. How do you feel about the ability to repeat those or your outlook for some of those revenues?

Colm Kelleher

Look, one of the unfortunate consequences of what’s happened in the market is that’s clearly some of our competitors are impaired or distracted or gone. And I think barriers to re-entry of them be very high in this business for some of the reasons you’ve said. So I feel incredibly confident that when normal markets return with strong customer flow, we are going to be incredibly well-positioned.

Mike Mayo - Deutsche Bank

I guess I was thinking of commodities. Commodities have come down a little bit here.

Colm Kelleher

Yes. But the way, I think there’s a misunderstanding on the way we trade commodities. We tend not to trade from the directional basis; we tend to trade from a relative value basis, Mike, based very much on strong cost or input.

Mike Mayo - Deutsche Bank

Lastly, non-U.S, it’s been a big growth focus. You mentioned it’s slowing some. Are you allocating relatively less capital outside? Are you slowing hiring? What are you doing in response?

Colm Kelleher

No, not at the moment but I do think we’re not allocating less at the moment. But let’s be honest. We think the smart thing to do here is to hire some great talent and we started doing that, some of which you know about and that is global. But we’ll also have an opportunity to hire some superb talent in the U.S.

Operator

Your next question comes from Ron Mendel – GIC.

Ron Mendel – GIC

Question I guess relates to, you referred several times to when markets normalize and so on and we all know the old saying about how long it can take markets to normalize versus our patience, and so on. And so I guess looking at your credit default slots and the investment banking model is really built for credit defaults slots spread to be, I don’t know, maybe under 100 or under 200 but apparently considerably less than they are now. So I guess what I’m wondering is what is plan B if it does take longer to normalize and how your business model might change in dealing with that.

Colm Kelleher

Well, Ron, the issue is I don’t think you can make that decision yet. If we have a systemic change in the model because of funding, we will change our allocation of capital resources and size the sheet accordingly. We have been through various changes in the cycle to do that. But at the moment –

Ron Mendel - GIC

What are some of the changes that you’ve made so far that might be a guidance to what we might –

Colm Kelleher

Well, you would clearly reduce your balance sheet and you would take away from the capital intensive businesses or more capital intensive business but frankly, we’re not about position at the moment. I think it’s far too early to know. What we’re certainly have been doing a much better job of is focusing on businesses that are on risk adjusted basis, give us a better return so we’re already been pulling away from certain businesses and you’ve seen that.

But frankly, to talk about funding levels here or how that’s going to affect our business at the moment, I don’t know the answer but I’m pretty sure that we will return to a more normal level of funding and at that point, we will address the issues of what the competition of our balance sheet is and how and we allocate capital.

Ron Mendel - GIC

Yes. I guess my concern is that, I’ve been saying, if it takes longer than expected then you need to maintain very high levels of capital and high levels of liquidity which then have the potential negative effect of reducing profitability. So I guess I’m just worried about being proactive to make sure that it doesn’t get to that point.

Colm Kelleher

Well, we clearly are very proactive about, Ron, and we’ll stay in touch on it, yes?

Operator

Your next question comes from Guy Moszkowski – Merrill Lynch.

Guy Moszkowski – Merrill Lynch

Colm, I just wanted to come back to the capital issue, specifically with respect to Tier One and the, I guess you’d call it, an exposure draft that the BIS has out for comment by mid-October, looking at reweighting RWA to put more weight on market risk assets and I was wondering if you had any comment on that and if you’ve done any work to try to quantify the impact on yourselves.

Colm Kelleher

Well, we have reviewed the new BIS standards which, as you said, regarding incremental risks and credit products within our training book and we’ve clearly been talking with the SEC about these. We’re not sure, in fact we’re pretty sure that these will not have a material impact on our own capital reporting given our own economic capital model anyway.

But one of the things that I have been convinced about, Guy, and I’ve spoken to you before about is that in this environment, you will need to put up more capital against various parts of your trading book and that comes back to the issue of risk adjusted returns and how you allocate capital. And I feel pretty comfortable that we can react accordingly in that.

Guy Moszkowski – Merrill Lynch

But you don’t see all, that you’ve already essentially incorporated that, is that if you feel you’re going to need to do more, you’re not doing it yet.

Colm Kelleher

No, no, no. Well, we certainly incorporated that, which you refer to but generally, I think that if you were looking forward, you’ve got to assume that certain trading books will attract more capital charge and when that happens, you’re going to have to deal with what that means. And one of the reasons I’ve maintained such a large capital surplus is to deal with potential regular exchanges.

Operator

Your next question comes from Douglas Sipkin – Wachovia Capital Markets, LLC.

Douglas Sipkin – Wachovia Capital Markets, LLC

Just wanted to follow up a little bit more on the wealth management segment because I think Prashant alluded to it. Just feels like there’s a great opportunity for you guys, especially the business with the traction it’s gaining recently. I guess I just wanted to ask a question around how the compensation structures are changing for hiring brokers. Just looking to get a range of what you guys are have to paying over the last trailing 12 months and how that’s progressing downward or upward over time. How should we be thinking about that?

Colm Kelleher

Well, it’s not changing at the moment and I don’t want to get into more detail than that. But suffice to say that James and Ellyn McColgan are very excited. We’re getting a lot of incoming calls, top quality people and we feel very, very positive like you do about that business. So I think people are attracted to the Morgan Stanley brand and franchise. They like the nature of this business and the actual stages of ours as an independent investment bank so we get a lot of income. And as you can see, we’re beginning to hire quite aggressively.

Douglas Sipkin – Wachovia Capital Markets, LLC

The next question is just an extension of, I think, what a couple of the other analysts have talked about. Obviously, it’s a panic stricken environment, CDS market, etc. And I know the decisions to buy back stock are in your control. I see in the aftermarket, your stocks at about $28.20, your book value is $31.25 and I know you guys believe wholeheartedly in your book value and I’m not implying that something needs to be done now given the precarious state of the markets but in your viewpoint, that balancing act, is that becoming more possible if the market stabilizes, if the stock stays here below book value?

Colm Kelleher

I am preserving all options in the interest of the shareholders so I will keep a very close eye on it.

Douglas Sipkin – Wachovia Capital Markets, LLC

Finally, any color on how you guys are positioning yourselves to potentially take advantage of what’s likely to be a lot of distressed selling over the next couple of months? I know you guys have done a good job reshifting your balance sheet to maybe exploit opportunities so you can see yourself being aggressive in that stance or you guys are still working through legacy exposures that you still want to be careful?

Colm Kelleher

No, I don’t think we’re working through legacy. My view is we look at risk adjusted returns, right? You can clearly see in CMBS, we’ve taken on that exposure up a bit. We see value there and that’s why we continue to give you more disclosure. But look, on a risk adjusted basis we feel we have the ammunition and fire power to take advantage of these markets. Some of these prices, frankly, have got to silly and irrational levels so we’re going to have the ability to take advantage of that, the markets continue to down trade. Now, I believe in an inflection point in certain asset classes so we’ll see, yes?

Douglas Sipkin – Wachovia Capital Markets, LLC

Finally, I know you guys have done a good job on the leverage side bringing down the assets. It just feels like the market, and for better or worse and for right or wrong, wants to see that leverage ratio lower. Any thought to, and I asked this on your competitor’s call this morning, any thought to potentially just doing something to calm the market? I think at this point, the mark would probably look favorably upon it.

Colm Kelleher

Like what?

Douglas Sipkin – Wachovia Capital Markets, LLC

In terms of shrinking the leverage with more equity.

Colm Kelleher

You know, I’m not second guess this market. This market is a very strange market so I think we’re comfortable where we are and we’re just going to continue to disclose and be as transparent as we can be.

Operator

Your last question comes from Roger Freeman – Lehman Brothers.

Roger Freeman – Lehman Brothers

I guess I heard your comments with respect to the feedback loop between CDS and the stock price. Certainly, I understand that one well. I guess when you think about the short term impact of the CDS res blowing out, is there an impact in the fixed income business with clients’ willingness to engage in CDS trading, that sort of thing? Is there any immediate fallout from that?

Colm Kelleher

Look, we’ve not seen too much yet but this is a very compressed period of time. Most of our clients continue to trade with us. At most, the vast majority, you have some people who are playing games but they’re playing games across the street. In fact, I’ve taken a number of phone calls in the last two days from my contemporaries at other institutions to find out the games that are going on. But I do think it’s a temporary phenomena, Roger, and I think that the market will stabilize.

Roger Freeman – Lehman Brothers

I guess in terms of some of the flow commentary you were talking about: rates, currencies, commodities. If you were to aggregate that, August versus June, July and September versus August –

Colm Kelleher

No. I mean, rates as far as June. Look, here’s the way I’d put it broadly and then we can, June was a very good month. May, as you know, was a good month if you look back in the quarter. May began with a very weak first month. Hilltop ended in a strong month. We went into June, which is a very strong month. July slowed down and August actually was a high [inaudible], generally, across all. So that’s the way I look at it and that’s what you’re getting is peaks and troughs in trading activity here where the market seems to freeze for a while and then come back. See, you have to make sure you’re positioned and agile.

Roger Freeman – Lehman Brothers

And in September, so far, obviously a lot of volatility. How does the –

Colm Kelleher

Looking good so far.

Roger Freeman – Lehman Brothers

In your commercial loan and securities portfolio in aggregate, can you bucket at all the property types behind those in terms of retail versus multi-family, anything like that?

Colm Kelleher

Not really. It’s main commercial, right? You mean our commercial loans?

Roger Freeman – Lehman Brothers

Yes, within commercial, property types. How much –

Colm Kelleher

Well, are you talking about –

Roger Freeman – Lehman Brothers

Multi-family apartments, that sort of thing.

Colm Kelleher

Well, it’s mainly, well, we forget the categories. We have whole loans, which are commercial whole loans. You’ll see it on the schedule. Within Crescent, there is a percentage of residential, which is a small amount of residential in that. But by and large, CMBS is commercial whole loans or CMBS, yes?

Roger Freeman – Lehman Brothers

Just lastly, in terms of the hiring that you’ve talked about and was written about widely, I guess back in August, what portion of that may be directed at wealth management as opposed to other parts of the business? Can you comment on –

Colm Kelleher

No, I think the hiring in wealth management is ongoing business because that’s a very strong franchise which James built up and Ellyn is now already developing so I wouldn’t call that strategic. The hiring that we’ve referred to was the ability to go and unclog gaps and as you know, there’s some pretty big names that have come across. Frankly, we got some new people we can go after given recent events, Roger.

Thank you, everybody.

Operator

Thank you for your participation in today’s conference. This concludes the presentation.

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Source: Morgan Stanley F3Q08 (Qtr End 06/30/08) Earnings Call Transcript
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