Morgan Stanley F3Q07 (Qtr End 8/31/07) Earnings Call Transcript

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Morgan Stanley (NYSE:MS) F3Q07 Earnings Call September 19, 2007 11:00 AM ET

TRANSCRIPT SPONSOR
Wall Street Breakfast

Executives

David Sidwell - EVP, Exiting CFO

Colm Kelleher - Head, Global Capital Markets, Incoming CFO

Analysts

Mike Mayo - Deutsche Bank

Roger Freeman - Lehman Brothers

Glenn Schorr - UBS

Prashant Bhatia - Citigroup

Michael Hecht - Banc of America Securities

Douglas Sipkin - Wachovia Securities

Guy Moszkowski - Merrill Lynch

Meredith Whitney - CIBC World Markets

Bill Tanona - Goldman Sachs

Ron Mandel - GIC

Jeff Harte - Sandler O'Neill & Partners

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 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 until October 19, 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 date on which they are made, which reflect 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 preceding Part 1, Item 1; Competition and Regulation in Part 1, Item 1; Risk Factors in Part 1, Item 1(a); 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 7(a), of the company's Annual Report on Form 10-K for the fiscal year ended November 30, 2006; Management's Discussion and Analysis of Financial Condition and Results of Operations; and Risk Factors in the Company's quarterly reports on Form 10-Q, for the quarterly period ended February 28, 2007 and May 31, 2007; and other items throughout the Form 10-K, and the company's 2007 current reports on Form 8-K.

The information provided may also include certain non-GAAP financial measures. The reconciliations of such measures to 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 and Colm Kelleher for today's conference call.

David Sidwell

Thanks everyone for joining us today. I am glad to have my colleague and incoming CFO Colm with me to discuss our results. This has been a quarter with many challenging market dynamics. My goal is to be as clear as possible as to how this impacted our results.

Third quarter income from continuing operations was $1.5 billion, down from our record last quarter of $2.4 billion. Earnings per share from continuing operations was $1.38 per share, versus a record $2.24 a share last quarter. Return on equity from continuing operations was 17.2%, down from 29%.

Results for Discover for all periods have been reclassified to discontinued operations, including the one-month results for June in the current quarter.

Diluted earnings per share was $1.44 a share, compared with $2.45 last quarter. We have reported net revenues of $8 billion; 24% lower than our quarterly record in the second quarter, driven by the decrease in institutional securities revenues.

Let me highlight the areas that are key to understanding our results. The credit markets deteriorated considerably over the course of the quarter, with increased volatility, significant spread widening, lower levels of liquidity and reduced price transparency at all parts of the capital structure. These factors affected the leveraged lending markets, the effectiveness of hedging strategies, sub-prime mortgage markets including the CDO market, as well as other structured credit products. This credit environment significantly impacted our results in relationship and leveraged lending, and credit sales and trading.

First in relationship and leveraged lending, where markdowns to our loans and commitments led to losses of approximately $940 million reported in our other sales and trading net revenues. The earnings per share impact from these losses was approximately $0.33 a share. These losses include the $726 million impact of marking to market including certain fees a $31 billion pipeline of leveraged loan commitments made to support acquisitions made by financial sponsors.

Second, corporate credit and securitized credit product sales and trading businesses, including our residential and commercial mortgage businesses, had lower revenues than the strong second quarter. Revenues were approximately $260 million this quarter, compared with $1.3 billion last quarter, with the largest decrease in corporate credit where losses in our structured credit business, as the extreme market moves impaired the performance of hedge strategies, more than offset strong investment grade and other trading results.

Our residential and commercial mortgage business had lower revenues than the second quarter as the market continued to deteriorate, particularly in the senior portion of the capital structure. We significantly reduced our positions during the course of the quarter in light of the market continues in corporate, residential, and commercial credit.

The final area I want to highlight is quantitative strategies, which had losses of approximately $480 million. The strategies in question were market neutral strategies where the trading portfolios were comprised of long and short positions that had little or no exposure to an index or market pricing factor. Losses peaked in the midst of the market deleveraging in early August, but were reduced by gains -- albeit at much reduced positions -- subsequent to the deleveraging. This is reported in our equity sales and trading net revenues.

The credit environment impact on our lending and credit sales and trading was partially offset by an approximately $390 million gain from the spread widening in Morgan Stanley's credit on some of our own structured notes. Of this amount, approximately $290 million was reported in fixed income sales and trading and $100 million in equity sales and trading.

The turn in the environment coming on the heels of our strongest quarter ever exacerbated the steepness of the sequential quarterly decline. However, the diversity of our platform enabled us to generate a solid, firm-wide 17.2% return on equity. Institutional securities were strong in investment banking; our equities business produced strong results, excluding quantitative strategies; we had record interest rate and currency trading and prime brokerage results; and commodities had a solid quarter.

We continued to demonstrate significant progress in improving our global wealth management and active management results. All of these businesses mitigated the impact the significant market disruption had on our overall results.

Let me now turn to address other aspects of our firm-wide results, which are outlined on pages 1 and 2 of the supplement. While our revenues decreased 24% from the second quarter, total non-interest expenses were $5.7 billion, down 19%. The largest component, compensation benefits expense, was $3.6 billion, down sequentially from $5 billion primarily reflecting the low revenues in the quarter, as well as adjustments to the full year estimated payout to reflect revenue trends and outlook for institutional securities and asset management. The nine months compensation to net revenue ratio is 47%.

Non-compensation expense was $2.1 billion, up 4.5%, driven by higher brokerage and clearing reflecting an unprecedented volume of trade. The non-compensation to net revenue ratio was 26% this quarter. Year-to-date the ratio is at 21%, which is an improvement over the 22% ratio for the same period last year.

Our effective income tax rate for continuing operations increased from the second quarter by 1.8 percentage points to 34.4%. This was primarily due to lower estimated tax credits due to the higher anticipated phase out of coal credits. The year-to-date tax rate in continuing operations remain 33%, consistent with last year's normalized rate.

Now I would like to hand over the call to Colm, who will discuss the details of our business segment results.

Colm Kelleher

Thank you, David and thank you all for joining us today. David and I have been working closely together this quarter to ensure a smooth transition of the CFO function. That seamless transition has been particularly important given the market turmoil of the past quarter.

As David mentioned, we produced a healthy 17.2% return on equity, despite the material dislocation in the credit markets. There are many moving parts in our results, and we are going to provide you with enough analytic metrics to help you model future scenarios based on your overall market assumptions.

Let me begin with institutional securities detailed on page 5 of the supplement. The market conditions, as David mentioned, drove the segment's revenues lower in equity and fixed income sales and trading, as well as investment banking. Net revenues of $5 billion were down 33% from the second quarter of '07. Non-interest expenses of $3.5 billion decreased 22%, driven by lower compensation in light of the lower revenues. PBT of $1.5 billion was down 49% from last quarter's record, and the profit before tax margin of 30%, was down from the 40% reported last quarter. We achieved here a return on equity of 16%, down from 35%.

Looking at page 6 of the supplement, investment banking revenues were $1.4 billion, down 16% from the record set in the second quarter of '07. All categories were lower than last quarter, but higher than last year. We continue to maintain leading M&A market shares with a number one year-to-date rank in M&A completed, number two in announced, with approximately 30% market shares in each.

Our year-to-date rank in U.S. IPOs is number one and we are number two in global IPOs. We are number one year-to-date in U.S. equity and related issues, and number four globally. In debt underwriting, our year-to-date rank was number, with a stable share of the market. Our year-to-date rank in Investment Grade debt is three. This is the most vibrant area of the market, and our participation remains strong. Our year-to-date non-investment grade rank was nine.

The Investment Banking environment was mixed during the quarter. Non-investment grade debt markets effectively dried up during the second half, while investment grade issuance continued at a brisk pace. Equity capital market volumes and completed M&A remain relatively healthy, up from last year, down slightly from the second quarter.

Our backlogs remain relatively strong with M&A flat to last quarter, equity down, investment grade debt up, and non-investment grade down. However, these deals are subject to market conditions and investor receptivity. Recognizing this, we are cautiously optimistic.

There has been a lot of attention given to the financial sponsor business. As you would expect, the proportion of financial sponsored transactions in our pipelines has decreased. Strategic deals continue to be a meaningful component of our backlog in both M&A and underwriting. In the long-term, we believe the financial sponsors will continue to play a significant role in the market, though currently there is a pause in their activity.

Advisory revenues decreased 8% to $664 million from our record quarter last quarter. Equity underwriting revenues were down 13% to $429 million, following our near record second quarter of '07. Fixed income underwriting revenues were $346 million, down 29% from our second quarter record, largely reflecting the sharp decline in both the high yield bond and leveraged loan markets.

Also on page 6 of the supplement, you can see we had a weaker sales and trading quarter with total revenues of $3.1 billion, down 39% from our strong second quarter. This quarter was characterized by a deteriorating credit environment and extreme volatility across markets. Specifically, equity sales and trading revenues of $1.8 billion were 21% lower than our record quarter set last quarter. The decrease was driven by losses sustained in our quantitative strategies business. The other businesses that make up our equities business were up from last quarter by 8%.

David has addressed the losses in quantitative strategies, so I will focus on other parts of the business. Derivative revenues reached a second consecutive record quarter on higher customer flow. Financing products had record revenues with strong commission revenues driven by increased client activity. The cash business had lower revenues, as higher commission revenues were offset by loss ratios.

The contribution of electronic trading improved significantly this quarter in a record-setting volume environment. Our prime brokerage business produced record revenues, and had record average customer balances for the 18th consecutive quarter, although balances were affected by the market dynamics during the quarter. Average balances increased 10% to peak levels in July, and then fell back to levels roughly equal to where they were at the beginning of the quarter.

During the quarter, there were no hedge fund defaults amongst our prime brokerage clients, and we did not see margin calls ramp up beyond normal market movements.

In fixed income sales and trading, $2.2 billion in revenues were down 24% from our strong second quarter results. Difficult credit markets drove the decrease from the second quarter. Credit market revenues were down 72%, and David has covered the primary drivers of the decrease.

Record interest rate and currency results were 49% higher than second quarter, despite lower revenues in emerging markets. A driver of the increase of the revenues from the impact of widening Morgan Stanley credit spreads on firm-issued structured notes that David has mentioned. The other increases were broad-based. We were well-positioned in interest rates for market movements, and in derivatives for the flight to quality seen during the quarter when foreign exchange trading revenues were higher.

Commodities decreased 12% driven by increased gains from structured deals, and strong results in the transactional and flow business, offset by lower trading revenues.

Loans and commitment details are on page 7 of the financial supplement. Total loans and commitments net of hedges rose $8.3 billion to $67.2 billion. Our policy is to mark-to-market loans and commitments, and during the quarter we recorded an overall loss of approximately $940 million in our lending business. As of the end of the third quarter, we have commitments of $31 billion in the pipeline related to leveraged acquisition financings, including both bank loans and bridge financings primarily to non-investment grade names, which are accepted but not yet closed commitments. This pipeline is subject to change, either because the transaction is not completed, or the terms are changed.

The pipeline of loan commitments is mark-to-market including certain fees and based on a deal by deal assessment. The writedown in the quarter was $726 million net of certain fees. The gross was $1.2 billion. This represents our marks as of August 31. The ultimate realized economics could change, depending on the extent that they are renegotiated, repriced, or the transaction does not occur. These valuations are largely the result of liquidity issues; credit analysis would not indicate this degree of loss.

Corporate loans within current-only tests, or covenant light deals, represent under 40% of the pipeline.

Our leveraged finance business has been to originate and distribute and accordingly our intent is to distribute our current book. However, this may take longer than in the past, and we are subject to market conditions changing during the whole period. Our ability to address issues in our pipeline will improve as liquidity reenters the market.

Principal transactions investment revenues were $217 million, a $179 million decrease. The decrease was primarily driven by lower real estate and private equity gains on this corresponding deferred compensation markup.

Aggregate average trading and non-trading value at risk, VaR, increased to $91 million from $87 million last quarter, driven predominantly by increases in interest rate and credit spread of VaR. Period end aggregate trading and non-trading VaR decreased in the quarter to $84 million from $93 million, as we actively reduced positions during the quarter. It is important to realize the change in market conditions imply a higher volatility, and therefore higher risk as measured by VaR on these reduced exposures. As an illustration of this dynamic, if the period end risk positions were measured using last quarter's market levels, risk would be approximately 15% lower.

Our average surplus or unallocated capital was $3.5 billion, down from $4.2 billion in the last quarter. The amount of capital allocated to institutional securities increased $2 billion to $25.7 billion Tier 1 equity, largely due to the increased market volatility, particularly in the credit markets.

During the quarter we were extremely focused on our liquidity position, and measuring the sources and uses of liquidity daily. We took advantage of available market opportunities to issue CD and long-term debt to further strengthen our liquidity.

Now turning to page 8 of the financial supplement in our global wealth management business, despite the environment and typical seasonal trends, wealth management had strong results. There were higher levels of client activity, including net new assets, continued strong financial advisor productivity, and a number of new product launches. Revenues reached $1.7 billion, up 2% from the second quarter of '07, our best revenue quarter since the second quarter of 2000, reflecting slightly higher asset management revenues, as well as increased net interest due to growth in the bank deposit program.

Non-interest expenses of $1.4 billion, net of an insurance recovery, were up slightly from last quarter because of the increase in business activities. Profit before tax of $287 million was up 9%, and the PBT margin increased to 17% from 16%. The return on equity for this business was 39%.

This business continues to build on its momentum showing strength in many areas. On page 9 of the supplement you can see this in a number of productivity metrics. Net new assets of $14.6 billion represents our sixth consecutive quarter of client inflows, and the highest since we started tracking this metric. Assets in the $1 million plus household segment increased $2 billion on 71% of our total client asset base, versus 66% at this point last year. Total client assets increased 1% sequentially to $734 billion, driven by net new assets. Fee-based assets represented 29% of the total.

Average production and total client assets per global representative were inline with the second quarter at $817,000 and $88 million respectively, as our FA headcount increased to over 8,300 producers, with the addition of our most recent trading class as well as targeted hires of high quality producers. We continue to hire producers with higher production than those we lose.

Our bank deposit program continued to grow, ending the quarter over $19 billion, on track to exceed our goal of $20 billion by year end.

We had another successful product launch in coordination with asset management, the Van Kampen dynamic credit opportunities closed end fund, with sales of over $1 billion. We also launched a new type of account, Morgan Stanley Advisory, a non-discretionary advisory account, in part to help mitigate some of the changes related to fee-based brokerage accounts in the industry.

Let me turn to our asset management business. As you can see on page 10 of the supplement, net revenues of $1.4 billion were down 10%. However, income before taxes was $491 million, up 62%; PBT margin was 36%, and our return on equity increased to 35%, driven by a decrease in expenses primarily compensation.

Looking first at revenues, the decline was driven by principal transaction investment revenues of $338 million that were 43% lower than last quarter on lower private equity and real estate and alternative gains. Of the $338 million, $211 million was from real estate and $136 million was from private equity. These numbers include the gross-up in employee deferred compensation in these businesses, which is offset by a similar gross-up in compensation expense. We expect principal transactions investment revenues will be a growing but lumpy in nature part of our revenues, as we build our real estate, private equity and infrastructure businesses.

Management and admin fees, a key indicator of the positive momentum in this business, continue to show good growth quarter to quarter, increasing 10% to $926 million, largely driven by higher average asset growth across all of our businesses as well as higher incentive fees in our alternatives business.

Non-interest expenses of $873 million were down 28%, driven primarily by the reduction in compensation, reflecting our current view of full-year performance and the related compensation payout of lower investment related expenses in the quarter. Non-compensation expenses were also slightly lower this quarter, with lower professional service fees.

We have clearly generated PBT margins that exceeded the 20% level we were expecting earlier this year, primarily due to the strength in investment gains, and in this quarter the adjustment of the compensation payout. Given the dramatic increase in the assets under management and as part of the completion of the movement to real estate group to the asset management division, we have adjusted the compensation payouts in this area. The 28% year-to-date PBT margin reflects these factors to eliminate some of the quarterly noise.

Turning to page 11 of the supplement, you can see assets under management and supervision increased by $17 billion, to end the quarter at a record $577 billion. We had $20.8 billion in total net in-flows, which marks our fourth consecutive quarter of net asset inflows. Positive net flows were driving by strength in institutional liquidity with $12.4 billion of inflows, largely driven by new and expanded client relationships and institutions placing funds in short-term money markets as they determine the impact of the market dislocation. We would expect some of these funds to flow out as money managers put funds into long-term investments.

Non-U.S. channel had $6.1 billion of inflows, $1.2 billion in the Americas Intermediary channel, $1.1 billion in the Van Kampen branded funds, and $300 million in U.S. institutional. This positive activity reflected strong flows from the alternatives and real estate products included in the launch of a Van Kampen dynamic credit opportunities closed end fund via the Van Kampen branded channel.

Morgan Stanley branded retail funds showed modest outflows during the quarter. Our total year-to-date net inflows of $34.6 billion compared favorably to the $14.3 billion in net outflows we saw through the nine months ended 2006. Flows into our newer products, primarily in real estate and other alternative areas, remain very strong in the quarter and we continue to broaden our product offerings. We launched and incubated 24 new products in the third quarter, including 14 in alternatives, seven in equities, and three in fixed income. This positive trend in net flows in the face of down trending market indexes, contributed to our record assets under management of $577 billion at quarter end, up 3% from the last quarter which is key evidence of the progress we are making on our key initiatives and the momentum being built in the business.

In summary, 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 businesses. We have also completed the build out of our senior management team, and continue to execute on our critical initiatives for growth across the business globally.

As we told you last quarter and you saw in our 10-Q, following the spin of Discover we expected our share count to increase, reflecting the impact of the adjustment for the spin of employee held Morgan Stanley restricted shares. We repurchased approximately 10 million shares of common stock for approximately $627 million. Year-to-date we have repurchased approximately 42 million shares of common stock for approximately $3.2 billion.

With respect to the pace of repurchases, we evaluate and balance the needs of our business for additional capital to invest in organic growth and make attractive acquisitions with our objective over time of offsetting the dilutive impact of equity compensation to employees. We have $2.8 billion remaining under our current board authorization.

On page 3 of the supplement, you can see that this quarter we have added regional revenue disclosure at the firm-wide level. Year-to-date, 58% of our revenues have come from the Americas, 28% from Europe, Middle East and Africa, and 14% from Asia. Year-to-date international revenues increased 50%, continuing to outpace the growth rate of the U.S. which increased 18%.

U.S. results included the majority of trading losses therefore our results this quarter are skewed in favor of non-U.S. results. The methodology used differs slightly from the regional disclosure we have previously provided in our 10-Ks, which is based on a legal entity basis. The methodology is defined in the footnote on page 3 of the supplement.

Now a bit on the outlook. The challenging market conditions that we experienced in the third quarter and in many parts of the credit markets were intense and have continued into September. The environment remains one of the high volatility, wide credit spreads, lack of observable market price and low liquidity, with investors very much on the sidelines waiting for more certainty of asset values. This affects not just trading opportunities, but the flow of origination and securitization activity.

In addition, being a major market player, we remain exposed to risk exposures through a number of instruments: lending commitments, sub-prime, CDOs, commercial mortgages are examples. We believe it will take at least a quarter or two for the credit markets to return to a more normal extension of credit and provision of liquidity.

Other parts of the fixed income business remain strong, with strong client interest rate, foreign exchange, and commodity products. In addition, equity markets have remained resistant and there is high market volume interest in derivatives and financing products. So while we may continue to see challenging market conditions in the months ahead, we believe turbulent times like this are an opportunity for Morgan Stanley to distinguish itself and outpace our peers.

These near term cyclical challenges do not change our view of the long-term secular growth opportunities we see. We will continue to invest in the long-term growth of our business and our people, who are focused on working together to deliver to our clients as we help them navigate through these challenges markets.

At this point in the quarter, we are seeing early signs of reengagement by investors in the credit markets. The recent market events have had a severe impact on the ability to distribute loans; we believe this will ultimately normalize, and the market will return. The Fed action yesterday was welcome, but is a first step. We have spoken in the past about the importance of the leveraged lending market. We have pursued market share in this market with strong risk management disciplines. We felt that pricing in the market had become excessive, and you can see our relative restraint in our non-investment grade league table ranking. Equity volatility and downward indexes movement will impact fees in average assets under management, and while retail has been very active and we continue to make strides and improve margins, prolonged equity market disruptions will likely slow the level of retail transaction activity.

I mentioned earlier that our investment banking pipelines across advisory equities and fixed income are relatively healthy. Obviously results in the principal investment activities will depend on the overall level of the market.

The fourth quarter tends to be seasonally slower than both the first and second quarters, both in the retail and institutional side. Clearly we are very focused on our control of expenses and resource allocation given the market disruptions and the business activity levels. While it is too early to forecast if we will be able to reduce the ratio of operating expense to net revenues, we are actively working on our forecasting and budgeting models to ensure that we are maximizing our capital and human resources to capture business growth and market positions in an optimal and most efficient manner.

Having said that, we remain optimistic about the future for Morgan Stanley. Our fixed income business remains on solid ground, and our views of the difficulties we saw this quarter, represented a necessary repricing of the markets, and did not impair the overall fixed income business. What we saw this quarter and specifically in August represents short-term market dislocations of the market, and we are confident that both domestic and European markets will recover. Given the strong results in Asia and Russia this quarter, the bifurcation of the markets and the breadth of our business model across products and geographies is evident.

We continue to invest in the long-term growth of our businesses, and feel that we are well-positioned to deliver value to shareholders as we implement our strategy to capture the substantial growth opportunities we see around the globe.

Before we turn it over for question and answers, I am going to hand it back to David.

David Sidwell

Thanks, Colm. I want to spend a minute on fair value measurements. There has obviously a lot of attention given to fair value measures in recent weeks. We adopted the relevant FASB's 157 and 159 at the beginning of the year and you have seen the relevant footnotes in our last two 10-Q filings. The disclosure provides our assets and liabilities are recorded at fair value, categorized based upon a fair value hierarchy. In some cases the inputs used to measure fair value fall into different levels of the hierarchy. In those instances, the asset or liability is categorized at the lowest level input that is significant to the fair value measurement.

Given the third quarter market dynamics, more instruments have become illiquid and as you would expect, the level of financial assets categorized in Level 3, which is the most illiquid category, have increased. Our total asset position of Level 3 in the second quarter was approximately 5% of our total assets. Level 3 liabilities represented approximately 2% of total liabilities.

While we are still working on the third quarter disclosures, we anticipate that the total of Level 3 asset positions will increase to approximately 8% of total assets when we file our Q. Of the increase, approximately one-fourth or one-quarter represents Level 2 assets moving into the Level 3 category. Level 3 liabilities will represent about 3% of total liabilities.

The major components of Level 3 are the same as we disclosed in the second quarter. Corporate and other debt, derivatives -- which is primarily complex structured instruments -- and investments which includes real estate funds and private equity. Corporate and other debt in the assets category includes closed leveraged acquisition finance loans, commercial and residential whole loans to be securitized, commercial whole loans for private placements, and mortgage-backed residuals. Corporate and other debt in the liability category includes the marking to market of our pipeline of leveraged loan commitments.

Turning to the income statement on page 44 of last quarter's Q, you saw that we recognized just under $600 million in gains on Level 3 assets and liabilities. When we report our 10-Q for this quarter, you will see a net increase in gains in Level 3 driven by derivative contracts, which offset losses on other cash instruments included in those classified within Level 1 and 2.

Level 3 is where there are unobservable inputs, and includes situations where there is little if any market activity for the asset or liability. This is, generally speaking, the category where we are marking to model. The valuation methodology on these illiquid instruments applies modeling techniques that use relevant empirical data, including available indices to extrapolate an estimated fair value. The inputs reflects assumptions that market participants use in pricing an asset or liability in a current transaction. Representing a determined exit price, and also the cash flows ultimately expected.

Our valuation models are calibrated to the market on a frequent basis. The parameters and inputs are adjusted for assumptions about risk, and in all cases if market data exists, that data will be used to price the assets or liabilities. The valuation of these instruments are reviewed by an independent valuation group outside of the business units and subject to the scrutiny of our auditors so we are confident that we have appropriately valued these positions.

Having given that rather detailed explanation of Level 3, let me open it up to questions.

Question-and-Answer Session

Operator

The first question comes from Mike Mayo - Deutsche Bank.

Mike Mayo - Deutsche Bank

I had some questions on the unusual items. First, the $940 million loan writedown, you said $726 million of that was on the $31 billion in the pipeline, so that is a 4% writedown on the pipeline?

David Sidwell

I am not going to do the math but yes, on the $31 billion of pipeline, we took $726 million of losses, and that is as we had said, net of fees, so the gross mark was $1.2 billion.

Mike Mayo - Deutsche Bank

Then the other remaining portion would be what was on your balance sheet?

David Sidwell

Our policy is to mark-to-market all loans and commitments. We really wanted to make sure we focused where I know all of you had interest, which was on the leveraged lending and specifically on the pipeline. In addition to leveraged lending, we have a large relationship lending business where in the quarter we also took losses. In addition and actually offsetting that, is earlier in the quarter there was actually a positive P&L from commitments that closed and cleared the market on the LAF side.

Mike Mayo - Deutsche Bank

You mentioned ineffective hedges. How large were the hedging losses and in what area?

David Sidwell

Let me be absolutely clear for everyone on the phone. That is not a comment in connection with the lending and acquisition finance pipeline. That is where we were talking about the sales and trading results in the credit markets overall and saying that when you actually look at the markets in the third quarter, you saw a number of factors widening credit spreads.

You also see the impact of a lack of liquidity and one of the impacts -- probably most important -- is the normal relationships between various parts of the capital structure broke down in the quarter and I think we certainly saw that we had the senior parts of capital structures more impacted than we would have expected, and that is basically what we mean by hedging.

The economic hedging, a part of our sales and trading activities in credit products, all of which shows up in fixed income sales and trading.

Mike Mayo - Deutsche Bank

When you talk about corporate credit and securitized sales and trading having declined from $1.3 billion to $260 million, is that where you're seeing the impact?

David Sidwell

Yes.

Mike Mayo - Deutsche Bank

What would be a more normal rate for that one line item, or how much of that would you perceive as unusual?

David Sidwell

Well obviously the second quarter of this year was a record. The credit markets has been a very large and successful business for us, including both the origination securitization and trading. It is included in our fixed income results, and quarter by quarter some parts in fixed income do better than others, so I suggest if you are trying to look at trends, I would look at the overall fixed income sales and trading line.

Mike Mayo - Deutsche Bank

Lastly, prime brokerage did better than expected. It is kind of surprising in this environment. Are you gaining share, or what is going on there?

David Sidwell

Prime brokerage as you know, we are a leading prime broker. As you heard from Colm, we did see the level of balances increase in the early part of the quarter before they came off. We have very good relationships with our prime brokerage clients, and I think we saw the benefit of that this quarter.

Mike Mayo - Deutsche Bank

I guess a lot of people say to me you must be gaining share from Bear Stearns. What would your response be?

David Sidwell

To be honest, I don't really want to get into who we gain, who we lose share to.

Operator

Your next question comes from Roger Freeman - Lehman Brothers.

Roger Freeman - Lehman Brothers

I wanted to ask first of all with respect to the loss in the equity business, the decline of about $500 million, can you talk about what the peak of that decline was and how much you gained back? There were reports during August that you were down $500 million, and it seemed like that is where you ended the quarter as well.

David Sidwell

The 480 is the performance for the quarter. It is across a number of groups that have quantitative strategies. The number was higher, as you heard us say earlier in the quarter. We did gain some of that back, and I think probably what is most important here, we gained it back on reduced positions. I don't really want to get into day by day loss and then earn back that is made up in that 480 number.

Roger Freeman - Lehman Brothers

The question I was trying to get at is did you pull back from the strategy that would have limited some of the ability to fall back because the back half of the month was much better?

David Sidwell

As I said, we did reduce. At the peak we made a decision that we did not like the overall level of risk that we had in these strategies, and while if you look over time these have been extremely profitable strategies, we wanted to reflect the market conditions in August and as a result we significantly reduced those positions. So the revenues we generated after the deleveraging were based on lower positions.

Roger Freeman - Lehman Brothers

That is helpful. Again, just coming back to Mike's question, as we look at the decline in the credit mortgage part of the business, you are not able to break out how much of that billion dollar swing is actually due to the mark? Or rather can you give us the total impact of marks across the entire fixed income business and leveraged lending in the quarter?

David Sidwell

We will give obviously a lot more disclosure on the Level 3 information when we file the 10-Q. I think the thing to remember across many of these businesses, and let's just use the residential and commercial mortgage business as an example. We use a variety of instruments, some of which are liquid and so would be in Level 1. Some have models with very observable inputs which would fall into Level 2 and then we have other instruments that fall into Level 3.

In any of our trading strategies, we tend to utilize products that are in a variety of levels of disclosure. Overall, our residential mortgage business in the quarter did make money. It made less money in revenue terms than it had in the second quarter, but it was still positive. When you see, as I mentioned, the disclosures that we make in our Q, you will see there was an increase in the marks in the Level 3 but that was offset then by reduced, or losses, in other levels of our fair value.

I wish I could make it as simple as, and I think it would be, for instance, if we were talking about the real estate investments or private equity investments, where you can give an absolute inventory and then you can talk about what happened to the P&L. Given the nature of these businesses, the complexity of the products, I don't think there is an easy simple answer that I can give you that you would find satisfying.

Roger Freeman - Lehman Brothers

Lastly, can you talk about the implications of marking some of your structured debt to market in terms of (a) does that have an implication for higher interest expense going forward, as you have to amortize that gain? And (b) if credit spreads compress again, if the credit markets gets loosened up here, are we going to see a reversal of that in the fourth quarter?

David Sidwell

Anything that we mark-to-market will reflect the mark in the period that we are in, so if you think about our structured notes, where we fair value those notes, obviously given what happened to credit spreads broadly and to Morgan Stanley specifically where our credit spreads widened during the quarter, the liability which is represented by those structured notes, given the widening in our credit spread, we take a gain on that.

To some degree, that represents that if you wanted to buy back that piece of paper, presumably you would pay less to buy it back because of the counterparties view of your credit worthiness. So obviously to the extent next quarter credit spreads change, that mark will change. So to the extent credit spreads tighten, you would expect to see a gain; to the extent they widen further, you would expect to see a loss if credit spreads tighten from where we are and if they widen, incremental gains.

Roger Freeman - Lehman Brothers

What is the total amount of the debt that is marked that way?

David Sidwell

I am sorry. I don't have that information with me.

Operator

Your next question comes from Glenn Schorr - UBS.

Glenn Schorr - UBS

One more thing on the FAS 159, I just want to make sure I understand the mechanics. I look at the Level 3 disclosure stuff on both the asset and liability side of your last Q. You have you about $20.5 billion worth of the long-term borrowings that I think the bulk, if not all, are these structured notes we are talking about?

David Sidwell

That is correct.

Glenn Schorr - UBS

So I want to make sure I think about it the right way. Spreads, you call it $20 billion or $21 billion. You have spreads widen X basis points and then you have, what, an average maturity of these? And you do the multiplication on those three components, and that's how you get what the mark-to-market up or down is on a given quarter?

David Sidwell

Actually this isn't even a Level 3 issue, just so that we are clear.

Glenn Schorr - UBS

I understand.

David Sidwell

We have pretty readily available market inputs our own credit spreads, so actually it is moving into a different hierarchy. You are broadly correct.

Glenn Schorr - UBS

Is it the actual debt of Morgan Stanley, or is it the credit defaults normally we would be talking about the same thing, but in an environment like this, your debt widened out a lot less than the default swaps. Which is the one that I should think about?

David Sidwell

In terms of which is the underlying index that we use to do the mark-to-market?

Glenn Schorr - UBS

Correct.

David Sidwell

It is the debt.

Glenn Schorr - UBS

That's what I thought, because that is the actual debt. Good. Is there a place I can go to see the average maturity of all the different structured notes, because there is a bunch of them, and is five years about right?

David Sidwell

Glenn, I am sorry. You have really called me out here. I just don’t have it.

Glenn Schorr - UBS

No worries, we can follow up. I just wanted to make sure I had the mechanics down.

David Sidwell

We will make sure Bill has the data available to the extent we publish it.

Glenn Schorr - UBS

No problem. Shift over. I think we are seeing a trend here where leverage ratios would go up because certain assets stay on balance sheet, because we couldn't sell them out into the market, so balance sheet usage goes up, and leveraged ratios go up. At what point -- 18.8 is not alarming, but it is higher than where it has been. At what point do we say uncle? At what point do you get uncomfortable in the leveraged ratio, as limited as a ratio as it is? I am just kind of curious.

David Sidwell

Let me be clear about one thing. One of the drivers of our leveraged ratio has been the taking out of Discover so taking out the equity and related assets of Discover has been a driver of this. We think that certainly growth leverage and I know you use the adjusted leverage, we still think those are relatively crude measures. We have increasingly been using internally data which we and our competitors and our peers will be making available next year, which is the regulatory capital Tier 1 ratios and total ratios but I think we tend to emphasize the Tier 1 ratio, so we internally use that measure.

We do obviously recognize the point your are making that we want to make sure we understand our gross leverage and how we fit with our competitors, but I think at this point in time, we do feel comfortable with this 18.8 times adjusted leverage and 32 gross. We do monitor these ratios, along with our Tier 1 ratio, on a weekly basis and make sure we continue to feel comfortable.

Glenn Schorr - UBS

Nobody else on the broker-dealer side is disclosing that Tier 1 just yet?

David Sidwell

No.

Glenn Schorr - UBS

Bottom line is, comparing it to some of the larger banks that we all look at, is it fair to say that yours would be reasonably higher?

David Sidwell

Glenn, I am sorry, I don't want to say --

Glenn Schorr - UBS

No problem. Last thing is I think you mentioned in your remarks that you issued some CP during the quarter. Really, I didn't know you could, and how come? Just to keep the balance on the maturity profile?

David Sidwell

We basically, as you heard from Colm, were very focused day by day making sure we understand our liquidity, and we took advantage of the market opportunities during the quarter, and we have continued to do that subsequent to the quarter to both access CP and access the long-term markets. In the early part of August, obviously it was tougher than we are seeing now, and the maturities for CPs have stretched out a little bit since the end of the quarter, which is obviously a good sign.

Liquidity is one of the key things we focus on, and so it obviously is something that has a cost to it in terms of the cost of retaining so much liquidity, but we thought it was important to build our liquidity to the extent we could. It both supports the business we are in and probably just as importantly, gives us the ability as we see new opportunities not to have to say no because we don't have the cash.

Operator

Your next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

Just with the dislocation in the marketplace, you clearly had more of a risk appetite lately. What is your assessment of how the risk management function actually has performed? Based on our outlook of a couple of more challenging quarters, is there an opportunity here to take risk management higher, or has that appetite changed internally?

Colm Kelleher

Well, I don't think the appetite has changed internally at all. I think what has happened is we had a very stressed market environment, and I think overall we feel that our risk measurement systems performed very well, and in fact we reacted to those accordingly, particularly as you saw in the quantitative trading strategy.

Our view of the market still is in a period of dislocation, we think there will be some very good opportunities to deploy capital going forward and we are cautiously optimistic, but to answer the first question, our risk systems performed well, our risk management performed very well. To answer the second question, these are early days. I think there will be opportunities, and we will apply the same criteria to assess those opportunities as we go forward.

Prashant Bhatia - Citigroup

Great. Again based on your outlook, the $31 billion that are commitments right now, do you have any kind of view on how much you think may end up sitting on the balance sheet at the end of the year, and how does that impact decisions on deploying capital? Does that make you a little more cautious?

Colm Kelleher

Clearly our capital management is based upon the liquidity of our balance sheet accordingly, and our balance sheet actually is, as David referred to, very much more liquid.

As regards to the $31 billion, it is very simple. It is a function of when the markets reopen. We have seen evidence out of Europe that there are buyers coming back into the leveraged lending space. There is some evidence that TLOs are beginning to get more active again, but I think a lot of it will depend on the overall market conditions. We took the mark as of 8/31 knowing the factors that were relevant at that time. We do want to fully distributable model, and that is what we would aim to do.

Prashant Bhatia - Citigroup

Finally on the cost base and the flexibility, I think you had roughly about 2,000 in terms of growth in headcount here. How do you think about that going forward? I think you mentioned you are potentially looking at budgets, and how to best utilize people and so on?

David Sidwell

I think obviously as you would expect, at times like this you want to make sure in your resource allocation that you are making the right investments and where you see the opportunities. Similarly if you don't see the opportunities that you make adjustments not just in people but in capital, and the other resources that the businesses use. No decisions at this point, but we are going to as you heard from Colm, watch this very closely.

I would say just to reiterate something that we have been saying for a while, we do view that we want to continue to invest. Asia is a perfect example, that has obviously done very well this last quarter compared with the rest of the world, and as a further demonstration you need to make sure you continue to invest and diversifying our business by product and by the regions of the world.

Prashant Bhatia - Citigroup

Any kind of rough breakdown on where that headcount growth over the past quarter has gone to?

David Sidwell

If you break it down basically institutional is the largest driver, just for everyone else's benefit, it is up a little under 2,000 people. Institutional is about three-quarters of that, and then the other quarter is wealth management and asset management together. Obviously just to use an example we mentioned that the number of FAs is up in wealth management. That is included in headcount.

Operator

Your next question comes from Michael Hecht - Banc of America Securities.

Michael Hecht - Banc of America Securities

Just to follow-up on the $31 billion in commitments, can we get a sense, for the LBO commitments that is, how that compares to last quarter? And just to be clear, the $1.2 billion gross mark that you mentioned, is that gross for both fees and hedges, or just fees?

Also, it works out to a 4% mark if you do it on the $31 billion. Is a better way to think about it on the 40% or less that you mentioned had lighter covenants, et cetera, that might be more susceptible to writedowns and such?

David Sidwell

Let me start by saying this is just net of fees. This is not a book that we hedge, or relationship lending book. We do have hedges, but in our acquisition finance, given the nature of the names and the intentions to distribute, we have not had a hedging strategy here.

Let me actually provide you a roll forward, because I know this is something that everyone is interested in. At the end of last quarter the equivalent of the $31 billion was $42.8 billion. During the course of the quarter, we closed $3.9 billion of deals. There were deals that sponsors withdrew of $10.9 billion, and there were decreases for a number of other reasons like for instance, the commitment level was reduced of $7.1 billion. Then there were new deals of $10.4 billion. That is the roll forward of from $42.8 billion to $31 billion.

Michael Hecht - Banc of America Securities

That is great. The $10.4 billion, would that be aftermarket conditions kind of got tighter?

David Sidwell

There hasn't been a whole lot of activity in this market.

Michael Hecht - Banc of America Securities

The marks you mentioned on the credit side of the business more coming from the corporate side versus the mortgage side, which I think was included in credit and on the mortgage side any writedowns related to Saxon?

David Sidwell

Obviously we look at our residential and commercial mortgage business as a total business, and so Saxon is now integrated very much as we think about our residential mortgage business. As I said overall, that business had positive revenues. To answer in a very technical manner, there was an impairment of our goodwill in the quarter on Saxon. There was no impairment because we evaluate goodwill at the fixed income level, not at the Saxon level. There was a slight impairment of the intangible assets that was very small.

Michael Hecht - Banc of America Securities

Can you clarify for us what your exposure is to ABCP Conduits? I think there is some rating agencies out there that put your liquidity lines at relatively big numbers, and I was hoping for a little clarification there.

Colm Kelleher

We have ABCP Conduits as such, in terms of providing stand-bys, we have negligible exposure. In terms of investment management we act basically in ABCP as an arranger and placer of paper. As you know, that market actually is showing signs of life and issuance is coming back.

Within investment management we clearly, like everybody, hold a commercial paper issued by the Conduits, and some of the SIVs; not surprising, given that the outstanding of that market was $1.2 trillion out of $2.2 trillion, and you know that position has been significantly reduced. We stopped buying that paper rolling it over early on, and we feel pretty relaxed about the positions we hold there for the time being.

David Sidwell

We were given a bit of a note here too that the rating agencies seem to have a wrong number for us here, so as Colm said, we do not think we have a significant number.

Michael Hecht - Banc of America Securities

Okay. That is helpful. On the asset management side, obviously seems to be a pretty positive story with the revenues, margins, and flows pretty strong across the board. One area I am just trying to reconcile is the near term performance, the one year number in particular in the earnings release about 41% of long-term fund assets in the top half of LIPA rankings, I think that compares to 52% last quarter.

I would just like you to talk a little more where you are seeing weaker areas of performance, and what you are doing, or can do to turn that around?

David Sidwell

It depends obviously to the extent that you have the offering that you have in performance. We have seen a couple of our larger funds under perform and as a result that impacts the overall percentages. It is my understanding is a handful -- by which I mean one or two -- large funds that drive that number. It is based on the strategy of those funds.

Michael Hecht - Banc of America Securities

Then maybe just to follow up on the headcount question. With comp expense overall up 35% year-to-date versus the 29% increase in top line, any thoughts on whether we may see a comp accrual similar to last year in the fourth quarter? Obviously it depends on the environment, but I guess what I am getting at, anything structurally different, accounting wise or methodology wise, that would suggest a more flattish comp ratio in the fourth quarter?

David Sidwell

I am glad to say that hopefully all of the accounting noise around 123-R is behind us. I would suggest you keep focused on the year-to-date rates because obviously that does avoid some of the quarterly noise and we do try every quarter to base the accrual on our expectation for the full year. So obviously things can change, but our current compensation reflects what is our best estimate as of this date as to our compensation.

Operator

Your next question comes from Douglas Sipkin – Wachovia.

Douglas Sipkin - Wachovia

I wanted to drill a little more on the alternative business as it relates to asset management. Are you guys still, given what has transpired in some of the strategies, still seeking to grow via acquisition if the right opportunity presents itself as it relates to asset management, and I guess more specifically alternatives?

David Sidwell

Let me just start by saying I think we at this point feel very pleased with the investments we made in this business, whether it is FrontPoint or the other acquisitions that we did to broaden our offering. The fact that we now have over $100 billion of the assets under management in alternatives, which obviously also includes our real estate offering is something that we feel very good about. We think this is an important asset class. We were under-represented and needed to increase it.

I would say more broadly that we will continue to do what we have been doing. We will look for opportunities across a number of our businesses to jump start or accelerate the pace of growth by acquisition and I think alternatives fits that bill as much as anything. My major point is we got a lot done in 2007 and 2006, and it is already, in our view, having a very positive impact.

Douglas Sipkin - Wachovia

Any sort of benefits from a firm standpoint you guys are realizing with the absence of Discover, maybe a little bit more synergy or focus in certain businesses, or anything like that that we could point to as part of the rationale for spinning out the business?

David Sidwell

I cut my time in preparing for this call by 20% I would say. I actually think we are seeing exactly the reasons that we said we should do this, Morgan Stanley, that we are focused on what we need to do to build the securities business, and at a time like this third quarter, it was very clear we could stay extremely focused on those things we needed to get done, and presumably Discover can do the same. That was a large part of the rationale, and I think from sitting in Morgan Stanley, the logic has made sense.

Operator

Your next question comes from Guy Moszkowski - Merrill Lynch.

Guy Moszkowski - Merrill Lynch

You alluded to the fact that the $940 million or so in net writedowns to the loan part of the business, the loan book, was essentially not offset by hedges. You also talked about around a $1 billion reduction in sequential quarters in revenues in the fixed income business.

David Sidwell

The credit products within fixed income.

Guy Moszkowski - Merrill Lynch

Which includes mortgage. Can you give us a sense for what the gross and net there would have been with respect to hedging?

David Sidwell

Guy, I think maybe I didn't say very clearly earlier on. When you actually think about those businesses, whether it is the core business, the residential or commercial mortgage business, we are a very significant participant. We use a number of instruments both in our trading strategies, which would include strategies with our clients. Those would include both cash instruments and derivative instruments, and I think overall the point we were trying to make that we may enter into transactions which we view as part of an economic hedge of some positions in those trading books, and that the relationships of these instruments behaved in a way that was obviously impacted very considerably by what was going on in the marketplace, which is part of why we had a less successful quarter in this business than we had compared with the second quarter when we had a record.

It wasn't that it is as simple as saying I think the example I alluded to, was if you have private equity and the market moves X, you can clearly layout what drove the P&L. This was very much across instruments, across a number of strategies.

Guy Moszkowski - Merrill Lynch

Is it worthwhile to think about sort of intra-period ineffectiveness? In other words, that maybe the value of some of the hedges would have been recognized during the first half?

David Sidwell

I would say that obviously August was a much more difficult month than the early part of the quarter, although I think you did to some degree see the beginnings of this in July, and obviously we began to see big moves in instruments so if you had structures which were either long or short, there were very significant gross moves on both of those, driven by what was going on in the market where spreads broadly widened.

Guy Moszkowski - Merrill Lynch

I was actually thinking more in terms of timing differences between big economic hedges that you might have had which might have actually shown up as positives during the first half of the year and mark-to-market on underlying, which may have affected the third quarter more?

David Sidwell

No, because we are a mark-to-market shop so each quarter reflects that. If you remember, we did get a very big benefit from our trading activity in the residential mortgage business in the first quarter; and if you remember, we also said in the second quarter that the business overall was much lower revenues compared with the first quarter.

I just reiterate that we do mark-to-market all our positions in this business, so every quarter stands on its own legs.

Guy Moszkowski - Merrill Lynch

Just to switch to another topic, the clearance costs, and you did note this popped very significantly, and obviously to some extent that is driven very much by the volumes that you were seeing. Isn't there any opportunity to get some operating leverage on some of those costs, though? It seems like they popped so dramatically, that it was a little surprising, even given some of the volumes that we were seeing in the markets. Maybe you can help us understand whether there was some increase there that was driven by a mix shift, and what was actually trading.

David Sidwell

I think that the top line is that it was just driven by extremely high volumes across a number of products. In terms of the efficiency or the cost per trade, we obviously try to be as efficient with the suppliers of those services to us as we can. I think that if you look over time this is a line that has been growing reflecting the increase in volumes, and we saw huge, and I mean huge volumes in our equities business in August.

Operator

Your next question comes from Meredith Whitney – CIBC Markets.

Meredith Whitney - CIBC World Markets

I need some help to put the quantitative strategies issues this quarter into context, and it is not an area that has been talked about much by management for some time now. Can you give some historical perspective, as to when the last time you have made note of this in terms of it being material over the years? How many quarters on a percentage basis has it been materially profitable, not profitable, et cetera, just some context would be very helpful. Thank you.

David Sidwell

Meredith, just to provide a perspective on this, this is a number of strategies in our equities business on a number of debts. Many of these businesses have been around for many years. Over time it has been a very profitable business for us and to the extent in any one quarter, it has driven trading results to be something that we should know, we do refer to that. It just in any one period hasn't been so large.

As you see this quarter, it has as I said been over the years that we have been involved are very profitable business. We felt we just wanted to be absolutely crystal clear on what the drivers were this quarter, and so that was what prompted us to give the number across the different strategies.

Meredith Whitney - CIBC World Markets

David, if I could just press a little harder, when was the last time in your memory that you made note of it either positively or negatively in a quarterly release or in a quarterly conference call?

David Sidwell

I believe in the first quarter we highlighted it as an issue. This has not, to my knowledge, been a business that has had overall losses certainly in the last couple of years. I would have to go back in the files and look but as I said overall, this has been year in and year out a very profitable business strategy for us.

Operator

Your next question comes from Bill Tanona - Goldman Sachs.

Bill Tanona - Goldman Sachs

Just in terms of clarification, as I look at the supplement and look at the Fixed Income revenues for this quarter, you have got $2.2 billion but in your reference, David, early on talking about the credit revenues going from 1.3 to 260, I suspect that includes the writedowns for the leveraged loans which isn't incorporated in that fixed income number?

David Sidwell

It does not.

Bill Tanona - Goldman Sachs

It does not?

David Sidwell

It does not. If you look at the table on page 6, you will see that there is a line which is called other which has a loss of 877 in the third quarter, the August 31 quarter. That is where the 940 of loan losses are.

Don't forget, when we talked about the movement in fixed income, we also talked about some of the businesses that were very strong in the quarter so you heard from Colm talking about that we had a record interest rate and currency markets quarter, driven by strong FX, so there are some positives which offset that negative.

Bill Tanona - Goldman Sachs

I understand that is where the leveraged loan hits are on the supplemental, but to drag it back to your commentary in the beginning, the credit revenues going from 1.3 last quarter to 260, does that include or not include hits to leveraged loans?

David Sidwell

It does not.

Bill Tanona - Goldman Sachs

Listening to your commentary as well, thinking about the commodities business, you said it was down 12%. I guess I was surprised to hear that that business is down, just given how volatile it has been, the activity and the price of oil. Just wondering what happened in the commodities business?

David Sidwell

There is really nothing of note. The structured business was as you heard from Colm, very consistent, and then trading was a little bit weaker, but there is really nothing of note, Bill. I think in any of these businesses quarter by quarter you are going to get ups and downs, and this was what I call in the normal range of up and down and that is why we highlighted what happened in credit products, because that was obviously a very big driver.

Bill Tanona - Goldman Sachs

Fair enough. In terms of the 390 related to FAS 157 and 159, how did you decide what to allocate to fixed income and what to allocate to equities? Seemed like you did 290 for FIC, and 100 for equities?

David Sidwell

Well, as we said, these are notes which basically support our client activity, so we know which notes are equity linked, and we know which ones are fixed income including commodity linked, so we can do it based on deal by deal, which gets allocated by each business. It is not done based on a broad allocation method.

Bill Tanona - Goldman Sachs

Lastly, in global wealth management you guys mentioned there that you had some benefit from it looked like insurance recoveries related to litigation settlements. What would the margin have been in that business, or what was that benefit in global wealth Management this quarter?

David Sidwell

It really wasn't that big of a deal. Outside of that you actually did see quarter on quarter, if we hadn't had the insurance settlement our non-comps would have been a little bit higher in this business, but as you know this is a business where James is very focused on managing the margin and the expense base, so if you actually look over time, the non-comps have been reasonably consistent driven sometimes by the litigation reserve.

I think the good news is you haven't been hearing us saying as much on the negative side of the cost of litigation, and hopefully that will continue.

Bill Tanona - Goldman Sachs

So would the margins have improved there if you excluded that?

David Sidwell

The margin actually would have been slightly less if you took out the benefit of the insurance supplement.

Operator

Your next question comes from Ron Mandel - GIC.

Ron Mandel - GIC

Two questions, one on the trading strategies. I wanted to make sure I understood that after all of this, and that is the $480 million, that was the actual amount of red ink that the trading strategies posted during the quarter?

David Sidwell

Yes.

Ron Mandel - GIC

I guess my then my question is, what was a somewhat normal quarter, so I can get a better feel for what the swing was versus normal?

David Sidwell

Ron, I thought it was very important for to us single this out because it was such a big driver. As you know, we don't tend to try and we would produce a telephone directory if we went business by business talking about performance in each period. I would say the track record, as I just answered Meredith, over time has been very positive although quarter by quarter there are some swings, and for instance as I said in the first quarter, we did mention one of those swings.

Ron Mandel - GIC

In regard to the Level 3 assets, I think you said you had a $600 million mark to whatever, mark to model gain in the second quarter.

David Sidwell

The Level 3 assets number is around that, yes.

Ron Mandel - GIC

And you said it was bigger this quarter. I was wondering how much bigger it was.

David Sidwell

We are still actually making sure that we are -- it is a fairly complicated exercise to make sure you go asset by asset and bucket them into 1, 2, and 3. We are expecting the number to increase, and that increase reflects as I said, both the movement from Level 2 into Level 3, but probably just as importantly that given the widening of spreads and other market moves there are a number of derivative instruments on which we have made mark-to-market gains which show up in Level 3. I do want to highlight that on balance those are then offset by losses in Levels 1 and 2.

Ron Mandel - GIC

I guess where I was going was, I would think that the more complicated structures in Level 3 were to some extent the hedges so the implication being you had hedge gains of some sort that were offset by more cash-like losses elsewhere, I was just trying to get a feel if that is what the Level 3 gains that you were referring to are related to, to some extent?

David Sidwell

Ron, I don't want to be obtuse on this because it is so complicated, because you really have to look at instrument by business and by trading strategy, so it is a mixture of really all of the above, so there are items in Level 3 that are hedges of other levels but there are also items which are being hedged by Levels 1 and 2.

Again, I am not trying to be evasive, this stuff is all mark-to-market, but it is very hard to think of trading strategies just in terms of Level 3. You have to think of it in terms of the overall instruments used, many of which are in Levels 1 and 2. As I said when you think about our overall business, it is a relatively small part of our total assets, so a lot of what generates our business is occurring in the other levels.

Operator

Your final question comes from Jeff Harte - Sandler O'Neill.

Jeff Harte - Sandler O’Neill

I typically shy away from asking outlook questions because nobody really knows, but can you follow up a little bit on the comments you made earlier, about it maybe taking a couple of quarters for credit to get to a more normalized environment? Just kind of given the freeze of the this last quarter and the frost of the first half of the year, when you are saying more normalized, what kind of environment are you envisioning?

Colm Kelleher

I think what we were looking at was the necessary repricing of credit with spreads that got too tight. We also had various business lines that were predicated upon a distribution model. I think what is not certain is the degree to which some of those distribution lines will be reopened. I am reasonably confident that the U.S. mortgage market, for instance, will resume or we are beginning to see early signs of commercial and residential mortgage origination and securitization and buyers of that. There are other parts of the capital products where that distribution is not yet proven, and that is what I am referring to as being unsure on outlook.

I think some of the more opaque products will suffer in this. I think transparency will be key in terms of products and pricing for a while, yes, and that is why we have a cautious outlook. The jury will be out. The more obvious markets, leveraged lending, the investment grade markets, high yield markets and so on I think are opening, there will be a repricing which will accommodate that but I think we cannot yet be certain about which of these distribution models will be as efficient as they were.

Jeff Harte - Sandler O’Neill

Finally, should we read anything into lending related commitments to LBOs declining pretty meaningfully on a sequential quarter basis, but then the corporate lending commitments in the aggregate on page 7 of the disclosure actually increasing by 16% on a sequential quarter basis? Is there anything to read into the spread between those?

Colm Kelleher

Not really. We do as a matter of course relationship lending, which supports a very, very large investment banking franchise, so as we increase market share in our investment banking M&A activities, one would expect to see our relationship lending going up as well, so I don't think you can see anything, or read anything into that other than that.

Jeff Harte - Sandler O’Neill

Thank you.

David Sidwell

I want to thank everyone for joining us today. We had as a goal to try to be transparent, so there are a lot of new disclosures that we made, so please if you have additional feedback on that, Colm and I would very much like to hear it. We do want to make sure we are transparent. Thank you very much for joining.

Colm Kelleher

Thank you.

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