摩根士丹利 (MS) 2008 Q2 法說會逐字稿

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 the webcast will be available through the company's website and by phone through July 18th, 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 were 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 one, item one, competition and regulation in part one, item one, risk factors in part one, item 1A, legal proceedings in part one, item three, management's discussion and analysis of financial condition and results of operations in part two, item seven, and quantitative and qualitative disclosures about market risks in part two, item 7A of the company's annual report on form 10K for the fiscal year ended November 30th, 2007, and other items throughout the form 10K and the company's quarterly report on form 10Q for the period ended February 29th, 2008, also the company's 2008 current reports on form 8K.

The presentation may also include certain nonGAAP financial measures.

The reconciliation of such measures to the comparable GAAP figures are included in our annual report on form 10K, our quarterly report on form 10Q and our current reports on 8K which are available on our website, www.MorganStanley.com.

Any recordings, rebroadcasts or any other use of this presentation in whole or part is strictly prohibited without prior written consent of Morgan Stanley.

This presentation is copywrited and proprietary to Morgan Stanley.

At this time I'd like to turn the program over to Mr.

Colm Kelleher for today's call.

Good morning, and thank you for joining us.

What I'm going to review with you today will be consistent with what we have been saying about business conditions in the quarter.

Strong client flows characterized the first quarter.

Second quarter flows were severely disrupted by the Bear Stearns situation and the fall-out of the forced liquidations of hedge funds and financial institutions continuing to raise capital and recognize further writedowns an ongoing theme.

Following the events in March that froze the markets, client activity improved, but remains subdued throughout the remainder of the quarter and had a significant impact on revenues in our institutional securities business.

There were a few attractive risk adjusted opportunities and we continue to be prudent in our use of capital.

The strength and health of our balance sheet will be evident when we disclose our tier one ratio in the 10Q.

While we are still finalizing the numbers, we expect our tier one ratio will be between 11.5% and 12%.

The themes that we laid out last quarter including market deleveraging and derisking continue.

We further reduced our leverage to 25.1 times, adjusted leverage to 14.1 times and increased our peered end liquidity to $169 billion and feel we have navigated through this difficult quarter.

Let me begin with an overview of our firm-wide results outlined on pages one and two of our financial supplement.

We generated net income of $1 billion, diluted earnings per share of $0.95 and a return on equity of 12%.

These results included the divestiture of our Spanish on-shore mass affluent wealth management business, reported in global wealth management, which affected profit before tax by $698 million and EPS earnings per share by $0.43.

We also completed a partial sale of our investment in MSCI to a second reoffering that had an additional impact on our profit before tax of $732 million and a 45% impact on earnings per share.

Results also included severance charges related to our recent reduction in force that reduced EPS by $0.15.

While extremely challenging markets had a broad impact several franchise businesses performed well including prime brokerage, cash equity trading and foreign exchange.

Our global wealth management business contributed strong results due to the momentum we have established with increasingly productive brokers and the fact that retail investors remain relatively engaged.

Firm-wide net revenues were $6.5 billion and PBG margin was 22%.

Noninterest expenses were $5.1 billion, down 17% from the first quarter, driven by lower compensation that included severance expenses of approximately $245 million.

On page three of the financial supplement you can see that total global head count decreased from 4% by year end reflecting our continued efforts to resize certain businesses in this difficult operating environment.

The compensation to net revenue ratio was 46% or 54% excluding the severance of the impact from the gains.

Our current estimate of compensation to net revenue ratio for the next two quarters will be closer to the first quarter of '08, excluding severance charges of 47%.

This is the ratio you should model going forward.

Noncompensation expenses were at $2.1billion.

Our noncomp levels are consistent with prior periods as we are using operating efficiencies to fund investments in technology and geographic expansion to enhance our client service capabilities.

Now let me turn to the businesses.

Starting with institutional securities detailed on page five of the supplement, these results were significantly affected by the ongoing market challenges and the corresponding decrease in client activity that we experienced this quarter.

Net revenues of $3.6 billion were 42% lower than the first quarter and included $744 million from the secondary reoffering of MSCI that you will see in other revenues in the institutional securities income statement.

Excluding the gain, revenues decreased 54%.

Noninterest expense of $2.9 million -- billion decreased 28% from the first quarter of ' 08 excluding the severance charge in both quarters, these expenses decreased 31% from the first quarter primarily driven by lower compensation as a result of lower revenues.

Pretax income was $679 million with an ROE of 9%.

Revenues and investment banking decreased 11% from the first quarter although our overall pipelines continue to be healthy with corporate maintaining high levels of strategic dialogue.

This quarter we've participated in several high-profile deals, including: Time Warner Cable $42 billion separation transaction, Northwest Airlines announced merger with Delta, GE Capital's $8.5 billion debt offering, New World Resources $2.5 billion IPO and CIT Group's $1.5 billion concurrent, common and convertible offering.

Looking at page six for supplement investment banking revenues were $875 million.

Advisory revenues of $367 million, a 17% decrease in the first quarter in line with completed industry volumes.

Underwriting revenues decreased 5% to $508 million as higher equity underwriting revenues were offset by lower revenues in fixed income underwriting.

Sequentially equity underwriting revenues of $298 million were up 14% driven by improved activity levels from the first quarter of ' 08.

Fixed income underwriting decreased 24% to $210 million reflecting lower revenues from loans and securitized products which offset strong results in bond issuance particularly investment grade.

Page six of the supplement shows total sales and trading revenues at $2 billion down 61% from strong results of last quarter.

Last quarter our trading businesses produced exceptional results on the back of our client franchise.

Since then client activity, the liquid credit markets and poor positioning drove trading revenues significantly lower particularly on fixed income.

Total fixed income sales and trading revenues were $414 -- $414 million down 85% from the first quarter of ' 08 on low revenues across all major categories as the difficult credit environment continued to weigh on the corporate and credit mortgage businesses.

While volumes and interest rate and currency businesses remain strong, unfavorable rates positioning drove revenues lower.

Interest rates credit and currency trading revenues combined were down 63% from the first quarter.

Credit trading generated a loss.

In addition to overall subdued customer activity levels, our results included losses of $390 million, which I will refer to again later for monoline exposures.

The credit trading loss also included $120 million negative adjustment to marks previously taken in our London's traders book that did not comply with firm policies.

Let me add here that our evaluation review group and business unit controllers in the course of evaluation review became aware of some anomalies and marks and reacted accordingly.

We continue to work out our mortgage propriety trading business on significantly reduced losses versus last quarter.

Our commodities business declined 67% from last quarter on poor positioning in North America electricity.

Firm issued structured notes had little impact on this quarter's fixed income results.

Equity sales and trading revenue of $2.1 billion were 39% lower than last quarter's record result as the market environment led significantly low derivatives and proprietary trading revenues which offset continued strength in prime brokerage and cash trading.

Despite the severe drop in volumes to the credit markets global equity volumes remain strong resulting in slightly higher cash equity revenues.

Derivative revenues were 25% lower than the first quarter as volatility levels decreased creating fewer trading opportunities.

Prime brokerage business produced strong revenues with average customer balances up slightly from last quarter.

The quarter's equity results also benefited from a $90 million gain on firm issued structured notes.

Let me now update you on our progress on managing down our exposures in those areas most affected by the credit cycle downturn that began last summer.

At that time our exposures were at peak levels in areas that concerned us most, mainly leverage lending, commercial real estate and residual subprime.

Today and in our 10Q, we will be disclosing broader gross exposure information to help you understand the financial impact of the marks we have taken in commercial mortgage banks and monolines.

Our leverage acquisition portfolio is now down to $12.7 billion from a peak of $35 billion in the third quarter.

This number is imbedded in the noninvestment grade loans and commitments of $22.3 billion on page seven of the supplement.

Some liquidity did return here to marketplace this quarter.

We had net positive market movements of $430 million on noninvestment grade loans and commitments which were offset by losses on hedges of $910 million resulting in net losses of $496 million.

These losses were primarily in the leverage acquisition portfolio.

These are the major components of the $519 million loss reported in other sales and trading.

Last year we anticipated CMBS commercial home loan issues early and repositioned our portfolio across regions with a greater proportion of the reduction in net exposure coming out of the U.S.

We have provided details of our gross and net exposure in CMBS and commercial home loans on page 17 of our financial supplement.

We continue to get observable market prices from executed trades.

And as you can see in the supplement we reduced our net exposure to $6.4 billion from $11.6 billion, and our gross exposure to $22.1 billion and $23.5 billion.

Please note that included in the gross exposure are other secured financings that we do not consider to be at risk assets.

Total losses this quarter here were $100 million.

On page 16 of the supplement, we reduced our total ABS CDO subprime net exposure this quarter to $300 million from $1.8 billion.

I have stated earlier we have optimized our subprime portfolio with exposure primarily in higher quality vintages which we are managing more efficiently.

Our hedges have performed well producing a $300 million gain and we reduced our super senior mezzanine exposure by $1.2 billion from last quarter through dispositions and writedowns.

In other mortgage-related exposures including ALT-A, RMBS problems and European mortgage loans, we reduced our net exposure to $6.7 billion from $8.7 billion.

Our gross exposure was $12.3 billion at quarter end down from $14.5 billion last quarter.

Within the $6.7 billion there was $2.4 billion in ALT-A exposure down from $4.6 billion last quarter through executed trades and corresponding marks calibrate to those trades.

Total writedowns were $300 million and are the main driver of our losses in mortgage propriety trading.

RMBS bonds and European mortgage loans that make up the remaining net exposure in the nonsubprime residential category were flat to last quarter and did not include any significant net losses or writedowns.

Our aggregate net direct exposure to monolines is down $1.9 billion to $2.8 billion.

Our net exposure includes: $1 billion of ABS wrap bonds held by our subsidiary banks, $1.3 billion of insured municipal bond securities and net counterparty exposure to monolines of $500 million, which represents gross exposure of $3.6 billion net of hedges and cumulative credit valuation adjustments of $900 million.

As I mentioned our losses related to monolines of $390 million this quarter, which included an increase in credit valuation adjustments of $250 million.

Turning to capital liquidity we are still very focused on maintaining a strong capital position, high levels of liquidity and prudent leverage ratios.

Page four of the supplement highlights our current capital position.

We continue to be well capitalized with excess capital.

As I mentioned before, while we are still finalizing the numbers, we expect our tier one ratio will be between 11.5% and 12% in our 10Q.

This ratio represents the overall strength of our balance sheet.

We are still placing a significant emphasis on our capital liquidity to ensure we have enough dry powder to continue investing in our businesses and to take advantage of attractive risk adjusted opportunities.

We further strengthened our liquidity position and built on the momentum of the previous few quarters.

We ended the quarter with total liquidity of $169 billion, up $46 billion from the prior quarter end.

Let me take you through the components.

During the quarter we accessed the capital markets to raise $14.3 billion in unsecured parent company debt bringing our year to date public long term debt issuance activity to $22.9 billion.

This amount together with incremental nonpublic issuance activity exceeds our schedule maturities for 2008.

We continue to actually manage down positions requiring significant cash funding and reallocate balance sheet to liquid assets with significant two-way customer flows.

And lastly with higher levels in our liquidity reserve we reduced our commercial paper outstanding to $12.3 billion for this quarter end, a reduction of roughly $5 billion from the first quarter and down from a peak of $28 billion.

Total liquidity which we have added to our financial supplements on page three includes liquidity at the parent company, bank and nonbank subsidiary levels.

Total liquidity averaged $135 billion in the quarter, up 11% from the record levels of $122 billion in the first quarter.

Parent company liquidity was $80 billion at quarter end and averaged $74 billion, up from $71 billion averaged in the first quarter.

Bank and nonbank subsidiary liquidity position was $89 billion at quarter end, on average $61 billion on the quarter.

Last quarter I told you that the weighted average maturity of our fixed income repo book turning to secured financing was 34 days which is a relatively long duration.

Recently in that books average repo maturity has been around 48 days.

The more comprehensive metric that we planned to disclose for you in our 10Q filings going forward is the weighted average maturity across all asset classes in our repo and stock lending books.

The weighted average maturity of these books has recently been about 45 days.

We continue to work to extend the term of this book as part of our overall liquidity planning and financing capabilities.

We are managing our balance sheet prudently and further reduce the 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 leverage ratio to 25.1 times from 27.4, and our adjusted leverage ratio down to 14.1 from 16 times.

This combination of our strong capital, high liquidity and reduced leverage positions us to take advantage of market opportunities.

As regards value at risk, total average trading and nontrading VaR increased to $112 million from $103 million last quarter.

Average trading value at risk was up slightly to $99 million from $97 million.

Moderate increases in VaR were driven primarily by higher realized market volatility that more than offset reductions in key trading risks.

In addition, the increased in aggregate trading and nontrading VaR was also driven by the issuance of long-term debt referred to earlier used to fund the increase in the company's total capital.

In our 10Q filing in addition to our tier one ratio will be reporting risk rated assets -- actually to market credit not operational risk.

This will provide you an additional tool to evaluate our risk taking each period.

Turning to page eight of the supplement and our global wealth management business.

As I mentioned at the beginning of the call, we divested our Spanish on-shore mass affluent wealth management business during the quarter, and our results reflect the impact of that transaction.

The net gain on the sale after accounting for related expenses was $698 million of PBT.

Excluding this gain [PBT] for the quarter was $291 million and the PBT margin was 17%.

Revenues excluding the divestiture increased 6% sequentially, reflecting a significant amount of new issue activities that increased investment banking revenues by 46% primarily in fixed income underwriting.

Fees and commissions to clients slightly from last quarter and low market levels and client activity.

The increase in principal transaction revenues reflect stronger volumes primarily in municipals and corporate equities.

Excluding certain expenses related to the divestiture noninterest expenses increased 4% from last quarter.

The increase was primarily driven by higher business development expenses on an increase and legal reserves.

Excluding the divestiture ROE for the business was 51%.

On page nine you can see the productivity metrics.

Net new assets of $13.3 billion represent our ninth consecutive quarter of positive client inflows on our second highest ever.

After this the $1 million plus household segment increased 4% from last quarter to $511 billion and represented 72% of our total client asset base.

Total client assets increased 2% from last quarter to $739 billion largely reflecting market levels and net new assets.

An average FA production excluding the divestiture increased to $810,000 as a result of increased revenues.

Average assets per FA of $89 million increased also 5% compared to last quarter reflective of asset levels in the quarter.

And if you exclude the reduction of brokers from the divestiture, FA headcount increased slightly compared with the first quarter of '08.

Our bank deposits grew to $34.3 billion, our clients kept assets in cash due to the volatile markets.

Let me turn to asset management which continues to be negatively impacted by the turmoil in the markets.

On page 10 of the supplement, our asset management business reported a pretax loss of $227 million.

Revenues were down 10% sequentially, primarily reflecting investment losses in merchant banking partially offset by higher revenues in our core business.

Merchant banking posted losses on principle investments of $212 million primarily driven by markdowns in real estate.

$150 million of these mark downs relate to the write down of one major investment that was acquired in 2007 as part of the building of a future real estate fund.

Presently our REIT includes high quality office buildings in investments and resorts and residential developments located in select high growth markets across the United States.

Due to factors including changes in market conditions the time and valuation and size of the investment we will not include present to the investor fund.

As a result $4.6 million of assets have been consolidated onto our balance sheet.

We will continue to evaluate these assets and position them for sale as opportunities arise.

Core results include lower management and administration fees primarily reflecting lower performance fees in our alternatives business and lower trading losses.

The trading results include losses of approximately $86 million related to market and securities issued by structured investment vehicles held on balance sheet by asset management.

The total structured investment vehicle or SIV exposure in our money fund as of quarter end was $1.3 billion which are all bank sponsored down from $3.6 billion at the end of last quarter.

This decrease came from maturity sales and paydowns.

The current balance is approximately $1 billion and which will drop below $600 million by the end of June.

For value of assets relating to SIVS on our balance sheet was approximately $500 million by the end of the quarter.

Noninterest expense of $715 million increased slightly from the first quarter driven by higher compensation partially offset by lower noncompensation expenses.

These results contrast sharply from the strong results we delivered last year.

There has been a significant fall off in this business and it continues to be a difficult environment particularly for real estate.

The primarily driver of the volatility in revenue is negative marks the real estate portfolio compared to substantial gain in the prior year and to a lesser extent the SIV-related marks to our proprietary positions.

We continue to see investor interest in real estate because of our strong track record and ability to take advantage of the distressed market.

Turning to pages 11, 12 and 13 of the supplement, as you can see the assets under management and asset flow data.

This quarter we revised our disclosure to provide more transparency around assets and flows by products and channels including a breakdown of our merchant banking business.

Total assets under management increased 5% to a record $605 billion.

We generated $15.5 billion in flows, our seventh consecutive quarter of positive flows.

From a product perspective we now show asset flows in both the merchant banking.

business.

There were $13.8 billion of inflows into core, with strong inflows to fixed income and alternative products, we get our outflows from equities.

Core inflows were driven primarily by institutional money markets.

Flows into merchant banking products remain positive while we recorded $1.7 billion in asset flows in the quarter.

We continue to show positive flows in our nonU.S.

and U.S.

institutional channels while retail channels recorded outflows in the quarter.

As we have said earlier we are committed to improving our performance in the retail and mutual fund space.

This continues to be a major focus of the management team.

On page three of the supplement you can see the regional revenue disclosure at the firm wide level.

This quarter 57% of our revenues were international with 43% from Europe, the Middle East and Africa and 14% from Asia, and 43% have come from the Americas.

Finally a few words on the outlook.

After a difficult start to the quarter, customer flow activity returned to more normal levels in May and these flows have continued into June.

Clearly the markets are still nervous and although there are encouraging signs of a trend many issues remain.

Rising inflation, higher energy prices, rising unemployment and the ongoing housing downturn will continue to pressure the U.S.

consumer.

Uncertainty remains surrounding potential regulatory and accounting changes.

Against this backdrop the underlying trends in our customer business is good.

We are starting to see an increase in risk taking and leverage loans and financial bonds, credit and the emergence of interest in CLOs.

While securitization markets are relatively quiet, we have been able to reduce gross exposures with cash sales.

In particular we have seen normal leverage buys of distressed assets in this class.

Retail clients remain engaged all be it safer and lower margin investments and our emerging market pipelines are fast.

So we will continue to stay close to shore given the current market conditions, importantly we continue to focus on liquidity, capital and balance sheet transparency and we are very focused on servicing our clients.

We are confident that our global platform is strongly positioned to capture the opportunities of the market dislocations and to look for risk adjusted returns.

Thank you, and I will now be happy to take your questions.

Please stand by while we wait for the question and answer portion of the conference to begin.

Your first question comes from the line of Guy Moszkowski with Merrill Lynch.

Go ahead.

Good morning, Colm.

First question just a very quick one, could you remind us in calculating your liability marks, did you use CDS spreads or do you use specific bond spreads?

On our liability marks we use bond spreads.

Okay.

Bond spreads.

I would like to talk for a minute about the leverage finance hedge loss.

Can you give us a sense for what sort of mix of hedges and type of hedges you use in hedging that portfolio?

Yes.

Well, in broad terms we actually had hedge losses across our whole book on noninvestment grade as well.

The preponderance of those losses was in the -- what I would call the bridge facilities.

And the reason for that, Guy, is that it's much harder to get specific CDS against them and you have to use by and large indexes of proxy, so we've been dynamically managing it on that basis and that really has been the bulk of the loss on those hedges, because as you know there is huge idiosyncratic risk there.

It's very name specific and very concentrated.

And I guess basically then what we saw was a -- despite the attempt to use single name hedges an inability to get enough of those to really protect you and therefore some macro level hedges which had a lot of basis risk this quarter?

Yes.

I think that is fair.

I guess the next thing I would like to talk about and I think this is probably a little bit more of a complex discussion is maybe if we can go to page 16 of the supplement.

And what I would like to try to do on the sub prime and resi analysis is we relate the exposures and P&L impact that we see here to the some odd $430 million net mark that you talked about towards the prop mortgage business.

And then separately how can we interpret these exposure numbers to really get comfortable that your exposure here is being brought down through sales and losses?

Okay.

So let's start, our mortgage proprietary trading, as disclosed on page 16, includes most of our legacy U.S.

subprime -- sorry, our mortgage proprietary in total includes most of our U.S.

legacy subprime positions, but also ALT-A and a few commercial positions.

So if you look at the loss itself, the net $300 million is made up of a gross $400 million loss mortgage proprietary trading and a $100 million gain on credit trading.

And I will break that down for you.

Within that -- within mortgage proprietary trading subprime it was a write up of $100 million, in a commercial writedown of $200 million, a nonsub prime residential which is primarily the ALT-A, which is the $300 million mark.

That's $400 million.

In credit trading, you have $100 million, which is made up of a write off and sub prime of $200 million.

So that $200 million plus $100 million gives you the $300 million writeup you see on the schedule.

The commercial write up $100 million in credit trading nets against the $200 million write down in the prop desk to give you the net write down of $100 million that is on the schedule on page 17.

Right?

And that kind of balances it for you.

Okay.

And --

Let me just clarify one thing.

If the schedule prevent all of our direct exposures they include positions that were outside what were the legacy proprietary trading debts.

So that credit trading number I'm giving you offsets the mortgage proprietary trading debts which is what you relate to in the fourth quarter.

Okay.

I think I get that.

And then just not to beat the dead horse, but I just want to essentially get some comfort around the idea that because of the losses that you talked about as well as actual portfolio sales, it is really a fair analysis to say that your exposure is being significantly wound down here such that for example in sub prime we really are at $300 million.

Yes.

Look, as you know the financial supplement, the analysis we present to present all our U.S.

subprime gross and that exposure, we are continually and we said we would manage down our exposure in the areas where we incurred our greatest losses in 2007, and that was through a combination of dispositions and write downs and that has been calibrating our valuations and so on.

That is clearly evidenced by the $1.8 billion decline you see in the net exposure in our super senior mezz line, right, and the APS bonds position.

But I also said last quarter given market dynamics we'd continue to look for opportunities to manage our overall risk exposure in this portfolio.

So there is some dynamic hedging on it's short side which means in fact you should feel very comfortable that we are managing this exposure down.

The numbers seem to say that, but like I said I wanted to reconcile, and I think you did a good job of helping us think that through.

The final question I'm going to ask is that on the $120 million mismarking that you talked about in London, I assume that the person or people involved in that are no longer with Morgan Stanley.

Well, it is not quite that simple, because we have to go through process.

The person responsible is suspended.

There is an investigation involving a number of bodies which we reported.

We immediately informed the FSA when we discovered this through our controls.

There is a full internal review of this matter.

I'm sure we know what the sentence is going to be, but I don't want to be like the Queen of Hearts.

Okay.

That's fair.

Alright.

Thanks very much.

Our next question comes from the line of Roger Freeman with Lehman Brothers.

Go ahead.

Hi, good morning, Colm.

I guess what I would like to ask is, you think about all the changes you have made around risk management, and you talk about the sort of federal, local sort of split, how fully has that been implemented and how is it working so far?

And I guess tied to that you kind of look in the trading results this quarter.

You see a number of places where -- and the results are not up to par, where bets were taken whether it was electricity, mortgage trading losses positioning for widening when they compress.

How is that factoring into the risk management and how do we get comfort that maybe some of that volatility decreases?

In fact, VaR actually went up in the quarter.

There are a number of questions, Roger.

I'm very glad you asked them, so let me address them one at a time.

Alright.

First of all, I would say that I will end up with risk management as the conclusion from what we come through.

Right.

First of all the mortgage proprietary trading losses we are taking are relating to by and large I just explained to Guy the previous legacy portfolios we have.

So along these things we need more efficient markets to reduce the exposures.

So I don't think there is an issue there.

And I do think actually if you look at the bulk of the charges we have taken they relate to legacy positions.

In terms of the commodities of a position, look, we have a great commodities business year in and year out, it has been one of the two top businesses.

They made a strategic bet, well thought out, well reasoned on the base of information we had.

We got it wrong.

We are in the risk game.

Occasionally we get things wrong.

We're not blas about it.

But that's -- we get more right than we get wrong.

Unfortunately this quarter, so we are not worried about that.

The risk is well managed.

It was just the wrong view and so on.

In terms of level three assets which you mentioned we got those under control the 7% of the others, so -- 7% of the total balance sheet, so they're in line, even though we reduced our balance sheet.

So I think we have got these positions where we -- under control.

Now risk management has played a very active role in this whole process.

The reason we have disclosed this loss from the London trader is to be open to the street.

I don't want to be blas about the fact that we discovered it, because we are very angry about it, but in this sort of environment of stressed markets, one would expect to see people try to behave improperly.

The issue is, do you have the controls to catch them.

We belive we do.

So that's where I would end up.

I think Ken deRegt is our Chief Risk Officer.

The hiring of [Keshi Hatsuki] as Head of MRD, and a thorough overhaul of where we were.

I feel very comfortable that our balance sheet is in good order and we understand our risks.

Did I leave anything out?

VaR, you say it has gone up, and it has.

It has gone up marginally.

But actually if you look at the inputs of that volatility itself, particularly feeding it, you will see if we were to normalize it, our previous inputs has gone down, our balance sheet has come down, our gross exposures have come down, our net exposures have come down.

What you are seeing a dynamic in the market that is driving VaR up.

If we had taken more trading risk, that VaR would have been significantly more pronounced.

Our nontrading VaR is up, purely as a function of the increased funding we did and what I propose to do next quarter is to try and see if we can work on some better disclosure around -- on trading VaR, or the quarter after, but we will work on that.

Okay.

That's helpful.

And switching to your commercial mortgage securities loans exposure, can you just help me think through any basis risk that -- is there basis losses that apparently you didn't have in the quarter that I guess I would have have expected given the big difference between gross and net there?

No.

We disclosed that we had a $100 million loss in the first quarter.

We didn't take losses managing this business down.

There are different risks in this book.

We show gross and net.

If you look at the bottom line you will see that we have an accounting gross that nets that off.

The stable financial condition which is bonds, warehouse, lines and loans grace exposure was reduced $2.5 million.

The net exposure reduced $3.6 billion.

You can see that.

And it is reasonably well distributed regionally and in terms of the loans themselves more disclosure commercial loans of 71% senior, 29% mezzanine.

So I think if you look at it and take out the gross ops, I think we have this position under control, well down from the peak which we had of probably $35 billion to where we are now and we have taken a lot of the basis risk out.

In addition, remember, I've always said that the best basis for our valuation to pre-empt these questions is we recalibrate the trades to external markets.

We have been justified on the marks, we have been taking on that, Roger.

Okay.

But the primary mechanism for hedging exposures is -- is it more single name CDS, or --

It depends on the name.

It could be credit to fault index in total rate of return swaps.

It depends.

What we are showing you is that the way we are managing it zero loss in management position the first quarter, $100 million this quarter which has been a very stressed environment for basis risk and index performance, look, effectively the best hedges get your gross exposures down.

That's what we have been doing.

Okay.

And then the mix between fixed and floating what is the average duration of the floating rate on the loans?

I will get back to you on that, if that's okay.

Yes.

One last question and I will jump back in --

I can tell you floaters 94%, fixed 6%.

Okay.

I guess with respect to these CSC ratios your tier one ratio obviously looks pretty good relative to what we have heard so far this quarter.

How do you think that ratio will be given?

You will talk about some of the risk components in the Q.

But one piece that is not captured is the liquidity risk.

Do you think that's going to end up having to get reworked?

Do you think these are useful metrics?

I really don't want to comment on that.

But we are clearly heavily involved.

The fact that we are running the liquidity the way we are is telling you that we think liquidity is a main input.

I do think there is a measurement of risk.

I do think the [basil two] and the trading book review is a very thorough exercise.

So personally when you see the risk weighted assets disclosed and the composition of those I think it will be a much more useful tool than actually accounting classifications.

Okay.

Alright.

Thanks.

Our next question comes from William Tanona with Goldman Sachs.

Go ahead.

Good morning, Colm.

Just on the loss of the $120 million.

Obviously you guys also had losses I think it was in the fourth quarter of last year as it related to the CDO book.

Just can you elaborate and help us understand exactly where these losses stem from exactly?

What didn't comply, and as you think about these losses, $120 million for I guess a single trader is significant.

So just trying to understand over what time frame this occurred as well.

Okay.

Well, let's -- very different set of circumstances.

What we had in the fourth quarter was a propriety trade.

There was never issue of financial control or mismarking anything.

It was a bad trade that went south very badly, and we have given you the data points on that.

Alright?

What we have had this quarter is we have a trader who was mismarking his book, right?

And we found it.

Our controls picked it up.

Obviously an environment like issue, we will get more of that.

There was some involvement going back to the previous quarter, possibly even the quarter below that.

It is subjective.

We did not think it was material, but we certainly did think it was time to disclose it to people and to send a very strong message that we have zero tolerance on this sort of behavior.

So I do believe it is isolated.

I think it is a very different situation from a prop trading bet going wrong.

I think it is just something we caught.

Our controls caught and we dealt with.

Okay.

And then I guess on the prop trading side, I mean, obviously there are numerous businesses that seem to be negative impacted by prop trading this quarter even on the equity side.

I know one of the big initiatives that John Mack had implemented when he got there was increased risk taking.

And just wondering whether or not you are re-thinking your ability or willingness to take risks, just given some of these losses this quarter or was it just a perfect storm of events of bad luck for you guys?

First of all, I think losses this quarter a lot of these losses relate to previous positions.

Our equity division still produced $2.1 billion, which is one of our best quarters ever.

So I don't think that impacted that business.

It shows the breadth diversification and so on.

In terms of risk taking, look, we will take risks, but we want to take adjusted risk.

We did not believe we flagged throughout this quarter that we felt that these were very, very treacherous waters.

The events that took place, as you say, is a perfect storm.

People cannot gloss over lightly the event that took place in March and the affect that it had on the market.

And since then you have a number of deteriorations in the consumer lending sector and so on.

So that is made us pull down the sails, sail close to shore, preserve our ammunition, we do have excess capital, we do have excess liquidity.

We do have leverage if we want to where we can take risks and we can optimize our balance sheet.

That is our priority.

Okay.

Fair enough.

And then lastly, in terms of the regional revenue break out when you strip out the games that you had highlighted from MSCI as well as the wealth management business, it looks like all of the regions were down anywhere from 25% to 50%.

Were the losses that you highlighted in kind of the trading businesses across all the regions or were the core international trends really that weak this quarter?

No core international trends were strong.

It was just that -- look, the way I would answer it is the first quarter we did well because we had very good client activity and that's really our edge.

That's where we had a good ROE.

This quarter we saw generally a fall off in client activity in broad terms.

That is what's affected us.

In Asia if you look at it down a little bit primarily in sales and trading.

Investment banking was up slightly.

Europe was fine.

We were 57% in of our revenues, if you normalize that for the loss we are still around the 50/50 level.

Not losses, sorry, the markdowns were taken on legacy positions and so on.

So I think that our diversification is paying off.

And I say also if you look at a normalized operating rate, yes you can look at some of the gains we have taken, but you've also got to look at some of the losses we have taken and try to work out the run rate, and hopefully we have given you enough information for you to be able to compute that.

Okay.

Thanks.

Our next question comes from the line of Glenn Schorr with UBS.

Go ahead.

Thank you.

Follow-up question on [SIV].

We can stay at the high level I know I will not get to specific levels.

$2.8 billion last quarter, we go to $400 million or so this quarter, we have the prop mortgage issues, we have lower customer volume issue and then we have the commodity.

Yes.

It still feels like, wow, were customer volumes that soft across the board, or was the commodity number actually that big?

No, customer volumes froze, and I know some of our competitors have come up with slightly different stories.

I will tell you, customer volumes were down.

I think we have a good market position in March.

I have never seen anything like the drop off we have seen.

April -- if I scale it this way, and I have done this before, so I apologize for repeating, if you say zero is no volume, $5 million is very good volume.

March was zero, April was $2 million.

May came up to about a $4 million.

We have definitely seen an improvement since into June, but yes, we were hit hard by the lack of customer volume.

Yes.

I guess everyone is going to try to think about the impossible task of modeling going forward.

Can you box in -- 67% fallen fall off in commodities seems like a big fall off, because I know the commodity business has been doing pretty well.

So it seems like a reasonably large number and is that normal that a directional that can account for such a chunk of commodities.

You have a phenomenal commodities practice.

There is some accounting noise in there as well.

You have some mismatch between GAAP and economic accounting.

So -- but I can't really give you more clarification on that.

Okay.

If we could just switch over to slide 17 on commercial real estate.

Sure.

Just a couple of things, one is there any equity component included there?

It wouldn't fall in within any of those lines, so I'm assuming no.

No.

And then the bond section, if you could help, is that mostly mezz?

Well, in the commercial loans 71% is senior, 29% is mezz, and the bonds are primarily just straightforward bonds, yes.

Okay.

And who were the swaps with?

And I don't mean exactly who, but I'm just curious in general buckets who do you tend to do the swaps against?

That's one of the major differences between your gross and net exposure.

So I'm trying to think about counterpart exposure there.

I don't think there is any one persons to diversify portfolio of people most of which is done on our class-realized base anyway.

In the 10Q we will be publishing and accounting for what the swap counterparties are anyway.

But not at this granular level.

Right?

I rather wait and get the right levels.

But in principal what I'd say to you is, look, we are very comfortable with our swap counterparties.

Understood.

And then maybe last quicky.

Is -- in a lower volume environment it becomes a slippery slope to bother even asking, but market share and rank have moved lower in a bunch of the banking categories.

Is that a function of you got less of the [fig] storm in terms of banking it because there has been a lot of activity?

I think there are a number of things there, Glenn.

It certainly is true, we got less of the U.S.

fig, but as you know in Europe which is going to be more of a third quarter event, we did five out of the seven right issues.

If I look at my pipeline, I think that our pipeline in terms of ECM, DCM -- sorry, excuse me, equity capital markets and debt capital markets and M&A are all up on the last quarter and we have a very healthy pipeline.

There is a little bit of development of timing there.

I have no doubt we will reassert our rankings but there is a bit of a lag and there is temporary distortion because of volume in markets which have been a bit lopsided.

Cool.

And last one, to end on something good, wealth management flows are pretty awesome considering the environment.

Can you talk about how much of that is coming from say the existing FA base versus your -- what appeared to be a great ability to recruit during a tough time?

I think it is a combination of both.

We are getting very good productivity from the existing FA base, but as you know that is a good cumulative affect.

But in addition, we have been clearly been doing very well on what they call the balance of payments in hiring versus losses.

I think James and [Ella McCulkin] who is running [GW] have really done a fantastic job there.

Alright.

Thanks very much.

Our next question comes from the line of Mike Mayo with Deutsche Bank.

Go ahead.

Good morning.

Can you comment on the investment banking pipeline?

You said it was healthy, but could you quantify that a little bit more?

And also down 11% is a bit worse than some of your competitors, if you could give some more color on that.

Well, I would say we are -- it would be very difficult for me to say -- to give you specifics on that.

We are up in the first quarter significantly in announcement pending on M&A pipeline and also on our probability wages revenue on that basis and we are marginally up, to reasonable number up in equity and debt capital markets.

I think that's all I want to say on that, Mike.

Okay.

And then Asia was down 1/4 link quarter and it looks like the lowest level since quarter ending around rate '06.

The real swing factor, as I've said before, In Asia was the sales and trading which was the swing factor there.

What I can tell you is, our investment banking business in Asia, slightly positive, our pipelines in Asia are very, very strong.

And the sales and trading, did that relate to the legacy mortgage --

Not at all in Asia.

That was just literally reduced client volume.

Was there any outside loss there?

That is still a pretty big swing.

No, not at all.

And then just going back to the big picture here.

I tried to add up all the numbers you gave on the call and I got $1.7 billion of writedowns and losses.

I can go through the list.

You said it kind of quickly, monoline $390 million, the mismarking on the trade $120 million, leverage loans writedowns $496 million, and commercial real estate CMBS $100 million, all day $300 million, the trade loss $86 million.

Yes.

And then mark downs and private equity of $200 million.

Is that --

Yes.

That's correct.

There is nothing missing there.

So as we think about go forward, I think what you are implying here if you are marking everything correctly, in the perfect world if nothing changed, there is $1.7 billion of marks would go away or not necessarily?

Where do we stand with these kind of writedowns.

Look, I'm not going to give specific details on marks and I will tell you why.

I think we have been very clear about our philosophy on marking itself.

We calibrate the trades.

If you look at the sub prime exposure.

Let me give you an example, which is anecdotal, if you look at page 16 which subprime exposure if you look at that now, we brought that down , we've got the exposure down to a net of $300 million, but if you look in the footnotes we now have marks that are implying losses in the range of 18% to 41%.

Those cumulative loss levels at a severity rate of 55% are implying the 73% to 84%.

So if you take that as an example the fact that we disclosed this all fully.

We have calibrated trades.

We have done that in CMBS.

We have done that in leverage lending.

My view is, the marks are what they are.

We've improved subsequent trade that they're the right marks.

Sometimes we have done better than that obviously.

Whether we are going to get continued deterioration on them or not, I don't know.

There has been a big writedown already.

They are marked appropriately.

And it is a function of whether the markets return or

And then the tier one ratio you mentioned you want to keep dry powder.

The tier one 11.5%, 12% preliminary.

Does that reflect dry powder or is that where you want to run it?

You will have to judge that yourself.

There is a lot of uncertainty in the market.

We know where our contemporaries are in tier one.

We feel good about that.

But also we have uncertainty in the market generally.

So it does give us a capital buffer, which is the way I look at it.

So, yes, I feel good about a capital buffer.

Alright.

Thank you.

Our next question comes from the line of Prashant Bhatia with Citi.

Go ahead.

Hi.

Good.

Just your comments that you are going to continue to stay close to shore.

Does that imply that it is just too early in the cycle right here to take more or deploy capital more aggressively and you are okay to let some opportunities pass by, or is it more the view that you just don't think there will be much near term?

Well, we actually, if you remember at the end of last quarter I gave a more positive outlook, not that I have ever been Mr.

Happy.

But the issue is, there were definitely better signs of recovery in the market and then March was a pretty nasty event, right?

So when we looked at the outlook this time, it clearly is not as rosy as it would have been end of the first quarter, where various people are talking about sports innings and so on, right?

But I do think there is going to be an opportunity to make money here.

Right?

So it is an issue of taking advantage of dislocation, of taking advantage of opportunities that will present themselves.

We were hoping that will be the case this year -- this quarter, sorry, but the key for us, Prashant, is risk adjusted, and we really did not feel and you see that in our volume numbers -- we did not feel that our risk adjusted basis we didn't.

It was worth taking bets away from areas where we were comfortable with.

Now clearly in commodities, we made a trade on the basis of good fundamentals and so on.

It didn't work, but more often than not we get those right.

So I'm not saying we're in risk reduction mode, we clearly have reduced the risk, we have reduced the balance sheet.

We are liquid.

We have got capital.

We clearly feel we can make money through bear cycles and bull cycles, and we are just waiting for the right risk adjusted opportunity to come along.

Okay.

That is helpful.

And then just on the size of the asset base, the $1 trillion gross, [$580 million] net, where do you think that ends up settling?

Is there a fair amount more to go, or would you stay at these levels?

I kind of think we are in the right spot at the moment in the terms of giving us the optionality we need to be opportunistic and to be defensive.

Obviously, we would like more normalized market to get rid of some of this legacy portfolio so we can optimize the return on the balance sheet.

But we feel comfortable that we have optionality sitting where we are at the moment, given all the uncertainty around.

Okay.

And then on the $6 billion of commercial loans in your disclosure, do you have at hand what the delinquency rate is on that loan portfolio, or just anything else that you can provide to just help people understand the quality there?

It seems pretty good because I don't think you have taken any --

I haven't.

I believe it is very good quality which is our view and that is evident in our marks as well.

But we will see what we can -- I just think in general we have considered it to be very good quality and well marked.

Okay.

And then, just on the asset management side, it looks like the alternative asset flows are actually pretty strong over the past several quarters, that is a little different than what we have seen on some of the peers.

Can you talk about, is that partly driven by distributing into retail or what is the driver there?

I think there is a number of drivers.

We have had some very good performance within that historically.

We have got a broad suite of products and it is by retail as well.

Okay.

And then just one final on, can you elaborate --

The other thing I would point out is remember one of the big drivers this quarter has been institutional money markets.

Okay.

And then just on, could you point out areas in the business where you are actually seeing higher returns on the capital you are deploying, that pricing power you talked about a little bit in prime brokerage in the past?

Are there other areas where you are seeing -- you are basically getting paid more on capital being deployed?

Well, I think our equity business is strong and our ratios there look good, prime brokerage is good.

Obviously we are improving our profit margin in our retail business.

That's kind of where I'd point to.

But I mean, drawing a trend away from this quarter, away from those which I mentioned before is kind of hard.

Okay.

And then finally on head count, any -- could you share maybe what your budget is to end your year at?

We don't look at head count.

We look at cost.

And we have done pretty big moves on cost as you can see.

Head count is the secondary reconsideration.

So we are really looking at comp expense and by that you get a proxy by head count, and you can clearly see we are with a smaller reduction in head count and some others, but a big reduction in comp.

We are trying to get our bang for our buck if that allocation of our resources.

Okay.

Thank you.

That's helpful.

We have time for one more question from the line of Michael Hecht with Banc of America.

Go ahead.

Alright.

Thanks for taking my question.

How are you doing?

Can you give us a sense of where level three assets ended the period and just any components of the change, transfers in and out, that kind of stuff?

No.

It is a bit early yet to get into a that detail and I've noticed that can be a dangerous thing to do, but we are at 7% of the balance sheet roughly proportionally decreased with the overall balance sheet itself when we took it down.

The Q will give you specific disclosure on that.

So there is no specific story for us on level three.

And the same sort of stuff you'd expect in there broadly proportionally will be in there at the end of the Q.

Okay.

That's fair enough.

The $90 million in structured note gains you noted in equities, what were the total firm wide gains on structured notes this quarter?

That was it, the $90 million.

Just $90 million.

Okay.

On the monoline exposure, the market you guys took, can you give us a sense of how you guys come up with the credit valuation adjustment?

Sure, we've always done -- we don't do our credit valuation on ratings, we do it on spread.

So a spread wide we take increasing reserve so it is on that basis.

I think that is conservative.

We've -- this time around we showed our gross exposures as well as because obviously monolines have been more topical on that basis.

So you can see that, yes?

Okay.

And then on the gross and net leverage which came in quite a bit, I think you kind of said you think the balance sheet is appropriately sized.

Should we expect leverage to continue to fall and what do you think the implications are for the type of ROE you guys can earn through the cycle and are you seeing any pressure from regulators, rating agencies, investors to bring leverage down further?

Well, we are obviously in constant touch with a broad array of regulators.

What we have been doing is taking down the balance sheet because on a risk adjusted basis that's what we want to do.

And that's the same thing -- we have been running cash because we wanted to do that given our risk profile.

So the answer is we're in constant dialogue, but we are not getting any pressure.

In the terms of cycle ROE it's clear that increased leverage has been popping up ROEs, I do think it is top slices our return off of it.

But I think you can make up a good chunk of that by optimizing your balance sheet more efficiently.

To do that however we're going to need more normalized markets to liquidate positions.

Okay.

That's fair.

And just a quick follow-up on the equities business.

It's not like the flow of business is in cash and derivatives were pretty strong, prime brokerage as well.

But it's all really a function of the profiteering losses.

Can you give us any additional color on those?

Was it more just of the bad positioning versus environmental?

No, not really.

I think some of those small -- as I have said to you before some of those small prop trading desks we have found down, so I think generally look -- let me just restate, equities was $2.1 billion.

Our record quarter was $2.5 billion.

It was still a very strong quarter.

It was broad based.

I think it was our fourth best quarter, but I will have to confirm that.

I think that's right.

So I think it is just a testament to the strength of that business.

The story this quarter was clearly our fixed income fall off in flows.

Okay.

Maybe a quick calculating one, just any color on the tax rate it was a little lower than expected this quarter?

Should we -- where it's running --

No, it is just reflecting the changing nature of our business globally.

So that's what it is.

Okay.

Great.

Thanks.

Well, look, thank you very much, everybody.

And I'm sure we will have follow ups.

Thanks.

Ladies and gentlemen, thank you for your participation in today's conference.

That does conclude the meeting.

You may now disconnect.

Have a wonderful day.