Edgar Filing: MORGAN STANLEY

Form 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2012

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934

Commission File Number 1-11758

LOGO

(Exact Name of Registrant as specified in its charter)

Delaware

(State or other jurisdiction of

incorporation or organization)

1585 Broadway

New York, NY 10036

(Address of principal executive

offices, including zip code)

36-3145972

(I.R.S. Employer Identification No.)

(212) 761-4000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):


Large Accelerated Filer x				Accelerated Filer ¨
Non-Accelerated Filer ¨				Smaller reporting company ¨
(Do not check if a smaller reporting company)

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of October 31, 2012, there were 1,974,320,133 shares of the Registrant’s Common Stock, par value $0.01 per share, outstanding.

LOGO

QUARTERLY REPORT ON FORM 10-Q

For the quarter ended September 30, 2012


Table of Contents		Page
Part I—Financial Information
Item 1.	Financial Statements (unaudited)		1
	Condensed Consolidated Statements of Financial Condition—September 30, 2012 and December 31, 2011		1
	Condensed Consolidated Statements of Income—Three and Nine Months Ended September 30, 2012 and 2011		3
	Condensed Consolidated Statements of Comprehensive Income—Three and Nine Months Ended September 30, 2012 and 2011		4
	Condensed Consolidated Statements of Cash Flows—Nine Months Ended September 30, 2012 and 2011		5
	Condensed Consolidated Statements of Changes in Total Equity—Nine Months Ended September 30, 2012 and 2011		6
	Notes to Condensed Consolidated Financial Statements (unaudited)		8
	Report of Independent Registered Public Accounting Firm		91
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		92
	Introduction		92
	Executive Summary		93
	Business Segments		104
	Accounting Developments		120
	Other Matters		121
	Critical Accounting Policies		123
	Liquidity and Capital Resources		128
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		144
Item 4.	Controls and Procedures		160
Financial Data Supplement (Unaudited)			161

Part II—Other Information
Item 1.	Legal Proceedings		167
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		172
Item 6.	Exhibits		172


		i

AVAILABLE INFORMATION

Morgan Stanley files annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). You may read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, NE, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on the public reference room. The SEC maintains an internet site that contains annual, quarterly and current reports, proxy and information statements and other information that issuers (including Morgan Stanley) file electronically with the SEC. Morgan Stanley’s electronic SEC filings are available to the public at the SEC’s internet site, www.sec.gov.

Morgan Stanley’s internet site is www.morganstanley.com. You can access Morgan Stanley’s Investor Relations webpage at www.morganstanley.com/about/ir. Morgan Stanley makes available free of charge, on or through its Investor Relations webpage, its proxy statements, Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. Morgan Stanley also makes available, through its Investor Relations webpage, via a link to the SEC’s internet site, statements of beneficial ownership of Morgan Stanley’s equity securities filed by its directors, officers, 10% or greater shareholders and others under Section 16 of the Exchange Act.

Morgan Stanley has a Corporate Governance webpage. You can access information about Morgan Stanley’s corporate governance at www.morganstanley.com/about/company/governance. Morgan Stanley posts the following on its Corporate Governance webpage:

•

Amended and Restated Certificate of Incorporation;

•

Amended and Restated Bylaws;

•

Charters for its Audit Committee; Operations and Technology Committee; Compensation, Management Development and Succession Committee; Nominating and Governance Committee; and Risk Committee;

•

Corporate Governance Policies;

•

Policy Regarding Communication with the Board of Directors;

•

Policy Regarding Director Candidates Recommended by Shareholders;

•

Policy Regarding Corporate Political Contributions;

•

Policy Regarding Shareholder Rights Plan;

•

Code of Ethics and Business Conduct;

•

Code of Conduct; and

•

Integrity Hotline information.

Morgan Stanley’s Code of Ethics and Business Conduct applies to all directors, officers and employees, including its Chief Executive Officer, Chief Financial Officer and Deputy Chief Financial Officer. Morgan Stanley will post any amendments to the Code of Ethics and Business Conduct and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange LLC (“NYSE”) on its internet site. You can request a copy of these documents, excluding exhibits, at no cost, by contacting Investor Relations, 1585 Broadway, New York, NY 10036 (212-761-4000). The information on Morgan Stanley’s internet site is not incorporated by reference into this report.


		ii

Part I—Financial Information.

Item 1.

Financial Statements.

MORGAN STANLEY

Condensed Consolidated Statements of Financial Condition

(dollars in millions, except share data)

(unaudited)


	September 30, 2012		December 31, 2011
Assets
Cash and due from banks ($487 and $511 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities generally not available to the Company)	$	18,239	$	13,165
Interest bearing deposits with banks		18,347		34,147
Cash deposited with clearing organizations or segregated under federal and other regulations or requirements		28,847		29,454
Financial instruments owned, at fair value (approximately $133,773 and $140,749 were pledged to various parties at September 30, 2012 and December 31, 2011, respectively):
U.S. government and agency securities		52,134		63,449
Other sovereign government obligations		37,171		29,059
Corporate and other debt ($2,261 and $3,007 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities, generally not available to the Company)		55,439		68,923
Corporate equities		55,575		47,966
Derivative and other contracts		34,568		48,064
Investments ($1,855 and $1,666 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities, generally not available to the Company)		8,501		8,195
Physical commodities		7,920		9,697

Total financial instruments owned, at fair value		251,308		275,353
Securities available for sale, at fair value		40,498		30,495
Securities received as collateral, at fair value		12,811		11,651
Federal funds sold and securities purchased under agreements to resell (includes $625 and $112 at fair value at September 30, 2012 and December 31, 2011, respectively)		136,282		130,155
Securities borrowed		138,545		127,074
Receivables:
Customers		45,506		33,977
Brokers, dealers and clearing organizations		7,673		5,248
Fees, interest and other		10,399		9,444
Loans (net of allowances of $101 and $17 at September 30, 2012 and December 31, 2011, respectively)		24,344		15,369
Other investments		4,749		4,832
Premises, equipment and software costs (net of accumulated depreciation of $5,350 and $4,852 at September 30, 2012 and December 31, 2011, respectively) ($227 and $234 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities, generally not available to the Company)		6,083		6,457
Goodwill		6,622		6,686
Intangible assets (net of accumulated amortization of $1,162 and $910 at September 30, 2012 and December 31, 2011, respectively) (includes $6 and $133 at fair value at September 30, 2012 and December 31, 2011, respectively)		3,905		4,285
Other assets ($327 and $446 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities, generally not available to the Company)		10,827		12,106

Total assets	$	764,985	$	749,898

See Notes to Condensed Consolidated Financial Statements.


		1

MORGAN STANLEY

Condensed Consolidated Statements of Financial Condition—(Continued)

(dollars in millions, except share data)

(unaudited)


	September 30, 2012			December 31, 2011
Liabilities
Deposits (includes $1,942 and $2,101 at fair value at September 30, 2012 and December 31, 2011, respectively)	$	70,757		$	65,662
Commercial paper and other short-term borrowings (includes $697 and $1,339 at fair value at September 30, 2012 and December 31, 2011, respectively)		2,123			2,843
Financial instruments sold, not yet purchased, at fair value:
U.S. government and agency securities		26,651			19,630
Other sovereign government obligations		27,528			17,141
Corporate and other debt		7,649			8,410
Corporate equities		28,026			24,497
Derivative and other contracts		35,033			46,453
Physical commodities		—			16

Total financial instruments sold, not yet purchased, at fair value		124,887			116,147
Obligation to return securities received as collateral, at fair value		16,441			15,394
Securities sold under agreements to repurchase (includes $287 and $348 at fair value at September 30, 2012 and December 31, 2011, respectively )		116,220			104,800
Securities loaned		35,920			30,462
Other secured financings (includes $9,674 and $14,594 at fair value at September 30, 2012 and December 31, 2011, respectively) ($1,176 and $2,316 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities and are non-recourse to the Company)		18,173			20,719
Payables:
Customers		117,193			117,241
Brokers, dealers and clearing organizations		7,447			4,082
Interest and dividends		3,347			2,292
Other liabilities and accrued expenses ($119 and $121 at September 30, 2012 and December 31, 2011, respectively, related to consolidated variable interest entities and are non-recourse to the Company)		14,561			15,944
Long-term borrowings (includes $45,756 and $39,663 at fair value at September 30, 2012 and December 31, 2011, respectively)		168,444			184,234

		695,513			679,820

Commitments and contingent liabilities (see Note 12)
Redeemable noncontrolling interests (see Notes 2, 3 and 14)		4,302			—
Equity
Morgan Stanley shareholders’ equity:
Preferred stock		1,508			1,508
Common stock, $0.01 par value;
Shares authorized: 3,500,000,000 at September 30, 2012 and December 31, 2011;
Shares issued: 2,038,893,979 at September 30, 2012 and 1,989,377,171 at December 31, 2011; Shares outstanding: 1,975,040,372 at September 30, 2012 and 1,926,986,130 at December 31, 2011		20			20
Paid-in capital		23,202			22,836
Retained earnings		39,441			40,341
Employee stock trust		2,979			3,166
Accumulated other comprehensive loss		(146	)		(157	)
Common stock held in treasury, at cost, $0.01 par value; 63,853,607 shares at September 30, 2012 and 62,391,041 shares at December 31, 2011		(2,226	)		(2,499	)
Common stock issued to employee trust		(2,979	)		(3,166	)

Total Morgan Stanley shareholders’ equity		61,799			62,049
Nonredeemable noncontrolling interests		3,371			8,029

Total equity		65,170			70,078

Total liabilities, redeemable noncontrolling interests and equity	$	764,985		$	749,898

See Notes to Condensed Consolidated Financial Statements.


		2

MORGAN STANLEY

Condensed Consolidated Statements of Income

(dollars in millions, except share and per share data)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Revenues:
Investment banking	$	1,152		$	1,031		$	3,319		$	3,940
Principal transactions:
Trading		607			4,960			5,483			11,421
Investments		290			(298	)		438			433
Commissions and fees		988			1,476			3,205			4,198
Asset management, distribution and administration fees		2,257			2,149			6,677			6,406
Other		152			347			432			110

Total non-interest revenues		5,446			9,665			19,554			26,508

Interest income		1,379			1,753			4,244			5,573
Interest expense		1,536			1,608			4,621			5,490

Net interest		(157	)		145			(377	)		83

Net revenues		5,289			9,810			19,177			26,591

Non-interest expenses:
Compensation and benefits		3,929			3,638			11,993			12,545
Occupancy and equipment		388			382			1,160			1,174
Brokerage, clearing and exchange fees		359			443			1,167			1,254
Information processing and communications		493			456			1,439			1,340
Marketing and business development		138			143			440			436
Professional services		477			440			1,367			1,310
Other		985			623			1,948			1,976

Total non-interest expenses		6,769			6,125			19,514			20,035

Income (loss) from continuing operations before income taxes		(1,480	)		3,685			(337	)		6,556
Provision for (benefit from) income taxes		(524	)		1,415			(244	)		1,709

Income (loss) from continuing operations		(956	)		2,270			(93	)		4,847

Discontinued operations:
Gain (loss) from discontinued operations		(15	)		(5	)		61			(55	)
Provision for (benefit from) income taxes		(15	)		(28	)		40			(37	)

Net gain (loss) from discontinued operations		—			23			21			(18	)

Net income (loss)	$	(956	)	$	2,293		$	(72	)	$	4,829
Net income applicable to redeemable noncontrolling interests		8			—			8			—
Net income applicable to nonredeemable noncontrolling interests		59			94			446			469

Net income (loss) applicable to Morgan Stanley	$	(1,023	)	$	2,199		$	(526	)	$	4,360

Earnings (loss) applicable to Morgan Stanley common shareholders	$	(1,047	)	$	2,153		$	(599	)	$	2,335

Amounts applicable to Morgan Stanley:
Income (loss) from continuing operations	$	(1,007	)	$	2,178		$	(522	)	$	4,383
Net gain (loss) from discontinued operations		(16	)		21			(4	)		(23	)

Net income (loss) applicable to Morgan Stanley	$	(1,023	)	$	2,199		$	(526	)	$	4,360

Earnings (loss) per basic common share:
Income (loss) from continuing operations	$	(0.55	)	$	1.15		$	(0.32	)	$	1.48
Net gain (loss) from discontinued operations		—			0.01			—			(0.01	)

Earnings (loss) per basic common share	$	(0.55	)	$	1.16		$	(0.32	)	$	1.47

Earnings (loss) per diluted common share:
Income (loss) from continuing operations	$	(0.55	)	$	1.14		$	(0.32	)	$	1.47
Net gain (loss) from discontinued operations		—			0.01			—			(0.02	)

Earnings (loss) per diluted common share	$	(0.55	)	$	1.15		$	(0.32	)	$	1.45

Average common shares outstanding:
Basic		1,889,300,631			1,848,246,471			1,883,813,883			1,589,519,478

Diluted		1,889,300,631			1,868,743,943			1,883,813,883			1,607,962,757

See Notes to Condensed Consolidated Financial Statements.


		3

MORGAN STANLEY

Condensed Consolidated Statements of Comprehensive Income

(dollars in millions)

(unaudited)


	Three Months Ended September 30,						Nine Months Ended September 30,
	2012			2011			2012			2011
Net income (loss)	$	(956	)	$	2,293		$	(72	)	$	4,829
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustments(1)	$	43		$	(108	)	$	(88	)	$	23
Amortization of cash flow hedges(2)		2			1			5			5
Net unrealized gains on Securities available for sale(3)		62			76			84			90
Pension, postretirement and other related adjustments(4)		(4	)		1			15			8

Total other comprehensive income (loss)	$	103		$	(30	)	$	16		$	126

Comprehensive income (loss)	$	(853	)	$	2,263		$	(56	)	$	4,955
Net income applicable to redeemable noncontrolling interests		8			—			8			—
Net income applicable to nonredeemable noncontrolling interests		59			94			446			469
Other comprehensive income (loss) applicable to redeemable noncontrolling interests		(1	)		—			(1	)		—
Other comprehensive income applicable to nonredeemable noncontrolling interests		29			63			5			72

Comprehensive income (loss) applicable to Morgan Stanley	$	(948	)	$	2,106		$	(514	)	$	4,414

(1)	Amounts are net of provision for (benefit from) income taxes of $(150) million and $239 million for the quarters ended September 30, 2012 and 2011, respectively, and $26 million and $103 million for the nine months ended September 30, 2012 and 2011, respectively.

(2)	Amounts are net of provision for income taxes of $1 million and $2 million for the quarters ended September 30, 2012 and 2011, respectively and $3 million and $4 million for the nine months ended September 30, 2012 and 2011, respectively.

(3)	Amounts are net of provision for income taxes of $46 million and $52 million for the quarters ended September 30, 2012 and 2011, respectively, and $63 million and $62 million for the nine months ended September 30, 2012 and 2011, respectively.

(4)	Amounts are net of provision for income taxes of $8 million and $1 million for the quarters ended September 30, 2012 and 2011, respectively, and $18 million and $1 million for the nine months ended September 30, 2012 and 2011, respectively.

See Notes to Condensed Consolidated Financial Statements.


		4

MORGAN STANLEY

Condensed Consolidated Statements of Cash Flows

(dollars in millions)

(unaudited)


	Nine Months Ended September 30,
	2012			2011
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	(72	)	$	4,829
Adjustments to reconcile net income to net cash provided by (used for) operating activities:
Loss on equity method investees		24			788
Compensation payable in common stock and options		898			1,006
Depreciation and amortization		1,218			1,187
Gain on business dispositions		(108	)		(24	)
Gain on sale of securities available for sale		(53	)		(130	)
Gain on retirement of long-term debt		(29	)		(46	)
Impairment charges and other-than-temporary impairment charges		224			57
Changes in assets and liabilities:
Cash deposited with clearing organizations or segregated under federal and other regulations or requirements		607			(11,684	)
Financial instruments owned, net of financial instruments sold, not yet purchased		31,556			34,742
Securities borrowed		(11,471	)		14,826
Securities loaned		5,458			(1,309	)
Receivables and other assets		(23,625	)		3,263
Payables and other liabilities		9,807			22,501
Federal funds sold and securities purchased under agreements to resell		(6,127	)		(21,571	)
Securities sold under agreements to repurchase		14,465			(37,545	)

Net cash provided by operating activities		22,772			10,890

CASH FLOWS FROM INVESTING ACTIVITIES
Net proceeds from (payments for):
Premises, equipment and software costs		(865	)		(1,088	)
Business dispositions, net of cash disposed		1,536			—
Loans		(1,739	)		(7,252	)
Purchases of securities available for sale		(17,492	)		(13,968	)
Sales, maturities and redemptions of securities available for sale		8,200			16,809

Net cash used for investing activities		(10,360	)		(5,499	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from (payments for):
Commercial paper and other short-term borrowings		(720	)		(375	)
Distributions related to nonredeemable noncontrolling interests		(186	)		(489	)
Derivatives financing activities		102			54
Other secured financings		(4,291	)		1,705
Deposits		5,095			2,372
Net proceeds from:
Excess tax benefits associated with stock-based awards		42			30
Issuance of long-term borrowings		16,196			30,063
Payments for:
Long-term borrowings		(36,386	)		(31,936	)
Repurchases of common stock for employee tax withholding		(222	)		(311	)
Purchase of additional stake in the Wealth Management Joint Venture from Citi		(1,890	)		—
Cash dividends		(349	)		(714	)

Net cash provided by (used for) financing activities		(22,609	)		399

Effect of exchange rate changes on cash and cash equivalents		(42	)		140

Effect of cash and cash equivalents related to variable interest entities		(487	)		362

Net increase (decrease) in cash and cash equivalents		(10,726	)		6,292
Cash and cash equivalents, at beginning of period		47,312			47,615

Cash and cash equivalents, at end of period	$	36,586		$	53,907

Cash and cash equivalents include:
Cash and due from banks	$	18,239		$	12,255
Interest bearing deposits with banks		18,347			41,652

Cash and cash equivalents, at end of period	$	36,586		$	53,907

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Cash payments for interest were $3,423 million and $4,832 million for the nine months ended September 30, 2012 and 2011, respectively.

Cash payments for income taxes were $330 million and $791 million for the nine months ended September 30, 2012 and 2011, respectively.

See Notes to Condensed Consolidated Financial Statements.


		5

MORGAN STANLEY

Condensed Consolidated Statements of Changes in Total Equity

Nine Months Ended September 30, 2012

(dollars in millions)

(unaudited)


	Preferred Stock		Common Stock		Paid-in Capital			Retained Earnings			Employee Stock Trust			Accumulated Other Comprehensive Income (Loss)			Common Stock Held in Treasury at Cost			Common Stock Issued to Employee Trust			Non- Redeemable Non- controlling Interests			Total Equity
BALANCE AT DECEMBER 31, 2011	$	1,508	$	20	$	22,836		$	40,341		$	3,166		$	(157	)	$	(2,499	)	$	(3,166	)	$	8,029		$	70,078
Net loss applicable to Morgan Stanley		—		—		—			(526	)		—			—			—			—			—			(526	)
Net income applicable to nonredeemable noncontrolling interests		—		—		—			—			—			—			—			—			446			446
Dividends		—		—		—			(374	)		—			—			—			—			—			(374	)
Shares issued under employee plans and related tax effects		—		—		473			—			(187	)		—			495			187			—			968
Repurchases of common stock		—		—		—			—			—			—			(222	)		—			—			(222	)
Net change in cash flow hedges		—		—		—			—			—			5			—			—			—			5
Pension, postretirement and other related adjustments		—		—		—			—			—			10			—			—			5			15
Foreign currency translation adjustments		—		—		—			—			—			(88	)		—			—			—			(88	)
Change in net unrealized gains on securities available for sale		—		—		—			—			—			84			—			—			—			84
Purchase of additional stake in the Wealth Management Joint Venture		—		—		(107	)		—			—			—			—			—			(1,718	)		(1,825	)
Reclassification to redeemable noncontrolling interests		—		—		—			—			—			—			—			—			(4,296	)		(4,296	)
Other net increases in nonredeemable noncontrolling interests		—		—		—			—			—			—			—			—			905			905

BALANCE AT SEPTEMBER 30, 2012	$	1,508	$	20	$	23,202		$	39,441		$	2,979		$	(146	)	$	(2,226	)	$	(2,979	)	$	3,371		$	65,170

See Notes to Condensed Consolidated Financial Statements.


		6

MORGAN STANLEY

Condensed Consolidated Statements of Changes in Total Equity—(Continued)

Nine Months Ended September 30, 2011

(dollars in millions)

(unaudited)


	Preferred Stock			Common Stock		Paid-in Capital			Retained Earnings			Employee Stock Trust			Accumulated Other Comprehensive Income (Loss)			Common Stock Held in Treasury at Cost			Common Stock Issued to Employee Trust			Non- Redeemable Non- controlling Interests			Total Equity
BALANCE AT DECEMBER 31, 2010	$	9,597		$	16	$	13,521		$	38,603		$	3,465		$	(467	)	$	(4,059	)	$	(3,465	)	$	8,196		$	65,407
Net loss applicable to Morgan Stanley		—			—		—			4,360			—			—			—			—			—			4,360
Net income applicable to nonredeemable noncontrolling interests		—			—		—			—			—			—			—			—			469			469
Dividends		—			—		—			(527	)		—			—			—			—			—			(527	)
Shares issued under employee plans and related tax effects		—			—		(917	)		—			(249	)		—			1,873			249			—			956
Repurchases of common stock		—			—		—			—			—			—			(312	)		—			—			(312	)
Net change in cash flow hedges		—			—		—			—			—			5			—			—			—			5
Pension, postretirement and other related adjustments		—			—		—			—			—			8			—			—			—			8
Foreign currency translation adjustments		—			—		—			—			—			(49	)		—			—			72			23
Change in net unrealized gains on securities available for sale		—			—		—			—			—			90			—			—			—			90
Other increase in equity method investments		—			—		86			—			—			—			—			—			—			86
MUFG stock conversion		(8,089	)		4		9,811			(1,726	)		—			—			—			—			—			—
Other net decreases in nonredeemable noncontrolling interests		—			—		—			—			—			—			—			—			(471	)		(471	)

BALANCE AT SEPTEMBER 30, 2011	$	1,508		$	20	$	22,501		$	40,710		$	3,216		$	(413	)	$	(2,498	)	$	(3,216	)	$	8,266		$	70,094

See Notes to Condensed Consolidated Financial Statements.


		7

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.	Introduction and Basis of Presentation.

The Company. Morgan Stanley, a financial holding company, is a global financial services firm that maintains significant market positions in each of its business segments—Institutional Securities, Global Wealth Management Group and Asset Management. Unless the context otherwise requires, the terms “Morgan Stanley” and the “Company” mean Morgan Stanley and its consolidated subsidiaries and the term “Parent” means the parent company, Morgan Stanley.

A summary of the activities of each of the Company’s business segments is as follows:

Institutional Securities provides capital raising; financial advisory services, including advice on mergers and acquisitions, restructurings, real estate and project finance; corporate lending; sales, trading, financing and market-making activities in equity and fixed income securities and related products, including foreign exchange and commodities; and investment activities.

Global Wealth Management Group, which includes the Company’s 65% interest in Morgan Stanley Smith Barney Holdings LLC (the “Wealth Management Joint Venture” or “Wealth Management JV”), provides brokerage and investment advisory services to individual investors and small-to-medium sized businesses and institutions covering various investment alternatives; financial and wealth planning services; annuity and other insurance products; credit and other lending products; cash management services; retirement services; and trust and fiduciary services and engages in fixed income principal trading, which primarily facilitates clients’ trading or investments in such securities.

Asset Management provides a broad array of investment strategies that span the risk/return spectrum across geographies, asset classes and public and private markets to a diverse group of clients across the institutional and intermediary channels as well as high net worth clients.

Discontinued Operations.

Saxon. On October 24, 2011, the Company announced that it had reached an agreement to sell Saxon, a provider of servicing and subservicing of residential mortgage loans, to Ocwen Financial Corporation. The transaction, which was restructured as a sale of Saxon’s assets during the first quarter of 2012, was substantially completed in the second quarter of 2012. The remaining operations of Saxon are expected to be wound down within the year. The Company expects to incur incremental wind-down costs in future periods. The results of Saxon are reported as discontinued operations within the Institutional Securities business segment for all periods presented.

Quilter. On April 2, 2012, the Company completed the sale of Quilter & Co. Ltd. (“Quilter”), its retail wealth management business in the United Kingdom (“U.K.”). The results of Quilter are reported as discontinued operations within the Global Wealth Management Group business segment for all periods presented.

Prior period amounts have been recast for discontinued operations. See Note 21 for additional information on discontinued operations.

Basis of Financial Information. The condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S.”), which require the Company to make estimates and assumptions regarding the valuations of certain financial instruments, the valuation of goodwill and intangible assets, compensation, deferred tax assets, the outcome of litigation and tax matters, and other matters that affect the condensed consolidated financial statements and related disclosures. The Company believes that the estimates utilized in the preparation of the condensed consolidated financial statements are prudent and reasonable. Actual results could differ materially from these estimates.

Intercompany balances and transactions have been eliminated.


		8

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011 (the “Form 10-K”). The condensed consolidated financial statements reflect all adjustments of a normal recurring nature that are, in the opinion of management, necessary for the fair presentation of the results for the interim period. The results of operations for interim periods are not necessarily indicative of results for the entire year.

Consolidation. The condensed consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and other entities in which the Company has a controlling financial interest, including certain variable interest entities (“VIE”) (see Note 7). For condensed consolidated subsidiaries that are less than wholly owned, the third-party holdings of equity interests are referred to as noncontrolling interests. The portion of net income attributable to noncontrolling interests for such subsidiaries is presented as either Net income (loss) applicable to redeemable noncontrolling interests or Net income (loss) applicable to nonredeemable noncontrolling interests in the condensed consolidated statements of income. The portion of the shareholders’ equity of such subsidiaries that is redeemable is presented as Redeemable noncontrolling interests outside of the equity section in the condensed statements of financial condition. The portion of the shareholders’ equity of such subsidiaries that is nonredeemable is presented as Nonredeemable noncontrolling interests in the condensed consolidated statements of financial condition.

For entities where (1) the total equity investment at risk is sufficient to enable the entity to finance its activities without additional support and (2) the equity holders bear the economic residual risks and returns of the entity and have the power to direct the activities of the entity that most significantly affect its economic performance, the Company consolidates those entities it controls either through a majority voting interest or otherwise. For VIEs (i.e., entities that do not meet these criteria), the Company consolidates those entities where the Company has the power to make the decisions that most significantly affect the economic performance of the VIE and has the obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE, except for certain VIEs that are money market funds, investment companies or are entities qualifying for accounting purposes as investment companies. Generally, the Company consolidates those entities when it absorbs a majority of the expected losses or a majority of the expected residual returns, or both, of the entities.

For investments in entities in which the Company does not have a controlling financial interest but has significant influence over operating and financial decisions, the Company generally applies the equity method of accounting with net gains and losses recorded within Other revenues. Where the Company has elected to measure certain eligible investments at fair value in accordance with the fair value option, net gains and losses are recorded within Principal transactions—Investments (see Note 4).

Equity and partnership interests held by entities qualifying for accounting purposes as investment companies are carried at fair value.

The Company’s significant regulated U.S. and international subsidiaries include Morgan Stanley & Co. LLC (“MS&Co.”), Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. International plc (“MSIP”), Morgan Stanley MUFG Securities, Co., Ltd. (“MSMS”), Morgan Stanley Bank, N.A. and Morgan Stanley Private Bank, National Association.

Income Statement Presentation. The Company, through its subsidiaries and affiliates, provides a wide variety of products and services to a large and diversified group of clients and customers, including corporations, governments, financial institutions and individuals. In connection with the delivery of the various products and services to clients, the Company manages its revenues and related expenses in the aggregate. As such, when


		9

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

assessing the performance of its businesses, primarily in its Institutional Securities business segment, the Company considers its principal trading, investment banking, commissions and fees and interest income, along with the associated interest expense, as one integrated activity.

2.	Significant Accounting Policies.

For a detailed discussion about the Company’s significant accounting policies, see Note 2 to the consolidated financial statements for the year ended December 31, 2011 included in the Form 10-K.

During the nine months ended September 30, 2012, other than the following, no other updates were made to the Company’s significant accounting policies.

Noncontrolling Interests.

For consolidated subsidiaries that are less than wholly owned, the third-party holdings of equity interests are referred to as noncontrolling interests.

As a result of the modifications to the purchase agreement regarding the Wealth Management JV, the Company now classifies Citigroup, Inc.’s (“Citi’s”) interest in the Wealth Management JV as redeemable noncontrolling interests, as the interest is redeemable at both the option of the Company and upon the occurrence of an event that is not solely within the Company’s control. This interest is classified outside of the equity section in Redeemable noncontrolling interests in the condensed consolidated statements of financial condition. Noncontrolling interests that do not contain such redemption features are presented as nonredeemable noncontrolling interests within the equity section of the condensed consolidated statements of financial condition.

Financial Instruments and Fair Value—Valuation Process.

The Valuation Review Group (“VRG”) within the Financial Control Group (“FCG”) is responsible for the Company’s fair value valuation policies, processes and procedures. VRG is independent of the business units and reports to the Chief Financial Officer (“CFO”), who has final authority over the valuation of the Company’s financial instruments. VRG implements valuation control processes to validate the fair value of the Company’s financial instruments measured at fair value including those derived from pricing models. These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and the assumptions are reasonable.

The Company’s control processes apply to financial instruments categorized in Level 1, Level 2 or Level 3 of the fair value hierarchy, unless otherwise noted. These control processes include:

Model Review. VRG, in conjunction with the Market Risk Department (“MRD”) and, where appropriate, the Credit Risk Management Department, both of which report to the Chief Risk Officer, independently review the valuation model’s theoretical soundness, the appropriateness of the valuation methodology and calibration techniques developed by the business units using observable inputs. Where inputs are not observable, VRG reviews the appropriateness of the proposed valuation methodology to ensure it is consistent with how a market participant would arrive at the unobservable input. The valuation methodologies utilized in the absence of observable inputs may include extrapolation techniques and the use of comparable observable inputs. As part of the review, VRG develops a methodology to independently verify the fair value generated by the business unit’s valuation model. Before trades are executed using new valuation models, those models are required to be independently reviewed. All of the Company’s valuation models are subject to an independent annual VRG review.


		10

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Independent Price Verification. The business units are responsible for determining the fair value of financial instruments using approved valuation models and valuation methodologies. Generally on a monthly basis, VRG independently validates the fair values of financial instruments determined using valuation models by determining the appropriateness of the inputs used by the business units and testing compliance with the documented valuation methodologies approved in the model review process described above.

VRG uses recently executed transactions, other observable market data such as exchange data, broker/dealer quotes, third-party pricing vendors and aggregation services for validating the fair values of financial instruments generated using valuation models. VRG assesses the external sources and their valuation methodologies to determine if the external providers meet the minimum standards expected of a third-party pricing source. Pricing data provided by approved external sources is evaluated using a number of approaches; for example, by corroborating the external sources’ prices to executed trades, analyzing the methodology and assumptions used by the external source to generate a price and/or by evaluating how active the third-party pricing source (or originating sources used by the third-party pricing source) is in the market. Based on this analysis, VRG generates a ranking of the observable market data to ensure that the highest-ranked market data source is used to validate the business unit’s fair value of financial instruments.

For financial instruments categorized within Level 3 of the fair value hierarchy, VRG reviews the business unit’s valuation techniques to ensure these are consistent with market participant assumptions.

The results of this independent price verification and any adjustments made by VRG to the fair value generated by the business units are presented to management of the three business segments (i.e., Institutional Securities, Global Wealth Management Group and Asset Management), the CFO and the Chief Risk Officer on a regular basis.

Review of New Level 3 Transactions. VRG reviews the model and valuation methodology used to price all new material Level 3 transactions and both FCG and MRD management must approve the fair value of the trade that is initially recognized.

Securities Available for Sale—Other-than-temporary Impairment.

For available for sale (“AFS”) debt securities, a credit loss exists if the present value of cash flows expected to be collected is less than the amortized cost basis of the security. When determining if a credit loss exists, the Company considers all relevant information including the length of time and the extent to which the fair value has been less than the amortized cost basis; adverse conditions specifically related to the security, an industry, or geographic area; changes in the financial condition of the issuer of the security, or in the case of an asset-backed debt security, changes in the financial condition of the underlying loan obligors; the historical and implied volatility of the fair value of the security; the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future; failure of the issuer of the security to make scheduled interest or principal payments; any changes to the rating of the security by a rating agency and recoveries or additional declines in fair value after the balance sheet date. When estimating the present value of expected cash flows, information includes the remaining payment terms of the security, prepayment speeds, financial condition of the issuer(s), expected defaults and the value of any underlying collateral.

For AFS equity securities, the Company considers various factors including the intent and ability to hold the equity security for a period of time sufficient to allow for any anticipated recovery in market value in evaluating whether an other-than-temporary impairment (“OTTI”) exists. If the equity security is considered other-than-temporarily impaired, the security will be written down to fair value, with the full difference between fair value and cost recognized in earnings.


		11

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Condensed Consolidated Statements of Cash Flows.

For purposes of the condensed consolidated statements of cash flows, cash and cash equivalents consist of Cash and due from banks and Interest bearing deposits with banks, which are highly liquid investments with original maturities of three months or less and readily convertible to known amounts of cash, and are held for investment purposes. In the nine months ended September 30, 2012, the Company’s significant non-cash activities include approximately $2.4 billion and $1.0 billion, respectively of assets and liabilities disposed of, in connection with business dispositions. At June 30, 2011, Mitsubishi UFJ Financial Group, Inc. (“MUFG”) and the Company converted MUFG’s outstanding Series B Non-Cumulative Non-Voting Perpetual Convertible Preferred Stock (“Series B Preferred Stock”) in the Company with a face value of $7.8 billion (carrying value $8.1 billion) into the Company’s common stock. As a result of the adjustment to the conversion ratio, pursuant to the transaction agreement, the Company incurred a one-time, non-cash negative adjustment of approximately $1.7 billion in its calculation of basic and diluted earnings per share during the nine months ended September 30, 2011 (see Note 15).

During the third quarter of 2012, the Company identified that activities related to certain loans had been reported as cash flows from operating activities and should have been presented as investing activities. The Company corrected the previously presented cash flows for these loans and in doing so, for the nine months ended September 30, 2011, the condensed consolidated statement of cash flows were adjusted to increase net cash flows from operating activities by $7.3 billion with a corresponding decrease in net cash flows from investing activities. The Company has evaluated the effect of the incorrect presentation, both qualitatively and quantitatively, and concluded that it did not have a material impact on, nor require amendment of, any previously filed annual or quarterly consolidated financial statements.

Accounting Developments.

Reconsideration of Effective Control for Repurchase Agreements.

In April 2011, the Financial Accounting Standards Board (the “FASB”) issued accounting guidance that modified the criteria that must be satisfied for a transfer of financial assets to be accounted for as a sale. If the transferor maintains effective control over the transferred assets, the transaction is to be accounted for as a financing. This guidance eliminated from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, and (2) the collateral maintenance implementation guidance related to that criterion. This guidance became effective for transfers occurring on and after January 1, 2012. The adoption of this accounting guidance did not have a material impact on the Company’s condensed consolidated financial statements.

Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.

In May 2011, the FASB issued an accounting update that clarified existing fair value measurement guidance and changed certain principles or requirements for measuring fair value or disclosing information about fair value measurements. This update resulted in common principles and requirements for measuring fair value and for disclosing information about fair value measurement in accordance with U.S. GAAP and International Financial Reporting Standards (“IFRS”). The guidance became effective for the Company beginning on January 1, 2012. See Note 4 for additional disclosures as required by this accounting guidance.


		12

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Goodwill and Intangible Assets.

In September 2011, the FASB issued accounting guidance that simplified how entities test goodwill for impairment. This guidance allows entities an option to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under that option, an entity no longer would be required to calculate the fair value of a reporting unit unless the entity determines, based on that qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. This guidance became effective for the Company beginning on January 1, 2012. The adoption of this accounting guidance did not have a material impact on the Company’s condensed consolidated financial statements.

During the third quarter ended September 30, 2012, the Company changed the brand name of the U.S. Wealth Management business from Morgan Stanley Smith Barney to Morgan Stanley Wealth Management. The Smith Barney tradename will continue to be legally protected by the Company and will continue to be used as stipulated by our regulators as the legal entity name for the retail broker dealer (“Morgan Stanley Smith Barney LLC”). As a result of the change in intended use of this tradename, the Company determined that the tradename should be reclassified from an indefinite–lived to a finite–lived intangible asset. This change required the Company to test the intangible asset for impairment. Based on a comparison of the fair value to the carrying value of the tradename as of the date of the name change, no impairment was identified. The carrying value of the tradename will be amortized over its remaining estimated useful life.

3.	Wealth Management Joint Venture.

On May 31, 2009, the Company and Citi consummated the combination of the Company’s Global Wealth Management Group and the businesses of Citi’s Smith Barney in the U.S., Quilter Holdings Ltd. in the U.K. and Smith Barney Australia (collectively, “Smith Barney”). The combined businesses operate as Morgan Stanley Wealth Management. Prior to September 2012, the Company owned 51% and Citi owned 49% of the Wealth Management JV.

In September 2012, the Company reached an agreement with Citi for the Company to purchase from Citi an additional 14% stake in the Wealth Management JV at an implied 100% valuation for the Wealth Management JV of $13.5 billion, and receive a transfer of approximately $5.4 billion of deposits at no premium from Citi.

In addition, subject to obtaining the required regulatory approvals, Morgan Stanley and Citi have reached an agreement with respect to the purchase of Citi’s remaining 35% stake in the Wealth Management JV at the same implied $13.5 billion valuation, and receive a transfer of deposits of approximately $54 billion at no premium from Citi, no later than June 1, 2015. The Company also agreed to purchase the next 15% stake in the Wealth Management JV by June 1, 2013, subject to regulatory approvals.

The Company completed the purchase of the additional 14% stake in the Wealth Management JV from Citi on September 17, 2012 for $1.89 billion. The related $5.4 billion of deposits were transferred at no premium in October of 2012. At September 30, 2012, the Company holds a 65% stake in the Wealth Management JV. The Company must use reasonable best efforts to obtain regulatory approvals required to purchase the remaining 35% stake in the Wealth Management JV by June 1, 2015, and, subject to receipt of such approvals, the Company must consummate such acquisition by that date at a purchase price of $4.725 billion (or a pro rata portion of such amount if less than 35% of the total outstanding stake are being purchased).

The change in the terms of the Wealth Management JV’s noncontrolling interests resulted in a reclassification of approximately $4.3 billion from nonredeemable noncontrolling interests to redeemable noncontrolling interests


		13

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

on the condensed consolidated statements of financial condition. At September 30, 2012, the redeemable noncontrolling interest is not reflected as a liability at its redemption amount because it is not deemed probable that the noncontrolling interest will become redeemable due to the fact that regulatory approvals are required.

4.	Fair Value Disclosures.

Fair Value Measurements.

A description of the valuation techniques applied to the Company’s major categories of assets and liabilities measured at fair value on a recurring basis follows.

Financial Instruments Owned and Financial Instruments Sold, Not Yet Purchased.

U.S. Government and Agency Securities.

•

U.S. Treasury Securities. U.S. Treasury securities are valued using quoted market prices. Valuation adjustments are not applied. Accordingly, U.S. Treasury securities are generally categorized in Level 1 of the fair value hierarchy.

•

U.S. Agency Securities. U.S. agency securities are composed of three main categories consisting of agency-issued debt, agency mortgage pass-through pool securities and collateralized mortgage obligations. Non-callable agency-issued debt securities are generally valued using quoted market prices. Callable agency-issued debt securities are valued by benchmarking model-derived prices to quoted market prices and trade data for identical or comparable securities. The fair value of agency mortgage pass-through pool securities is model-driven based on spreads of the comparable To-be-announced (“TBA”) security. Collateralized mortgage obligations are valued using quoted market prices and trade data adjusted by subsequent changes in related indices for identical or comparable securities. Actively traded non-callable agency-issued debt securities are generally categorized in Level 1 of the fair value hierarchy. Callable agency-issued debt securities, agency mortgage pass-through pool securities and collateralized mortgage obligations are generally categorized in Level 2 of the fair value hierarchy.

Other Sovereign Government Obligations.

•

Foreign sovereign government obligations are valued using quoted prices in active markets when available. These bonds are generally categorized in Level 1 of the fair value hierarchy. If the market is less active or prices are dispersed, these bonds are categorized in Level 2 of the fair value hierarchy.

Corporate and Other Debt.

•

State and Municipal Securities. The fair value of state and municipal securities is determined using recently executed transactions, market price quotations and pricing models that factor in, where applicable, interest rates, bond or credit default swap spreads and volatility. These bonds are generally categorized in Level 2 of the fair value hierarchy.

•

Residential Mortgage-Backed Securities (“RMBS”), Commercial Mortgage-Backed Securities (“CMBS”) and other Asset-Backed Securities (“ABS”). RMBS, CMBS and other ABS may be valued based on price or spread data obtained from observed transactions or independent external parties such as vendors or brokers. When position-specific external price data are not observable, the fair value determination may require benchmarking to similar instruments and/or analyzing expected credit losses, default and recovery rates. In evaluating the fair value of each security, the Company considers security collateral-specific attributes, including payment priority, credit enhancement levels, type of collateral, delinquency


		14

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

rates and loss severity. In addition, for RMBS borrowers, Fair Isaac Corporation (“FICO”) scores and the level of documentation for the loan are also considered. Market standard models, such as Intex, Trepp or others, may be deployed to model the specific collateral composition and cash flow structure of each transaction. Key inputs to these models are market spreads, forecasted credit losses, default and prepayment rates for each asset category. Valuation levels of RMBS and CMBS indices are also used as an additional data point for benchmarking purposes or to price outright index positions.

RMBS, CMBS and other ABS are generally categorized in Level 2 of the fair value hierarchy. If external prices or significant spread inputs are unobservable or if the comparability assessment involves significant subjectivity related to property type differences, cash flows, performance and other inputs, then RMBS, CMBS and other ABS are categorized in Level 3 of the fair value hierarchy.

•

Corporate Bonds. The fair value of corporate bonds is determined using recently executed transactions, market price quotations (where observable), bond spreads or credit default swap spreads obtained from independent external parties such as vendors and brokers adjusted for any basis difference between cash and derivative instruments. The spread data used are for the same maturity as the bond. If the spread data do not reference the issuer, then data that reference a comparable issuer are used. When position-specific external price data are not observable, fair value is determined based on either benchmarking to similar instruments or cash flow models with yield curves, bond or single name credit default swap spreads and recovery rates as significant inputs. Corporate bonds are generally categorized in Level 2 of the fair value hierarchy; in instances where prices, spreads or any of the other aforementioned key inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.

•

Collateralized Debt Obligations (“CDO”). The Company holds cash CDOs that typically reference a tranche of an underlying synthetic portfolio of single name credit default swaps collateralized by corporate bonds (“credit-linked notes”) or cash portfolio of asset-backed securities (“asset-backed CDOs”). Credit correlation, a primary input used to determine the fair value of credit-linked notes, is usually unobservable and derived using a benchmarking technique. The other credit-linked note model inputs such as credit spreads, including collateral spreads, and interest rates are typically observable. Asset-backed CDOs are valued based on an evaluation of the market and model input parameters sourced from similar positions as indicated by primary and secondary market activity. Each asset-backed CDO position is evaluated independently taking into consideration available comparable market levels, underlying collateral performance and pricing, deal structures, as well as liquidity. Cash CDOs are categorized in Level 2 of the fair value hierarchy when either the credit correlation input is insignificant or comparable market transactions are observable. In instances where the credit correlation input is deemed to be significant or comparable market transactions are unobservable, cash CDOs are categorized in Level 3 of the fair value hierarchy.

•

Corporate Loans and Lending Commitments. The fair value of corporate loans is determined using recently executed transactions, market price quotations (where observable), implied yields from comparable debt, and market observable credit default swap spread levels obtained from independent external parties such as vendors and brokers adjusted for any basis difference between cash and derivative instruments, along with proprietary valuation models and default recovery analysis where such transactions and quotations are unobservable. The fair value of contingent corporate lending commitments is determined by using executed transactions on comparable loans and the anticipated market price based on pricing indications from syndicate banks and customers. The valuation of loans and lending commitments also takes into account fee income that is considered an attribute of the contract. Corporate loans and lending commitments are categorized in Level 2 of the fair value hierarchy except in instances where prices or significant spread inputs are unobservable, in which case they are categorized in Level 3 of the fair value hierarchy. Corporate loans and lending commitments are presented within Loans and lending commitments in the fair value hierarchy table.


		15

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

•

Mortgage Loans. Mortgage loans are valued using observable prices based on transactional data or third party pricing for identical or comparable instruments, when available. Where position-specific external prices are not observable, the Company estimates fair value based on benchmarking to prices and rates observed in the primary market for similar loan or borrower types or based on the present value of expected future cash flows using its best estimates of the key assumptions, including forecasted credit losses, prepayment rates, forward yield curves and discount rates commensurate with the risks involved or a methodology that utilizes the capital structure and credit spreads of recent comparable securitization transactions. Mortgage loans valued based on observable market data for identical or comparable instruments are categorized in Level 2 of the fair value hierarchy. Where observable prices are not available, due to the subjectivity involved in the comparability assessment related to mortgage loan vintage, geographical concentration, prepayment speed and projected loss assumptions, mortgage loans are categorized in Level 3 of the fair value hierarchy. Mortgage loans are presented within Loans and lending commitments in the fair value hierarchy table.

•

Auction Rate Securities (“ARS”). The Company primarily holds investments in Student Loan Auction Rate Securities (“SLARS”) and Municipal Auction Rate Securities (“MARS”) with interest rates that are reset through periodic auctions. SLARS are ABS backed by pools of student loans. MARS are municipal bonds often wrapped by municipal bond insurance. ARS were historically traded and valued as floating rate notes, priced at par due to the auction mechanism. Beginning in fiscal 2008, uncertainties in the credit markets have resulted in auctions failing for certain types of ARS. Once the auctions failed, ARS could no longer be valued using observations of auction market prices. Accordingly, the fair value of ARS is determined using independent external market data where available and an internally developed methodology to discount for the lack of liquidity and non-performance risk.

Inputs that impact the valuation of SLARS are independent external market data, the underlying collateral types, level of seniority in the capital structure, amount of leverage in each structure, credit rating and liquidity considerations. Inputs that impact the valuation of MARS are recently executed transactions, the maximum rate, quality of underlying issuers/insurers and evidence of issuer calls/prepayment. ARS are generally categorized in Level 2 of the fair value hierarchy as the valuation technique relies on observable external data. SLARS and MARS are presented within Asset-backed securities and State and municipal securities, respectively, in the fair value hierarchy table.

Corporate Equities.

•

Exchange-Traded Equity Securities. Exchange-traded equity securities are generally valued based on quoted prices from the exchange. To the extent these securities are actively traded, valuation adjustments are not applied, and they are categorized in Level 1 of the fair value hierarchy; otherwise, they are categorized in Level 2 or Level 3 of the fair value hierarchy.

•

Unlisted Equity Securities. Unlisted equity securities are valued based on an assessment of each underlying security, considering rounds of financing and third-party transactions, discounted cash flow analyses and market-based information, including comparable company transactions, trading multiples and changes in market outlook, among other factors. These securities are generally categorized in Level 3 of the fair value hierarchy.

•

Fund Units. Listed fund units are generally marked to the exchange-traded price or net asset value (“NAV”) and are categorized in Level 1 of the fair value hierarchy if actively traded on an exchange or in Level 2 of the fair value hierarchy if trading is not active. Unlisted fund units are generally marked to NAV and categorized as Level 2; however, positions which are not redeemable at the measurement date or in the near future are categorized in Level 3 of the fair value hierarchy.


		16

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Derivative and Other Contracts.

•

Listed Derivative Contracts. Listed derivatives that are actively traded are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Listed derivatives that are not actively traded are valued using the same approaches as those applied to over-the-counter (“OTC”) derivatives; they are generally categorized in Level 2 of the fair value hierarchy.

•

OTC Derivative Contracts. OTC derivative contracts include forward, swap and option contracts related to interest rates, foreign currencies, credit standing of reference entities, equity prices or commodity prices.

Depending on the product and the terms of the transaction, the fair value of OTC derivative products can be either observed or modeled using a series of techniques and model inputs from comparable benchmarks, including closed-form analytic formulas, such as the Black-Scholes option-pricing model, and simulation models or a combination thereof. Many pricing models do not entail material subjectivity because the methodologies employed do not necessitate significant judgment, and the pricing inputs are observed from actively quoted markets, as is the case for generic interest rate swaps, certain option contracts and certain credit default swaps. In the case of more established derivative products, the pricing models used by the Company are widely accepted by the financial services industry. A substantial majority of OTC derivative products valued by the Company using pricing models fall into this category and are categorized in Level 2 of the fair value hierarchy.

Other derivative products, including complex products that have become illiquid, require more judgment in the implementation of the valuation technique applied due to the complexity of the valuation assumptions and the reduced observability of inputs. This includes certain types of interest rate derivatives with both volatility and correlation exposure and credit derivatives including credit default swaps on certain mortgage-backed or asset-backed securities, basket credit default swaps and CDO-squared positions (a CDO-squared position is a special purpose vehicle that issues interests, or tranches, that are backed by tranches issued by other CDOs) where direct trading activity or quotes are unobservable. These instruments involve significant unobservable inputs and are categorized in Level 3 of the fair value hierarchy.

Derivative interests in credit default swaps on certain mortgage-backed or asset-backed securities, for which observability of external price data is limited, are valued based on an evaluation of the market and model input parameters sourced from similar positions as indicated by primary and secondary market activity. Each position is evaluated independently taking into consideration available comparable market levels as well as cash-synthetic basis, or the underlying collateral performance and pricing, behavior of the tranche under various cumulative loss and prepayment scenarios, deal structures (e.g., non-amortizing reference obligations, call features, etc.) and liquidity. While these factors may be supported by historical and actual external observations, the determination of their value as it relates to specific positions nevertheless requires significant judgment.

For basket credit default swaps and CDO-squared positions, the correlation input between reference credits is unobservable for each specific swap or position and is benchmarked to standardized proxy baskets for which correlation data are available. The other model inputs such as credit spread, interest rates and recovery rates are observable. In instances where the correlation input is deemed to be significant, these instruments are categorized in Level 3 of the fair value hierarchy; otherwise, these instruments are categorized in Level 2 of the fair value hierarchy.

The Company trades various derivative structures with commodity underlyings. Depending on the type of structure, the model inputs generally include interest rate yield curves, commodity underlier price curves, implied volatility of the underlying commodities and, in some cases, the implied correlation between


		17

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

these inputs. The fair value of these products is determined using executed trades and broker and consensus data to provide values for the aforementioned inputs. Where these inputs are unobservable, relationships to observable commodities and data points, based on historic and/or implied observations, are employed as a technique to estimate the model input values. Commodity derivatives are generally categorized in Level 2 of the fair value hierarchy; in instances where significant inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.

For further information on derivative instruments and hedging activities, see Note 11.

Investments.

•

The Company’s investments include direct investments in equity securities as well as investments in private equity funds, real estate funds and hedge funds, which include investments made in connection with certain employee deferred compensation plans. Direct investments are presented in the fair value hierarchy table as Principal investments and Other. Initially, the transaction price is generally considered by the Company as the exit price and is the Company’s best estimate of fair value.

After initial recognition, in determining the fair value of non-exchange-traded internally and externally managed funds, the Company generally considers the NAV of the fund provided by the fund manager to be the best estimate of fair value. For non-exchange-traded investments either held directly or held within internally managed funds, fair value after initial recognition is based on an assessment of each underlying investment, considering rounds of financing and third-party transactions, discounted cash flow analyses and market-based information, including comparable company transactions, trading multiples and changes in market outlook, among other factors. Exchange-traded direct equity investments are generally valued based on quoted prices from the exchange.

Exchange-traded direct equity investments that are actively traded are categorized in Level 1 of the fair value hierarchy. Non-exchange-traded direct equity investments and investments in private equity and real estate funds are generally categorized in Level 3 of the fair value hierarchy. Investments in hedge funds that are redeemable at the measurement date or in the near future are categorized in Level 2 of the fair value hierarchy; otherwise, they are categorized in Level 3 of the fair value hierarchy.

Physical Commodities.

•

The Company trades various physical commodities, including crude oil and refined products, natural gas, base and precious metals and agricultural products. Fair value for physical commodities is determined using observable inputs, including broker quotations and published indices. Physical commodities are categorized in Level 2 of the fair value hierarchy; in instances where significant inputs are unobservable, they are categorized in Level 3 of the fair value hierarchy.

Securities Available for Sale.

•

Securities available for sale are composed of U.S. government and agency securities (e.g., U.S. Treasury securities, agency-issued debt, agency mortgage pass-through securities and collateralized mortgage obligations), Federal Family Education Loan Program (“FFELP”) student loan asset-backed securities, auto loan asset-backed securities, corporate bonds and equity securities. Actively traded U.S. Treasury securities, non-callable agency-issued debt securities and equity securities are generally categorized in Level 1 of the fair value hierarchy. Callable agency-issued debt securities, agency mortgage pass-through securities, collateralized mortgage obligations and FFELP student loan asset-backed securities, auto loan asset-backed securities and corporate bonds are generally categorized in Level 2 of the fair value hierarchy. For further information on securities available for sale, see Note 5.


		18

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Deposits.

•

Time Deposits. The fair value of certificates of deposit is determined using third-party quotations. These deposits are generally categorized in Level 2 of the fair value hierarchy.

Commercial Paper and Other Short-term Borrowings/Long-term Borrowings.

•

Structured Notes. The Company issues structured notes that have coupon or repayment terms linked to the performance of fixed income or equity securities, indices, currencies or commodities. Fair value of structured notes is determined using valuation models for the derivative and debt portions of the notes. These models incorporate observable inputs referencing identical or comparable securities, including prices that the notes are linked to, interest rate yield curves, option volatility and currency, commodity or equity prices. Independent, external and traded prices for the notes are also considered. The impact of the Company’s own credit spreads is also included based on the Company’s observed secondary bond market spreads. Most structured notes are categorized in Level 2 of the fair value hierarchy.

Securities Purchased under Agreements to Resell, and Securities Sold under Agreements to Repurchase.

•

The fair value of a reverse repurchase agreement or repurchase agreement is computed using a standard cash flow discounting methodology. The inputs to the valuation include contractual cash flows and collateral funding spreads, which are estimated using various benchmarks, interest rate yield curves and option volatilities. In instances where the unobservable inputs are deemed significant, reverse repurchase agreements and repurchase agreements are categorized in Level 3 of the fair value hierarchy; otherwise, they are categorized in Level 2 of the fair value hierarchy.

The following fair value hierarchy tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis at September 30, 2012 and December 31, 2011.


		19

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Assets and Liabilities Measured at Fair Value on a Recurring Basis at September 30, 2012.


	Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Counterparty and Cash Collateral Netting			Balance at September 30, 2012
	(dollars in millions)
Assets at Fair Value
Financial instruments owned:
U.S. government and agency securities:
U.S. Treasury securities	$	25,532		$	—		$	—		$	—		$	25,532
U.S. agency securities		1,593			25,009			—			—			26,602

Total U.S. government and agency securities		27,125			25,009			—			—			52,134
Other sovereign government obligations		31,178			5,990			3			—			37,171
Corporate and other debt:
State and municipal securities		—			1,952			2			—			1,954
Residential mortgage-backed securities		—			1,446			20			—			1,466
Commercial mortgage-backed securities		—			1,602			126			—			1,728
Asset-backed securities		—			1,130			10			—			1,140
Corporate bonds		—			16,569			757			—			17,326
Collateralized debt obligations		—			566			2,031			—			2,597
Loans and lending commitments		—			11,605			7,825			—			19,430
Other debt		—			9,787			11			—			9,798

Total corporate and other debt		—			44,657			10,782			—			55,439
Corporate equities(1)		53,263			1,941			371			—			55,575
Derivative and other contracts:
Interest rate contracts		1,590			874,089			4,164			—			879,843
Credit contracts		—			73,612			6,621			—			80,233
Foreign exchange contracts		6			47,326			126			—			47,458
Equity contracts		1,493			43,321			747			—			45,561
Commodity contracts		4,408			21,757			2,248			—			28,413
Other		—			146			—			—			146
Netting(2)		(6,694	)		(959,322	)		(8,620	)		(72,450	)		(1,047,086	)

Total derivative and other contracts		803			100,929			5,286			(72,450	)		34,568
Investments:
Private equity funds		—			5			2,246			—			2,251
Real estate funds		—			6			1,354			—			1,360
Hedge funds		—			375			564			—			939
Principal investments		155			2			3,026			—			3,183
Other		160			132			476			—			768

Total investments		315			520			7,666			—			8,501
Physical commodities		—			7,920			—			—			7,920

Total financial instruments owned		112,684			186,966			24,108			(72,450	)		251,308
Securities available for sale		17,756			22,742			—			—			40,498
Securities received as collateral		12,766			41			4			—			12,811
Federal funds sold and securities purchased under agreements to resell		—			625			—			—			625
Intangible assets(3)		—			—			6			—			6

Total assets measured at fair value	$	143,206		$	210,374		$	24,118		$	(72,450	)	$	305,248


		20

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


	Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Counterparty and Cash Collateral Netting			Balance at September 30, 2012
	(dollars in millions)
Liabilities at Fair Value
Deposits	$	—		$	1,942		$	—		$	—		$	1,942
Commercial paper and other short-term borrowings		—			683			14			—			697
Financial instruments sold, not yet purchased:
U.S. government and agency securities:
U.S. Treasury securities		25,194			—			—			—			25,194
U.S. agency securities		1,318			139			—			—			1,457

Total U.S. government and agency securities		26,512			139			—			—			26,651
Other sovereign government obligations		25,548			1,980			—			—			27,528
Corporate and other debt:
State and municipal securities		—			100			—			—			100
Residential mortgage-backed securities		—			—			4			—			4
Corporate bonds		—			6,222			91			—			6,313
Collateralized debt obligations		—			347			1			—			348
Unfunded lending commitments		—			552			62			—			614
Other debt		—			215			55			—			270

Total corporate and other debt		—			7,436			213			—			7,649
Corporate equities(1)		27,049			965			12			—			28,026
Derivative and other contracts:
Interest rate contracts		1,842			844,049			4,263			—			850,154
Credit contracts		—			71,299			3,998			—			75,297
Foreign exchange contracts		10			52,619			537			—			53,166
Equity contracts		1,529			47,179			2,082			—			50,790
Commodity contracts		5,129			23,590			1,480			—			30,199
Other		—			58			3			—			61
Netting(2)		(6,694	)		(959,322	)		(8,620	)		(49,998	)		(1,024,634	)

Total derivative and other contracts		1,816			79,472			3,743			(49,998	)		35,033

Total financial instruments sold, not yet purchased		80,925			89,992			3,968			(49,998	)		124,887
Obligation to return securities received as collateral		16,378			43			20			—			16,441
Securities sold under agreements to repurchase		—			89			198			—			287
Other secured financings		—			9,258			416			—			9,674
Long-term borrowings		—			43,302			2,454			—			45,756

Total liabilities measured at fair value	$	97,303		$	145,309		$	7,070		$	(49,998	)	$	199,684

(1)	The Company holds or sells short for trading purposes equity securities issued by entities in diverse industries and of varying size.

(2)

For positions with the same counterparty that cross over the levels of the fair value hierarchy, both counterparty netting and cash collateral netting are included in the column titled “Counterparty and Cash Collateral Netting.” For contracts with the same counterparty, counterparty netting among positions classified within the same level is included within that level. For further information on derivative instruments and hedging activities, see Note 11.

(3)	Amount represents mortgage servicing rights (“MSR”) accounted for at fair value. See Note 7 for further information on MSRs.

Transfers Between Level 1 and Level 2 During the Quarter Ended September 30, 2012.

For assets and liabilities that were transferred between Level 1 and Level 2 during the period, fair values are ascribed as if the assets or liabilities had been transferred as of the beginning of the period.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the quarter ended September 30, 2012, the Company reclassified approximately $1.2 billion of derivative assets and approximately $1.5 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted


		21

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

prices from the exchange. Also during the quarter ended September 30, 2012, the Company reclassified approximately $0.5 billion of derivative assets and approximately $0.5 billion of derivative liabilities from Level 1 to Level 2 as transactions in these contracts did not occur with sufficient frequency and volume to constitute an active market.

Transfers Between Level 1 and Level 2 During the Nine Months Ended September 30, 2012.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the nine months ended September 30, 2012, the Company reclassified approximately $2.7 billion of derivative assets and approximately $2.6 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange. Also during the nine months ended September 30, 2012, the Company reclassified approximately $0.3 billion of derivative assets and approximately $0.3 billion of derivative liabilities from Level 1 to Level 2 as transactions in these contracts did not occur with sufficient frequency and volume to constitute an active market.


		22

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Assets and Liabilities Measured at Fair Value on a Recurring Basis at December 31, 2011.


	Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Counterparty and Cash Collateral Netting			Balance at December 31, 2011
	(dollars in millions)
Assets at Fair Value
Financial instruments owned:
U.S. government and agency securities:
U.S. Treasury securities	$	38,769		$	1		$	—		$	—		$	38,770
U.S. agency securities		4,332			20,339			8			—			24,679

Total U.S. government and agency securities		43,101			20,340			8			—			63,449
Other sovereign government obligations		22,650			6,290			119			—			29,059
Corporate and other debt:
State and municipal securities		—			2,261			—			—			2,261
Residential mortgage-backed securities		—			1,304			494			—			1,798
Commercial mortgage-backed securities		—			1,686			134			—			1,820
Asset-backed securities		—			937			31			—			968
Corporate bonds		—			25,873			675			—			26,548
Collateralized debt obligations		—			1,711			980			—			2,691
Loans and lending commitments		—			14,854			9,590			—			24,444
Other debt		—			8,265			128			—			8,393

Total corporate and other debt		—			56,891			12,032			—			68,923
Corporate equities(1)		45,173			2,376			417			—			47,966
Derivative and other contracts:
Interest rate contracts		1,493			906,082			5,301			—			912,876
Credit contracts		—			123,689			15,102			—			138,791
Foreign exchange contracts		—			61,770			573			—			62,343
Equity contracts		929			44,558			800			—			46,287
Commodity contracts		6,356			31,246			2,176			—			39,778
Other		—			292			306			—			598
Netting(2)		(7,596	)		(1,045,912	)		(11,837	)		(87,264	)		(1,152,609	)

Total derivative and other contracts		1,182			121,725			12,421			(87,264	)		48,064
Investments:
Private equity funds		—			7			1,936			—			1,943
Real estate funds		—			5			1,213			—			1,218
Hedge funds		—			473			696			—			1,169
Principal investments		161			104			2,937			—			3,202
Other		141			21			501			—			663

Total investments		302			610			7,283			—			8,195
Physical commodities		—			9,651			46			—			9,697

Total financial instruments owned		112,408			217,883			32,326			(87,264	)		275,353
Securities available for sale		13,437			17,058			—			—			30,495
Securities received as collateral		11,530			121			—			—			11,651
Federal funds sold and securities purchased under agreements to resell		—			112			—			—			112
Intangible assets(3)		—			—			133			—			133

Total assets measured at fair value	$	137,375		$	235,174		$	32,459		$	(87,264	)	$	317,744


		23

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)


	Quoted Prices in Active Markets for Identical Assets (Level 1)			Significant Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)			Counterparty and Cash Collateral Netting			Balance at December 31, 2011
	(dollars in millions)
Liabilities at Fair Value
Deposits	$	—		$	2,101		$	—		$	—		$	2,101
Commercial paper and other short-term borrowings		—			1,337			2			—			1,339
Financial instruments sold, not yet purchased:
U.S. government and agency securities:
U.S. Treasury securities		17,776			—			—			—			17,776
U.S. agency securities		1,748			106			—			—			1,854

Total U.S. government and agency securities		19,524			106			—			—			19,630
Other sovereign government obligations		14,981			2,152			8			—			17,141
Corporate and other debt:
State and municipal securities		—			3			—			—			3
Residential mortgage-backed securities		—			—			355			—			355
Commercial mortgage-backed securities		—			14			—			—			14
Corporate bonds		—			6,217			219			—			6,436
Collateralized debt obligations		—			3			—			—			3
Unfunded lending commitments		—			1,284			85			—			1,369
Other debt		—			157			73			—			230

Total corporate and other debt		—			7,678			732			—			8,410
Corporate equities(1)		24,347			149			1			—			24,497
Derivative and other contracts:
Interest rate contracts		1,680			873,466			4,881			—			880,027
Credit contracts		—			121,438			9,288			—			130,726
Foreign exchange contracts		—			64,218			530			—			64,748
Equity contracts		877			45,375			2,034			—			48,286
Commodity contracts		7,144			31,248			1,606			—			39,998
Other		—			879			1,396			—			2,275
Netting(2)		(7,596	)		(1,045,912	)		(11,837	)		(54,262	)		(1,119,607	)

Total derivative and other contracts		2,105			90,712			7,898			(54,262	)		46,453
Physical commodities		—			16			—			—			16

Total financial instruments sold, not yet purchased		60,957			100,813			8,639			(54,262	)		116,147
Obligation to return securities received as collateral		15,267			127			—			—			15,394
Securities sold under agreements to repurchase		—			8			340			—			348
Other secured financings		—			14,024			570			—			14,594
Long-term borrowings		10			38,050			1,603			—			39,663

Total liabilities measured at fair value	$	76,234		$	156,460		$	11,154		$	(54,262	)	$	189,586

(1)	The Company holds or sells short for trading purposes equity securities issued by entities in diverse industries and of varying size.

(2)

(3)	Amount represents MSRs accounted for at fair value. See Note 7 for further information on MSRs.

Transfers Between Level 1 and Level 2 During the Quarter Ended September 30, 2011.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the quarter ended September 30, 2011, the Company reclassified approximately $1.0 billion of derivative assets and approximately $0.9 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.


		24

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Financial instruments owned—Other sovereign government obligations. During the quarter ended September 30, 2011, the Company reclassified approximately $1.8 billion of other sovereign government obligations assets and approximately $2.1 billion of other sovereign government obligations liabilities from Level 1 to Level 2. These reclassifications primarily related to European peripheral government bonds as transactions in these securities did not occur with sufficient frequency and volume to constitute an active market.

Transfers Between Level 1 and Level 2 During the Nine Months Ended September 30, 2011.

Financial instruments owned—Derivative and other contracts and Financial instruments sold, not yet purchased—Derivative and other contracts. During the nine months ended September 30, 2011, the Company reclassified approximately $0.8 billion of derivative assets and approximately $1.2 billion of derivative liabilities from Level 2 to Level 1 as these listed derivatives became actively traded and were valued based on quoted prices from the exchange.

Financial instruments owned—Other sovereign government obligations. During the nine months ended September 30, 2011, the Company reclassified approximately $1.8 billion of other sovereign government obligations assets and approximately $2.1 billion of other sovereign government obligations liabilities from Level 1 to Level 2. These reclassifications primarily related to European peripheral government bonds as transactions in these securities did not occur with sufficient frequency and volume to constitute an active market.

Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis.

The following tables present additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the quarter and nine months ended September 30, 2012 and 2011, respectively. Level 3 instruments may be hedged with instruments classified in Level 1 and Level 2. As a result, the realized and unrealized gains (losses) for assets and liabilities within the Level 3 category presented in the tables below do not reflect the related realized and unrealized gains (losses) on hedging instruments that have been classified by the Company within the Level 1 and/or Level 2 categories.

Additionally, both observable and unobservable inputs may be used to determine the fair value of positions that the Company has classified within the Level 3 category. As a result, the unrealized gains (losses) during the period for assets and liabilities within the Level 3 category presented in the tables below may include changes in fair value during the period that were attributable to both observable (e.g., changes in market interest rates) and unobservable (e.g., changes in unobservable long-dated volatilities) inputs.

For assets and liabilities that were transferred into Level 3 during the period, gains (losses) are presented as if the assets or liabilities had been transferred into Level 3 at the beginning of the period; similarly, for assets and liabilities that were transferred out of Level 3 during the period, gains (losses) are presented as if the assets or liabilities had been transferred out at the beginning of the period.


		25

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Quarter Ended September 30, 2012.


	Beginning Balance at June 30, 2012			Total Realized and Unrealized Gains (Losses)(1)			Purchases			Sales			Issuances			Settlements			Net Transfers			Ending Balance at September 30, 2012			Unrealized Gains (Losses) for Level 3 Assets/ Liabilities Outstanding at September 30, 2012(2)
	(dollars in millions)
Assets at Fair Value
Financial instruments owned:
Other sovereign government obligations	$	1		$	—		$	1			—		$	—		$	—		$	1		$	3		$	—
Corporate and other debt:
State and municipal securities		3			1			—			(2	)		—			—			—			2			—
Residential mortgage-backed securities		24			1			1			(4	)		—			—			(2	)		20			(1	)
Commercial mortgage-backed securities		256			13			7			(54	)		—			(99	)		3			126			8
Asset-backed securities		9			1			—			—			—			—			—			10			1
Corporate bonds		745			50			86			(157	)		—			—			33			757			51
Collateralized debt obligations		1,457			92			569			(200	)		—			—			113			2,031			127
Loans and lending commitments		7,794			183			1,098			(366	)		—			(674	)		(210	)		7,825			148
Other debt		13			—			12			(2	)		—			—			(12	)		11			—

Total corporate and other debt		10,301			341			1,773			(785	)		—			(773	)		(75	)		10,782			334
Corporate equities		482			9			48			(95	)		—			—			(73	)		371			9
Net derivative and other contracts(3):
Interest rate contracts		(172	)		(282	)		5			—			(10	)		187			173			(99	)		(76	)
Credit contracts		3,842			(791	)		22			—			(17	)		(266	)		(167	)		2,623			(870	)
Foreign exchange contracts		(224	)		(101	)		—			—			—			(12	)		(74	)		(411	)		(102	)
Equity contracts		(1,173	)		(2	)		126			(12	)		(57	)		32			(249	)		(1,335	)		(8	)
Commodity contracts		937			(84	)		11			—			(3	)		(5	)		(88	)		768			(28	)
Other		(27	)		—			—			—			—			6			18			(3	)		—

Total net derivative and other contracts		3,183			(1,260	)		164			(12	)		(87	)		(58	)		(387	)		1,543			(1,084	)
Investments:
Private equity funds		2,005			162			127			(48	)		—			—			—			2,246			153
Real estate funds		1,326			44			20			(36	)		—			—			—			1,354			30
Hedge funds		533			19			42			(46	)		—			—			16			564			14
Principal investments		3,047			1			33			(50	)		—			—			(5	)		3,026			3
Other		543			4			11			(9	)		—			—			(73	)		476			5

Total investments		7,454			230			233			(189	)		—			—			(62	)		7,666			205
Securities received as collateral		—			—			—			—			—			—			4			4			—
Intangible assets		8			—			—			—			—			(2	)		—			6			—

Liabilities at Fair Value
Commercial paper and other short-term borrowings	$	2		$	—		$	—		$	—		$	—		$	—		$	12		$	14		$	—
Financial instruments sold, not yet purchased:
Corporate and other debt:
Residential mortgage-backed securities		4			—			—			—			—			—			—			4			—
Corporate bonds		127			(26	)		(116	)		56			—			—			(2	)		91			(45	)
Collateralized debt obligations		1			—			—			1			—			—			(1	)		1			—
Unfunded lending commitments		51			(11	)		—			—			—			—			—			62			(11	)
Other debt		63			2			(6	)		—			—			—			—			55			2

Total corporate and other debt		246			(35	)		(122	)		57			—			—			(3	)		213			(54	)
Corporate equities		47			26			(21	)		—			—			—			12			12			(3	)
Obligation to return securities received as collateral		—			—			—			—			—			—			20			20			—
Securities sold under agreements to repurchase		185			(13	)		—			—			—			—			—			198			(13	)
Other secured financings		470			(22	)		—			—			—			(76	)		—			416			(22	)
Long-term borrowings		2,210			(215	)		—			—			259			(223	)		(7	)		2,454			(231	)


		26

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(1)	Total realized and unrealized gains (losses) are primarily included in Principal transactions—Trading in the condensed consolidated statements of income except for $230 million related to Financial instruments owned—Investments, which is included in Principal transactions—Investments.

(2)	Amounts represent unrealized gains (losses) for the quarter ended September 30, 2012 related to assets and liabilities still outstanding at September 30, 2012.

(3)	Net derivative and other contracts represent Financial instruments owned—Derivative and other contracts net of Financial instruments sold, not yet purchased—Derivative and other contracts. For further information on derivative instruments and hedging activities, see Note 11.

Financial instruments owned—Net derivative and other contracts. The net loss in Net derivative and other contracts was primarily driven by tightening of credit spreads on underlying reference entities of basket credit default swaps.


		27

MORGAN STANLEY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis for the Nine Months Ended September 30, 2012.


	Beginning Balance at December 31, 2011			Total Realized and Unrealized Gains (Losses)(1)			Purchases		Sales			Issuances				Settlements			Net Transfers			Ending Balance at September 30, 2012			Unrealized Gains (Losses) for Level 3 Assets/ Liabilities Outstanding at September 30, 2012(2)
	(dollars in millions)
Assets at Fair Value
Financial instruments owned:
U.S. agency securities	$	8		$	—		$	—	$	(7	)	$	—			$	—		$	(1	)	$	—		$	—
Other sovereign government obligations		119			—			2		(118	)		—				—			—			3			—
Corporate and other debt:
State and municipal securities		—			2			—		(3	)		—				—			3			2			—
Residential mortgage-backed securities		494			(24	)		4		(267	)		—				—			(187	)		20			(36	)
Commercial mortgage-backed securities		134			36			123		(65	)		—				(100	)		(2	)		126			28
Asset-backed securities		31			1			9		(31	)		—				—			—			10			—
Corporate bonds		675			8			367		(314	)		—				—			21			757			(1	)
Collateralized debt obligations		980			193			1,215		(321	)		—				—			(36	)		2,031			147
Loans and lending commitments		9,590			54			2,592		(2,205	)		—				(2,019	)		(187	)		7,825			(144	)
Other debt		128			15			8		(140	)		—				—			—			11			9

Total corporate and other debt		12,032			285			4,318		(3,346	)		—				(2,119	)		(388	)		10,782			3
Corporate equities		417			(2	)		153		(184	)		—				—			(13	)		371			3
Net derivative and other contracts(3):
Interest rate contracts		420			(338	)		98		—			(15	)			7			(271	)		(99	)		(85	)
Credit contracts		5,814			(1,733	)		46		—			(421	)			(533	)		(550	)		2,623			(2,048	)
Foreign exchange contracts		43			(163	)		—		—			—				(142	)		(149	)		(411	)		(221	)
Equity contracts		(1,234	)		156			272		(5	)		(122	)			(205	)		(197	)		(1,335	)		143
Commodity contracts		570			152			17		—			(8	)			29			8			768			145
Other		(1,090	)		59			—		—			—		&nbs