Morgan Stanley (NYSE: MS)
F2Q08 Earnings Conference Call
June 18, 2008 11:00 AM ET

Management Summary

Operator
Welcome to the Morgan Stanley conference call. The following is a live broadcast by Morgan Stanley and is provided as a courtesy. Please note that this call is being broadcast on the internet through the company's website at www.morganstanley.com. A replay of the call and the webcast will be available through the company's website, and by phone, through July 18th, 2008.

This presentation may contain forward-looking statements. You are cautioned not to place undue reliance on forward-looking statements, which: speak only as of the date on which they are made; which reflect management's current estimates, projections, expectations or beliefs; and which are subject to risks and uncertainties that may cause actual results to differ materially.

For a discussion of additional risks and uncertainties that may affect the future results of the company, please see "Forward-Looking Statements" immediately preceding Part 1, Item 1; "Competition and Regulation" in Part 1, Item 1; "Risk Factors" in Part 1, Item 1(a); "Legal Proceedings" in Part 1, Item 3; "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part 2, Item 7; and "Quantitative and Qualitative Disclosures about Market Risk" in Part 2, Item 7(a) of the company's annual report on Form 10-K for the fiscal year ended November 30th, 2007, and other items throughout the Form 10-K and the company's quarterly report on Form 10-Q for the period ended February 29th, 2008. Also, the company's 2008 current reports on Form 8-K.

The presentation may also include certain non-GAAP financial measures. The reconciliation of such measures to the comparable GAAP figures are included in our annual report on Form 10-K, our quarterly report on Form 10-Q, and our current reports on 8-K which are available on our website, www.morganstanley.com.

Any recording, rebroadcast or other use of this presentation, in whole or in part, is strictly prohibited without prior written consent of Morgan Stanley. This presentation is copyrighted and proprietary to Morgan Stanley.

At this time, I would like to turn the program over to Mr. Colm Kelleher for today's call.

Colm Kelleher, Chief Financial Officer
Good morning, and thank you for joining us. What I am going to review with you today will be consistent with what we have been saying about business conditions in the quarter. Strong client flows characterized the first quarter. Second quarter flows were severely disrupted by the Bear Stearns situation and the fallout of the forced liquidation of hedge funds, and financial institutions continuing to raise capital and recognize further writedowns are ongoing themes.

Following the events in March that froze the markets, client activity improved, but remained subdued throughout the remainder of the quarter and had a significant impact on revenues in our Institutional Securities business. There were a few attractive risk adjusted opportunities and we continue to be prudent in our use of capital. The strength and health of our balance sheet will be evident when we disclose our Tier 1 ratio in the 10-Q. While we are still finalizing the numbers, we expect our Tier 1 ratio will be between 11.5% and 12%.

The themes that we laid out last quarter, including market deleveraging and derisking continue. We further reduced our leverage to 25.1X, adjusted leverage to 14.1X and increased our period-end liquidity to $169 billion and feel we have navigated through this difficult quarter.

Let me begin with an overview of our firm-wide results outlined on pages 1 and 2 of our financial supplement. We generated net income of $1 billion, diluted earnings per share of $0.95 and a return on equity of 12%. These results included the divestiture of our Spanish onshore mass affluent wealth management business, reported in Global Wealth Management, which affected profit before tax by $698 million and EPS, earnings per share, by $0.43.

We also completed a partial sale of our investment in MSCI through a secondary offering that had an additional impact on our profit before tax of $732 million and a $0.45 impact on earnings per share. Results also included severance charges related to our recent reduction in force that reduced EPS by $0.15. While extremely challenging markets had a broad impact, several franchise businesses performed well, including prime brokerage, cash equity trading and foreign exchange.

Our Global Wealth Management business contributed strong results due to the momentum we have established with increasingly productive brokers and the fact that retail investors remained relatively engaged. Firm-wide net revenues were $6.5 billion, and PBT margin was 22%.

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

On page 3 of the financial supplement you can see the total global head count decreased by 4% from year end, reflecting our continued efforts to resize certain businesses in this difficult operating environment. The compensation to net revenue ratio was 46% or 54% excluding the severance and the impact from the gains. Our current estimate of compensation to net revenue ratio for the next two quarters would be closer to first quarter of '08, excluding severance charges of 47%. This is the ratio you should model going forward.

Non-compensation expenses were $2.1 billion. Our non-comp levels are consistent with prior periods, as we are using operating efficiencies to fund investments in technology and geographic expansion to enhance our client-servicing capabilities. Now let me turn to the businesses.

Starting with Institutional Securities detailed on page 5 of the supplement, these results were significantly affected by the ongoing market challenges and the corresponding decrease in client activity that we experienced this quarter. Net revenues of $3.6 billion were 42% lower than the first quarter and included $744 million from the secondary offering of MSCI that you will see in other revenues in the Institutional Securities income statement. Excluding the gain, revenues decreased 54%.

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

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

Revenues in Investment Banking decreased 11% from the first quarter, although our overall pipelines continue to be healthy, with corporates maintaining high levels of strategic dialogue. This quarter we've participated in several high profile deals, including:

Time Warner Cable's $42 billion separation transaction;
Northwest Airlines' announced merger with Delta;
GE Capital's $8.5 billion debt offering;
New World Resources' $2.5 billion IPO;
CIT Group's $1.5 billion concurrent common and convertible offering.

Looking at page 6 of the supplement, Investment Banking revenues were $875 million.

Advisory revenues were $367 million, a 17% decrease from the first quarter, in line with completed industry volumes. Underwriting revenues decreased 5% to $508 million, as higher equity underwriting revenues were offset by lower revenues in fixed income underwriting.

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

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

Page 6 of the supplement shows total sales and trading revenues of $2 billion, down 61% from the strong results of last quarter. Last quarter our trading businesses produced exceptional results on the back of our client franchise. Since then, client activity, illiquid credit markets and poor positioning drove trading revenues significantly lower, particularly in fixed income.

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

While volumes in interest rate and currency businesses remained strong, unfavorable rates positioning drove revenues lower. Interest rate, credit and currency trading revenues combined were down 63% from the first quarter.

Credit trading generated a loss. In addition to overall subdued customer activity levels, our results included losses of $390 million, which I'll refer to again later from monoline exposures. The credit trading loss also included $120 million negative adjustment to marks previously taken in our London traders book that did not comply with firm policies.

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

We continue to work out our mortgage proprietary trading business and significantly reduced its losses versus last quarter.

Our commodities business declined 67% from last quarter on poor positioning in North American electricity. Firm-issued structured notes have little impact on this quarter's fixed income results.

Equity sales and trading revenue of $2.1 billion were 39% lower than last quarter's record results as the market environment led to significantly lower derivatives and proprietary trading revenues, which offset continued strength in prime brokerage and cash trading. Despite the severe drop in volumes in the credit markets, global equity volume has remained strong, resulting in slightly higher cash equity revenues.

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

The prime brokerage business produced strong revenues, with average customer balances up slightly from last quarter. The quarter's equity results also benefitted from a $90 million gain on firm-issued structured notes.

Let me now update you on our progress in managing down our exposures in those areas most affected by the credit cycle downturn that began last summer. At that time our exposures were at peak levels in areas that concerned us most: namely leveraged lending, commercial real estate and residual sub-prime. Today and in our 10-Q we will be disclosing broader gross exposure information to help you understand the financial impact of the marks we have taken in commercial mortgage-backed and monolines.

Our leveraged acquisition portfolio is now down to $12.7 billion from a peak of $35 billion in the third quarter. This number is embedded in the non-investment grade loans and commitments of $22.3 billion on page 7 of the supplement.

Some liquidity did return here to the marketplace this quarter. We had net positive market movements of $430 million on non-investment grade loans and commitments, which were offset by losses on hedges of $910 million, resulting in net losses of $496 million. These losses were primarily in the leveraged acquisition portfolio. These are the major components of the $590 million loss reported in other sales and trading.

Last year we anticipated CMBS commercial whole loan issues early and repositioned our portfolio across regions with a greater proportion of the reduction in net exposure coming out of the U.S. We have provided details of our gross and net exposure to CMBS and commercial whole loans on page 17 of our financial supplement.

We continue to get observable market prices from executed trades and as you can see in the supplement, we reduced our net exposure to $6.4 billion from $11.6 billion and our gross exposure to $22.1 billion from $23.5 billion. Please note that included in the gross exposure are other secured financings that we do not consider to be at-risk assets. Total losses this quarter here were $100 million.

On page 16 of the supplement, we reduced our total ABS CDO subprime net exposure this quarter to $300 million from $1.8 billion. As stated earlier, we have optimized our sub-prime portfolio with exposure primarily in higher quality vintages which we are managing more efficiently. Our hedges have performed well, producing a $300 million gain and we reduced our super senior mezzanine exposures by $1.2 billion from last quarter, through dispositions and writedowns.

In other mortgage-related exposures, including alt-A, RMBS bonds and European mortgage loans, we reduced our net exposure to $6.7 billion from $8.7 billion. Our gross exposure was $12.3 billion at quarter end, down from $14.5 billion last quarter. Within the $6.7 billion there was $2.4 billion in alt-A exposure, down from $4.6 billion last quarter, through executed trades and corresponding marks calibrated to those trades. Total writedowns were $300 million and are the main driver of our losses in mortgage proprietary trading.

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

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

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

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

Turning to capital liquidity, we are still very focused on maintaining a strong capital position, high levels of liquidity and prudent leverage ratios. Page 4 of the supplement highlights our current capital position. We continued to be well capitalized with excess capital. As I mentioned before, while we are still finalizing the numbers, we expect our Tier 1 ratio will be between 11.5% and 12% in our 10-Q. This ratio represents the overall strength of our balance sheet. We are still placing a significant emphasis on our capital and liquidity to ensure we have enough dry powder to continue investing in our businesses and to take advantage of attractive risk-adjusted opportunities.

We further strengthened our liquidity position and built on the momentum of the previous few quarters. We ended the quarter with total liquidity of $169 billion, up $46 billion from the prior quarter end.

Let me take you through the components:

During the quarter we accessed the capital markets and raised $14.3 billion in unsecured parent company debt, bringing our year-to-date public long-term debt issuance activity to $22.9 billion. This amount, together with incremental non-public issuance activity, exceeds our scheduled maturities for 2008. We continue to actively manage down positions requiring significant cash funding and reallocate balance sheet to liquid assets with significant two-way customer flows.

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

Total liquidity, which we have added to our financial supplements on page 3, includes liquidity at the parent company, bank and non-bank subsidiary levels. Total liquidity averaged $135 billion in the quarter, up 11% from the record levels of $122 billion in the first quarter.

Parent company liquidity was $80 billion at quarter end and averaged $74 billion, up from $71 billion averaged in the first quarter. Bank and non-bank subsidiaries' liquidity position was $89 billion at quarter end and averaged $61 billion in the quarter.

Last quarter I told you that the weighted average maturity of our fixed income repo book, turning to secured financing, was 34 days, which is a relatively long duration. Recently average repo maturity has been around 48 days. The more comprehensive metric that we plan to disclose to you in our 10-Q filings going forward is the weighted average maturity across all asset classes in our repo and stock lending books. The weighted average maturity of these books has recently been about 45 days. We continue to work to extend the term of this book as part of our overall liquidity planning and financing capabilities.

We are managing our balance sheet prudently and further reduced the total and adjusted assets during the quarter. Our discipline in maintaining an appropriately-sized balance sheet in today's environment, along with our strong capital position, has brought our total leverage ratio down to 25.1X from 27.4X, and our adjusted leverage ratio down to 14.1X from 16X. This combination of our strong capital, high liquidity and reduced leverage positions us to take advantage of market opportunities.

As it regards value at risk (VaR), total average trading and non-trading VaR increased to $112 million from $103 million last quarter. Average trading value at risk was up slightly to $99 million from $97 million. Moderate increases in VaR were driven primarily by higher realized market volatility that more than offset reductions in key trading risks. In addition, the increase in aggregate trading and non-trading VaR was also driven by the issuance of long-term debt referred to earlier used to fund the increase in the company's total capital.

In our 10-Q filing, in addition to our Tier 1 ratio, we will be reporting risk weighted assets attributable to market, credit and operational risk. This will provide you an additional tool to evaluate our risk-taking each period.

Turning to page 8 of the supplement and our Global Wealth Management business, as I mentioned at the beginning of the call, we divested our Spanish onshore mass affluent wealth management business during the quarter and our results reflect the impact of that transaction. The net gain on the sale after accounting for related expenses was $698 million of PBT.

Excluding this gain, PBT for the quarter was $291 million, and the PBT margin was 17%. Revenues, excluding the divestiture, increased 6% sequentially, reflecting a significant amount of new issue activities that increased investment banking revenues by 46%, primarily in fixed income underwriting.

Fees and commissions declined slightly from last quarter in lieu of market levels and client activity. The increase in principal transaction revenues reflects stronger volumes, primarily in municipals and corporate equities.

Excluding certain expenses related to the divestiture, non-interest expense has increased 4% from last quarter. The increase was primarily driven by higher business development expenses and an increase in legal reserves.

Excluding the divestiture, ROE for the business was 51%. On page 9 you can see the productivity metrics. Net new assets of $13.3 billion represented our 9th consecutive quarter of positive client inflows and our second-highest ever.

Assets in the $1 million-plus household segment increased 4% from last quarter to $511 billion and represented 72% of our total client asset base. Total client assets increased 2% from last quarter to $739 billion, largely reflecting market levels and net new assets.

Average FA production, excluding the divestiture, increased to $810,000 as a result of increased revenues. Average assets per FA of $89 million increased also 5% compared to last quarter, reflective of asset levels in the quarter. If you exclude the reduction in brokers from the divestiture, FA head count increased slightly compared with the first quarter of '08. Our bank deposits grew to $34.3 billion as clients kept assets in cash due to the volatile markets.

Let me turn to asset management, which continued to be negatively impacted by the turmoil in the markets. On page 10 of the supplement, our asset management business reported a pre-tax loss of $227 million. Revenues were down 10% sequentially, primarily reflecting investment losses in merchant banking partially offset by higher revenues in our core business.

Merchant banking posted losses on principal investments of $212 million, primarily driven by markdowns in real estate. $150 million of these markdowns relate to the writedown of one major investment that was acquired in 2007 as part of the building of a future real estate fund. Crescent (Crescent Real Estate Equities Co.), a REIT, includes high quality office buildings and investments in resorts and residential developments located in select high growth markets across the United States.

Due to factors including changes in market conditions, the timing, valuation and size of the investment, we will not include Crescent in the investor fund. As a result, $4.6 billion of assets are being consolidated onto our balance sheet. We will continue to evaluate these assets and position them for sale as opportunities arise.

Core results include lower management and administration fees, primarily reflecting lower performance fees in our alternatives business and lower trading losses. The trading results include losses of approximately $86 million related to marking securities issued by structured investment vehicles held on balance sheet by asset management.

The total structured investment vehicle, or SIV, exposure in our money fund as of quarter end was $1.3 billion, which are all bank sponsored, down from $3.6 billion at the end of last quarter. This decrease came from maturity sales and paydowns. The current balance is approximately $1 billion and will drop below $600 million by the end of June.

The value of assets relating to SIVs on our balance sheet was approximately $500 million at the end of the quarter. Non-interest expense of $715 million increased slightly from the first quarter driven by higher compensation, partially offset by lower non-compensation expenses. These results contrast sharply from the strong results we delivered last year. There has been a significant falloff in this business, and it continues to be a difficult environment, particularly for real estate.

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

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

Turning to pages 11, 12, and 13 of the supplement, you can see the assets under management and asset flow data. This quarter we revised our disclosure to provide more transparency around assets and flows by product and channel, including a breakdown of our merchant banking business. Total assets under management increased 5% to a record $605 billion. We generated $15.5 billion in flows, our 7th consecutive quarter of positive flows.

From a product perspective, we now show asset flows at both the core and merchant banking businesses. There were $13.8 billion of inflows into core, with strong inflows into fixed income and alternative products, and we had outflows from equities.

Core inflows were driven primarily by institutional money markets. Flows into merchant banking products have remained positive and we recorded $1.7 billion in asset flows in the quarter. We continue to show positive flows at our non-U.S. and U.S. institutional channels, while retail channels recorded outflows in the quarter.

As we have said earlier, we are committed to improving our performance in the retail and mutual fund space. This continues to be a major focus of the management team.

On page 3 of the supplement, you can see the regional revenue disclosure at the firm-wide level. This quarter, 57% of our revenues were international with 43% from Europe, the Middle East, Africa (EMEA); 14% from Asia; and 43% have come from the Americas.

Finally a few words on the outlook. After a difficult start to the quarter, customer flow activity returned to more normal levels in May and these flows have continued into June. Clearly the markets are still nervous and whilst there are encouraging signs to the trend, many issues remain. Rising inflation, higher energy prices, rising unemployment and the ongoing housing downturn will continue to pressure the U.S. consumer. Uncertainty remains surrounding potential regulatory and accounting changes.

Against this backdrop, the underlying trends in our customer businesses are good. We are starting to see an increase in risk-taking in leveraged loans and financial bonds, credit and the emergence of interest in CLOs.

While securitization markets are relatively quiet, we have been able to reduce gross exposures with cash sales. In particular, we have seen non-leveraged buys of distressed assets in this class.

Retail clients remain engaged, albeit in safer and lower margin investments, and our emerging market pipelines are robust. So we will continue to stay close to shore given the current market conditions. Importantly, we continue to focus on liquidity, capital and balance sheet transparency and we are very focused on servicing our clients. We are confident that our global platform is strongly positioned to capture the opportunities of the market dislocations as we look for risk-adjusted returns.

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

Q&A

Operator
Please stand by while we wait for the question-and-answer portion of the conference to begin. Your first question comes from the line of Guy Moszkowski with Merrill Lynch. Go ahead.

Guy Moszkowski, Merrill Lynch
Good morning, Colm.

Colm Kelleher
Hi.

Guy Moszkowski, Merrill Lynch
First question, just a very quick one. Could you remind us in calculating your liability marks, do you use CDS spreads or do you use specific bond spreads?

Colm Kelleher
On our liability marks we use bond spreads.

Guy Moszkowski, Merrill Lynch
Okay, bond spreads. I'd like to talk for a minute about the leveraged finance hedge loss. Can you give us a sense for what sort of mix of hedges and type of hedges you use in hedging that portfolio?

Colm Kelleher
Yes. In broad terms, I mean we actually had hedge losses across our whole book on non-investment grade as well. The preponderance of those losses was in what I would call the bridge facilities. The reason for that, Guy, is that it is much harder to either get specific CDS against them and you have to use, by and large, index as a proxy so we've been dynamically managing it on that basis. That really has been the bulk of the loss on those hedges because as you know, there is huge idiosyncratic risk there; it's very name-specific and very concentrated.

Guy Moszkowski, Merrill Lynch
Basically then what we saw was, despite the attempt to use single-name hedges, an inability to get enough of those to really protect you, and therefore some macro level hedges which just had a lot of basis risk this quarter?

Colm Kelleher
Yes, I think that's fair.

Guy Moszkowski, Merrill Lynch
I guess the next thing I'd like to talk about -- and I think this is probably a little bit more of a complex discussion -- is maybe if we can go to page 16 of the supplement. What I'd like to try to do on the sub-prime and resi analysis is relate the exposures and P&L impact that we see here to the $430 million odd net marks that you talked about for the prop mortgage business. Separately, how can we interpret these exposure numbers to really get comfortable that your exposure here is being brought down through sales of losses?

Colm Kelleher
Our mortgage proprietary trading in total includes most of our legacy U.S. sub-prime positions, but also alt-A and a few commercial positions. So if you look at the loss itself, the net $300 million is made up of a gross $400 million loss on mortgage proprietary trading and a $100 million gain on credit trading, and I'll break that down for you.

Within mortgage proprietary trading, sub-prime there was a write-off of $100 million. We had a commercial writedown of $200 million and non sub-prime residential -- which is primarily the alt-A -- is the $300 million mark. That's $400 million.

In credit trading, you have $100 million which is made up of a write-off in sub-prime of $200 million, so that $200 million plus $100 million gives you the $300 million write-off you see on the schedule.

The commercial write-off of $100 million in credit trading nets against the $200 million writedown in the prop desk to give you the net writedown of $100 million that is on the schedule on page 17. That kind of balances it for you.

Now let me just clarify one thing. As the schedules present all of our direct exposures, they include positions that are outside what were the legacy proprietary trading desk. That credit trading number I'm giving you offsets those mortgage proprietary trading desks which is what you relate to in the fourth quarter.

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

Colm Kelleher
Yes, well look; as you know, the financial supplement, the analysis we present, it presents all our U.S. sub-prime gross and net exposure. Now we are continually, and we have said we would manage down our exposure in the areas where we incurred our greatest losses in 2007, and that was through a combination of dispositions and writedowns. That has been calibrating our valuations and so on. That's clearly evidenced by the $1.8 billion decline you see in the net exposure in our super senior mezz line and the ABS bond positions.

But I also said last quarter, given the market dynamics we'll continue to look for opportunities to manage our overall risk exposure on this portfolio, so there is some dynamic hedging from the short side which feeds into that. But you should feel very comfortable that we are managing this exposure down.

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

Colm Kelleher
Thank you.

Guy Moszkowski, Merrill Lynch
The final question I'm going to ask is on the $120 million mis-marking that you talking about in London.

Colm Kelleher,
Yes.

Guy Moszkowski, Merrill Lynch
I assume that the person or people involved in that are no longer with Morgan Stanley?

Colm Kelleher
Well, it's not quite that simple because we've got to go through process. The person responsible is suspended. There is an investigation involving a number of bodies which we reported. We immediately informed the FSA when we discovered this through our controls. There's a full internal review of this matter. I'm sure we know what the sentence is going to be, but I don't want to be like the Queen of Hearts.

Guy Moszkowski, Merrill Lynch
Right, okay. That's fair. Thanks very much.

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

Roger Freeman, Lehman Brothers
Hi, good morning, Colm.

Colm Kelleher
Hi, Roger.

Roger Freeman, Lehman Brothers
So what I would like to ask is, as you think about all the changes you've made around risk management and you talk about the Federal/local split, how fully has that been implemented and how is it working so far?

Tied to that, when you look in the trading results this quarter, you see a number of places where the results are not up to par; where bets were taken, whether it was I guess in electricity, mortgage, trading losses, positioning for spread widening when they compress. How is that factoring into the risk management and how do we get comfort that maybe some of that volatility decreases? In fact, VaR actually went up in the quarter.

Colm Kelleher
Well, there are a number of questions there Roger and I am very glad you asked. Let me address them one at a time, all right?

First of all, I would say that -- and I will end up with risk management at the conclusion from what we come through, all right? First of all, the mortgage proprietary trading losses we are taking are related to, by and large as I've just explained to Guy, the previous legacy portfolios we have. We're long these things, we need more efficient markets to reduce the exposures. I don't think there's an issue there. I do think, actually, if you look at the bulk of the charges we've taken, they relate to legacy positions.

In terms of the commodities positions, look -- we have got a great commodities business. Year in, year out, it's been one of the two top businesses. Occasionally, they made a strategic bet, well thought out, well reasoned on the basis of information they had. We got it wrong. We're in the risk game, occasionally we get things wrong. We're not blase about it, but we get more right than we get wrong, so we're not worried about that. The risk was well-managed, it was just the wrong view, and so on.

In terms of Level 3 assets which you mentioned, we have got those under control, the 7% of the total balance sheet so they're in line, even though we've reduced our balance sheet. I think we've got these positions under control.

Now risk management has played a very active role in this whole process. The reason we've disclosed this loss from the London trader is to be open to The Street. I don't want to be blase about the fact that we discovered it because we're very angry about it, but in this sort of environment of stressed markets, one would expect to see people trying to behave improperly.

The issue is: do you have the controls to catch them? We believe we do. So that's where I would end up. I think Ken deRegt as our Chief Risk Officer, the hiring of [Kashii Hotzuki] as Head of [inaudible] and a thorough overhaul of where we were, I feel very comfortable that our balance sheet is in good order and we understand our risks.

Did I leave anything out? Oh, VaR, sorry. VaR, you say it's gone up; well it has. It has gone up marginally but actually if you look at the inputs on that, volatility itself particularly feeding it, you can see that I would say that if we were to normalize this versus previous inputs it has gone down. Our balance sheet has come down, our gross exposures have come down, our net exposures have come down. So what you're seeing is a dynamic in the market that is driving VaR up. If we had taken more trading risk, that VaR would be significantly more pronounced.

Non-trading VaR is up purely as the function of the increased funding we did. What I propose to do next quarter is to try and see if we can work out some better disclosure around non-trading VaR, or the quarter after, but we'll work on that.

Roger Freeman, Lehman Brothers
Okay, that's helpful. And then switching to your commercial mortgage securities, loans exposure, can you just help me think through any basis risk, basis losses that apparently you didn't have in the quarter that I would have expected, given the big difference between gross and net there?

Colm Kelleher
No, we didn't. We disclosed that we had $100 million loss. For the first quarter we didn't take losses managing this position down. I mean, there are different risks in this book; we show gross and net. If you look at the bottom line, you'll see that we have an accounting gross up which nets that off.

The statement of financial condition, which is bonds, warehouse, lines and loans, greatest exposure was reduced $2.5 billion. The net exposure reduced $3.6 billion. You can see that and it's reasonably well distributed regionally. In terms of the loans themselves, more disclosure, commercial loans was 71% senior, 29% mezzanine. I think if you look at it, take out the gross ups, I think we've actually got this position under control, well down from the peak which we had of I believe $35 billion to where we are now. We've taken a lot of the basis risk out.

In addition, remember, I've always said that the best basis for our valuation to preempt these questions is recalibrating the trades. We've been justified in the marks we've been taking on that, Roger.

Roger Freeman, Lehman Brothers
Okay, but the primary mechanism for hedging of exposures, is it more single-name CDS or CMBS?

Colm Kelleher
It depends on the name. It could be credit default index and total rate of return swaps; you know, it depends. What we're showing you is that the way we're managing this, zero loss in the management of the position the first quarter, $100 million this quarter in what has been a very stressed environment for basis risk and index performance.

Look -- effectively the best hedge is getting your gross exposures down. That's what we've been doing.

Roger Freeman, Lehman Brothers
Okay. And the mix between fixed and floating, what's the average duration of the floating rate?

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

Roger Freeman, Lehman Brothers
All right, I will ask one last question here and jump back in.

Colm Kelleher
Oh, I can tell you. Floaters are 94%, fixed 6%.

Roger Freeman, Lehman Brothers
I guess with respect to these CSE ratios, your Tier 1 ratio obviously looks pretty good relative to what we've heard so far this quarter. How useful do you think that ratio is going to be? I think you're going to talk about some of the risk components in the Q, but one piece that's not captured is the liquidity risk. Do you think that's going to end up having to get reworked? Do you think these are going to be useful metrics?

Colm Kelleher
I really don't want to comment on that. We're clearly heavily involved. The fact that we're running liquidity the way we are is telling you that we think liquidity is a main input. But I do think there's a measurement of risk; I do think Basel II and the trading book review is a very thorough exercise. So personally, when you see risk weighted assets disclosed and the composition of those, I think it will be a much more useful tool than actual accounting classifications.

Roger Freeman, Lehman Brothers
All right, thanks.

Operator
Our next question comes from the line of William Tanona with Goldman Sachs. Go ahead.

William Tanona, Goldman Sachs
Good morning, Colm.

Colm Kelleher
Hi.

William Tanona, Goldman Sachs
Just on the loss, the $120 million, obviously you guys also had losses -- I think it was in the fourth quarter of last year -- as it related to the CDO book. Can you elaborate and help us understand exactly where these losses stem from? Exactly what didn't comply? As you think about these losses, $120 million for a single trader is significant, so just trying to understand over what timeframe this had occurred as well.

Colm Kelleher
Okay, well very different set of circumstances. What we had in the fourth quarter was a proprietary trade. There was never any issue of financial control mismarking, anything. It was a bad trade that went south very badly and we've given you the data points on that, all right?

What we've had here this quarter is we've had a trader who was mismarking his book. We found it, our controls picked it up. Obviously in an environment like this you will get more of that. There was some involvement, going back to the previous quarter, possibly the quarter below that, it had become subject before that; it's subjective. We did not think it was material, but we certainly did think it was time to disclose this to people and to send a very strong message that we have zero tolerance on this sort of behavior.

So I do believe it's isolated. I think it's a very different situation from a prop trading bet going wrong. I think it's just something we caught, our controls caught and we dealt with it.

William Tanona, Goldman Sachs
Okay. And then I guess on the prop trading side, I mean obviously there are numerous businesses that seem to be negatively impacted by prop trading this quarter, even though on the equity side I know one of the big initiatives that John Mack had implemented when he got there was increased risk-taking.

I was just wondering whether or not you guys are rethinking your ability or willingness to take risk, just given some of these losses this quarter? Or was it just a perfect storm of events of bad luck for you guys?

Colm Kelleher
First of all, I think losses this quarter, as I said before, a lot of these losses relate to redispositions. Our equity division still produced $2.1 billion this quarter, which is one of our best quarters ever, so I don't think that that impacted that business. It shows the breadth, diversification and so on.

In terms of risk-taking, look: we will take risk, but we want to take risk-adjusted risk. We did not believe -- we flagged throughout this quarter, that we felt these were very, very treacherous waters. We saw events that took place that you say, a perfect storm.

People cannot gloss over lightly the event that took place in March and the effect that had on the market. Since then you've had a number of other deteriorations in the consumer lending sector, and so on. So that is what made us pull down the sails, sail close to shore, preserve our ammunition. We do have excess capital, we do have excess liquidity, we do have leverage if we want to where we can take risk. That is our priority.

William Tanona, Goldman Sachs
Fair enough. Lastly, in terms of the regional revenue breakout, when you strip out the gains that you had highlighted from MCSI as well as the wealth management business. It looks like all of the regions were down anywhere from 25% to 50%. Were the losses that you highlighted in the trading businesses across all of the regions, or were the core international trends really that weak this quarter?

Colm Kelleher
No, I mean core international trends were strong. It was just that... look, the way I would answer it is the first quarter we did well because we had very good client activity. That's really our edge, that's where we had a good ROE. This quarter we saw generally a fall-off in client activity in broad terms and that's what has affected us.

In Asia, if you look at it, down a little bit primarily in sales and trading; investment banking was up slightly, Europe was fine. We were 57% international of our revenues. If you normalize that for the loss it was still very much roundabout the 50/50 level. So not losses, sorry, the markdowns were taken on legacy positions and so on. I think that our diversification is paying off.

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

William Tanona, Goldman Sachs
Okay, thanks.

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

Glenn Schorr, UBS
Thank you. A follow-up question on FICC. We can stay at the high level because I know I'm not going to get the specific numbers, but if we're at $2.8 billion last quarter, we go to $400 million or so this quarter, we have the prop mortgage issues; we have lower customer volume issues and then we have the commodity. It still feels like wow, were customers volumes that soft across the board? Or was the commodity number actually that big?

Colm Kelleher
Customer volumes for us -- and I know some of our competitors have come out with slightly different stories -- I will tell you customer volumes for us and I think we have a very good market position, in March, I have never seen anything like the drop off that we saw and we went back to test that.

April, if I scale it this way -- and I've done this to you before, so I apologize for repeating -- if you say zero is no volume, five is very good volume, March was zero, April was two, May came up to about a four, we've definitely have seen an improvement since into June. But yes, we were hit hard by the lack of customer volume.

Glenn Schorr, UBS
I guess everyone is going to just try to think about the impossible task of modeling going forward. Can you box it in? A 67% fall off in commodities seems like a big fall off because I know that the commodities business has been doing pretty well. So it seems like a reasonably large number. Is that normal that a directional bet can account for such a big chunk of commodities? I know you have a phenomenal commodities practice.

Colm Kelleher
There are some accounting volumes in there as well, which is that you have some mismatch between GAAP and economic accounting. But I can't really give you more clarification than that.

Glenn Schorr, UBS
If we could just switch over to slide 17 on commercial real estate. Just a couple of things. One is, is there any equity component included there, because it wouldn't fall in within any of those lines, so I'm assuming no.

Colm Kelleher
No.

Glenn Schorr, UBS
And then the bond section if you could help. Is that mostly mezz?

Colm Kelleher
Well in the commercial loans, 71% is senior, 29% is mezz. The bonds are primarily just straightforward bonds; senior.

Glenn Schorr, UBS
Okay. Who are the swaps with? I don't mean exactly who, but I'm just curious in general buckets, who do you tend to do the swaps against because that's one of the major differences between your gross and net exposure. I'm just trying to think about counterparty exposure there.

Colm Kelleher
I don't think there's any one person; it's a diversified portfolio of people, most of which is done on a collateralized base anyway. As you know in the 10-Q, we will be publishing and disclosing who our swap counterparties are anyway.

Glenn Schorr, UBS
But not at this granular level, right?

Colm Kelleher
I'd rather wait and get the right numbers. But in principle, what I'd say to you is look, we're very comfortable with our swap counterparties.

Glenn Schorr, UBS
Understood. And then maybe a last quickie. Always in a lower volume environment it becomes a very slippery slope to bother even asking, but market share and rank have moved lower in a bunch of the banking categories. Is that a function of just you got less of the FICC storm in terms of banking it, because that's where there has been a lot of activity?

Colm Kelleher
I think there are a number of things there Glenn. I mean it is certainly true we got less of the US FICC but as you know in Europe which is probably going to be more of a third quarter event, we did five out of the seven rights issues. If I look at my pipeline, I think that our pipeline in terms of equity capital markets, debt capital markets and M&A are all up over the last quarter and we have a very healthy pipeline.

I think there's an element of timing there. I have no doubt we'll reassert our rankings, but there is a bit of lag. I think there's some temporary distortion because of volumes in markets which have been a bit lopsided.

Glenn Schorr, UBS
Cool. Last one is, to end on something good, wealth management flows were pretty awesome considering the environment. Can you talk about how much of that is coming from say the existing FA base versus what appeared to be a great ability to recruit during a tough time?

Colm Kelleher
I think it's a combination of both. We're getting very good productivity from the existing FA base but as you know, that's a good cumulative effect. But in addition, we've clearly been doing very well on what they call the balance of payments in hiring versus losses. So I think James, and Ellyn Mccolgan who's running GW have really done a fantastic job there.

Glenn Schorr, UBS
All right, thanks very much.

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

Mike Mayo, Deutsche Bank
Good morning.

Colm Kelleher
Hi, Mike.

Mike Mayo, Deutsche Bank
Can you comment on the investment banking pipeline? You said it was healthy, but can you quantify that a little bit more? Also, down 11% is a bit worse than some of your competitors, if you can give some more color on that.

Colm Kelleher
I would say it -- it is very difficult for me to say, give you specifics on that. We are up in the first quarter significantly in announced and pending on the M&A pipeline and also on probability rated revenue on that basis. We are marginally up to a reasonable number up in equity and debt capital markets. I think that's all I want to say on that, Mike.

Mike Mayo, Deutsche Bank
Okay. And then Asia was down one-fourth linked quarter and it looks like the lowest level since the quarter ending around late '06.

Colm Kelleher
I mean the real swing factor, as I said before, in Asia was our sales and trading which was the swing factor there. What I can tell you is our investment banking business in Asia, slightly positive. Our pipelines in Asia are very, very strong.

Mike Mayo, Deutsche Bank
The sales and trading, did that relate to the legacy mortgage position?

Colm Kelleher
Not at all in Asia. That was just literally reduced client volume.

Mike Mayo, Deutsche Bank
Was there any outsized loss there? Because that's still a pretty big swing.

Colm Kelleher
No.

Mike Mayo, Deutsche Bank
Okay. And then just going back to the big picture here, I try to add up all the numbers you gave on the call and I got $1.7 billion of writedowns and losses. I can go through the list. You said it, but kind of quickly. Monoline $390 million; the mismarking on the trade $120 million; leveraged loan writedowns, $496 million; commercial real estate CMBS $100 million; alt-A $300 million; the trading loss of $86 million; and then markdowns on private equity of $200 million.

Colm Kelleher
That's correct.

Mike Mayo, Deutsche Bank
And there's nothing missing there. So as we think about go-forward, I think what you're implying here if you're marking everything correctly, in the perfect world if nothing changed, those $1.7 billion of marks would go away? Or not necessarily? Where do we stand with these writedowns?

Colm Kelleher
Well look, I am not going to give specific details on marks and I'll tell you why. I think we've been very clear about our philosophy on marking itself. We calibrate the trades, if you look at the sub-prime exposure -- let me give you an example which is anecdotal. If you look at page 16 which is sub-prime exposure, if you look at that now, we've marked that down, we've got the exposure down to a net of $300 million but if you look in the footnotes, we've now got marks that are implying losses in the range of 18% to 41%. Those cumulative loss levels at a severity rate of 55% are implying defaults of 73% to 84%.

So if you take that as an example and the fact that we disclosed this all fully, we've calibrated trades, we've done that in CMBS, we've done that in leveraged lending. My view is the marks are what they are; we've proven in subsequent trades that they are the right marks; sometimes we've done better than that, obviously. Whether we're going to get continued deterioration in them or not, I don't know. I mean there's been a big writedown already; they're marked appropriately and it is a function of whether the markets return or not.

Mike Mayo, Deutsche Bank
And then the Tier 1 ratio, you mentioned you want to keep dry powder. The Tier 1, 11.5% to 12% preliminary, does that reflect dry powder or is that where you'd want to run it?

Colm Kelleher
Well you are going to have to judge that for yourselves. There's a lot of uncertainty in the market. We know where our contemporaries are in Tier 1. We feel pretty good about that, but also we have uncertainty in the market generally so it does give us a capital buffer, which is the way I look at it. So yes, I feel good about it.

Mike Mayo, Deutsche Bank
Thank you.

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

Prashant Bhatia, Citi
Hi.

Colm Kelleher
Hi, how are you?

Prashant Bhatia, Citi
Good. Just your comment that you're going to continue to stay close to shore, does that imply that it's just too early in the cycle right here to take more or deploy capital more aggressively and you're okay to let some opportunities pass by? Or is it more the view that you just don't think there will be much near term?

Colm Kelleher
Well we actually think that if you remember the end of last quarter, I gave a more positive outlook. I mean not that I've ever been Mr. Happy, but the issue is there were definitely better signs of recovery in the markets then; March actually was a pretty nasty event.

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

But I do think there's going to be an opportunity to make money here. It is an issue of taking advantage of dislocation, taking advantage of opportunities that will present themselves. We were hoping that would be the case this year -- this quarter, sorry. But the key for us, Prashant, is risk-adjusted. We really did not feel, and you see that in our VaR numbers, we really did not feel that on a risk-adjusted basis it was worth taking bets away from areas where we were comfortable with.

Now clearly in commodities we made a trade on the basis of good fundamentals and it didn't work; but more often than not we get those right. So I'm not saying we're in risk reduction mode; we clearly have reduced the risk, we've reduced the balance sheet, we're liquid, we've got capital, we clearly feel we can make money through bear cycles and bull cycles and we're just waiting for the right risk-adjusted opportunity to come along.

Prashant Bhatia, Citi
Okay, that's helpful. Just on the size of the asset base, the trillion gross, $580 billion net, where do you think that ends up settling? Is there a fair amount more to go or would you stay at these levels?

Colm Kelleher
I kind of think we're in the right sort of spot at the moment in terms of giving us the optionality we need to be opportunistic and to be defensive. Obviously we'd like a more normalized market to get rid of some of this legacy portfolio so we can optimize return to the balance sheet. But I think we feel comfortable that we've got optionality sitting where we are at the moment given all the uncertainty around it.

Prashant Bhatia, Citi
Okay. And then on the $6 billion of commercial loans in your disclosure, do you have at hand what the delinquency rate is on that loan portfolio? Or just anything else that you could provide to just help people understand the quality there. It seems pretty good because I don't think you've taken any --

Colm Kelleher
I have it, I believe it is very good quality which is in our view and that's evidenced in our marks as well. But we'll see what we can -- I just think generally we consider it to be very good quality and well marked.

Prashant Bhatia, Citi
Okay. And then just on the asset management side, it looks like the alternative asset flows are actually pretty strong over the past several quarters. That's a little different than what we've seen at some of the peers. Can you just talk about, is that partly driven by distributing into retail a little bit more or what's the driver there?

Colm Kelleher
I think it's a number of drivers. I mean we've had some very good performance within that historically. We've got a broad suite of products and it is by retail as well.

Prashant Bhatia, Citi
Okay. And then just one final on, can you just elaborate –

Colm Kelleher
The other thing as well I would point out is that remember one of the big drivers this quarter has been institutional money market.

Prashant Bhatia, Citi
Okay. Could you point out areas in the business where you're actually seeing higher returns on the capital you are deploying? That pricing power you talked about a little bit in prime brokerage in the past. Are there other areas where you're seeing that you're basically getting paid more on capital being deployed?

Colm Kelleher
Well I think our equity business is strong and our ratios there look good. Prime brokerage is good. Obviously we're improving our profit margin, indeed, on our retail business. That's kind of where I'd point to. But I mean, drawing a trend away from this quarter, away from those which I had mentioned before is kind of hard.

Prashant Bhatia, Citi
Okay. And then finally on headcount, could you share maybe what your budget is to end the year at?

Colm Kelleher
We don't look at headcount, we look at cost. We've done some pretty big moves on costs, as you can see. Headcount is a secondary consideration. We are really looking at comp expense and by that you get a proxy for headcount. You can clearly see that we are, with a smaller reduction in headcount than some others but a big reduction in comp, what we're trying to do is really get a bang for our buck in that allocation of resources.

Prashant Bhatia, Citi
Okay, thank you, that is helpful.

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

Michael Hecht, Banc of America
Thanks for taking my questions.

Colm Kelleher
Hi, Michael.

Michael Hecht, Banc of America

How are you doing? Can you give us a sense of where Level 3 assets ended the period, and just any components to the change, transfers in and out, that kind of stuff?

Colm Kelleher
No, I mean it's a bit early yet to get into that much detail. I've noticed it can be a dangerous thing to do. But we are at 7% of the balance sheet, roughly proportionally decreased of the overall balance sheet itself as we took it down and in the Q we'll give you the full disclosure on that. So there's no specific story for us in Level 3. The same sort of stuff you'd expect in there, broadly, proportionality will be in there at the end of the Q.

Michael Hecht, Banc of America
That's fair enough. The $90 million in structured note gains you noted in equities, what were the total firm-wide gains on structured notes this quarter?

Colm Kelleher
That was it, $90 million.

Michael Hecht, Banc of America
Just $90 million, okay. On the monoline exposure, the mark that you guys took, can you give us a sense of how you guys come up with the credit valuation?

Colm Kelleher
Sure. We've always done -- we don't do our credit valuation on ratings, we do it on spread. So as spreads widen we take increasing reserve and it's on that basis. I think that's conservative. This time around we've shown our gross exposures as well because obviously monolines have been more topical on that basis, so you can see that, yes.

Michael Hecht, Banc of America
And then on the gross and net leverage which came in quite a bit, I think you said you think the balance sheet is appropriately sized, but should we expect leverage to continue to fall? What do you think the implications are for the type of ROE you guys can earn through this cycle? Are you seeing any pressure here from regulators, rating agencies, investors, to bring leverage down further?

Colm Kelleher
Well we are obviously in constant touch with a broad array of regulators. I mean what we've been doing is taking down the balance sheet because on a risk-adjusted basis, that's what we want to do. That's the same thing, we've been running cash because we wanted to do that given our risk profile.

So the answer is we're in constant dialogue but we're not getting any pressure in terms of the cycle ROE. I mean it's clear that increased leverage has been popping up ROE. I do think it top slices our return off it, but I think you can make up a good chunk of that by optimizing your balance sheet more efficiently.

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

Michael Hecht, Banc of America
Okay, that's fair. Just a quick follow-up on the equities business. I mean it sounded like the flow businesses in cash and derivatives were pretty strong; prime brokerage as well but it's all really a function of the prop trading losses. Can you give us any additional color on those and was it more of the bad positioning versus environmental?

Colm Kelleher
No, not really. I mean I think some of those small, as I've said to you before,some of those small prop trading desks we've wound down. I think generally -- look, let me just restate, equities was $2.1 billion; our record quarter was $2.5 billion.

It was still a very strong quarter and it was broad-based. I think it was our 4th best quarter but I'll have to confirm that, I think that's right.

So I think it's just a testament to the strength of that business. The story this quarter was clearly our fixed income fall-off in flows.

Michael Hecht, Banc of America
Okay. Maybe a quick housekeeping one. Just any color on the tax rate? It was a little bit lower than expected this quarter. Should we, where it is running --

Colm Kelleher, Chief Financial Officer
It's just the changing nature of our business globally, so that's what it is.

Michael Hecht, Banc of America
Okay, great. Thanks.

Colm Kelleher
Well look, thank you very much everybody and I am sure we will have follow-ups. Thanks.

Operator
Ladies and gentlemen, thank you for your participation in today's conference. That does conclude the meeting, you may now disconnect. Have a wonderful day.

Corporate Participants
Colm Kelleher, Chief Financial Officer
Analysts
Guy Moszkowski, Merrill Lynch
Roger Freeman, Lehman Brothers
William Tanona, Goldman Sachs
Glenn Schorr, UBS
Mike Mayo, Deutsche Bank
Prashant Bhatia, Citi
Michael Hecht, Banc of America