2005 was a year of challenge and change for Morgan Stanley—a turbulent period for employees and shareholders alike. Nevertheless, through constant dedication and commitment to our clients, we finished the year strongly, and we have begun 2006 with renewed momentum and focus on performance.

This firm has tremendous potential. We are in the right mix of businesses—businesses our competitors want to be in. We have the scale, expertise and capabilities to succeed globally. We are an unrivaled leader in delivering innovative solutions to our clients' most complex problems. We boast a superb investment banking franchise, preeminence in key businesses such as prime brokerage and commodities, and leading positions in high-growth emerging markets. Our Retail Brokerage business holds more than $600 billion in client assets, and our Asset Management business manages more than $400 billion for both retail and institutional clients. Our credit card business is a unique, successful franchise that generates high-quality earnings and cash flow.


Most important, the Morgan Stanley franchise has never been stronger, and our people remain the most talented in the industry. Indeed, this past summer when I returned home to the firm where I had spent nearly 30 years, my most profound impression was of the quality and commitment of Morgan Stanley's people.

This team took full advantage of an attractive market environment in 2005 to deliver a strong finish to the year. The firm's focus and commitment delivered record revenues for the year, record earnings for the fourth quarter and two consecutive quarters of improving financial performance.

This powerful finish was helped by particularly strong results in Institutional Securities, which continued to demonstrate its broad and powerful franchise. In 2005, we achieved record fixed income sales and trading revenues, record prime brokerage revenues and the highest advisory revenues in five years. In our U.S. Retail Brokerage business, we increased the percentage of client households with over $1 million in assets to 62% of total assets. Asset Management continued to deliver solid margins of 29% during 2005, excluding private equity, and we believe we can generate profitable growth in this area. At Discover, we saw pressure on earnings from the rising cost of funds, but benefited from positive underlying credit trends, despite the rise in bankruptcy filings this past fall.


Even with this improvement at the end of 2005, there clearly is substantial room for further gains across all of our businesses. We have the right team, the right assets and the right business mix in place. Now we must maintain a relentless focus on one priority: performance.

What is our plan to achieve the level of performance our firm is capable of delivering and our investors have every right to expect?

Strategically, we will continue to be a diversified, global firm focused on improving growth, profit margins and return on equity. We will take full advantage of our global scale and our world-class franchise by further integrating our businesses and putting more of our own capital to work in principal investments. We are committed to addressing underinvestment in both our Retail and Asset Management businesses and will build our capabilities in areas where the firm is underrepresented. We will aggressively pursue new opportunities for organic growth and, when appropriate, acquisitions that will help grow the scope and scale of our key businesses. We will tear down any barriers that impede our ability to work as one team across Morgan Stanley and create a cohesive "one firm" culture where every employee acts and feels like an owner of the firm. We will continue to nurture and support the first-rate talent that makes this firm what it is, and we will relentlessly execute on the operating plan we've developed to drive growth and increase earnings.


We have already undertaken significant steps to improve our overall performance. We've further strengthened our management team, drawing on talent from both inside and outside the firm. We hired, among others, James Gorman to lead Retail Brokerage and Gary Lynch, the former head of enforcement for the Securities and Exchange Commission, to be our Chief Legal Officer. We have assembled a new leadership team and organizational structure in Institutional Securities, where Neal Shear and Jerker Johansson have continued to integrate the firm's equity and fixed income businesses to drive revenue growth and improve the delivery of multi-asset-class opportunities to our clients. Owen Thomas was appointed our new head of Asset Management in December, and he has already started to implement a strategy to deliver growth and profitability in that business. We also reached an agreement in January 2006 to sell our non-core aircraft leasing business, and we plan to invest the sale proceeds in our core businesses.


We are moving aggressively to improve performance:

• In Institutional Securities, we're focusing on maintaining a leadership position in areas with the highest expected growth while investing to increase our scale in areas where we are underrepresented, such as principal investments, equity derivatives and European mortgages. We will expand our capabilities across fixed income, equities and investment banking by creating structured products and more innovative solutions for clients. For instance, we plan to enhance our strong commodities business by using it as a platform for investing in physical assets such as power plants. We also are committed to building our leveraged finance business to better focus on profitable and underexploited opportunities in the middle market.
  
  
• Emerging markets, with their high projected GDP growth rates, offer significant opportunities for expansion, particularly in countries like Russia, China, India, Turkey, Brazil, South Korea, Mexico and in the Middle East. We plan to capitalize on this potential by marshaling our current strengths, improving cooperation across divisions and adding resources to these areas. For example, we enhanced our presence in both South Korea and Russia by obtaining bank licenses to better serve our clients. We also are continuing to build on our decade-old relationship with China.
  
  
• We are employing more of our own equity capital to work in principal investing, both independently and together with clients as investment partners. Morgan Stanley's global franchise provides us with a vast array of investment ideas, and we believe that applying our own capital in this fashion will have significant benefits in terms of client collaboration and increased returns for the firm.
  
  
• In Asset Management, we are shifting our focus to manage for growth rather than just maximizing margins. We are addressing the major growth opportunities in alternative investments and in international markets through both organic growth and acquisitions. We also are taking steps to improve performance and stem outflows from our proprietary funds.
  
• In Retail Brokerage, we continue to build our high-net-worth business, which is a key growth opportunity. We are expanding our product offerings and adding other banking capabilities and investment products to further improve the breadth of services we offer to individual investors. A recent example of these new initiatives is the successful offering of a BlackRock closed-end fund—our first such launch since 1998—which leveraged both institutional and retail capabilities. We also are investing in technology and compliance to help get this business where we want it to be.
  
  
• Discover offers significant growth potential, driven by attractive market conditions and the October 2004 ruling in the U.S. Department of Justice's antitrust suit, which opened the debit and third-party issuance markets to us for the first time. We already have begun to move aggressively into these markets, acquiring the PULSE Network and expanding our third-party relationships. International opportunities also are just beginning to accelerate. In 2005, we launched a strategic alliance with China UnionPay, the only national bankcard payment network in China, and agreed to acquire the Goldfish credit card business in the U.K. to build scale in that attractive market.

Achieving all of the demanding targets we have set for ourselves won't happen overnight. During 2006, you will see investment in these initiatives and progress on many of these plans. But some areas—like Retail Brokerage—may take two or three years to improve margins. Nevertheless, we will be vigilant in executing on our strategy and maintaining our focus on superior performance. And we will be open and transparent with you about our progress along the way.

Our strategy is designed to help us deliver superior returns to our shareholders, but we intend to remain open to other opportunities and mindful of changing circumstances. If businesses aren't performing, we'll take the necessary action to ensure we are maximizing shareholder value. As the marketplace changes, we will move quickly to take advantage of opportunities we see to enhance our businesses or accelerate our growth. We will evaluate how we are doing along the way, whether opportunities have changed and whether we need to adjust our strategy accordingly.

During the past year, the firm also undertook significant corporate governance changes, which include:

• Modifying the Board's corporate governance policies to create a lead independent director position and to consider "withhold" votes in the election of directors; and
  
  
• Approving several charter amendments to recommend to shareholders for approval at the company's 2006 shareholders' meeting, including accelerating Board de-staggering, eliminating supermajority vote requirements to remove directors and eliminating the requirement that directors be elected by plurality vote.

Further, between June 2005 and year-end, the Board of Directors was substantially reshaped through the resignation of nine directors and the election of four new, non-employee directors: Roy Bostock, Erskine Bowles, Charles Noski and Griff Sexton. We appreciate the dedicated service of all the directors who stepped down this past year and thank them for their commitment and many contributions to the firm.


This year truly tested Morgan Stanley, but the firm has emerged a stronger and more unified organization. We are grateful to all of you who continue to put your faith in the people of this great firm. As we mark Morgan Stanley's 70th anniversary this year, I strongly believe that the firm's finest years lie ahead of us, and I am confident that those who continue to invest in Morgan Stanley will reap the rewards of the performance we are committed to achieving.