UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to

JEFFERIES GROUP, INC.

(Exact name of registrant as specified in its charter)

Delaware		95-4719745
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)
520 Madison Avenue, 12th Floor, New York, New York		10022
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (212) 284-2550

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 þ       No o

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 þ		Accelerated filer o		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o       No þ

Indicate the number of shares outstanding of the registrant’s class of common stock, as of the latest practicable date. 163,473,293 shares as of the close of business November 5, 2008.

 

 

JEFFERIES GROUP, INC. AND SUBSIDIARIES
INDEX TO QUARTERLY REPORT ON FORM 10-Q
SEPTEMBER 30, 2008

		Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Financial Condition (unaudited)- September 30, 2008 and December 31, 2007			3
Consolidated Statements of Earnings (unaudited)- Three Months and Nine Months Ended September 30, 2008 and 2007			5
Consolidated Statement of Changes in Stockholders’ Equity (unaudited)- Nine Months Ended September 30, 2008 and Year Ended December 31, 2007			6
Consolidated Statements of Cash Flows (unaudited)- Nine Months Ended September 30, 2008 and 2007			7
Notes to Consolidated Financial Statements (unaudited)			9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			44
Item 3. Quantitative and Qualitative Disclosures About Market Risk			64
Item 4. Controls and Procedures			68
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			68
Item 1A. Risk Factors			68
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			73
Item 6. Exhibits			74
Signature			75
EX-10.1
EX-31.1
EX-31.2
EX-32

PART I. FINANCIAL INFORMATION

		September 30,				December 31,
		2008				2007
ASSETS
Cash and cash equivalents		$	919,566			$	897,872
Cash and securities segregated and on deposit for regulatory purposes or deposited with clearing and depository organizations			1,226,233				614,949
Financial instruments owned, including securities pledged to creditors of $577,861 and $1,087,906 in 2008 and 2007, respectively:
Corporate equity securities			1,721,068				2,266,679
Corporate debt securities			2,184,513				2,162,893
U.S. Government, federal agency and other sovereign obligations			289,086				730,921
Mortgage- and asset-backed securities			1,143,411				26,895
Loans			43,504				—
Derivatives			456,872				338,779
Investments at fair value			91,745				104,199
Other			328				2,889
Total financial instruments owned			5,930,527				5,633,255
Investments in managed funds			129,610				293,523
Other investments			129,805				78,715
Securities borrowed			8,281,663				16,422,130
Securities purchased under agreements to resell			3,496,365				3,372,294
Receivable from brokers, dealers and clearing organizations			2,092,531				715,919
Receivable from customers			744,559				764,833
Premises and equipment			146,056				141,472
Goodwill			352,275				344,063
Other assets			541,678				514,792
Total assets		$	23,990,868			$	29,793,817

See accompanying unaudited notes to consolidated financial statements.

JEFFERIES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (UNAUDITED) — CONTINUED
(Dollars in thousands, except per share amounts)

		September 30,				December 31,
		2008				2007
LIABILITIES AND STOCKHOLDERS’ EQUITY
Bank loans		$	16,033			$	280,378
Financial instruments sold, not yet purchased:
Corporate equity securities			1,277,834				1,389,099
Corporate debt securities			1,562,253				1,407,387
U.S. Government, federal agency and other sovereign obligations			320,400				206,090
Derivatives			398,359				327,076
Other			221				314
Total financial instruments sold, not yet purchased			3,559,067				3,329,966
Securities loaned			4,934,717				7,681,464
Securities sold under agreements to repurchase			6,678,345				11,325,562
Payable to brokers, dealers and clearing organizations			1,537,273				878,740
Payable to customers			1,983,685				1,415,803
Accrued expenses and other liabilities			666,193				627,597
			19,375,313				25,539,510
Long-term debt			1,764,353				1,764,067
Mandatorily redeemable convertible preferred stock			125,000				125,000
Minority interest			539,691				603,696
Total liabilities			21,804,357				28,032,273
STOCKHOLDERS’ EQUITY
Common stock, $.0001 par value. Authorized 500,000,000 shares; issued 170,304,533 shares in 2008 and 155,375,808 shares in 2007			17				16
Additional paid-in capital			1,444,654				1,115,011
Retained earnings			857,883				1,031,764
Less:
Treasury stock, at cost, 6,875,479 shares in 2008 and 30,922,634 shares in 2007			(103,914	)			(394,406	)
Accumulated other comprehensive (loss) income:
Currency translation adjustments			(10,302	)			10,986
Additional minimum pension liability			(1,827	)			(1,827	)
Total accumulated other comprehensive (loss) income			(12,129	)			9,159
Total stockholders’ equity			2,186,511				1,761,544
Total liabilities and stockholders’ equity		$	23,990,868			$	29,793,817

See accompanying unaudited notes to consolidated financial statements.

JEFFERIES GROUP, INC. AND SUBSIDIARIES

		Three Months Ended								Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2008				2007				2008				2007
Revenues:
Commissions		$	113,416			$	95,652			$	329,588			$	255,778
Principal transactions			(3,430	)			47,325				138,303				320,804
Investment banking			130,125				189,780				338,704				582,988
Asset management fees and investment (loss) income from managed funds			(3,431	)			(6,283	)			(17,748	)			29,586
Interest			209,183				334,056				624,614				845,957
Other			7,388				6,434				20,302				21,480
Total revenues			453,251				666,964				1,433,763				2,056,593
Interest expense			178,605				332,540				565,839				837,900
Revenues, net of interest expense			274,646				334,424				867,924				1,218,693
Non-interest expenses:
Compensation and benefits			246,186				183,503				783,651				662,771
Floor brokerage and clearing fees			18,946				19,155				50,482				50,264
Technology and communications			31,500				26,120				91,894				71,980
Occupancy and equipment rental			19,205				20,280				56,898				56,315
Business development			11,228				13,791				35,106				38,980
Other			25,342				16,254				66,440				51,178
Total non-interest expenses			352,407				279,103				1,084,471				931,488
(Loss) earnings before income taxes and minority interest			(77,761	)			55,321				(216,547	)			287,205
Income taxes			(6,090	)			21,608				(59,966	)			107,312
(Loss) earnings before minority interest			(71,671	)			33,713				(156,581	)			179,893
Minority interest in (loss) earnings of consolidated subsidiaries, net			(40,367	)			(5,060	)			(60,355	)			11,026
Net (loss) earnings		$	(31,304	)		$	38,773			$	(96,226	)		$	168,867
(Loss) earnings per share:
Basic		$	(0.18	)		$	0.27			$	(0.60	)		$	1.19
Diluted		$	(0.18	)		$	0.26			$	(0.60	)		$	1.12
Weighted average shares:
Basic			173,757				142,822				160,458				141,905
Diluted			173,757				155,480				160,458				153,911

See accompanying unaudited notes to consolidated financial statements.

JEFFERIES GROUP, INC. AND SUBSIDIARIES

(Dollars in thousands, except per share amounts)

		Nine months				Year
		ended				ended
		September 30, 2008				December 31, 2007
Common stock, par value $0.0001 per share
Balance, beginning of period		$	16			$	14
Issued			1				2
Balance, end of period			17				16
Additional paid in capital
Balance, beginning of period			1,115,011				876,393
Benefit plan share activity (1)			50,244				38,053
Share-based amortization expense			138,079				144,382
Proceeds from exercise of stock options			743				5,233
Acquisitions and contingent consideration			5,647				9,240
Tax benefits for issuance of share-based awards			7,114				41,710
Issuance of treasury stock			90,160				—
Dividend equivalents on restricted stock units			37,656				—
Balance, end of period			1,444,654				1,115,011
Retained earnings
Balance, beginning of period			1,031,764				952,263
Cumulative effect of adjustment from adoption of FIN 48			—				(410	)
Net (loss) earnings			(96,226	)			144,665
Dividends and dividend equivalents			(76,477	)			(64,754	)
Acquisition adjustments			(1,178	)			—
Balance, end of period			857,883				1,031,764
Treasury stock, at cost
Balance, beginning of period			(394,406	)			(254,437	)
Purchases			(12,522	)			(147,809	)
Returns / forfeitures			(40,405	)			(7,785	)
Issued			343,419				15,625
Balance, end of period			(103,914	)			(394,406	)
Accumulated other comprehensive (loss) income
Balance, beginning of period			9,159				6,854
Currency adjustment, net of tax			(21,288	)			1,222
Pension adjustment, net of tax			—				1,083
Balance, end of period			(12,129	)			9,159
Total stockholders’ equity		$	2,186,511			$	1,761,544
Comprehensive income
Net (loss) earnings		$	(96,226	)		$	144,665
Other comprehensive income, net of tax			(21,288	)			2,305
Total comprehensive income		$	(117,514	)		$	146,970

See accompanying unaudited notes to consolidated financial statements.

JEFFERIES GROUP, INC. AND SUBSIDIARIES

		Nine Months Ended
		September 30,				September 30,
		2008				2007
Cash flows from operating activities:
Net (loss) earnings		$	(96,226	)		$	168,867
Adjustments to reconcile net (loss) earnings to net cash provided by (used in) operating activities:
Depreciation and amortization			21,998				21,123
Accruals related to various benefit plans, stock issuances, net of forfeitures			147,919				133,959
Increase in cash and securities segregated and on deposit for regulatory purposes or deposited with clearing and depository organizations			(617,039	)			(246,019	)
Minority interest			(60,355	)			11,026
Decrease (increase) in receivables:
Securities borrowed			8,139,139				(9,636,234	)
Brokers, dealers and clearing organizations			(1,351,409	)			(798,746	)
Customers			30,414				(87,043	)
Increase in financial instruments owned			(266,946	)			(1,629,313	)
Increase in other investments			(51,090	)			(35,417	)
Decrease (increase) in investments in managed funds			167,326				(8,274	)
Increase in securities purchased under agreements to resell			(124,071	)			(909,335	)
Increase in other assets			(26,993	)			(111,017	)
(Decrease) increase in payables:
Securities loaned			(2,746,747	)			2,100,026
Brokers, dealers and clearing organizations			641,199				706,661
Customers			566,157				73,283
Increase in financial instruments sold, not yet purchased			241,723				395,024
(Decrease) increase in securities sold under agreements to repurchase			(4,647,217	)			8,980,799
Increase (decrease) in accrued expenses and other liabilities			51,927				(176,154	)
Net cash provided by (used in) operating activities			19,709				(1,046,784	)
Cash flows from investing activities:
Cash paid for contingent consideration			(37,670	)			(25,720	)
Business acquisitions, net of cash received			—				(33,446	)
Deconsolidation of asset management entity			(63,665	)			—
Purchase of premises and equipment			(21,500	)			(50,393	)
Net cash used in investing activities			(122,835	)			(109,559	)

Continued on next page.

JEFFERIES GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS — CONTINUED (Unaudited)
(Dollars in thousands)

		Nine Months Ended
		September 30,				September 30,
		2008				2007
Cash flows from financing activities
Tax benefit from the issuance of share-based awards			7,114				38,263
Proceeds from reorganization of high yield secondary market trading			—				354,256
Redemption of capital units related to our reorganization of high yield secondary market trading			—				(25,780	)
Repayment of long-term debt			—				(100,000	)
Net proceeds from (payments on):
Equity financing			433,579				—
Bank loans			(269,717	)			399,806
Termination of interest rate swaps			—				8,452
Issuance of senior notes			—				593,176
Minority interest holders of consolidated subsidiaries related to high yield secondary market trading			(5,700	)			—
Minority interest holders of consolidated subsidiaries related to asset management activities			(660	)			3,586
Repurchase of treasury stock			(12,522	)			(61,766	)
Dividends			(38,821	)			(49,061	)
Exercise of stock options, not including tax benefits			743				3,652
Net cash provided by financing activities			114,016				1,164,584
Effect of foreign currency translation on cash and cash equivalents			10,804				57
Net increase in cash and cash equivalents			21,694				8,298
Cash and cash equivalents — beginning of period			897,872				513,041
Cash and cash equivalents — end of period		$	919,566			$	521,339
Supplemental disclosures of cash flow information:
Cash paid (received) during the period for:
Interest		$	599,838			$	828,671
Income taxes		$	(20,713	)		$	34,722
Non-cash proceeds from reorganization of high yield secondary market trading		$	—			$	230,169

On April 21, 2008, we issued 26,585,310 shares of common stock and made a cash payment to Leucadia National Corporation (“Leucadia”) of approximately $100 million. In exchange, we received from Leucadia 10,000,000 common shares of Leucadia. During the second quarter of 2008, we sold the 10,000,000 common shares of Leucadia and thus realized approximately $433.6 million in net cash from the issuance of our shares.

During the third quarter of 2008, we deconsolidated an entity related to our asset management activities due to changes in the nature and level of our investment in the entity. Prior to deconsolidation, total assets (including cash and cash equivalents) and total liabilities of the entity were $79.6 million and $22.8 million, respectively, and minority interest related to the entity was $0.7 million. Upon deconsolidation , we recorded an investment in this entity of $56.1 million, which is included in investments in managed funds on our Consolidated Statements of Financial Condition.

See accompanying unaudited notes to consolidated financial statements.

JEFFERIES GROUP, INC. AND SUBSIDIARIES

Index

		Page
Note 1. Organization and Summary of Significant Accounting Policies			10
Note 2. Cash, Cash Equivalents and Short-Term Investments			19
Note 3. Financial Instruments			20
Note 4. Short-Term Borrowings			24
Note 5. Long-Term Debt			24
Note 6. Mandatorily Redeemable Convertible Preferred Stock			25
Note 7. Income Taxes			25
Note 8. Benefit Plans			26
Note 9. Minority Interest			26
Note 10. Earnings Per Share			27
Note 11. Derivative Financial Instruments			27
Note 12. Other Comprehensive Income (Loss), Net of Tax			29
Note 13. Net Capital Requirements			31
Note 14. Commitments, Contingencies and Guarantees			31
Note 15. Segment Reporting			33
Note 16. Goodwill			35
Note 17. Quarterly Dividends			36
Note 18. Securitization Activities and Variable Interest Entities (“VIEs”)			36
Note 19. High Yield Secondary Market Trading			38
Note 20. Compensation Plans			38
Note 21. Related Party Transactions			42

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

Note 1. Organization and Summary of Significant Accounting Policies

Organization

The accompanying unaudited consolidated financial statements include the accounts of Jefferies Group, Inc. and all its subsidiaries (together, “we” or “us”), including Jefferies & Company, Inc. (“Jefferies”), Jefferies Execution Services, Inc., (“Jefferies Execution”), Jefferies International Limited, Jefferies Asset Management, LLC, Jefferies Financial Products, LLC and all other entities in which we have a controlling financial interest or are the “primary beneficiary,” including Jefferies High Yield Holdings, LLC (“JHYH”), Jefferies Special Opportunities Partners, LLC (“JSOP”) and Jefferies Employees Special Opportunities Partners, LLC (“JESOP”). The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S generally accepted accounting principles for complete financial statements. All adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine month period ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008. These unaudited consolidated financial statements should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2007.

On April 21, 2008, we issued 26,585,310 shares of common stock and made a cash payment to Leucadia National Corporation (“Leucadia”) of approximately $100 million. In exchange, we received from Leucadia 10,000,000 common shares of Leucadia. During the second quarter of 2008, we sold the 10,000,000 common shares of Leucadia and thus realized approximately $433.6 million in net cash from the issuance of our shares.

Reclassifications

Starting in the third quarter of 2007, we include investments and investments in managed funds as a component of cash flows from operating activities rather than cash flows from investing activities and accordingly have reclassed the prior period to be consistent with the current presentation. We believe that a change in classification of a cash flow item represents a reclassification of information and not a change in accounting principle. The amounts involved are immaterial to the consolidated financial statements taken as a whole. In addition, the change only affects the presentation within the Consolidated Statements of Cash Flows and does not impact the Consolidated Statements of Financial Condition or the Consolidated Statements of Earnings, debt balances or compliance with debt covenants.

Certain other reclassifications have been made to previously reported balances to conform to the current presentation.

Summary of Significant Accounting Policies

Principles of Consolidation

Our policy is to consolidate all entities in which we own more than 50% of the outstanding voting stock and have control. In addition, in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46(R), Consolidation of Variable Interest Entities (“FIN 46(R)”), as revised, we consolidate entities which lack characteristics of an operating entity or business for which we are the primary beneficiary. Under FIN 46(R), the primary beneficiary is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected residual returns, or both, as a result of holding variable interests, direct or implied. In situations where we have significant influence but not control of an entity that does not qualify as a variable interest entity, we apply the equity method of accounting or fair value accounting. We also have formed nonconsolidated investment vehicles with third-party investors that are typically organized as limited partnerships. We act as general partner for these investment vehicles and have generally provided the third-party investors with termination or “kick-out” rights as defined by Emerging Issues Task Force (“EITF”) EITF Issue No. 04-5, Determining Whether a General Partner, or

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.

All material intercompany accounts and transactions are eliminated in consolidation.

Revenue Recognition

Commissions. All customer securities transactions are reported on the Consolidated Statements of Financial Condition on a settlement date basis with related income reported on a trade-date basis. Under clearing agreements, we clear trades for unaffiliated correspondent brokers and retain a portion of commissions as a fee for our services. Correspondent clearing revenues are included in other revenue. We permit institutional customers to allocate a portion of their gross commissions to pay for research products and other services provided by third parties. The amounts allocated for those purposes are commonly referred to as soft dollar arrangements. Soft dollar expenses amounted to $12.4 million and $11.1 million for the three month period ended September 30, 2008 and 2007, respectively, and $32.7 million and $27.7 million for the nine month period ended September 30, 2008 and 2007, respectively. We account for the cost of these arrangements on an accrual basis. Our accounting policy for commission revenues incorporates the guidance contained in Emerging Issues Task Force (“EITF”) Issue No. 99-19, Reporting Revenues Gross versus Net, because we are not the primary obligor of such arrangements, and accordingly, expenses relating to soft dollars are netted against the commission revenues.

Principal Transactions. Financial instruments owned, securities pledged and financial instruments sold, but not yet purchased (all of which are recorded on a trade-date basis) are carried at fair value with unrealized gains and losses reflected in principal transactions in the Consolidated Statements of Earnings on a trade date basis, except for unrealized gains and losses on financial instruments held by consolidated asset management entities, which are presented in asset management fees and investment (loss) income from managed funds.

Investment Banking. Underwriting revenues and fees from mergers and acquisitions, restructuring and other investment banking advisory assignments are recorded when the services related to the underlying transaction are completed under the terms of the assignment or engagement. Expenses associated with such assignments are deferred until reimbursed by the client, the related revenue is recognized or the engagement is otherwise concluded. Expenses are recorded net of client reimbursements. Revenues are presented net of related unreimbursed expenses. Unreimbursed expenses with no related revenues are included in business development in the Consolidated Statements of Earnings. Reimbursed expenses totaled approximately $3.1 million and $2.0 million for the three month period ended September 30, 2008 and 2007, respectively, and totaled approximately $10.7 million and $7.8 million for the nine month period ended September 30, 2008 and 2007, respectively.

Asset Management Fees and Investment (Loss) Income From Managed Funds. Asset management fees and investment (loss) income from managed funds include revenues we receive from management, administrative and performance fees from funds managed by us, revenues from management and performance fees we receive from third-party managed funds and investment (loss) income from our investments in these funds. We receive fees in connection with management and investment advisory services performed for various funds and managed accounts. These fees are based on the value of assets under management and may include performance fees based upon the performance of the funds. Management and administrative fees are generally recognized over the period that the related service is provided based upon the beginning or ending net asset value of the relevant period. Generally, performance fees are earned when the return on assets under management exceeds certain benchmark returns, “high-water marks” or other performance targets. Performance fees are accrued on a monthly basis and are not subject to adjustment once the measurement period ends (annually) and performance fees have been realized.

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

Interest Revenue and Expense. We recognize contractual interest on financial instruments owned and financial instruments sold, but not yet purchased, on an accrual basis as a component of interest revenue and expense. Interest flows on derivative trading transactions and dividends are included as part of the fair valuation of these contracts in principal transactions in the Consolidated Statements of Earnings and are not recognized as a component of interest revenue or expense. We account for our short-term, long-term borrowings and our mandatorily redeemable convertible preferred stock on an accrual basis with related interest recorded as interest expense. In addition, we recognize interest revenue related to our securities borrowed and securities purchased under agreements to resell activities and interest expense related to our securities loaned and securities sold under agreements to repurchase activities on an accrual basis.

Cash Equivalents

Cash equivalents include highly liquid investments not held for resale with original maturities of three months or less.

Cash and Securities Segregated and on Deposit for Regulatory Purposes or Deposited With Clearing and Depository Organizations

In accordance with Rule 15c3-3 of the Securities Exchange Act of 1934, Jefferies & Company, Inc., as a broker-dealer carrying client accounts, is subject to requirements related to maintaining cash or qualified securities in a segregated reserve account for the exclusive benefit of its clients. In addition, certain financial instruments used for initial and variation margin purposes with clearing and depository organizations are recorded in this caption.

Foreign Currency Translation

Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the end of a period. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating foreign currency financial statements into U.S. dollars, net of hedging gains or losses and taxes, if any, are included in other comprehensive (loss) income. Gains or losses resulting from foreign currency transactions are included in principal transactions in the Consolidated Statements of Earnings.

Financial Instruments Owned and Financial Instruments Sold, not yet Purchased and Fair Value

Financial instruments owned and financial instruments sold, not yet purchased are recorded at fair value, either through the fair value option election or as required by other accounting pronouncements. These instruments primarily represent our trading activities and include both cash and derivative products. Realized and unrealized gains and losses are recognized in principal transactions in our Consolidated Statements of Earnings. The fair value of a financial instrument is the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price).

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

Fair Value Hierarchy

We adopted FASB 157, Fair Value Measurements (“FASB 157”), as of the beginning of 2007. FASB 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the inputs used to measure fair value and enhances disclosure requirements for fair value measurements. FASB 157 maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from independent sources. Unobservable inputs reflect our assumptions that market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. The hierarchy is broken down into three levels based on the transparency of inputs as follows:

Level 1:		Quoted prices are available in active markets for identical assets or liabilities as of the reported date.
Level 2:		Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these financial instruments include cash instruments for which quoted prices are available but traded less frequently, derivative instruments whose fair value have been derived using a model where inputs to the model are directly observable in the market, or can be derived principally from or corroborated by observable market data, and instruments that are fair valued using other financial instruments, the parameters of which can be directly observed.
Level 3:		Instruments that have little to no pricing observability as of the reported date. These financial instruments do not have two-way markets and are measured using management’s best estimate of fair value, where the inputs into the determination of fair value require significant management judgment or estimation.

Valuation Process for Financial Instruments

Financial instruments are valued at quoted market prices, if available. For financial instruments that do not have readily determinable fair values through quoted market prices, the determination of fair value is based upon consideration of available information, including types of financial instruments, current financial information, restrictions on dispositions, fair values of underlying financial instruments and quotations for similar instruments. Certain financial instruments have bid and ask prices that can be observed in the marketplace. For financial instruments whose inputs are based on bid-ask prices, mid-market pricing is applied and adjusted to the point within the bid-ask range that meets our best estimate of fair value. For offsetting positions in the same financial instrument, the same price within the bid-ask spread is used to measure both the long and short positions.

The valuation process for financial instruments may include the use of valuation models and other techniques. Adjustments to valuations (such as counterparty, credit, concentration or liquidity) derived from valuation models may be made when, in management’s judgment, either the size of the position in the financial instrument in a nonactive market or other features of the financial instrument such as its complexity, or the market in which the financial instrument is traded require that an adjustment be made to the value derived from the models. An adjustment may be made if a financial instrument is subject to sales restrictions that would result in a price less than the quoted market price. Adjustments from the price derived from a valuation model reflect management’s judgment that other participants in the market for the financial instrument being measured at fair value would also consider in valuing that same financial instrument and are adjusted for assumptions about risk uncertainties and market conditions. Results from valuation models and valuation techniques in one period may not be indicative of future period fair value measurements.

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Cash products — Where quoted prices are available in an active market, cash products are classified in Level 1 of the fair value hierarchy and valued based on the quoted price, primarily quoted exchange prices. Level 1 cash products are highly liquid instruments and include listed equity and money market securities and G-7 government and agency securities. Cash products classified within Level 2 of the fair value hierarchy are based primarily on broker quotations, pricing service data from external providers and prices for actual executed market transactions. If quoted market prices are not available for the specific security then fair values are estimated by using pricing models, quoted prices of cash products with similar characteristics or discounted cash flow models. Examples of cash products classified within Level 2 of the fair value hierarchy are corporate, convertible and municipal bonds and agency and non-agency mortgage-backed securities. Approximately 90% of our Level 2 cash products are valued based on broker quotations and pricing service data. If there is limited transaction activity or less transparency to observe market-based inputs to valuation models, cash products presented at fair value are classified in Level 3 of the fair value hierarchy. Fair values of cash products classified in Level 3 are generally based on an assessment of each underlying investment, cash flow models, market data of any recent comparable company transactions and trading multiples of companies considered comparable to the instrument being valued and incorporate assumptions regarding market outlook, among other factors. Cash products in this category include illiquid equity securities, equity interests in private companies, auction rate securities, commercial loans, private equity and hedge fund investments, distressed debt instruments and Alt-A and subprime non-agency mortgage-backed securities as little external price information is currently available for these products. For distressed debt instruments, commercial loans and loan commitments, loss assumptions must be made based on default scenarios and market liquidity and prepayment assumptions must be made for mortgage-backed securities.

Derivative products – Exchange-traded derivatives are valued using quoted market prices and are classified within Level 1 of the fair value hierarchy. Over-the-counter (“OTC”) derivative products are generally valued using models, whose inputs reflect assumptions that we believe market participants would use in valuing the derivative in a current period transaction. Inputs to valuation models are appropriately calibrated to market data, including but not limited to yield curves, interest rates, volatilities, equity, debt and commodity prices and credit curves. Fair value can be modeled using a series of techniques, including the Black-Scholes option pricing model and simulation models. For certain OTC derivative contracts, inputs to valuation models do not involve a high degree of subjectivity as the valuation model inputs are readily observable or can be derived from actively quoted markets. OTC derivative contracts thus classified in Level 2 include certain credit default swaps, interest rate swaps, commodity swaps, debt and equity option contracts and to-be-announced (“TBA”) securities. Derivative products that are valued based on models with significant unobservable market inputs are classified within Level 3 of the fair value hierarchy. Level 3 derivative products include equity warrant and option contracts where the volatility of the underlying equity securities are not observable due to the terms of the contracts and correlation sensitivity to market indices is not transparent for the term of the derivatives.

Investments in Managed Funds

Investments in managed funds include our investments in funds managed by us and our investments in third-party managed funds in which we are entitled to a portion of the management and/or performance fees. Investments in nonconsolidated managed funds are accounted for on the equity method. Gains or losses on our investments in managed funds are included in asset management fees and investment (loss) income from managed funds in the Consolidated Statements of Earnings.

Other Investments

Other investments includes investments entered into where we exercise significant influence over operating and capital decisions in private equity and other operating entities in connection with our capital market activities and loans issued in connection with such activities. Other investments are accounted for on the equity method or at cost, as appropriate.

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Receivable from and Payable to Customers

Receivable from and payable to customers includes amounts receivable and payable on cash and margin transactions. Securities owned by customers and held as collateral for these receivables are not reflected in the accompanying consolidated financial statements. Receivable from officers and directors represents balances arising from their individual security transactions. These transactions are subject to the same regulations as customer transactions and are provided on substantially the same terms.

Securities Borrowed and Securities Loaned

Securities borrowed and securities loaned are carried at cost. In connection with both trading and brokerage activities, we borrow securities to cover short sales and to complete transactions in which customers have failed to deliver securities by the required settlement date, and lend securities to other brokers and dealers for similar purposes. We have an active securities borrowed and lending matched book business in which we borrow securities from one party and lend them to another party. When we borrow securities, we generally provide cash to the lender as collateral, which is reflected in our Consolidated Statements of Financial Condition as securities borrowed. We earn interest revenues on this cash collateral. Similarly, when we lend securities to another party, that party provides cash to us as collateral, which is reflected in our Consolidated Statements of Financial Condition as securities loaned. We pay interest expense on the cash collateral received from the party borrowing the securities. A substantial portion of our interest revenues and interest expenses results from this matched book activity. The initial collateral advanced or received approximates or is greater than the fair value of the securities borrowed or loaned. We monitor the fair value of the securities borrowed and loaned on a daily basis and request additional collateral or return excess collateral, as appropriate.

Securities Purchased Under Agreements to Resell and Securities Sold Under Agreements to Repurchase

Securities purchased under agreements to resell and securities sold under agreements to repurchase (collectively “repos”) are accounted for as collateralized financing transactions and are recorded at their contracted repurchase amount. We earn net interest revenues from this activity which is reflected in our Consolidated Statements of Earnings.

We monitor the fair value of the underlying securities daily versus the related receivable or payable balances. Should the fair value of the underlying securities decline or increase, additional collateral is requested or excess collateral is returned, as appropriate.

We carry repos on a net basis when permitted under the provisions of FASB Interpretation No. 41, Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements (“FIN 41”).

Premises and Equipment

Premises and equipment are depreciated using the straight-line method over the estimated useful lives of the related assets (generally three to ten years). Leasehold improvements are amortized using the straight-line method over the term of the related leases or the estimated useful lives of the assets, whichever is shorter.

Goodwill

At least annually, and more frequently if warranted, we assess whether goodwill has been impaired by comparing the estimated fair value, calculated based on earnings and book value multiples, of each reporting unit with its estimated net book value, by estimating the amount of stockholders’ equity required to support each reporting unit. Periodically estimating the fair value of a reporting unit requires significant judgment and often involves the use of significant estimates and assumptions. These estimates and assumptions could have a significant effect on whether or not an

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impairment charge is recorded and the magnitude of such a charge. We have completed our annual assessment of goodwill as of September 30, 2008 and no impairment has been identified.

Income Taxes

We file a consolidated U.S. federal income tax return, which includes all of our qualifying subsidiaries. We also are subject to income tax in various states and municipalities and those foreign jurisdictions in which we operate. Amounts provided for income taxes are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for tax loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred income taxes are provided for temporary differences in reporting certain items, principally, amortization of share-based compensation, deferred compensation, unrealized gains and losses on investments and tax amortization on intangible assets. The realization of deferred tax assets is assessed and a valuation allowance is recorded to the extent that it is more likely than not that any portion of the deferred tax asset will not be realized. Tax credits are recorded as a reduction of income taxes when realized.

We adopted EITF Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”), as of January 1, 2008. EITF 06-11 requires that the tax benefit related to dividends and dividend equivalents paid on nonvested share based payment awards and outstanding equity options should be recognized as an increase to additional paid in capital. Prior to EITF 06-11, such income tax benefit was recognized as a reduction of income tax expense. These amounts are included in tax benefits for issuance of share-based awards on the Consolidated Statement of Changes in Stockholders’ Equity.

Legal Reserves

We recognize a liability for a contingency when it is probable that a liability has been incurred and when the amount of loss can be reasonably estimated. When a range of probable loss can be estimated, we accrue the most likely amount of such loss, and if such amount is not determinable, then we accrue the minimum of the range of probable loss.

We record reserves related to legal proceedings in accrued expenses and other liabilities. Such reserves are established and maintained in accordance with FASB 5, Accounting for Contingencies, and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss an Interpretation of FASB Statement No. 5. The determination of these reserve amounts requires significant judgment on the part of management. Our management considers many factors including, but not limited to: the amount of the claim; the basis and validity of the claim; previous results in similar cases; and legal precedents and case law. Each legal proceeding is reviewed with counsel in each accounting period and the reserve is adjusted as deemed appropriate by management.

Share-Based Compensation

We account for share-based compensation under the guidance of FASB 123R, Share-Based Payment (“FASB 123R”). Share-based awards are measured based on the grant-date fair value of the award and recognized over the period from the service inception date through the date the employee is no longer required to provide service to earn the award. Expected forfeitures are included in determining share-based compensation expense.

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Earnings per Common Share

Basic earnings per share of common stock are computed by dividing net earnings by the average number of shares outstanding and certain other shares committed to be, but not yet issued. Basic earnings per share include restricted stock and restricted stock units (“RSUs”) for which no future service is required. Diluted earnings per share of common stock are computed by dividing net earnings plus dividends on dilutive mandatorily redeemable convertible preferred stock divided by the average number of shares outstanding of common stock and all dilutive common stock equivalents outstanding during the period. Diluted earnings per share include the dilutive effects of restricted stock and RSUs for which future service is required.

Securitization Activities

We engage in securitization activities related to residential mortgage-backed securities. Generally, such transfers of financial assets are accounted for as sales when we have relinquished control over the transferred assets. The gain or loss on sale of such financial assets depends, in part, on the previous carrying amount of the assets involved in the transfer allocated between the assets sold and the retained interests, if any, based upon their respective fair values at the date of sale.

Accounting and Regulatory Developments

FSP FIN 39-1. In April 2007, the FASB issued a Staff Position (“FSP”) FIN 39-1, Amendment of FASB Interpretation No. 39 (“FSP FIN 39-1”). FSP FIN 39-1 defines “right of setoff” and specifies what conditions must be met for a derivative contract to qualify for this right of setoff. It also addresses the applicability of a right of setoff to derivative instruments and clarifies the circumstances in which it is appropriate to offset amounts recognized for those instruments in the statement of financial position. In addition, FSP FIN 39-1 permits offsetting of fair value amounts recognized for multiple derivative instruments executed with the same counterparty under a master netting arrangement and fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from the same master netting arrangement as the derivative instruments. These provisions were consistent with our current accounting practice. The adoption of FSP FIN 39-1 on January 1, 2008 did not have an impact on our consolidated financial statements.

SOP No. 07-1 and FSP FIN No. 46R-7. In June 2007, the American Institute of Certified Public Accountants issued Statement of Position No. 07-1, Clarification of the Scope of the Audit and Accounting Guide ‘Audits of Investment Companies’ and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies (“SOP 07-1”). SOP 07-1 clarifies the scope of when an entity may apply the provisions of the AICPA Audit and Accounting Guide, Investment Companies (“the Guide”). SOP 07-1 also provides guidance for determining whether the specialized industry accounting principles of the Guide should be retained in the financial statements of a parent company of an investment company or an equity method investor in an investment company, and includes certain disclosure requirements. In May 2007, the FASB issued FSP FIN No. 46R-7, Application of FIN 46R to Investment Companies (“FSP FIN 46R-7”). FSP FIN 46R-7 amends FIN 46R to make permanent the temporary deferral of the application of FIN 46R to entities within the scope of the revised Guide under SOP 07-1. FSP FIN 46R-7 is effective upon the adoption of SOP 07-1. In November 2007, the FASB issued a proposed FSP SOP No. 07-1-a, The Effective Date of AICPA Statement of Position 07-1, which proposes to indefinitely defer the effective date for SOP 07-1 and, consequently, FSP FIN 46R-7.

FASB 141R. In December 2007, the FASB issued FASB 141 (revised 2007), Business Combinations (“FASB 141R”). Under FASB 141R, an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies and contingent consideration measured at their fair value at the acquisition date for any business combination consummated after the effective date. It further requires that acquisition-related costs are to be recognized separately from the acquisition and expensed as incurred. This statement is effective for financial

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statements issued for fiscal years beginning after December 15, 2008. Accordingly, we will adopt FASB 141R effective January 1, 2009.

FASB 160. In December 2007, the FASB issued FASB 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51 (“FASB 160”). FASB 160 requires an entity to clearly identify and present ownership interests in subsidiaries held by parties other than the entity in the consolidated financial statements within the equity section but separate from the entity’s equity. It also requires the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; changes in ownership interest be accounted for similarly, as equity transactions; and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary and the gain or loss on the deconsolidation of the subsidiary be measured at fair value. This statement is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, we will adopt FASB 160 effective January 1, 2009. We are currently evaluating the impact of FASB 160 on our consolidated financial statements.

FSP FAS 140-3. In February 2008, the FASB issued FSP FAS 140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (“FSP FAS 140-3”). FSP FAS 140-3 requires an initial transfer of a financial asset and a repurchase financing that was entered into contemporaneously or in contemplation of the initial transfer to be evaluated as a linked transaction under FASB 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities (“FASB No. 140”) unless certain criteria are met. FSP FAS 140-3 is effective for fiscal years beginning after November 15, 2008. FSP FAS 140-3 is to be applied prospectively for new transactions entered into after the adoption date. We are currently evaluating the impact of FSP FAS 140-3 on our consolidated financial statements.

FASB 161. In March 2008, the FASB issued FASB 161, Disclosures about Derivative Instruments and Hedging Activities (“FASB 161”). FASB 161 amends and expands the disclosure requirements of FASB 133, Accounting for Derivative Instruments and Hedging Activities, and requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair values and amounts of gains and losses on derivative contracts and disclosures about credit-risk-related contingent features in derivative agreements. FASB 161 is effective for the fiscal years and interim periods beginning after November 15, 2008. Accordingly, we will adopt FASB 161 effective January 1, 2009.

FSP APB 14-1. In May 2008, the FASB issued FSP APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“FSP APB 14-1”). FSP APB 14-1 clarifies that convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) are not addressed by APB 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants and specifies that issuers of such instruments should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for fiscal years and interim periods beginning after December 31, 2008. We are currently evaluating the impact of FSP APB 14-1 on our financial condition and results of operations.

FSP EITF 03-6-1. In June 2008, the FASB issued FSP EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1). FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method described in FASB 128, Earnings per Share. Under FSP EITF 03-6-1, unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method. FSP EITF 03-6-1 is effective for fiscal years and interim periods beginning after December 31, 2008. All prior-period EPS data presented will be adjusted retrospectively. We are currently evaluating the impact of FSP EITF 03-6-1 on our presentation of earnings per share.

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FSP FAS 133-1 and FIN 45-4. In September 2008, the FASB issued FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161 (“FSP FAS 133-1 and FIN 45-4”). FSP FAS 133-1 and FIN 45-4 require enhanced disclosures by sellers of credit derivatives, including credit derivatives embedded in a hybrid instrument, and require additional disclosure about the current status of the payment/performance risk of a guarantee. FSP FAS 133-1 and FIN 45-4 are effective for our year end consolidated financial statements as of December 31, 2008.

FSP FAS 157-3. In October 2008, the FASB issued FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for that Asset is not Active (“FSP FAS 157-3”). FSP FAS 157-3 is consistent with the joint press release the FASB issued with the Securities and Exchange Commission on September 30, 2008, which provides general clarification guidance on determining fair value under FASB 157 when markets are inactive. FSP FAS 157-3 specifically addresses the use of judgment in determining whether a transaction in a dislocated market represents fair value, the inclusion of market participant risk adjustments when an entity significantly adjusts observable market data based on unobservable inputs, and the degree of reliance to be placed on broker quotes or pricing services. FSP FAS 157-3 is effective October 10, 2008 and should be applied prospectively. We do not believe that FSP FAS 157-3 will have a significant impact on our current fair value measurements.

Use of Estimates

Our management has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with U.S. generally accepted accounting principles. The most important of these estimates and assumptions relate to fair value measurements and compensation and benefits. Although these and other estimates and assumptions are based on the best available information, actual results could be materially different from these estimates.

Note 2. Cash, Cash Equivalents and Short-Term Investments

We generally invest our excess cash in money market funds and other short-term investments. Cash equivalents include highly liquid investments not held for resale with original maturities of three months or less. The following are financial instruments that are cash and cash equivalents or are deemed by our management to be generally readily convertible into cash as of September 30, 2008 and December 31, 2007 (in thousands of dollars):

		September 30, 2008				December 31, 2007
Cash and cash equivalents:
Cash in banks		$	720,845			$	248,174
Money market investments			198,721				649,698
Total cash and cash equivalents			919,566				897,872
Cash and securities segregated (1)			1,226,233				614,949
		$	2,145,799			$	1,512,821

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Note 3. Financial Instruments

The following is a summary of the fair value of major categories of financial instruments owned and financial instruments sold, not yet purchased, as of September 30, 2008 and December 31, 2007 (in thousands of dollars):

		September 30, 2008								December 31, 2007
						Financial								Financial
						Instruments								Instruments
		Financial				Sold,				Financial				Sold,
		Instruments				Not Yet				Instruments				Not Yet
		Owned				Purchased				Owned				Purchased
Corporate equity securities		$	1,721,068			$	1,277,834			$	2,266,679			$	1,389,099
Corporate debt securities			2,184,513				1,562,253				2,162,893				1,407,387
U.S. Government, federal agency and other sovereign obligations			289,086				320,400				730,921				206,090
Mortgage- and asset-backed securities			1,143,411				—				26,895				—
Loans			43,504				—				—				—
Derivatives			456,872				398,359				338,779				327,076
Investments at fair value			91,745				—				104,199				—
Other			328				221				2,889				314
		$	5,930,527			$	3,559,067			$	5,633,255			$	3,329,966

We elected to apply the fair value option to loans and loan commitments made in connection with our investment banking activities and certain investments held by subsidiaries that are not registered broker-dealers as defined in the AICPA Audit and Accounting Guide, Brokers and Dealers in Securities. Loans and investments at fair value are included in financial instruments owned and loan commitments are included in financial instruments sold, not yet purchased — derivatives on the Consolidated Statements of Financial Condition. The fair value option was elected for loans and loan commitments and investments held by subsidiaries that are not registered broker-dealers because they are risk managed by us on a fair value basis.

Financial instruments owned includes securities pledged to creditors. The following is a summary of the fair value of major categories of securities pledged to creditors as of September 30, 2008 and December 31, 2007 (in thousands of dollars):

		September 30, 2008				December 31, 2007
Corporate equity securities		$	576,239			$	985,783
Corporate debt securities			1,622				102,123
		$	577,861			$	1,087,906

At September 30, 2008 and December 31, 2007, the approximate fair value of collateral received by us that may be sold or repledged by us was $11.4 billion and $19.8 billion, respectively. This collateral was received in connection with resale agreements and securities borrowings. At September 30, 2008 and December 31, 2007, a substantial portion of this collateral received by us had been sold or repledged.

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The following is a summary of our financial assets and liabilities that are accounted for at fair value as of September 30, 2008 and December 31, 2007 by level within the fair value hierarchy (in thousands of dollars):

		As of September 30, 2008
														Counterparty
														and Cash
														Collateral
		Level 1				Level 2				Level 3				Netting				Total
Assets:
Financial instruments owned:
Securities		$	1,716,405			$	3,351,066			$	270,935			$	—			$	5,338,406
Loans			—				26,727				16,777				—				43,504
Derivative instruments			388,171				739,157				—				(670,456	)			456,872
Investments at fair value			—				—				91,745				—				91,745
Total financial instruments owned			2,104,576				4,116,950				379,457				(670,456	)			5,930,527
Level 3 assets for which the firm does not bear economic exposure (1)											(81,394	)
Level 3 assets for which the firm bears economic exposure											298,063
Liabilities:
Financial instruments sold, not yet purchased:
Securities			1,457,485				1,703,160				63				—				3,160,708
Derivative instruments			271,869				419,040				18,765				(311,315	)			398,359
Total financial instruments sold, not yet purchased			1,729,354				2,122,200				18,828				(311,315	)			3,559,067

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		As of December 31, 2007
														Counterparty
														and Cash
														Collateral
		Level 1				Level 2				Level 3				Netting				Total
Assets:
Financial instruments owned:
Securities		$	2,122,640			$	2,819,240			$	248,397			$	—			$	5,190,277
Derivative instruments			316,176				118,905				—				(96,302	)			338,779
Investments at fair value			—				—				104,199				—				104,199
Total financial instruments owned			2,438,816				2,938,145				352,596				(96,302	)			5,633,255
Level 3 assets for which the firm does not bear economic exposure (1)											(106,106	)
Level 3 assets for which the firm bears economic exposure											246,490
Liabilities:
Financial instruments sold, not yet purchased:
Securities			1,425,789				1,568,398				8,703				—				3,002,890
Derivative instruments			243,553				642,507				12,929				(571,913	)			327,076
Total financial instruments sold, not yet purchased			1,669,342				2,210,905				21,632				(571,913	)			3,329,966

The following is a summary of changes in fair value of our financial assets and liabilities that have been classified as Level 3 for the three months ended September 30, 2008 and 2007 (in thousands of dollars):

		Three Months Ended September 30, 2008
		Non-derivative				Non-derivative				Derivative				Derivative
		instruments -				instruments -				instruments				instruments
		Assets				- Liabilities				Assets				Liabilities				Investments
Balance, June 30, 2008		$	405,850			$	(47,804	)		$	727			$	(33,921	)		$	90,111
Total gains/ (losses) (realized and unrealized) (1)			(29,279	)			—				—				15,156				364
Purchases, sales, settlements, and issuances			(45,415	)			46,502				(727	)			—				1,271
Net transfers in and/or (out) of Level 3			(43,444	)			1,239				—				—				—
Balance, September 30, 2008		$	287,712			$	(63	)		$	—			$	(18,765	)		$	91,746
Change in unrealized gains/(losses) relating to instruments still held at September 30, 2008 (1)		$	(34,028	)		$	—			$	—			$	15,156				364

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		Three Months Ended September 30, 2007
		Non-derivative				Non-derivative
		instruments -				instruments -
		Assets				Liabilities				Investments
Balance, June 30, 2007		$	252,695			$	2,835			$	92,923
Total gains/ (losses) (realized and unrealized) (1)			8,358				45				12,854
Purchases, sales, settlements, and issuances			170,659				(803	)			(227	)
Net transfers in and/or out of Level 3			(17,341	)			20,000				—
Balance, September 30, 2007		$	414,371			$	22,077			$	105,550
Change in unrealized gains/ (losses) relating to instruments still held at September 30, 2007 (1)		$	10,072			$	(5	)		$	12,854

The following is a summary of changes in fair value of our financial assets and liabilities that have been classified as Level 3 for the nine months ended September 30, 2008 and 2007 (in thousands of dollars):

		Nine Months Ended September 30, 2008
		Non-derivative				Non-derivative				Derivative				Derivative
		instruments -				instruments -				instruments -				instruments -
		Assets				Liabilities				Assets				Liabilities				Investments
Balance, December 31, 2007		$	248,397			$	(8,703	)		$	—			$	(12,929	)		$	104,199
Total gains/ (losses) (realized and unrealized) (1)			(39,669	)			343				184				7,945				(4,312	)
Purchases, sales, settlements, and issuances			74,222				6,806				(727	)			8,577				(8,141	)
Net transfers in and/or (out) of Level 3			4,762				1,491				543				(22,358	)			—
Balance, September 30, 2008		$	287,712			$	(63	)		$	—			$	(18,765	)		$	91,746
Change in unrealized gains/ (losses) relating to instruments still held at September 30, 2008 (1)		$	(20,067	)		$	—			$	—			$	6,743				(4,312	)

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

		Nine Months Ended September 30, 2007
		Non-derivative				Non-derivative
		instruments -				instruments -
		Assets				Liabilities				Investments
Balance, December 31, 2006		$	205,278			$	—			$	97,289
Total gains/ (losses) (realized and unrealized) (1)			5,575				45				21,515
Purchases, sales, settlements, and issuances			220,292				515				(13,254	)
Net transfers in and/or out of Level 3			(16,774	)			21,517				—
Balance, September 30, 2007		$	414,371			$	22,077			$	105,550
Change in unrealized gains/ (losses) relating to instruments still held at September 30, 2007 (1)		$	(11,292	)		$	(5	)		$	21,515

Level 3 cash instruments are frequently hedged with instruments classified within Level 1 and Level 2, and accordingly, gains or losses that have been reported in Level 3 are frequently offset by gains or losses attributable to instruments classified within Level 1 or Level 2 or by gains or losses on derivative contracts classified in Level 3 of the fair value hierarchy.

Note 4. Short-Term Borrowings

Bank loans represent short-term borrowings that are payable on demand and generally bear interest at a spread over the federal funds rate. We had no outstanding secured bank loans as of September 30, 2008 and December 31, 2007. Unsecured bank loans are typically overnight loans used to finance securities owned or clearing related balances. We had $16.0 million and $280.4 million of outstanding unsecured bank loans as of September 30, 2008 and December 31, 2007, respectively. Average daily bank loans for the nine month period ended September 30, 2008 and the year ended December 31, 2007 were $122.6 million and $267.1 million, respectively.

Note 5. Long-Term Debt

The following summarizes long-term debt outstanding at September 30, 2008 and December 31, 2007 (in thousands of dollars):

		September 30, 2008				December 31, 2007
7.75% Senior Notes, due 2012, net of unamortized discount of $3,287 (2008)		$	328,444				328,594
5.875% Senior Notes, due 2014, net of unamortized discount of $1,446 (2008)			248,554				248,402
5.5% Senior Notes, due 2016, net of unamortized discount of $1,362 (2008)			348,638				348,501
6.45% Senior Debentures, due 2027, net of unamortized discount of $3,693 (2008)			346,307				346,236
6.25% Senior Debentures, due 2036, net of unamortized discount of $7,590 (2008)			492,410				492,334
		$	1,764,353			$	1,764,067

We previously entered into a fair value hedge with no ineffectiveness using interest rate swaps in order to convert $200 million aggregate principal amount of unsecured 7.75% senior notes due March 15, 2012 into floating rates based upon LIBOR. During the third quarter of 2007, we terminated these interest rate swaps and received cash

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

consideration less accrued interest of $8.5 million. The $8.5 million basis difference related to the fair value of the interest rate swaps at the time of the termination is being amortized as a reduction in interest expense of approximately $1.9 million per year over the remaining life of the notes through March 2012.

In June 2007, we sold in a registered public offering $600.0 million aggregate principal amount of our senior debt, consisting of $250.0 million of 5.875% senior notes due June 8, 2014 and $350.0 million of 6.45% senior debentures due June 8, 2027.

Note 6. Mandatorily Redeemable Convertible Preferred Stock

In February 2006, Massachusetts Mutual Life Insurance Company (“MassMutual”) purchased in a private placement $125.0 million of our Series A convertible preferred stock. Our Series A convertible preferred stock has a 3.25% annual, cumulative cash dividend and is currently convertible into 4,105,138 shares of our common stock at an effective conversion price of approximately $30.45 per share. The preferred stock is callable beginning in 2016 and will mature in 2036. As of September 30, 2008, 10,000,000 shares of preferred stock were authorized and 125,000 shares of preferred stock were issued and outstanding. The dividend is recorded as a component of interest expense as the Series A convertible preferred stock is treated as debt for accounting purposes. The dividend is not deductible for tax purposes because the Series A convertible preferred stock is considered “equity” for tax purposes.

Note 7. Income Taxes

We adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), as of January 1, 2007. As a result of adoption, we recognized a $0.4 million increase to reserves for uncertain tax positions. This increase was accounted for as an adjustment to the beginning balance of retained earnings on the Consolidated Statements of Financial Condition. As of September 30, 2008 and December 31, 2007, we had approximately $12.4 million and $8.8 million, respectively, of total gross unrecognized tax benefits. The total amount of unrecognized benefits that, if recognized, would favorably affect the effective tax rate in future periods was $8.0 million and $5.7 million (net of federal benefit of state taxes) at September 30, 2008 and December 31, 2007, respectively.

We are subject to U.S. federal income tax as well as income tax in multiple state and foreign jurisdictions. We have concluded all U.S federal income tax matters for the years through 2000. Substantially all material state and local and foreign income tax matters have been concluded for the years through 2000. New York State and New York City income tax returns for the years 2001 through 2004 and 2000 through 2002, respectively, are currently under examination. The final outcome of these examinations is not yet determinable. However, management anticipates that adjustments to the unrecognized tax benefits, if any, will not result in a material change to the results of operations or financial condition.

We recognize interest accrued related to unrecognized tax benefits in interest expense. Penalties, if any, are recognized in other expenses. As of September 30, 2008 and December 31, 2007, we had accrued interest and penalties related to unrecognized tax benefits of approximately $3.6 million and $1.4 million, respectively.

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

Note 8. Benefit Plans

The following summarizes the net periodic pension cost for the three month and nine month periods ended September 30, 2008 and 2007 (in thousands of dollars):

		Three Months Ended								Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2008				2007				2008				2007
Net pension cost included the following components:
Service cost (1)		$	31			$	69			$	169			$	207
Interest cost on projected benefit obligation			671				599				1,860				1,779
Expected return on plan assets			(825	)			(833	)			(2,287	)			(2,089	)
Amortization of net loss			—				(141	)			—				141
Net periodic pension (income) cost		$	(123	)		$	(306	)		$	(258	)		$	38

We contributed $2.0 million to our pension plan during the nine months ended September 30, 2008 and we do not anticipate contributing more during the remainder of 2008. Effective December 31, 2005, benefits under the pension plan have been frozen. There are no incremental benefit accruals for service after December 31, 2005.

Note 9. Minority Interest

Under FASB 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“FASB 150”), certain minority interests in consolidated entities may meet the definition of a mandatorily redeemable financial instrument and thus require reclassification as liabilities and remeasurement at the estimated amount of cash that would be due and payable to settle such minority interests under the applicable entity’s organization agreement, assuming an orderly liquidation of the entity, net of estimated liquidation costs. Our consolidated financial statements include certain minority interests that meet the definition of mandatorily redeemable financial instruments. These mandatorily redeemable minority interests represent interests held by third parties in Jefferies High Yield Holdings, LLC (“JHYH”). The mandatorily redeemable minority interests are entitled to a pro rata share of the profits and losses of JHYH, as set forth in JHYH’s organization agreements, and are scheduled to terminate in 2013, with an option to extend up to three additional one-year periods. A certain portion of these mandatorily redeemable minority interests represents investments from Jefferies Special Opportunities Partners, LLC (“JSOP”) and Jefferies Employees Special Opportunities Partners, LLC (“JESOP”), and are eliminated in consolidation as JSOP and JESOP are included within our consolidated group. The carrying amount of the mandatorily redeemable minority interests, after consolidation, was approximately $313.9 million at September 30, 2008.

Minority interest also includes the minority equity holders’ proportionate share of the equity of JSOP and JESOP. At September 30, 2008, minority interest related to JSOP and JESOP was approximately $188.3 million and $24.7 million, respectively.

At September 30, 2008, we had other minority interests of approximately $12.8 million primarily related to our consolidated asset management entities.

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

Note 10. Earnings Per Share

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for the three month and nine month periods ended September 30, 2008 and 2007 (in thousands, except per share amounts):

		Three Months Ended								Nine Months Ended
		September 30,				September 30,				September 30,				September 30,
		2008				2007				2008				2007
Net (loss)/ earnings		$	(31,304	)		$	38,773			$	(96,226	)		$	168,867
Add: Convertible preferred stock dividends			—				1,016				—				3,048
Net earnings for diluted earnings per share		$	(31,304	)		$	39,789			$	(96,226	)		$	171,915
Shares:
Average shares used in basic computation			173,757				142,822				160,458				141,905
Unvested restricted stock / restricted stock units			—				8,351				—				7,462
Stock options			—				236				—				480
Convertible preferred stock			—				4,071				—				4,064
Average shares used in diluted computation			173,757				155,480				160,458				153,911
(Loss)/ earnings per share:
Basic		$	(0.18	)		$	0.27			$	(0.60	)		$	1.19
Diluted		$	(0.18	)		$	0.26			$	(0.60	)		$	1.12

As a result of the net loss that was recorded in the three month and nine month periods ended September 30, 2008, our diluted (loss) per share for those periods does not assume the dilutive effects of unvested restricted stock and restricted stock units, the exercise of stock options or the conversion of our mandatorily redeemable convertible preferred stock as this would result in an antidilutive per-share amount. Therefore, our diluted (loss) per share equal our basic (loss) per share for the three month and nine month periods ended September 30, 2008.

Note 11. Derivative Financial Instruments

Off-Balance Sheet Risk

We have contractual commitments arising in the ordinary course of business for securities loaned or purchased under agreements to resell, repurchase agreements, future purchases and sales of foreign currencies, securities transactions on a when-issued basis and underwriting. Each of these financial instruments and activities contains varying degrees of off-balance sheet risk whereby the fair values of the securities underlying the financial instruments may be in excess of, or less than, the contract amount. The settlement of these transactions is not expected to have a material effect upon our consolidated financial statements.

Derivative Financial Instruments

Our derivative activities are recorded at fair value in the Consolidated Statements of Financial Condition, with realized and unrealized gains and losses recognized in principal transactions in the Consolidated Statements of Earnings on a trade date basis and as a component of cash flows from operating activities in the Consolidated

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

Statements of Cash Flows. Acting in a trading capacity, we may enter into derivative transactions to satisfy the needs of our clients and to manage our own exposure to market and credit risks resulting from our trading activities.

Derivatives are subject to various risks similar to other financial instruments, including market, credit and operational risk. In addition, we may be exposed to legal risks related to derivative activities. The risks of derivatives should not be viewed in isolation, but rather should be considered on an aggregate basis along with our other trading-related activities. We manage the risks associated with derivatives on an aggregate basis along with the risks associated with proprietary trading as part of our firmwide risk management policies.

A significant portion of our derivative activities are performed by Jefferies Financial Products, LLC (“JFP”). JFP is a market maker in commodity index products and a trader in commodity futures and options. Where appropriate, JFP utilizes various credit enhancements, including guarantees, collateral and margin agreements to mitigate the credit exposure relating to these swaps and options. JFP establishes credit limits based on, among other things, the creditworthiness of the counterparties, the transaction’s size and tenor, and estimated potential exposure. JFP maintains credit intermediation facilities with highly rated European banks (the “Banks”), which allow JFP customers that require a counterparty with a high credit rating for commodity index transactions to transact with the Banks. The Banks simultaneously enter into offsetting transactions with JFP and receive a fee from JFP for providing credit support. In certain cases, JFP is responsible to the Banks for the performance of JFP’s customers.

The following table presents the fair value of derivatives at September 30, 2008 and December 31, 2007. The fair value of assets/liabilities related to derivative contracts at September 30, 2008 and December 31, 2007 represent our receivable/payable for derivative financial instruments, gross of related collateral received and pledged:

		September 30, 2008								December 31, 2007
(in thousands)		Assets				Liabilities				Assets				Liabilities
Derivative instruments included in financial instruments owned and financial instruments sold, not yet purchased:
Swaps (1)		$	544,933			$	180,266			$	2,424			$	417,020
Option contracts (1)			410,676				379,043				355,119				404,525
Forward contracts			6,140				5,779				3,348				3,254
Total		$	961,749			$	565,088			$	360,891			$	824,799

The following tables set forth the remaining contract maturity of the fair value of OTC derivative assets and liabilities as of September 30, 2008 (in thousands):

		OTC derivative assets
														Cross-
		0 – 12				1 – 5				5 – 10				Maturity
		Months				Years				Years				Netting				Total
Commodity swaps		$	545,945			$	—			$	—			$	(1,012	)		$	544,933
Commodity options			6,280				20,948				—				—				27,228
Equity options			935				—				—				—				935
Forward contracts			7,910				—				—				(1,770	)			6,140
Total		$	561,070			$	20,948			$	—			$	(2,782	)		$	579,236

JEFFERIES GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED
(Unaudited)

		OTC derivative liabilities
														Cross-
		0 – 12				1 – 5				5 – 10				Maturity
		Months				Years				Years				Netting				Total
Commodity swaps		$	123,216			$	1,012			$	—			$	(1,012	)		$	123,216
Credit default swaps			—				327				—				—				327
Total return swaps			—				53,154				—				—				53,154
Interest rate swaps			—				—				3,569				—				3,569
Commodity options			15,987				59,352				—				—				75,339
Equity options			8,437				122				18,765				—				27,324
Forward contracts			5,779				1,770				—				(1,770	)			5,779
Total		$	153,419			$	115,737			$	22,334			$	(2,782	)		$	288,708