Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations This report contains or incorporates by reference "forward-looking statements" within the meaning of the safe harbor provisions of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements include statements about our future and statements that are not historical facts. These forward-looking statements are usually preceded by the words "believe," "intend," "may," "will," or similar expressions. Forward-looking statements may contain expectations regarding revenues, earnings, operations and other financial projections, and may include statements of future performance, plans and objectives. Forward-looking statements also include statements pertaining to our strategies for future development of our business and products. Forward-looking statements represent only our belief regarding future events, many of which by their nature are inherently uncertain and outside of our control. It is possible that the actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements. Information regarding important factors that could cause actual results to differ, perhaps materially, from those in our forward-looking statements is contained in this report and other documents we file. You should read and interpret any forward-looking statement together with these documents, including the following:
• the description of our business and risk factors contained in our annual report on Form 10-K for the fiscal year ended December 31, 2007 and filed with the SEC on February 29, 2008;

• the discussion of our analysis of financial condition and results of operations contained in this report under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations";

• the notes to the consolidated financial statements contained in this report; and

• cautionary statements we make in our public documents, reports and announcements.

Any forward-looking statement speaks only as of the date on which that statement is made. We will not update any forward-looking statement to reflect events or circumstances that occur after the date on which the statement is made. Critical Accounting Policies
The consolidated financial statements are prepared in conformity with U.S. generally accepted accounting principles, which require management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and related notes. Actual results can and will differ from estimates. These differences could be material to the financial statements. We believe our application of accounting policies and the estimates required therein are reasonable. These accounting policies and estimates are constantly re-evaluated, and adjustments are made when facts and circumstances dictate a change. Historically, we have found our application of accounting policies to be appropriate, and actual results have not differed materially from those determined using necessary estimates.
Our management believes our critical accounting policies (policies that are both material to the financial condition and results of operations and require management's most subjective or complex judgments) are our valuation of financial instruments and our use of estimates related to compensation and benefits during the year. For further discussion of these and other significant accounting policies, see Note 1, "Organization and Summary of Significant Accounting Policies," in our consolidated financial statements.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES Valuation of Financial Instruments
Financial instruments owned and financial instruments sold, not yet purchased are recorded at fair value. 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). Unrealized gains or losses are generally recognized in principal transactions in our Consolidated Statements of Earnings. 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 ¾ 26,895 ¾ Loans 43,504 ¾ ¾ ¾ Derivatives 456,872 398,359 338,779 327,076 Investments at fair value 91,745 ¾ 104,199 ¾ Other 328 221 2,889 314 $ 5,930,527 $ 3,559,067 $ 5,633,255 $ 3,329,966

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.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES The availability of observable inputs can vary for different products. Fair value is a market-based measure; therefore, when market observable inputs are not available, our judgment is applied to reflect those judgments that a market participant would use in valuing the same asset or liability. We use prices and inputs that are current as of the measurement date even in periods of market disruption or illiquidity. Greater judgment in valuation is required when inputs are less observable or unobservable in the marketplace and judgment must be applied in determining the appropriateness of available prices, particularly in assessing whether available data reflects current prices and/or reflects the results of recent market transactions. The valuation of financial instruments classified in Level 3 of the fair value hierarchy involves the greatest amount of management judgment.
Level 3 assets were $379.5 million and $352.6 million as of September 30, 2008 and December 31, 2007, respectively, and represented approximately 6.4% and 6.1%, respectively, of total assets measured at fair value. At September 30, 2008, Level 3 assets consisted primarily of investments in hedge funds and private equity funds, unsecured bank loans and corporate bonds. Level 3 liabilities were $18.8 million and $21.6 million as of September 30, 2008 and December 31, 2007, respectively, and represented approximately 0.5% and 0.6%, respectively, of total liabilities measured at fair value.
During the quarter ended September 30, 2008, we had net transfers of assets of $43.4 million from Level 3 to Level 2. These reclassifications were primarily related to high yield corporate bonds as valuation inputs for these instruments became more observable with transparency from recently executed transactions and actionable quotes. During the quarter ended September 30, 2008, we had net transfers of liabilities of $1.2 million from Level 3 to Level 2. Net unrealized losses on Level 3 assets of $33.7 million for the quarter ended September 30, 2008 are attributed primarily to equity warrants due to declining underlying equity prices and increased market volatility, collateralized loan obligations due to widening corporate credit spreads during the quarter and certain trade claims due to increasing default probabilities, partially offset by somewhat improved prices for certain corporate bonds. Net unrealized gains on Level 3 liabilities of $15.2 million for the quarter ended September 30, 2008 are attributed to gains on short equity options due to decreases in underlying equity prices.
See Note 3, "Financial Instruments," to the consolidated financial statements for information regarding the classification of our assets and liabilities measured at fair value.
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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JEFFERIES GROUP, INC. AND SUBSIDIARIES 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. Controls Over Valuation of Financial Instruments - Our Risk Management Department, independent of the trading function, plays an important role in asserting that our financial instruments are appropriately valued and that fair value measurements are reliable. This is particularly important where prices or valuations that require inputs are less observable. In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and that the assumptions are reasonable. These control processes include reviews of the pricing model's theoretical soundness and appropriateness by risk management personnel with relevant expertise who are independent from the trading desks. Where a pricing model is used to determine fair value, recently executed comparable transactions and other observable market data are considered for purposes of validating assumptions underlying the model. An independent price verification process, separate from the trading process, is in place to ensure that observable market prices and market-based inputs are applied in valuation where possible.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES Compensation and Benefits
The use of estimates is important in determining compensation and benefits expenses for interim and year end periods. A substantial portion of our compensation and benefits represents discretionary bonuses, which are finalized at year end. In addition to the level of net revenues, our overall compensation expense in any given year is influenced by prevailing labor markets, revenue mix and our use of share-based compensation programs. We believe the most appropriate way to allocate estimated annual discretionary bonuses among interim periods is in proportion to projected net revenues earned. Consequently, we have generally accrued interim compensation and benefits based on annual targeted compensation ratios, taking into account the guidance contained in FASB 123R regarding the timing of expense recognition for non-retirement-eligible and retirement-eligible employees.
Business Environment
During the third quarter of 2008, the U.S. markets experienced unprecedented challenges as credit contracted and economic growth slowed, and a number of major financial institutions faced serious problems. Concerns regarding future economic growth and corporate earnings, as well as illiquidity in the credit markets created challenging conditions for the equity markets which experienced significant broad-based declines over the quarter, with equity indices lower at the end of both the quarter and nine month periods of 2008 as compared to 2007. Subsequent to quarter end, difficult conditions have persisted within the equity markets with certain equity indices reaching their lowest levels in five years. The financial landscape has also been altered dramatically over the course of the quarter and subsequently with the bankruptcy of Lehman Brothers Holdings Inc., acquisitions and consolidations of major financial institutions, the Federal Government assuming a conservatorship role of both the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association and the conversion of Goldman Sachs Group, Inc. and Morgan Stanley into bank holding companies. In early October 2008, the Emergency Economic Stabilization Act of 2008 was enacted, which, among other matters, enables the U.S. Treasury to purchase mortgage-related and other trouble assets from U.S. financial institutions.
Markets outside of the U.S. have recently experienced similar conditions with foreign governments taking similar actions within their border to provide liquidity to financial institutions and also, in some cases, assuming conservatorship roles over certain financial institutions.
The results of our operations for the three months and nine months ended September 30, 2008 reflect these challenging market factors, which contributed to declining inventory valuations and reduced levels of capital markets activity. Competitor consolidation and the destabilization of the financial markets during these periods have conversely had a positive impact on business prospects as we have seen new customer activity across many of our businesses. A continuation of the volatile markets and unfavorable economic conditions of the third quarter could have a material adverse impact on our business and results of operations for the fourth quarter of 2008. In addition, the effects of the changes to the financial landscape that occurred during the third quarter and early into the fourth quarter could also have a material adverse impact on our business and results of operations for the fourth quarter of 2008.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES Consolidated Results of Operations
We recorded a net loss of $31.3 million for the quarter ended September 30, 2008, compared to net income of $38.8 million for the comparable third quarter of 2007. Net revenues (total revenues, net of interest expense) declined 18% to $274.6 million as challenging market conditions negatively affected certain of our businesses this quarter. Non-interest expenses of $352.4 million increased 26% from the third quarter of last year primarily due to increased compensation and benefit costs, increased technology and communications costs and losses incurred in connection with unwinding securities lending positions with Lehman Brothers as our counterparty. Diluted (loss) per share was $(0.18) for the quarter ended September 30, 2008 as compared to diluted earnings per share of $0.26 for the third quarter of 2007.
For the nine month period ended September 30, 2008, a net loss of $96.2 million was recorded, as compared to net income of $168.9 million for the nine months ended September 30, 2007. Net revenues decreased 29% to $867.9 million and non-interest expenses increased by 16% to $1,084.5 million for the comparable prior nine months. Diluted (loss) per share was $(0.60) compared with diluted earnings per share of $1.12 a year ago.
The effective tax rate was 7.8% for the third quarter of 2008, a decline in comparison to an effective tax rate of 39.1% for the third quarter of 2007, and was 27.7% and 37.4% for the nine month period ended September 30, 2008 and September 30, 2007, respectively. The decrease in our effective tax rate for the third quarter of 2008 was driven by an overall decrease in our expected tax rate for the full 2008 year, which in turn is driven by a decrease in forecasted profit before tax as a result of the net loss for the third quarter of 2008. In April 2008, we sold 26,585,310 shares of our common stock to Leucadia National Corporation ("Leucadia") (see Note 1, "Organization and Summary of Significant Accounting Policies," to the consolidated financial statements for additional discussion).
At September 30, 2008, we had 2,465 employees globally compared to 2,529 employees at the end of the third quarter of 2007 and 2,568 at December 31, 2007.
Revenues by Source
The Capital Markets reportable segment includes our traditional securities trading activities, including the results of our high yield secondary market trading activities as of the second quarter of 2007, and our investment banking activities. The Capital Markets reportable segment is managed as a single operating segment that provides the sales, trading and origination effort for various fixed income, equity and advisory products and services. The Capital Markets segment comprises many divisions, with interactions among each. In addition, we choose to voluntarily disclose the Asset Management segment even though it is currently an "immaterial non-reportable" segment as defined by FASB 131, Disclosures about Segments of an Enterprise and Related Information. For presentation purposes, the remainder of "Results of Operations" is presented on a detailed product and expense basis rather than on a business segment basis because the Asset Management segment is immaterial as compared to the consolidated Results of Operations.
Our earnings are subject to fluctuation since many economic factors and market events over which we have little or no control, particularly the overall volume of trading, the volatility and general level of market prices, and the number and size of investment banking transactions, may significantly affect our operations.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES The following provides a breakdown of total revenues by source 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 Equity $ 122,465 140,296 $ 409,800 457,916 Fixed income and commodities: Fixed income (excluding high yield) and commodities (1) 56,213 16,502 159,380 103,073 High yield (2) (61,304 ) (7,387 ) (80,987 ) 37,073 Total (5,091 ) 9,115 78,393 140,146 Investment banking 130,125 189,780 338,704 582,988 Asset management fees and investment (loss) income from managed funds (3): Asset management fees 3,804 5,369 14,847 22,114 Investment (loss) income from managed funds (7,235 ) (11,652 ) (32,595 ) 7,472 . . .