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, 2008 and filed with the SEC on February 27, 2009;

• 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.
We believe our critical accounting policies (policies that are both material to the financial condition and results of operations and require our most subjective or complex judgments) are our valuation of financial instruments, assessment of goodwill 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, 2009 and December 31, 2008 (in thousands of dollars):

September 30, 2009 December 31, 2008 Financial Financial Instruments Instruments Financial Sold, Financial Sold, Instruments Not Yet Instruments Not Yet Owned Purchased Owned Purchased Corporate equity securities $ 1,600,335 $ 1,472,146 $ 945,747 $ 739,166 Corporate debt securities 2,552,523 1,934,129 1,851,216 1,578,395 Government, federal agency and other sovereign obligations 1,752,027 1,508,786 447,233 211,045 Mortgage- and asset-backed securities (1) 3,275,192 14,486 1,035,996 ¾ Loans and other receivables 494,198 495,932 34,407 ¾ Derivatives 85,238 52,306 298,144 220,738 Investments 73,502 ¾ 75,059 ¾ Other ¾ ¾ ¾ 223 $ 9,833,015 $ 5,477,785 $ 4,687,802 $ 2,749,567

(1) A portion of our mortgage- and asset-backed securities inventory has been economically hedged through the forward sale of such securities with the execution of to-be-announced
("TBA") securities with a notional amount outstanding of $2,403 million and $534 million at September 30, 2009 and December 31, 2008, respectively. TBA securities had a net fair value of $6.7 million and $1.7 million at September 30, 2009 and December 31, 2008, respectively, and are included in Financial Instruments Owned and Financial Instruments Sold, Not Yet Purchased in our Consolidated Statement of Financial Condition.

Fair Value Hierarchy - In determining fair value, we maximize the use of observable inputs and minimize 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. We apply a hierarchy to categorize our fair value measurements 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 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.
Greater use of management judgment is required in determining fair value when the volume or level of trading activity for a financial instrument has decreased and when certain factors suggest that observed transactions may not be reflective of orderly market transactions. Prices or quotes are weighed when estimating fair value with greater reliability placed on information from transactions that are considered to be representative of orderly market transactions.
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 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 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. 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 exchange price, which is generally obtained from pricing services. 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 observed for recently 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, agency and non-agency mortgage-backed securities and to-be-announced ("TBA") securities. 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 certain mortgage-backed securities as little external price information is currently available for these products. For distressed debt instruments and commercial loans, loss assumptions must be made based on default scenarios and market liquidity and prepayment assumptions must be made for mortgage-backed securities.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES Derivative products - Exchange-traded derivatives are valued using quoted market prices, which are generally obtained from pricing services, 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 other comparable 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 classified in Level 2 include credit default swaps, interest rate swaps, foreign currency forwards, commodity swaps and option contracts, and debt and equity option contracts. 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 total return swaps and equity warrant and option contracts where the volatility of the underlying equity securities is not observable due to the terms of the contracts and the correlation sensitivity to market indices is not transparent for the term of the derivatives.
At September 30, 2009, the measurements of our cash products and derivative products at fair value were based on the following:

Financial Instruments Financial Instruments Valuation Basis Owned Sold, Not Yet Purchased Exchange closing prices 16 % 26 % Recently observed transaction prices 5 % 1 % Data providers/pricing services 59 % 48 % Broker quotes 9 % 19 % Valuation techniques 11 % 6 % 100 % 100 %

Pricing information obtained from external data providers may incorporate a range of market quotes from dealers, recent market transactions and benchmarking model derived prices to quoted market prices and trade data for comparable securities. External pricing data is subject to evaluation for reasonableness using a variety of means including comparisons of prices to those of similar product types, quality and maturities, consideration of the narrowness or wideness of the range of prices obtained, knowledge of recent market transactions and an assessment of the similarity in prices to comparable dealer offerings in a recent time period.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES Certain cash products and derivative products trade infrequently and therefore have little price transparency. As a result, we may use alternative valuation techniques or valuation models as methods for determining fair value. When using alternative valuation techniques or valuation models, the following techniques are applied to different financial instruments classes: Financial Instrument Classes Valuation Techniques Equity securities and Valuations based on pending transactions convertible bonds involving the issuer or comparable companies, subsequent financings or recapitalizations, changes in financial ratios and cash flows of the underlying issuer and prices of comparable securities High-yield corporate bonds Valuations based on pending transactions involving the issuer or comparable companies, subsequent financings or recapitalizations, changes in financial ratios and cash flows of the underlying issuer and prices of comparable securities Non-agency mortgage-backed and Benchmarked to yields from market prices for other asset-backed securities comparable securities and calibrated based on expected cash flow characteristics of the underlying assets Auction rate securities Benchmarked to transactions and market prices of comparable securities and adjusted for projected cash flows and security structure, where appropriate * Corporate bank and other References to prices for other debt commercial loans and other instruments of the same issuer; estimates of receivables expected future cash flows incorporating assumptions regarding creditor default and/or recovery Investments in hedge funds, Net asset values, as adjusted for any funds of funds and certain redemption restrictions private equity funds Investments in certain private Discounted cash flow techniques equity funds OTC equity and commodity options Black-Scholes and comparable simulation and equity warrants models Interest rate, credit default, Modeling, primarily involving discounted commodity and total return swaps cash flows, which incorporate observable and foreign exchange forward inputs related to interest rate curves, contracts commodity indices, equity prices and volatilities, foreign currency spot curves and credit spreads of the underlying credit

* Prior to the second quarter of 2009, a valuation technique utilizing an internal methodology based on projected cash flows discounted for lack of liquidity was applied in determining fair value.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES Level 3 Assets and Liabilities - Level 3 assets were $842.2 million and $469.4 million as of September 30, 2009 and December 31, 2008, respectively, and represented approximately 9% and 10%, respectively, of total assets measured at fair value. Level 3 liabilities were $504.0 million and $11.7 million as of September 30, 2009 and December 31, 2008, respectively, and represented approximately 9% and 0.4%, respectively, of total liabilities measured at fair value. While our financial instruments sold, not yet purchased, which are included within liabilities on our Consolidated Statement of Financial Condition, are accounted for at fair value, we do not account for any of our other liabilities at fair value. At September 30, 2009 and December 31, 2008, Level 3 financial instruments were comprised of the following asset and liability classes:

Financial Instruments Sold, Financial Instruments Owned Not Yet Purchased September 30, December 31, September 30, December 31, (in thousands) 2009 2008 2009 2008 Loans and other receivables $ 486,252 $ 107,929 $ 495,932 $ - Mortgage and asset-backed securities 105,179 65,154 - - Corporate debt securities 93,321 165,248 - 3,515 Investments 73,502 75,059 - - Auction rate securities 54,307 10,579 - - Corporate equity securities 20,403 43,227 38 - Collateralized debt obligations 6,742 2,179 - - Derivatives 2,399 - 8,017 8,197 Foreign government issued securities 138 - - - Total Level 3 financial instruments 842,243 469,375 503,987 11,712 Level 3 financial instruments for which the firm bears no economic exposure (377,227 ) (146,244 ) - - Level 3 financial instruments for which the firm bears economic exposure $ 465,016 $ 323,131 $ 503,987 $ 11,712

During the three and nine months ended September 30, 2009, we had transfers of assets of $4.3 million and $119.3 million, respectively, from Level 2 to Level 3 and transfers of $10.9 million and $100.7 million, respectively, from Level 3 to Level 2. Transfers of assets from Level 2 to Level 3 during the three and nine months ended September 30, 2009 were primarily related corporate equity warrants and corporate debt securities where observable transaction data became less available for the specific class of securities in inventory that were transferred. During the nine months ended September 30, 2009, transfers of assets from Level 2 to Level 3 were primarily related to residential mortgage-backed securities where observable transaction data was less available and some high yield corporate bond positions as market quotes became less observable throughout the quarter due to less frequent or nominal market activity and the opaqueness of observable credit spreads. Transfers of assets from Level 3 to Level 2 for the three and nine months ended September 30, 2009 were primarily related to high yield corporate bonds where pricing information, trading activity observed and recently executed transactions provided transparency for purposes of determining fair values and related to residential mortgage-backed securities. During the three and nine months ended September 30, 2009, we had transfers of liabilities of $-0- million and $3.0 million, respectively, from Level 2 to Level 3 and transfers of liabilities of $1.6 and $5.1 million from Level 3 to Level 2. Net gains on Level 3 assets of $75.4 million for the three months ended September 30, 2009 are attributed primarily to increases in the fair value of certain mortgage-backed securities and corporate loans. For the nine months ended September 30, 2009, net gains on Level 3 assets of $30.1 million were primarily attributed to increases in the fair value of certain mortgage-backed securities, partially offset by equity warrants and certain equity securities due to declining underlying equity prices and increased market volatility, declines in the pricing for certain corporate debt securities and net writedowns on auction rate securities as market-based pricing levels and redemptions dampened in the second quarter of 2009. Net losses on Level 3 liabilities were $1.0 million and $0.8 million for the three and nine months ended September 30, 2009, respectively.

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JEFFERIES GROUP, INC. AND SUBSIDIARIES 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. See Note 3, "Financial Instruments," to the consolidated financial statements for information regarding the classification of our assets and liabilities measured at fair value. . . .