Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

State Street Corporation (NYSE:STT)

Q3 2008 Earnings Call

October 15, 2008 7:30 am ET

Executives

Kelly McDonald - Senior Vice President, Investor Relations

Ronald E. Logue - Chairman and Chief Executive Officer

Edward J. Resch - Chief Financial Officer, Executive Vice President

Analysts

Glenn Schorr – UBS

Kenneth Usdin - Bank of America Securities

Brian Bedell – Merrill Lynch

Rob Rotschow - Deutsche Bank

Nancy Bush – NAB Research LLC

Brian Foran - Goldman Sachs

Vivek Juneja - JPMorgan

Betsy Graseck - Morgan Stanley

Operator

Welcome to State Street Corporations third quarter conference call and webcast. (Operator Instructions) Now I would like to introduce Kelly McDonald, Senior Vice President for Investor Relations at State Street.

Kelly McDonald

Before Ron Logue our Chairman and Chief Cxecutive Officer and Chief Financial Officer Ed Resch begin their remarks I would like to remind you that during this call we may be making forward-looking statements. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those filed on a Form 8-K this morning as well as State Street’s 2007 annual report on Form 10-K and its subsequent filings with the SEC. We encourage you to review those filings, including the sections on risk factors concerning any forward-looking statements we may make today. Any such forward-looking statements speak only as of today October 15, 2008 and the corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

I would also like to remind you that you can find slide presentations regarding the corporations investment portfolio and asset-backed commercial paper conduits as well as a separate presentation regarding the AMLS and the CPFF program and our third quarter 2008 earnings press release, which includes reconciliations of non-GAAP measures referred to on this web cast, in the investor relations section of our web site as referenced in our press release this morning.

Ronald Logue

Given the events of the last couple of days we thought it best to move our earnings call ahead and provide as much information as quickly as possible. Now I can’t recall a time when the need for clarity and understanding of issues is more important. So, I want to do something a little different today. I want to spend the time talking about the challenges we have faced in the current market and how we have managed them. I want to spend only a short time discussing the results of the third quarter, which were very good and continue to show momentum. I will let Ed, as he usually does, discuss the details of the third quarter.

Let me focus on the actions we have taken as a result of the extraordinary events taking place each day in our industry. Our purpose, obviously, is to emerge from these difficult times a stronger company. Not just from a capital adequacy perspective, but from a risk control perspective and importantly from a customer perspective protecting not only our franchise, but also the interests of our customers.

First let me bring you up to date with some of the current activities we have been involved with. We are pleased to be included as one of the nine institutions chosen by the US treasury to take a leadership role in the recently announced Capital Purchase Program that forms part of the TARP. Our selection demonstrates our role as a firm integral to the health and stability of the infrastructure of the financial markets and we are confident that the plan helps to restore stability and confidence to the financial markets.

We are also participating as a service provider in a number of Federal Reserve and Treasury programs to address the financial crisis. Acting on behalf of money market funds we have been one of the leading participants in the asset-backed commercial paper money market facility known as AMLF.

We have also, just yesterday, been selected as the custody provider for the recently announced commercial paper funding facility, or CPFF as it is known. State Street Global Advisors is also pleased to be one of the two managers selected by the US Treasury to manage the assets of the mortgage backed securities program.

Let me begin with a summary of our participation in the Capital Purchase Program. We have agreed to sell to the US Treasury department $2 billion of preferred shares as well as warrants to purchase common stock, which we anticipate will be minimally dilutive to our shareholders. We have a strong track record. A business model focused on continuing the success and strong prospects of continuous earnings and whatever advantage of strength we gain from this program will benefit us in the future.

That does not mean, however, that we will not consider raising additional capital to further strengthen our capital position under the right conditions. The CPFF in particular will help the market for asset-backed commercial paper in these distressed markets. The intent of the CPFF is to support the market for commercial paper which is vital to the capital markets. We believe that together with the AMLF this program should restore confidence to the commercial paper markets. Specifically, until the market becomes more liquid, the program will also provide an alternative source of liquidity to our conduits reducing the need to hold commercial paper on our balance sheet during these disruptive markets.

Also this morning, I would like to discuss the following issues that I know are on your mind: our securities lending program; our investment portfolio and the asset-backed commercial paper program; other issues that we addressed in the press release, including the Lehman reserve and the possibility of an additional fourth quarter non-operating charge to protect our customers in certain managed accounts.

There has clearly been a flight to quality and safety, particularly near the end of the quarter and our deposit base and our custody trading and asset management businesses have benefited from our reputation for stability.

We received a number of questions about our Securities Lending Program. Details about how it works as well as our view as to the future of this business, given the decision by several lenders to suspend participation.

First let me say that Securities Lending provides a vital source of liquidity to equity, bond, and money markets, as well as reduces the cost of trading and settlement, thereby benefiting all market participants. Our Securities Lending registered and non-registered funds are operating as we expected. Our program remains strong and these funds are invested conservatively. None of our funds that support State Street Securities lending business has lost money for our customers. Due primarily to declines in the market, but also suspension or reductions in securities lending by some customers, we have seen assets in our lending program decline by approximately 20%. As a result, we have seen increased withdrawal activity from the collateral pools, but we have been able to manage these outflows in a manner that protects our customers from loss [ph]. The current spreads and volatility are expected to at least partially offset the impact of lower volumes.

Let’s talk about the asset-backed commercial paper program and the investment portfolio. As we have said in the past and Ed will discuss in a minute, the assets in our investment portfolio and asset-backed commercial paper program are of high quality. Very few have been downgraded and none are in default. We continue to believe that the prices are not reflective of the underlying value of these securities if held to term, but reflect a continuing lack of liquidity in the market.

Next the Lehman related reserve. As we have stated publicly, we have no unsecured exposure to Lehman Brothers. We do have a secured exposure to Lehman which is now part of the bankruptcy proceeding. We have indemnified certain of our customers with respect to repurchase agreements with Lehman Brothers Commercial Paper Inc. These repurchase agreements of $1 billion were collateralized by $1.25 billion of mortgages. Following the Lehman bankruptcy, in light of current market conditions, we valued this collateral less than the repurchase obligations, so recorded a $200 million reserve. We believe this reserve will be adequate, although we will not know the ultimate outcome until the collateral is sold or matures.

We manage accounts that have the benefit of contractual arrangements with other financial institutions that allow the accounts to issue and redeem units at book value rather than at market value. The difference between market and book value on these accounts has increased to levels that may result in these financial institutions requiring that we sell the fixed income securities held in these accounts to limit any further risk to these other financial institutions. Such an action could negatively affect our customers and our reputation. Although we are not contractually obligated to do so we are evaluating whether we should provide support to these accounts. Although we have not currently committed to any course of action, a decision to support these accounts could result in a non-operating pre-tax charge of between $400 and $450 million in the fourth quarter. While we are still considering our options, we want to disclose the possibility of a charge of this magnitude to you.

Now before I turn the discussion over to Ed, let me remind you our third quarter performance, especially in light of the environment in which we are operating, was excellent. On an operating basis, earnings per share in the third quarter were $1.24, up 8% from $1.15 per share last year and down 11% from $1.40 in the second quarter.

Operating revenue on a fully taxable equivalent basis totaled $2.5 billion for the quarter, an increase of 12.4% from last years third quarter compared with a 9.5% increase in expenses to $1.7 billion on an operating basis. Compared to the second quarter of 2008 operating revenue on a fully taxable equivalent basis was down 6.1% and expenses on an operating basis increased 6.3%.

Return on equity on an operating basis was 15.4% in the third quarter, down from 15.8% in the third quarter of 2007, and down from 19.3% in the second quarter of 2008.

Our operating expenses in the third quarter declined 6% from the second quarter, due to our successful expense controls and we will continue to exercise this expense discipline as we have in the past.

Also, excluding the non-operating items in the quarter, we achieved 290 basis points of positive operating leverage when measured on a year-over-year basis, our 16th sequential quarter and 20 basis points when measured on a quarter-over-quarter comparison.

In addition to the government mandates we won $280 billion of asset servicing new business, including names such as Lovard [ph] asset management, the UK operations of Sun Life of Canada, the State of Georgia Pension Fund, and the London Borough of Enfield superannuation fund. SSGA won mandates from the Cabershire [ph] County Consult Pension Fund, the Bank Pension of Denmark, the Massachusetts State Pension Fund, and the Teachers Retirement System the State of Illinois. These new wins as well as the continuing installations of previous wins are expected to help offset some of the revenue loss due to reduced market valuations over our existing book of business.

Edward Resch

This morning all of my comments will be based on our operating basis results, excluding the CitiStreet gain the Lehman related reserve, the SILO related charge, the impact of the asset backed commercial paper liquidity facility offered through the Federal Reserve and the merger and integration costs associated with our acquisition of Investors Financial.

Ron provided an overview of the various issues in the quarter. Let me just briefly explain the additional SILO reserve.

In the third quarter we recorded a $98 million pre-tax charge against net interest revenue and a $39 million increase on the tax line. We believe that a majority of the pre-tax charge will come back into income over time. The company previously settled with the IRS on our LILO leases and over previous quarters has increased our reserve against the SILO exposure. During the third quarter, as the IRS began to become more successful in increasing its rate of settlement, particularly in light of recent court decisions, we decided that the more prudent course of action was to increase our Silo reserve again.

Let me now highlight certain components of our income statement.

Servicing and management fees both performed well, particularly in light of the significant declines in market valuations on both the S&P and the EFA. The continuing volatility in the market benefited our trading revenue growth particularly foreign exchange. Performance in securities finance was also strong on a year-over-year basis and was down about 30% from the second quarter due to the impact of the dividend season in Europe in the second quarter.

The decline in processing and other fees on both a year-over-year and a sequential quarter basis was due to lower fees. Of particular note on the lower fees from the asset backed commercial paper program were fees from this program declined from $13.2 million in the second quarter to $5.7 million in the third quarter.

Regarding the investors financial acquisition all of our metrics are on track and we continue to expect the transaction to be about $0.04 to $0.05 accretive to our 2008 results, significantly ahead of our original plan at the time of the acquisition.

Regarding expenses we had a $0.06 decline in third quarter expenses compared to the second quarter. I will comment on only two areas. First, salaries and benefits expenses declined 4% from the second quarter due primarily to a lower level of incentive compensation. Other expenses were down 19% compared to the second quarter primarily due to reductions in professional fees, lower costs in bank operations and lower securities processing costs as we controlled expenses in anticipation of a lower revenue environment.

As we anticipated on last quarter’s conference call, net interest revenue was down from the second quarter due to lower asset yields. In addition, net interest margin of 222 basis points was down 9 basis points from the second quarter of 2008.

Now let me turn to the investment portfolio.

The investment portfolio has not changed significantly in credit quality or size since the second quarter, however the unrealized mark-to-market losses have widened as of quarter end as a result of illiquidity in the market and the general global market stress. I will refer you to our investment portfolio slide presentation for the particulars of our portfolio composition.

During the quarter, particularly following the Lehman bankruptcy in mid-September, we saw spreads further widen in an incredibly illiquid market: the unrealized after tax mark widened by $1.3 billion from $2.0 billion at June 30, 2008, to $3.3 billion at September 30, 2008. To give you some idea of the impact of the Lehman bankruptcy, the mark as of September 12, 2008, before the Lehman bankruptcy, was $2.98 billion after tax. We continue to believe that these prices are not reflective of the underlying value of the securities if held to term, but indicate a continuing lack of liquidity in the fixed income market.

You will note that our entire portfolio remains rated as it was in June, 84.4% AAA rated and 8.7% AA rated. We have had only minimal down grades, no defaults, and all securities are current as to principle and interest.

As in past quarters, on our web site you will find the investor portfolio detail about the third quarter compared to the data we have presented for previous quarters. I strongly urge you to review those slides.

Our portfolio was well diversified with over 9,300 Q SIPs and if you look at the slides you notice that only 49 new securities, of which 13 were municipal bonds, were downgraded in the third quarter. These additional downgrades represent about $1.4 billion in asset value or less than 2% of the total portfolio: all are current and none are in default. In the context of a difficult market, more than 60% of these down grades were one letter grade or less.

The slides also contain data indicating the stresses we applied in testing our analysis of the portfolio. Rather than go through them all this morning I will point out two examples which represent asset classes we are often asked about.

We have about $2.3 billion, or $4,269 securities wrapped by an insurance provider. Of this number more than 99% or 4,242 are municipal bonds. Excluding these the remaining wrapped securities, 16 HELOCs and 10 sub-prime asset backed securities, equal about $300 million or 26 securities. With the exception of the insurer FSA we removed all of the wraps and stressed the bonds. As you can see on the slides the total HELOC loss would be about $29 million after tax.

The sub-prime assets which have declined more than $1 billion since last years third quarter now have 45% credit enhancement which comes from the structure itself and means that even if every mortgage in the security were to default we would not lose $1.00 until the recovery rate for those assets fell below 55%.

Now as to our outlook for non-interest revenue for the remainder of 2008: Last quarter we increased our outlook for net interest margin for 2008. I said that we expected the margin to be around 215 basis points or slightly higher. In the current environment, excluding the impact of the AMLF, we know expect our margin on average for the full year to be around 220 basis points.

As you can see our balance sheet grew considerably during the quarter, especially following the Lehman bankruptcy and the commencement of the AMLF. Increased liquidity from our customer deposits in the recent market environment and our participation in the AMLF have caused our balance sheet to grow temporarily. As of September 30, 2008 we had deposited an additional $54 billion in excess balances with Central Banks plus an additional $77 billion related to the AMLF program. I remind you that we bear no credit or capital risk for holding the AMLF assets.

On the subject of the AMLF I direct you to the AMLF slide presentation to give you some idea of the non-operating revenue we will earn as a facilitator of this program, for the last two weeks of September we earned about $8 million and for the fourth quarter, assuming an average balance of around $30 billion, we anticipate earning between $50 and $60 million in the quarter.

Let me review our capital ratios now.

The principle capital ratio that we manage to is the tier 1 leverage ratio. We have historically targeted between 5 ¼ and 5 ¾ %, but given the market environment we expect our leverage ration to continue to grow through a level above the top of this range in order to preserve flexibility in what appears to be a continuingly volatile market.

Had the capital purchase program been in place at September 30, 2008, the pro forma tier 1 ratio for the corporation would have been 18.84% and the pro forma leverage ratio would have been 9.76%. As of September 30, 2008 our tier 1 leverage ratio stands at 8.36%, up from 8.25% as of June 30, 2008. At September 30, 2008 our adjusted tangible common equity ratio is 4.80% down from 5.40% at June 30, 2008, primarily due to an increase in the unrealized loss on the investment portfolio.

We have adjusted the TCE ratio for the impact of the AMLF, the excess balances left with the Federal Reserve Banks and other Central Banks and the deferred tax liability. I refer you to the slides entitled Asset Backed Commercial Paper Conduits for a description of the methodology used to calculate the adjusted TCE ratio.

Next a discussion of the asset-backed commercial paper program:

As in the past, you can find a detailed quarterly review of the assets displayed by type, country of origin, and ratings in the asset-backed commercial slide presentation. Also there you will find the unrealized after tax mark-to-market losses for each asset type and the stresses we applied to them. In the interest of time I will not discuss them in detail today.

At September 30, 2008 the conduits held assets of $25.5 billion, down from $28.4 billion on June 30, 2008 due to asset amortization and the strengthening US dollar. As in the investment portfolio, the illiquidity in the market resulted in an increase in the unrealized after tax mark-to-market loss to $2.1 billion, an increase of about $500 million from June 30, 2008 due primarily to higher credit spreads on US mortgages. As I have stated many times, we created this program in 1992 primarily to address customer requests for high quality, highly rated commercial paper. The conduits have never suffered a credit loss on any asset they purchased, evidence of our strong credit discipline. 80% of the assets are rated AAA, AA or A; none of the assets in our conduit are sub-prime, nor are there any SIVs in the conduit program.

As of September 30, 2008 the assets continue to have an average weighted maturity of about four years and the paper has a weighted average maturity of 15 days, down from 20 days at June 30. All securities in the conduits are current as to principle and interest.

As I am sure you are aware, the commercial paper market has been considerably strained, particularly near the end of the third quarter. Following the Lehman bankruptcy and with several prominent money market funds having NAV less than $1.00 many investors withdrew from or limited their exposure to the ABCP market. As of September 30, 2008 excluding our own commercial paper pledge by money market funds to the federal reserve, we held $6.2 billion of our asset backed commercial paper on our balance sheet; however to give you some idea of the impact of the Lehman bankruptcy, as of September 12, the day before the Lehman bankruptcy was declared, we held $1.5 billion on our balance sheet.

If the disrupted markets continue and we are unable to sell the asset-backed commercial paper to customers we expect that a substantial amount of the commercial paper issued by our conduits will be eligible for sale to the Federal Reserve under the Commercial \Paper Funding Facility. If the Commercial Paper Funding Facility had been available at September 30, 2008 we believe that the amount of commercial paper we held on the balance sheet would have been materially lower. This program is described further in the slides we’ve provided.

Due to the high quality assets and their performance we do not currently believe we need to consolidate the conduits; however we are well prepared for consolidation if required by FASB as of January 1, 2010. From a funding standpoint the risk of a more immediate consolidation continues to be included in our contingency funding plan. As of September 30, 2008, given the market environment, we carried about $68 billion in liquid assets on our balance sheet, $54 billion of which was the excess reserve held at the Central Banks.

On a pro forma basis as of September 30 the consolidation of the [inaudible] assets onto our balance sheet would reduce our leverage ratio by about 151 basis points from 8.36% to 6.85% and the tangible common equity ratio about 175 basis points from 4.80% to 3.05%. I should also remind you that we have been generating 40 to 50 basis points of organic capital per quarter.

Ronald Logue

Looking at the turmoil resulting from the illiquidity in the capital markets I am particularly proud of the performance of State Street not only in the third quarter, but in many of the decisions we have made over the past year to prepare for the current market environment. I am also very proud of our employees around the globe who have focused on helping our customers to navigate the considerable challenges and complexities that I just outlined.

Because of our strong performance in the first nine months of 2008 we continue to confirm our earlier statements regarding our performance to our financial goals. We continue to expect our growth in operating earnings per share to be approaching the high end of the 10 to 15% range, operating revenue to be above the high end of the 14 to 17% range, and the operating return on equity to approach the high end of the 14 to 17% range.

As I said at the beginning of my comments this morning, the companies that will emerge from this turmoil in a position of strength are those with the right mix of businesses, with a focus on customer service, and a prudent plan for this environment.

We will continue to respond to changes in the environment and take whatever steps are necessary to enhance the strength and value of our unique franchise.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Glenn Schorr with UBS.

Glenn Schorr – UBS

Ron I was wondering if we could talk a little bit more about the situation of SSGA and the third party financial guarantors. I appreciate that you are not contractually obligated, but you are thinking about doing the right thing by customers. What drives that and maybe you can give us a little bit more color, because I think the situation in the short-term duration funds was different, but what we’re seeing in money market funds and sect lending funds and now this, a lot of companies are making a lot of clients hope. We are just trying to figure out how we draw the boundaries of clients having any risk at all.

Ronald Logue

That is going to be a grey area, obviously Glen. I think the factor there is going to be the, I guess, the attitude and the condition of the financial guarantors there. It is really not a situation that we can control as much as a situation that the financial guarantors can control; so it depends on, I guess, their attitude towards what they want to do. There is not much more I can tell you there.

Glenn Schorr – UBS

State Street, that is their decision, that it depends on the guarantor and your —?

Ronald Logue

Yes, absolutely. What is a State Street decision, however, is to determine what we would want to do in terms of protecting our customers. Even though as we have said and you have said, we are not contractually obligated to do that.

Glenn Schorr – UBS

To your knowledge is this an industry wide phenomenon where everyone is in the same boat?

Ronald Logue

It could be, I honestly don’t know [interposing].

Glenn Schorr – UBS

Is this the 4, 450?

Ronald Logue

I am sure it is different for each organization depending on where they are, but the situation in terms of who is responsible for what is probably the same.

Glenn Schorr – UBS

Does the 4, 450 represent the full amount or is that the clients portion? Meaning are you making them fully whole if you made that decision?

Ronald Logue

It will bring them up to an appropriate level, yes. We are conservatively reserving for that.

Glenn Schorr – UBS

You made a comment that I took as just kind of blanket cautionary, but I just want to ask for further color on the, we have big capital ratios, we got our money from the government, but this does not mean we wouldn’t raise further capital?

Ronald Logue

That’s correct.

Glenn Schorr – UBS

Is that just kind of blanket cautionary? In other words, I could appreciate having maybe deal related capital raised, but at an 18% + tier one, even the consolidation of the full conduit would keep you at pretty reasonable levels. I am just trying to think about what kind of situation would bring a capital raise in the foreseeable future?

Ronald Logue

I guess more disruptive markets essentially. I think, obviously what’s important is our capital base. We don’t have any immediate plans to raise capital right now, but I don’t want anyone to think that just because we got $2 billion from the Capital Purchase Program, that we’re not thinking about a strong capital base. That was really the intent there.

Glenn Schorr – UBS

Got it and then you affirmed your financial projections on ’08 at x point are you going to be thinking about ’09 as difficult as that task might be?

Ronald Logue

We are in the process of looking at that right now. I think the good news is that we have, for a couple of quarters, been working on the expense side. Obviously if we think we’re going to enter a slow growth environment we have to look at the expense side of the equation. We have been doing that and I think that a good proof point is the fact that we generated sequential quarter positive operating leverage and stuff, so we go that machine working.

Operator

Your next question comes from Kenneth Usdin with Bank of America Securities.

Kenneth Usdin - Bank of America Securities

I have a question on the conduits. Ed you mentioned that you don’t have any current plans to consolidate it and would be prepared, assuming that the FASB did make the changes. Can you just talk through outside of the FASB changes? What would cause the triggers for consolidation in any interim period? Meaning where are you relative to the tests and how much flexibility do you still have right now?

Edward Resch

Well the things that could cause a conduit consolidation are the same ones that we’ve always talked about, which are that if we would for some reason to not be on the right side of the FIN 46 model, which I’ll talk about in a minute in terms of our cushions, but it is basically that as well as any issues that were of a protracted nature that could cause the conduits funding costs to greatly exceed the asset yield. That’s kind of a going concern concept under the accounting rules. We are not in that position, we don’t have any expectation to be in that position, but that could cause a consolidation.

In terms of our cushions, they are very strong. Actually a little bit stronger than on one of the conduits, one of those big ones, then they were last quarter. I define cushion, again, as the available sub debt versus the requirement. On one of the large conduits it is well above 100% cushion and on the other larger conduit it is just over 40% cushion. On the two smaller conduits, one is at 40% and the other is about 30% cushion, so we are in a very strong position in terms of our subordinated debt, first loss notes versus our requirement.

Kenneth Usdin - Bank of America Securities

Ed as you gave some color relative to pre-Lehman, post-Lehman; can you give us any color as far as that profitability or ongoing concern test? Have the conduits on a day-to-day basis remained in the black so to speak? I mean have there been some days or weeks in the last couple weeks of the quarter where that test got tougher on a day-to-day basis I guess? I know it is measured over a longer period as far as the consolidation test is concerned, but can you just give us some color there?

Edward Resch

Yes, absolutely. Post the Lehman bankruptcy we saw the amount on our balance sheet go up, as I said. Investors pulled back, cash was kept, they were hoarding cash, and not investing in our asset backed commercial paper or others we believe, as the market kind of froze up. In terms of placing the paper that we did place it was all over night and it was at a much higher rate for that over night period, because of the market conditions. So given that the assets did not re-price overnight we were in for that increment of paper that we priced over night at a high rate we were in a negative position. Overall that was for a shorter period of time and not of concern from the standpoint of the going concern test.

Kenneth Usdin - Bank of America Securities

As far as the forward-looking can you just talk about how much changes in kind of the LIBOR rate would benefit that test and also how you expect the CPFF to work as far as when it starts on October 27 and any expectation of how quickly the market could start to improve?

Edward Resch

First, in terms of overall improvement we would expect that the intended effect a lot of these government programs would kick in and three month LIBOR versus Fed funds would come in from where it is, which has been obviously at a very high level, as the stress has actually increased over the end of the third quarter, so we would expect that to occur and that would obviously be a positive for the conduits in terms of their funding costs on their paper as well as the term to which we could place the paper, but that is yet to be determined.

As we move forward it is a little early to say what we precisely think the effect is going to be on the conduits, but we have over 22 billion of our 25 billion we believe as being eligible for the CPFF, if we needed to avail ourselves of that, so we feel pretty comfortable that even if the market did not repair itself as quickly as maybe everybody would like we still have the alternative funding source with the CPFF.

Operator

Your next question comes from Brian Bedell with Merrill Lynch.

Brian Bedell – Merrill Lynch

On the conduit again, for the decline from the $28.4 billion to $25.5 billion, what portion of that was due to the strengthening dollar, and what portion was due to amortization?

Edward Resch

About $1 billion is due to the strengthening dollar.

Brian Bedell – Merrill Lynch

Would you expect that amortization portion of that $2 billion to be a straight-line level or was that a little bit lumpy in the quarter?

Ronald Logue

No the overall conduit amortization is about $1 billion per quarter, but again you can’t assume that that’s going to be a straight line down in terms of the amortization because of the requirement to make sure we stay on size with the FIN 46 model.

Brian Bedell – Merrill Lynch

Right and in terms of keeping the credit quality at A1 T1 I guess?

Ronald Logue

Right.

Brian Bedell – Merrill Lynch

Just to go back to the test on FIN 46 again, what type of time frame would you need to be in a loss position to be forced to consolidate the conduits?

Ronald Logue

It would certainly be over a quarter or more. It is not a day or a week or a month test.

Brian Bedell – Merrill Lynch

Right, okay and what levels were the, I know the CP funding spreads were at 24 basis points for the average for the quarter. What were those funding spreads in the last two weeks of September post the Lehman bankruptcy?

Edward Resch

We don’t have that number at hand. We will have to get that to you.

Brian Bedell – Merrill Lynch

All right, so obviously it spiked up somewhat and you were in a loss position on certain days. I guess what I am trying to get at is to what degree going forward will the ability to lay that off on the Fed, would that program sort of guarantee you an ability to run this conduit profitably? Do you guys feel pretty comfortable in that?

Edward Resch

It is kind of, I think, a win win in that if the program works and spreads come back in we will be able, more likely than not, to be having less paper on our balance sheet and continue placing it as we had before the Lehman bankruptcy. If in fact it takes longer for normalcy to return, then the Fed program, the CPFF, is available to us and is very attractive. Either way, whether the market repairs quickly or it takes a little bit longer we feel like the conduits will be fine.

Brian Bedell – Merrill Lynch

Right, so the Fed program really guarantees you, the rates that they are doing it at, the swap with the 300 basis points is, what you are saying is that that will keep you comfortable that that will keep you in a profitable position even if you have to use the Fed program?

Edward Resch

Yes, in a disrupted market as we have today that is exactly right.

Brian Bedell – Merrill Lynch

On the default risk on the conduits what type of magnitude of defaults would trigger a FIN 46 consolidation?

Edward Resch

You said default?

Brian Bedell – Merrill Lynch

Yes, if you experienced an actual default within some of the actual securities within the conduit; so you have a loss in the conduit and then you add a reasonable cushion for protection against that. I know that’s another thing that can trigger FIN 46 and I was just trying to gauge.

Edward Resch

Right, I mean that’s asset specific. That is not taking into account any liquidity asset back stop that we have, but the technical answer is that an asset default would go against the subordinated debt in a conduit.

Brian Bedell – Merrill Lynch

Right, right so as long as you have that cushion…

Edward Resch

Yes, that would absolutely reduce the cushion if an asset were to default, but I would remind you that we have never had that happen.

Brian Bedell – Merrill Lynch

Right and do you have the ability to essentially buy that component of the conduit and bring that onto your balance sheet to avert a consolidation and then just obviously that portion you would just mark-to-market on your balance sheet?

Edward Resch

Yes, there are specific conditions under which that can occur, but generally speaking that is what the liquidity asset purchase agreements are for in order to protect the conduits and have State Street Bank and Trust back stop their liquidity.

Brian Bedell – Merrill Lynch

Then on the Central Banks, the $54 billion, I know that came out sort of towards the end of the quarter, but is that reflected in your average balance sheet? It looks like your average interest earning assets are pretty steady.

Edward Resch

Yes.

Brian Bedell – Merrill Lynch

It is reflected in your balance sheet, so if that is coming at the very end of the quarter what we should have, if it is that sticky into the fourth quarter we should have a pretty significant inflation in your operating interest earning assets, correct?

Edward Resch

Yes. If the liquidity position still carries forward into the fourth quarter, yes.

Brian Bedell – Merrill Lynch

Then does your comment on the NIM guidance include an assumption that you will continue to have that type of level of Central Bank deposits through much of the [interposing].

Edward Resch

Not that level, but lower than $50 billion. We are assuming that some level of normalcy will return and the excess liquidity will diminish over the quarter.

Brian Bedell – Merrill Lynch

Your higher funding costs within the average balance sheet here in terms of the other short-term borrowings and then your actual rates on the non-US transaction deposits, what drove those two factors? Like your other short-term borrowing costs went from 310 basis points, 384 and then your non-US deposit costs went from 153 to 169. I would have expected both of those to be stable or down.

Edward Resch

We will have to get back to you on that answer; I don’t have it specifically at hand right now.

Brian Bedell – Merrill Lynch

For managing to capital ratios, the tangible common equity is going to continue to potentially be constrained here, if we get more unrealized marks on the portfolio. When do you think the rating agencies might begin looking at tier 1 capital as more of a primary driver of your ratings rather than the tangible common equity?

Also, in valuing the securities on the portfolio, can you make a comment on mark-to-market accounting to what degree you might be able to make some of those securities level 3 assets because, as you said, there is not a great market for some of those securities?

Edward Resch

Well, in our conversations with the rating agencies they start from the regulatory ratios and go on from there. I think the prerequisite on the part of the rating agencies, at least as they have expressed it to us, is strong regulatory ratios and then they move on to the tangible comment and other things. Whether or not they move away from a focus on tangible comments as just the regulatory ratios or something else, that is a waiting question which, I guess, they had probably best address. But, up until now it has been focused on regulatory number one and then other ratios, number two.

In terms of the mark-to-market, we have prepared our financials consistently through time, before the crisis hit summer of ’07 and up to now. We are aware of the discussion and the emphasis that the FASB has placed on the mark-to-market accounting. Most of our assets are level 2; they will continue to be level 2 this quarter. About 90% of our assets are in the level 2 bucket under FAS 157.

We are evaluating what FASB says about fair value accounting, but for this quarter we have used the consistent methodology which for the investment portfolio is a third-party pricing service.

Brian Bedell – Merrill Lynch

Right so if they eased that somewhat from a FASB perspective your accountants might be able to go back using that as an in put and then also use a potential model for some of those assets? I mean that would sort of ease the unrealized losses a little bit.

Edward Resch

We look at that. We are looking at that, but at this point we have not reached a conclusion. We have to have a basis to determine that there is a disrupted market under this new guidance or this guidance that is confirming FAS 157 and we would have to have a better view, which is surrounded by a very rigorous process, in order to make a change to our methodology on valuing our securities.

Brian Bedell – Merrill Lynch

Ron, if you would just comment on maybe the new business pipeline. Obviously this has been a very stressed environment for everyone. What are you seeing from your potential custody customers that you have been talking with for some time in terms of their business decisions, whether they are more willing to outsource right now?

Kelly McDonald

Brian, it is almost impossible to hear you because you are on a head set.

Brian Bedell – Merrill Lynch

The pipeline for custody mandates, are you seeing people sort of slow down their decision-making and then also in conjunction with that do you see pension plans curtailing their securities lending activity, at least in the near term?

Ronald Logue

We are seeing some curtailment in the securities lending programs. I think I said we had about 20% reduction in volume; that’s happening in a very orderly fashion. I would expect over time they would come back. I think we reported a very robust new business wins; I think it was $280 billion, some big wins. If we are seeing anything in reduction it is in new fund openings from existing customers there has probably been a slow down there, but the new business wins continue to be strong as evidenced by the $280 billion. If there is one thing we are seeing, it is this flight to quality.

One thing I can say is that the customers are not only concerned about their securities; they are concerned about the cash that goes along with the securities. Evidence the $54 billion in excess deposits. We have seen this, I remember 15 years ago having the same issue and where there was a flight to quality, so I think that is playing some role in some of the new business, which has been helpful for us, it is showing up in some of the names. The $280 billion in net new business is good and the pipeline for new business continues to be strong, so if there is a slow down it is probably in new funds being opened.

Operator

Your next question comes from Rob Rotschow from Deutsche Bank.

Rob Rotschow - Deutsche Bank

Is it your understanding that all of the assets that are in the conduits are available in these various Fed programs to be pledged?

Edward Resch

Our understanding right now is that most of them, but to have them actually put into the tarp would require us to bring them on the company’s balance sheet. I don’t believe they could go, as we know right now, directly from the conduit into the tarp.

Rob Rotschow - Deutsche Bank

Which of the assets are available for the CPF program?

Edward Resch

It is not the actual conduits, it is the commercial paper that the conduits issue and it is all of our dollar denominated paper for less than 90-days maturity issued by US issuers. We have two conduits that are non-US issuers and those are the ones that would be excluded, but those are the smaller ones.

Ronald Logue

We said about 22 out of 25.

Edward Resch

Right, those are the two big conduits in the US.

Rob Rotschow - Deutsche Bank

My second question is on the interest income. It seems like there are several moving parts there. You have the $50 to $60 million from the Fed program. Can you tell us what sort of spread you are earning on those Central Bank assets or excess reserves and then separately what the outlook is sort of excluding those two factors?

Edward Resch

What we’re earning on the Central Bank reserves is zero, which is why we are highlighting it, separating it out from the various calculations given the unique nature of the quarter and the liquidity position that we have.

In terms of the other side of the balance sheet we have demand deposits on which we pay nothing of $70 billion, so it’s a little bit of a unique situation where we have zero earning assets in the central banks and we have a lot of liquidity, as we described, on the liability side.

In terms of going forward we are going to be excluding the AMLF from our operating results. We think that that’s the right way to look at it as the program may be rather short-term in nature. In terms of the Central Bank balances we will break them out if in fact they continue to be of a significant size.

I would just point out that the normal excess liquidity that we have has been in the range of $15 to $20 billion. We have been carrying that since the stress started in the summer of ’07 and obviously that’s much lower than $54.

In terms of the earnings we earned 75 basis points going forward on the excess Fed balances as they pay on reserves.

Rob Rotschow - Deutsche Bank

I have a question on the securities lending. I think you have said you had maybe 400 clients. How many of those have sort of ceased operations at this point?

Ronald Logue

About 5%.

Rob Rotschow - Deutsche Bank

It seems like your assets under management were down a little bit more than the market. I am curious as to whether there are any area’s in particular where you have seen weakness or outflows and also if you could comment on what’s happening with your client funds, which I guess is probably not [interposing].

Ronald Logue

No there is not one particular area where we have seen a big decrease. What we are beginning to see is an increase, however, in passive funds and I think you are going to continue to see that trend over the coming months. I would expect that there will be some inflows on the passive side probably more than they had been in the past, but there is no one area that I can point to that has had a significant outflow.

Operator

Your next question comes from Nancy Bush with NAB Research LLC.

Nancy Bush – NAB Research LLC

Ron if you could just speak to the implications for your participation in whatever they are calling the thing that came out yesterday, you being one of the nine banks. I think you said there was a $2 billion investment versus the $3 that has been reported, is that correct?

Ronald Logue

$2 billion yes.

Nancy Bush – NAB Research LLC

What does this mean in terms of payment of dividends? I mean what are the constraints that are put upon you by participation in this program, because there is a tremendous amount of information and disinformation out there.

Ronald Logue

Well there is a 5% coupon on it. You can’t raise the dividend, can’t buy back stock without are probably the biggest ones.

Nancy Bush – NAB Research LLC

At what point do you buy this back? Are you able to buy this back, are you compelled to buy this back? If you could just, how do you get out of this?

Ronald Logue

We can buy it back probably any time in the next three years. The intent here I think, to put it in my words, is to jump start capital formation. Obviously as we go forward the way we look at this is an opportunity during a difficult time to get some more strength, but we need to continue to look at how we are going to strengthen our balance sheet and we also believe that we will pay this back within that period of time.

Nancy Bush – NAB Research LLC

I don’t know how else to ask this, but were you compelled to receive this investment as sort of a quid pro quo for being involved in these programs?

Ronald Logue

No. There was general consensus in that room that this is the right thing to do and I don’t feel that at all. This was important. This was important for all of us to do this.

Nancy Bush – NAB Research LLC

Secondly, on the TCE ratio at 4.8%, I mean obviously that is still quite high. Is there a level at which you would feel that you would need to raise common equity again?

Ronald Logue

I think in the past we have always targeted around 3%, anything lower than 3%.

Nancy Bush – NAB Research LLC

Okay so there is quite a ways to go there. Thirdly, just finally if I could get your and Ed’s observations on the credit market environment. Are we seeing any loosening of the credit markets etc…?

Ronald Logue

I think we saw some shreds come in yesterday a little bit. It is a little too early to tell, but we did see some effect yesterday and we will closely watch it.

Edward Resch

I think that is right. I mean we saw a very good day yesterday overall, but it is just one day.

Operator

Your next question comes from Brian Foran with Goldman Sachs.

Brian Foran - Goldman Sachs

On that 3% target, you have talked about it in the past. Should we think of that including or excluding conduit consolidation and should we think of it including or excluding the government preferred?

Edward Resch

The government preferred has no effect on it, but in terms of conduit consolidation we present the pro forma ration for that very purpose. Our lower boundary as we think about TC is 3% and we include the pro forma consolidation on a pro forma basis there.

Brian Foran - Goldman Sachs

Okay so to be clear, the 3.05% right now is the number we should be focused on relative to your 3% minimum?

Edward Resch

Yes.

Brian Foran - Goldman Sachs

Then secondly, if I go through the transcript here there have been about ten questions on the conduit for every one question on the core business. Is there any point where you would consider pro actively consolidating the conduit and just try to put it behind you and get people refocused on what seemed like some pretty good results in a difficult environment?

Ronald Logue

No, because that is not the way to spend the shareholders money. We think this is money good. I can think of a lot of better ways to spend the shareholders money.

Brian Foran - Goldman Sachs

At what point does positive operating leverage become impossible to maintain, if ever, if the market continues to be flat to down from here? Is there a point where the reinvestment needs of the business just become so big that you can’t cut costs?

Ronald Logue

No, I think we are doing a pretty good job cutting the costs, obviously, depending on how disrupted things could potentially get in the future that would have an effect, but I think we are getting a lot better at creating that lever. As we have said many times, in this business you can’t completely stop reinvesting, because is you do you fall behind and that is going to have long-term effects, as we have seen in the past; so it is really more of a question of how you spend the money as opposed to not spending the money. It is an art and I think we are beginning to learn how to do that pretty well, again, evidence this quarter. And if you think that we are going to be in a slower growth environment we are going to have to continue to do that.

We are not going to change our view or our objectives of trying to generate positive operating leverage. The way we will look at it is if it is going to be a slower growth environment next year fine, but we are going to have to grow faster than our competitors. If it is not 10,12, 15% whatever it is we have to target it to grow what we think is going to be faster than our competitors and that is kind of the mind set that we go into the is with and positive operating leverage plays a big role in that.

Operator

Your next question comes from Vivek Juneja with JPMorgan.

Vivek Juneja - JPMorgan

Ed the chance of common equity reversal, you changed your methodology this quarter. I guess apples-to-apples versus where you were last quarter you were probably around the 2.75% range, I want to confirm that. Then given that change in methodology did you change your thinking on your target?

Edward Resch

You are correct in highlighting the fact that we added the deferred tax liability. In this quarter we felt that that was more appropriate to do given the rating agency treatment of the deferred tax liability as well as what some of our peers do.

Relative to changing the target, that is something that we have under consideration.

Vivek Juneja - JPMorgan

Ron, you mentioned that you are seeing more of an influent of passive assets in the management. Is that a shift from the enhanced or is that just a shift from active? Can you talk a little bit more about that? I think people move out of those categories where they took on a little more risk for supposedly higher yields over time?

Ronald Logue

Yes I think it is just some new money coming in being parked for a while. That is what I really think is going on. I guess you could say it is from both, but we are also seeing new money coming in and it actually being parked for a while. I think then the opportunity for us is once we have it, as things get better, can we convert it.

Vivek Juneja - JPMorgan

Ed, going back to the AMLF, the initial fees as you are buying this paper you are benefiting from where the paper has been trading at, but when you look at it on an ongoing business, what are the fees that you are doing on this?

Edward Resch

Assuming a certain level of the AMLF on average for the quarter we think we could get in the range of $40 to $50 million of fees on this for the…

Vivek Juneja - JPMorgan

That is over 10 basis points?

Edward Resch

Excuse me, about 50 to 60 in the fourth quarter.

Vivek Juneja - JPMorgan

So is that a fee that you get for actually for just buying this paper and selling it to the Fed and just charging a 10, 15 basis point fee?

Edward Resch

Yes, that is the program.

Vivek Juneja - JPMorgan

Where are your unrealized losses post the quarter currently and where are assets under custody and asset under management levels currently given what’s happened thus far in the fourth quarter?

Edward Resch

The unrealized after tax losses on the portfolio as of last night are $3.8 billion, so they have increased a bit since quarter end. On the conduits it has increased slightly to $2.2 billion. Overall conduit size though has decreased to $24.7 billion from the quarter end balances. AUC and AUM I do not have for you as of the close of last night.

Kelly McDonald

Vivek, we don’t usually disclose quarter end interim month.

Edward Resch

My sense is it is not a whole lot different than quarter end.

Operator

Your last question comes from Betsy Graseck from Morgan Stanley.

Betsy Graseck - Morgan Stanley

In SSGA the strategies that you are taking in the liquidity space, the fixed income space, I mean clearly we’ve moved from enhanced more towards passive. I am wondering going forward as you kind of look at this business is there anything you would do structurally differently to either capture more client assets in a world where enhanced index might not be what the flavor of the day is over the next several years?

Ronald Logue

I think generally what the opportunity for us here is is to capture new relationships, because I think you are going to see this flight to passive. The opportunity is that once you capture a new relationship that you had not had in any way shape or form, how you can increase that relationship. In SSGA it is about moving up the spectrum, if you will, into more active products, and this is where the synergy takes place. No matter how you capture a new relationship if you don’t have it on the servicing site as well there is an opportunity for you.

I think the strategy for us is to capture new relationships and find ways to cross sell into that new relationship that we would not normally have had if it weren’t for the situation.

Betsy Graseck - Morgan Stanley

Can you give us a sense as to the number of new clients that you have been able to capture over the past couple of quarters here?

Ronald Logue

I can’t other than the ones that, if you go back and look at the last two quarters I have probably identified maybe 15 or 20 pretty significant names. I would say at least half of those are brand new relationships, if not more.

Betsy Graseck - Morgan Stanley

In the past you have spoken about the opportunities in Europe. Clearly Europe is having similar kinds of dislocations that we are seeing here. How does that impact the opportunities for you?

Ronald Logue

I think, this is my opinion and something that we need to prepare for, as soon as we begin to see ore normalized markets there are going to be significant opportunities because I think organizations are going to focus on how do we trim ourselves down and how are we going to be able to deal with maybe not this level of disruption but continued disruptions? So, we are planning to see, I think, some significant opportunities. When is that going to happen? I don’t know, first, second, third quarter of next year assuming some more normalized markets, but history does repeat itself and usually after some level of disruption there is this introspection that goes on and a willingness to find ways to turn fixed costs into variable costs in the asset management business. I think that we are going to see some opportunities, especially in Europe actually.

Betsy Graseck - Morgan Stanley

I just wonder because of the degree of government involvement does that push off, potentially, some of these strategic changes in the industry?

Ronald Logue

No, I think just the opposite. I think to the extent that asset managers would want to off load operations that are, I guess, not government controlled, but where the government is involved they would want to do that and get back to what they do best which is investing money. I think that will probably add to that.

Operator

There are no further calls.

Ronald Logue

We thought it was important that we accelerate our earnings call just because of what has been going on this week and to get out as much clarity and information as we possibly could, as fast as we could, and we look forward to participating with the government and getting to a point where we get back to normal markets.

Thank you very much for coming early this morning, we appreciate it.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: State Street Corporation Q3 2008 Earnings Call Transcript
This Transcript
All Transcripts