Is State Street's Demise a Self-Fulfilling Prophecy?

Includes: AMBC, MBI, STT
by: Ron Finberg

State Street's (NYSE:STT) losses accompanied by their initial statements reminds me very much of MBI and ABK when they first began to crack followed by their impending crash. Two statements from STT's announcement that are striking are as follows:

  1. Comment about capital levels: “State Street evaluates the market from time to time. Following recent discussions with investors, State Street has determined not to raise equity capital in this turbulent market.”
  2. Statement that losses have improved: “Since year end the unrealized after-tax losses in the investment portfolio have improved $400 million to $5.9 billion as of Friday, January 16, 2009.”

The first statement seems to be management saying that they are aware of the problem and have conducted due diligence ($3.6 billion in additional mark-to-market losses didn’t occur out of nowhere), and only then decided that they are amply capitalized.

The second statement is STT’s way of saying, “it isn’t all that bad”. For the record, BK used language similar language when it described securities write-downs in its 4th quarter report:

We believe that the actual incurred loss will ultimately be materially lower based on current assumptions.

Similar to STT, we have two quotes from MBIA’s quarter report (October 25, 2007) when the stock was at $47.

The decline was due to a pre-tax net loss of $352.4 million, or $1.80 per share, that the Company recorded in the third quarter on financial instruments at fair value ("marked-to-market") and foreign exchange. The loss was a consequence of wider spreads affecting the valuation of the Company's structured credit derivatives portfolio. Compared with the previous quarter, spreads widened significantly on Commercial Mortgage-Backed Securities (CMBS) collateral and on other asset-backed collateral in the Company's structured credit derivatives portfolio. The Company believes that the "mark-to-market" loss does not reflect material credit impairment.

Also, a statement from Gary Dunton, MBIA Chairman and Chief Executive Officer,

We remain comfortable that our insured credit derivatives portfolio will not result in material credit losses. More important, wider spreads contributed to a substantially better pricing environment for our insurance and asset/liability management products.

Here too, we have MBI stating that losses are only mark to market, and over the long term, the increased volatility will only strengthen their business. The obvious end was that credit spreads continued to widen, mark to market losses, although they aren’t real yet, DO MATTER, and MBI was ill prepared to handle the situation.

The above situation of mark to market losses, write downs, and the need to increase capital has obviously been common among traditional banks, but I think the comparison of STT to the mortgage insurers is more applicable.

During 2007, ABK and MBI were recording record revenues and their “annuity” type business plan was growing. STT, although its assets under custodial management have decreased, has seen an increase in customers for its primary business, and has been a beneficiary of the move to ETFs. However, both were been burned by their inability to manage their secondary business (but not an upfront revenue generator) of gauging risks and potential effects.

Like the insurers before them, STT has gone on the offensive to differentiate themselves from traditional banks, but the more than doubling of their losses has telegraphed to the market that they are more than just a financial trust company collecting fees for custodial services and not immune from the crisis.

The obvious question becomes STT‘s survival. Fellow trusts BK and NTRS, who came out with healthier reports, will most likely aggressively go after STT’s custodial business. Also, STT may see a serious exit of deposits from their low risk money market accounts if the clients sense a danger of NAV levels less than $1.00 par.

On the positive side, and this is a big positive, STT’s custodial customers have a vested interest in STT staying solvent and a fully functioning company. For large institutional clients, a switch of trust companies will inevitability lead to increased expenses as the two sides work out compatibility issues. In this environment, financial firms aren’t willing to face increased expenses that aren’t definitively necessary.

To conclude, STT in all likelihood is well capitalized to survive its current losses, but like MBI and ABK, it has exposed itself to numerous dangerous fronts that could lead to its demise a lot quicker than anticipated.

Disclosure: no positions