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

State Street Corporation (NYSE:STT)

Q2 2009 Earnings Call

July 21, 2009 9:30 am ET

Executives

Kelley MacDonald – Vice President, Investor Relations

Ronald Logue – Chairman, Chief Executive Officer

Edward Resch – Chief Financial Officer

Analysts

Michael Mayo – CLSA

Kenneth Usdin – Bank of America Securities

Brian Foran – Goldman Sachs

Glenn Schorr – UBS

Betsy Graseck – Morgan Stanley

Howard Chen – Credit Suisse

[Steven Wharton – J.P. Morgan]

Gerard Cassidy – RBC.

Operator

Welcome to State Street Corporation's second quarter call and webcast. Today's discussion is being broadcast live on State Street's web site at www.statestreet.com/stockholder. This call is also being recorded for replay. State Street's call is copyrighted. All rights are reserved. The call may not be recorded for rebroadcast or distribution in whole or in part without express written authorization from State Street and the only authorized broadcast of this call is housed on State Street's web site. (Operator Instructions)

Now, I'd like to introduce Kelley MacDonald, Senior Vice President for Investor Relations at State Street.

Kelley MacDonald

Before Ron Logue, our Chairman and CEO and CFO Ed Resch begin their remarks, I'd like to remind you that during this call we will 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 discussed in State Street's 2008 annual report on Form 10-K and it's subsequent filings with the SEC, including its current report on Form 8-K dated May 18, 2009.

We encourage you to review those filings including the sections on risk factors concerning any forward-looking statements we make today. Any such forward-looking statements speak only as of today, July 21, 2009 and the corporation does not undertake to revise such forward-looking statements to reflect events or changes after today.

I'd also like to remind you that you can find slide presentations regarding the corporation's investment portfolio as well as our second quarter earnings press release which includes reconciliations of non-GAAP measures referred to on this webcast in the investor relations portion of our website as referenced in our press release this morning.

Ronald Logue

Good morning everybody. The story of the second quarter can be told in two parts. First, the events that occurred and the decisions we made to put behind us the capital issues that we and the industry faced, and the attendant government involvement in those issues. And second, the hard work being done every day by thousands of State Streeters building their businesses, deepening their relationships with their customers and strengthening their control environments.

First of the story received all the headlines, but it's the second part of the story that is quietly building the strong post TARP State Street. Let me quickly review the significant capital related milestones of the quarter which have positioned us to take advantage of opportunities as they present themselves.

First, we passed the stress test administered by the Federal Reserve Bank, finishing with one of the highest Tier One capital and Tier One common ratios among the banks tested. Importantly, the stress test assumed consolidation of the conduits and applied what the Fed defined as a more adverse scenario to the assets. Even under the more adverse scenario, we finished with more that twice the required minimum for Tier One capital and Tier One common ratios at the end of the tested scenarios.

Given our strong results in passing the stress test, we elected to take action that resulted in consolidation of the conduits onto our balance sheet effective May 15, 2009. Under the new accounting rules, we would have been required to do so like everyone else on January 1, 2010.

At the same time, we saw an opportunity to raise capital and raised $2.3 billion of common equity, up from our original target of $1.5 billion due to increased investor demand. We also issued $500 million of non-government guaranteed long term senior debt, demonstrating our ability to access the capital markets.

Actually, we are the only bank of the original nine TARP banks to raise more capital than we were asked to take by the Treasury back in October, 2008. The strong stress test results and a highly successful capital raise completed which resulted in strong capital ratios, even after consolidation of the conduits, we applied to the Treasury to redeem the preferred stock issued to the Treasury in October of 2008.

We returned the money in June, and in the first week of July, we were the first of the original nine TARP banks to repurchase the related warrant issued to the Treasury when we were asked to take the money in October of 2008.

As you know, in February of this year, we announced a tangible common equity improvement plan that we continue to execute against. As of June 30, 2009 our tangible common equity ratio stands at 4.96%, up from 1.9% adjusted for consolidation of the conduits at the end of 2008. And now, above the original year end target of 4.91%, we set for ourselves back in February.

As Ed will discuss, we're now targeting the tangible common equity ratio to be about 6.5% by the end of the year, all else being equal.

So we've come a long way in a very short time, but we cannot be satisfied with where we are. The economy is still fragile. Our markets are still repairing. Unemployment is still high and housing is still a problem.

The strong capital position we've created must not only be protected, but it must continue to grow this year if we are to be successful in this new emerging environment, and the best way to do that is with consistently strong earnings.

So let me focus now on the second part of the story. Given what we have all been through and what awaits us on the other side of this crisis, coupled with the record results in 2008, it's hard to define strong earnings on a year over year basis. So what I'm looking for is quarterly progress and I'm defining that quarterly progress as new sales, strong expense control and improving risk management.

Let's talk about new sales first. As investment managers are faced with weak markets and increasing expenses, they're looking to us to turn some of their fixed cost into variable costs. In the second quarter, we won mandates of $347 billion of assets to be serviced. State Street global advisors added net inflows an increase of $45 billion in the second quarter, especially into passive and ETF strategies.

We continue to win hedge fund service and mandates like Caxton and Associates which we announced recently. As alternative funds are beginning to move away from prime brokers to independent third party administrators and custodians, we are seeing substantial new business. Caxton is a hedge fund manager for whom we will provide fund accounting, fund administration and tax services for five months totaling $6 billion in assets.

As of the second quarter of 2009, we now service $263 billion in hedge fund assets, up from $252 billion in the first quarter. In addition, we have successfully converted from a competitor, 38 John Hancock retail funds with approximately $15 billion in assets.

Vanguard Investments U.K. awarded us and our joint venture partner, International Financial Data Services, a mandate to provide an extensive range of service solutions for its launch of U.S. domiciled funds.

State Street has been retained by Goldman Sachs for services in Luxembourg, providing custody, fund administration and other services for $13 billion in assets. Goldman Sachs has been a client of State Street since 1992 in Luxembourg.

We're also providing custody, accounting and securities lending for the City of Edmonton, Canada of $2.2 billion. Wells Fargo awarded us an additional $170 billion in assets as part of their acquisition of Wachovia. We will provide custody and accounting services for them.

We've also been appointed by Pensplan, a pension fund service provider in Italy to provide a range of investment services for 100 million Euro. Our private equity servicing business has added 10 new clients in the second quarter and now has $136 billion in assets under administration, up from $101 billion in the second quarter of 2008.

In addition to winning the service business for the City of Edmonton, SSGA also won an equity mandate. The Arizona Public Safety Retirement System has selected SSGA to run a $2 billion impassive equity.

Our securities finance business is stabilizing, growing 11% from the first quarter primarily due to seasonal demand. Since the third quarter of 2008, of the customers who suspended their participation in our program, more than half have returned to the market. Spreads however, have continued to compress from all time highs in 2008.

It has become increasing important to us as we operate in a low growth environment to continue to build a core competency and expense control, which I think we've been demonstrating during this difficult period. Again this quarter, we achieve positive operating leverage compared to last year's second quarter and also this quarter on a sequential quarter basis, each on an operating basis.

The investments we made during the higher revenue growth periods over the past several years are paying off in efficiencies without the sacrifice of quality. Our reduction in force is substantially complete. Our realigned fund groups are efficiently installing our new business, expenses are well monitored and we are making additional investments in our IT and risk management infrastructures.

Notwithstanding our positive achievements in cost control, we have continued to invest in risk management personnel and infrastructure. I believe one of the strengths that has enabled us to navigate through this economic crisis these last two years is our ability to balance our well-known capability to generate revenue with an increased competency to efficiently install it and consistently generate positive operating leverage.

Now I'll turn the call over to Ed.

Edward Resch

Ron has covered many of our significant accomplishments in the second quarter and I'll explain in detail how some of those affect our company.

First, progress on our tangible common equity improvement plan that we announced at our investor and analyst day on February 5. Second the impact of consolidation of the asset backed commercial paper conduits onto the balance sheet. Third, the improvement in the unrealized losses of our investment portfolio and finally, I will review the results of the second quarter.

First the progress on our TC improvement plan. In the second quarter we improved our TC ratio from 2.2% at March 31, 2009 which assumed consolidation of the conduits, to 4.96% at June 30, 2009 ahead of our original target of 3.62% when we introduced the plan in February.

180 basis points came from the equity issuance in May. 51 basis points of this improvement came from our organic capital generation. 51 basis points also came from price improvement in the investment portfolio. 26 basis points came from securities paying down or maturing the investment portfolio and 8 basis points from our dividend reduction.

These contributors to improvement were offset partially by a negative 41 basis points due to an increase in the size of the balance sheet following consolidation of the conduits, and another 9 negative 9 basis points following the repayment of the TARP CPP investment.

By the end of the year we are targeting our TC ratio to be about 6.5% with the effects of the fixed income markets on our investment portfolio and our actual financial results being the primary affective influence this result. The details behind this target displayed on a quarterly basis, are listed on Slide 15 in the slides detailing the investment portfolio which you can find on our website.

Second, the consolidation of the asset backed commercial paper conduits onto our balance sheet. On May 15, 2009 we consolidated the conduits onto our balance sheet adding $16.1 billion of assets and recognizing a $3.7 billion after tax loss as an extraordinary charge in our income statement.

Consistent with our estimates of the credit quality of the assets described in the slides, we expect the vast majority of this loss to creep back into earnings over the next eight years, with about two-thirds of it occurring from the first five years.

In the second quarter the discount accretion on the investment securities recorded in net interest revenue was about $112 million. For the remainder of 2009, we expect about an additional $365 million to accrete into net interest revenue with about $900 million in 2010 and about $800 million in 2011.

This outlook is based on the same assumptions that we disclosed on May 15 that the CPR is in the range of 8 to 12 and that our credit analysis on the securities is correct.

Third, the improvement in our realized loss in our investment portfolio, the unrealized after tax loss improved again this quarter due principally to spread compression following an improvement last quarter. it has improved by about $1.6 billion after tax since December 31, 2008 to approximately $4.7 billion unrealized after tax loss at June 30, 2009, an improvement from the $5.9 billion after tax unrealized loss at March 31, 2009.

Now let me move on to a discussion of our second quarter results. This morning all of my comments will be based on our operating basis results as defined in today's press release. Comparing the second quarter of 2009 with the first quarter, servicing fee revenue increase 4% and management fee revenue was up 7%.

Clearly securities, finance and trading services revenue were weaker when compared with the very strong second quarter in 2008 which represented an unusual growth for both businesses. Both improved however, compared to the first quarter. Securities finance revenue increased 11%, primarily due to seasonality and trading was up 27%, particularly due to strengthened brokerage and other.

Compared to the first quarter, foreign exchange was down slightly due to lower spreads, offset partially by higher volumes, but brokerage and other fee income was up significantly, over 100%. Transition management was particularly strong as pension plans began to re-allocate assets as markets start to repair.

We had $359 billion of securities on loan on average in the second quarter of 2009 compared with $660 billion in the second quarter of 2008 and down from $399 billion on average in the first quarter of 2009.

About 16 customers who temporarily suspended participation in our program, have re-entered our program in the second quarter and about five new customers have joined our program. So in addition to the eight customers who returned in the first quarter, we believe participation in our program is firming.

Our program has also attracted customers from competitors who have confidence in the management and quality of our program. However, with spreads continuing to contract, we expect revenue in the second half of the year to continue to trend down from last year's record.

Average lendable assets for the second quarter of 2009 were $1.9 trillion, down about 32% from $2.8 trillion in the second quarter of 2008 in line with market declines as measured by the S&P 500 or the EFA. The duration of the securities finance book is approximately 25 days.

The decline in processing and other fees on a sequential quarter basis was primarily due to decreases in product related revenue. Of particular note, is the effect of the consolidation of the asset backed commercial paper conduits onto the balance sheet. Fees from those products are now reported as net interest revenue.

Net interest revenue on a fully taxable equivalent basis declined about 11% from the second quarter of 2008 and was up 4% from the first quarter of 2009. The decline from the second quarter of 2008 was primarily due to a customer deposit volumes and spreads, partially offset by the $112 million of discount accretion following the consolidation of the conduits on May 15, as well as wider spreads on the fixed rate securities in the investment portfolio.

The increase compared to the first quarter of 2009 was due primarily to the discount accretion. Otherwise, net interest revenue would have declined due to narrower spreads in both the investment portfolio and on customer deposits. Net interest margin of 193 basis points was down 10 basis points from the first quarter of 2009 on a fully taxable equivalent basis. Excluding the accretion, the net interest margin would have been 157 basis points which is in line with our prior outlook.

We recorded $26 million of net securities gains in the quarter. This is comprised of about $90 million in gains and about $64 in OTTI. The OTTI was primarily due to anticipated credit losses in Alt A and R&BS securities. In addition, we added $14 million to the allowance for loan losses in order to provide for expected losses on $580 million of commercial mortgage loans held on our balance sheet that were acquired in the fourth quarter of 2008.

Regarding operating basis expenses, a 25% decrease in second quarter expenses compared to the second quarter of 2008 and a 5% increase from the first quarter of 2009, I will comment on two areas. First, salaries and benefits declined 34% from the second quarter of 2008 due primarily to a reduction in incentive compensation in the second quarter of 2009 as well as the effect of our reduction in force which was substantially compete by the end of the first quarter.

Salaries and benefits decreased 5% compared to the first quarter primarily due to a lower level of accrual for incentive compensation in the second quarter of 2009. We substantially reduced incentive compensation in the first half of 2009 as part of our TC improvement plan. In the second half of 2009, we expect to accrue incentive compensation at a more normal rate of course based on our overall performance.

Other expenses also declined significantly in the second quarter of 2009, down about 26% from the second quarter of last year, but up 55% from the first quarter of 2009 which was at an unusually low level. This increase was due primarily to the special assessment of $26 million from the FDIC in the second quarter and unusually low securities processing costs in the first quarter.

We will continue to be vigilant in managing these expenses. As I indicated last quarter, we expect these expenses on an annual basis to be down about 15% from last year. While they are running lower than this percentage reflects in the first half of the year, we continue to carefully monitor these so as to be sure we align our revenues with our expenses.

Now let me turn to the investment portfolio. The size of the average investment portfolio in the second quarter has increased about $4 billion since the second quarter of 2008 due primarily to the consolidation of the conduit assets offset partially by run off and sales from the portfolio.

The unrealized after tax losses in our investment portfolio improved about $1.1 billion from March 31, 2009. In our investment portfolio slide presentation, we have updated the data through quarter end for you to review. As of June 30, 2009 our portfolio is 79.6% rated, triple or double A. 67.3% triple A and 12.3% double A.

While overall performance of the investment portfolio continues to be good, during the quarter, we experienced 164 down grades excluding the municipal bonds and seven defaults. Compared to the first quarter the pace of down grades in the second quarter slowed significantly by almost half. Most of the second quarter down grades were in non agency mortgages, corporate bonds and HELOC's.

Our excess liquidity returned to more normalized levels and stood at about $15 billion at June 30, down $9 billion from March 31, 2009 as investors began to deploy their cash. As of June 30, 2009, we deposited about $20 billion in excess balances with central banks, down from $52 billion at the end of 2008 and down from $30 billion at March 31, 2009.

Let me make a few brief comments about our outlook for net interest margin in 2009. First of all, 2008 was an anomalous year with unusually strong growth in net interest revenue and atypical net interest margin expansion.

Our assumptions for the rest of 2009 include that we will begin to reinvest those assets that have matured or are paying down given our strong capital ratios in order to better position us for the future. We plan to keep our investments very conservative, investing mostly in triple A asset backed and mortgage backed securities as well as agency securities.

As of June 30, 2009 we have about $13 billion in assets which we expect to mature or pay down in the remaining two quarters of 2009 which are currently priced at a dollar price of about $86.00 on average.

We expect interest earning assets to decrease between 5% and 10% over the remainder of 2009. This decline is dependent on the continual, gradual improvement in the markets and our ability to carry lower levels of excess liquidity.

We continue to expect the net interest margin to be between 210 and 220 basis points on average for the year, excluding the impact of the AML in the first quartet of this year.

In the first quarter the Bank of England reduced to 50 basis points. We expect it to remain there for the rest of the year. In the second quarter the ECB cut us overnight rates of 100 basis points and we also expect it to remain there for the rest of the year, and we expect the Fed to keep the overnight Fed funds rate at 0 basis points for the rest of the year.

So in conclusion, markets appear to us to be recovering slowly, and if that trend continues we expect revenues in the second half to strengthen slightly as compared to the first half. Servicing and management fees are recovering somewhat and our pipeline is strong, although decision making is slower than we expected coming into the year.

Participation in our securities lending program is firming, but we expect securities lending to be negatively impacted by contracting spreads in the second half of the year compared to the second half of 2008.

Unrealized losses appear to be improving as well, decreasing significantly from year end as I just covered.

We maintained good expense control this quarter and intend to continue this vigilance throughout the year. We remain committed to achieving positive operating leverage on an annual basis although not necessarily every quarter.

We are maintaining the full year outlook we announced on May 18. Operating earnings per share we expect to be between $4.25 and $4.50 per share. We expect a decline in operating revenue of approximately 12% compared to operating revenue in 2009 with the record year of 2008, and operating return on equity of approximately 17%.

Now I'll turn the call back to Ron.

Ronald Logue

So in conclusion, where do we stand? While signs of improvement continue to give us more confidence, we are still cautious about the outlook for the economy and the recovery. To address the uncertainties, we're focused on the factors we can control like servicing our customers, managing our expenses and investing for the future.

In doing so, we are well positioned for a return to more normalized markets. Our pipeline continues to be strong, but as Ed pointed out, decision making is slow as our customers are distracted by the many challenges of the unprecedented economic climate.

The 7% increase in our total fee revenue in the second quarter from the first quarter represents a trend which we hope to build upon in the second half of 2009. As a result of the capital raise and the conduit consolidation, we believe we have put the capital issues behind us and we can now spend more time talking to you about business trends. We believe we are well positioned for a market recovery, even if that recovery reflects a period of slower growth and to increase our market share, both in the U.S. and abroad.

So with that, Ed and I will be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Mayo – CLSA.

Michael Mayo – CLSA

Your assets under custody were up more than the fees, at least the way I'm looking at it and I'm just wondering why that might be the case. It raises questions are you, is it a timing issue or are you cutting price or am I missing something?

Ronald Logue

No, we're not necessarily cutting price. It could just be the conversion process itself as the assets come on and the lag in the recognition of the income as we go through phases of installation. That's probably the only thing I could give you. But there's been no change.

Michael Mayo – CLSA

The new business as a percentage of assets under custody, it's an impressive list you led off with. Wells Fargo, everybody else, all this business you're getting, but can you give us some context for what that new business represents as a percentage of assets under custody?

Edward Resch

I don't know if I could give you the percentage under custody. There are a couple of variables there. First of all, they're coming in bigger chunks, $170 billion is a big piece. I think one of the things we said in the past is we're usually the beneficiary of merger and acquisition activity and the Wells situation is a good example, Wells buying Wachovia where we were servicing most of the Wachovia assets.

The other thing that's a variable is we win a lot of business but don't necessarily get the assets right away or may not at all, assets under administration. We've been basically just showing you assets under custody. So we've been getting service fee revenue without necessarily getting some of the asset administration as a good example. Investment manger outsourcing is a second example. So there are a couple of variables there that skew those.

Michael Mayo – CLSA

Personnel expenses were down for the second quarter in a row. Are there any new initiatives and is that sustainable?

Ronald Logue

No, there aren't any initiatives. We're still watching very carefully. As you know when we had the reduction in the fourth, we focused on the higher levels and kept the service units basically intact. I think we're just going to continue to watch that very, very closely.

Michael Mayo – CLSA

The core margin just based on what you said is down almost 50 basis points. Are they from 2.03 on a core basis down to 1.57, and that's kind of like a wow sort of change and I guess the difference there is the accretion back to earnings after your charge. How should we think about that margin change and how should we think about the accretion back into earnings? Do you get compensated based on the benefits from that accretion to earnings? Just some context and how we should think about that as investors.

Ronald Logue

Let me take the first one and I'll turn it over to Ed as well. There's nothing different in terms of the margin of the basis service business. If anything, those fees and margins have been firming.

Edward Resch

I think part of the reason, excluding the discounted accretion, the fact that we have not aggressively as part of the TC improvement plan is part of the decline excluding the effect of the discount accretion. That's one of the reasons why we want to start in the second half of the year going back at the triple A level and investing some more in order to bolster that margin going forward.

In terms of the question on are we compensated based on the discount accretion, the answer is no. Our comp plans exclude the discount accretion coming back in this year and in future years.

Operator

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

Kenneth Usdin – Bank of America Securities

Just one quick follow up on margins. Are you still expecting a 210 to 220 full year margin? That assumes a meaningful jump from the 193 and I'm just wondering, have you already started putting money back to work so you get that snap back in the second quarter or does it really kind of power up as you get through the year and move into next?

Ronald Logue

We've not started yet. We are planning on starting shortly. It will be more back loaded to the fourth quarter just given the timing of things, but there will be some affect in the third quarter as we see it.

Kenneth Usdin – Bank of America Securities

I guess the bigger question on that margin also is just as far as understanding. So that should carry then into next year as a positive because if I'm assuming that you're going to be continuously reinvesting and seeing the benefits of moving a lot of amounts of low spread names and roll off into higher yielding, should we presume also that that should carry into next year as a trend?

Edward Resch

Well yes. One of the reasons why we want to start doing it now is we have a lot of the issues that Ron talked about in terms of the capital raise, consolidation etc. behind us. Ratios are real strong. We want to make sure that we capture at least some of the value that we see out there. Spreads have come in a lot on a lot of the securities that we've invested in and we've benefited from that in terms of the mark clearly. We definitely want to start positioning us for the second half of this year and into 2010.

Kenneth Usdin – Bank of America Securities

With regards to the OTTI that you took in the portfolio this quarter and the rest of the book, can you give us an understanding again of how much of the conduit, what are the implied credit losses that you have built into your conduit re-accretion? $900 million this year and $800 million the following year, what proportion of the recapture is that of the total write down?

Edward Resch

Let's start with the total charge which was about $6.1 billion pre tax, and based on our credit analysis, we would expect all but let's say $500 million of that to come back in over time. I'm just using a round number for illustration. But that's in the range that we actually expect.

So we would make a judgment that we have $500 million of credit losses coming our way in the future which we will not accrete back, so that leaves $5.6 billion pre tax to come back in over the next eight years as I said, with the majority of it being front loaded into the remainder of this year and 2010 and 2011.

So those are the high level assumptions. Relative to OTTI, there were no conduit related assets or former conduit related assets that were part of the OTTI this quarter. They were all the legacy portfolio before the consolidation of conduits.

Kenneth Usdin – Bank of America Securities

Can you give us the same kind of math from the rest of the portfolios? Since its $500 million on a $6.1 billion number, can you give us the relative similarity on the investment portfolio.

Edward Resch

There isn't similarity in terms of us having to make a judgment about expected credit losses relative to the portfolio. We do that every quarter and that's the basis for OTTI. We do still firmly believe, and this was validated by the results of the stress test, that the mark on the portfolio is reflective of very significant still ill liquidity and not fundamental economic weakness, not fundamental credit losses underlying those securities in the vast majority.

So I don't have an analogous number for you on the portfolio as I just described for the conduits.

Operator

Your next question comes from Brian Foran – Goldman Sachs.

Brian Foran – Goldman Sachs

I'm sorry if I missed it but in terms of the EPS guidance, historically you've given guidance. Where do we stand relative to that historical guidance and if you are not actually giving guidance, any rational on the decision to why not to do so anymore?

Edward Resch

I gave guidance, and it's basically the same as we gave on I think it was May. 18. No change to the previously announced guidance.

Brian Foran – Goldman Sachs

And the impact of the Wells notice you announced during the quarter?

Ronald Logue

I've nothing to say about that. Don't know any impact.

Brian Foran – Goldman Sachs

Your TC improvement plan, you're obviously tracking ahead of schedule here. Should we still expect in the February schedule you gave 100 to 150 basis points of back half TC improvement or is it more in line with the core earnings generation, more like 35 a quarter or 70 over the back half of the year?

Ronald Logue

We're targeting 6.5% by the end of the year and we're going to continue to achieve against that plan. The TC improvement plan is laid out quarter by quarter in the investment portfolio deck, Slide 15 gives you the quarterly breakdown.

Operator

Your next question comes from Glenn Schorr – UBS.

Glenn Schorr – UBS

If you look at the consolidated report, you see the breakdown of the $90 million, the $167 million OTTI and the $103 million losses not related to credit. Can you just give a little detail on, you just mentioned on Ken's question that the $167 million was OTTI but not related to the conduit. The consolidated assets is from the legacy securities portfolio. Can you give a little bit more color on where the gains were taken, where the OTTI, what kind of assets produced the OTTI $167 million and then a little bit more detail on the $103 million because that's the piece I'm not quite sure on.

Ronald Logue

Can I just clarify before I start answering. What page are you referring to?

Glenn Schorr – UBS

The first page of the trends, quarterly financial trends. You have gains and losses related to investment securities. You've got the $90 million, the $167 million, the $103 million.

Ronald Logue

Let me tell you where we took gains which is the $90 million or so and the impairments that we took. First of all, in terms of the gains we saw in the portfolio, a fair amount of agency mortgage backed securities get what we call pretty rich, and that's the entire asset class that we generated the gains from.

A lot of the securities saw significant price appreciation and significantly over par, some of them in the range of 105 or so, and we took our gains there based on what we thought was an appropriate timing given the valuations that we saw in the market.

The net of the $167 million and the $103 million and the $64 million which is what we took net, that is in two asset classes. It is Altay and non agency mortgage backed securities. The securities that have been on a watch list for awhile, we do as you know, a stress test every quarter on those securities and we saw that as time has passed, the year in which the securities first broke under the stress had moved in by a couple of years.

And again, this is measured over a couple quarters of time and based on that, we made the judgment that it was appropriate to impair these securities. It was a relatively small amount. I think it was in the range of five to 10 securities that we actually impaired, but it was based on our stress analysis and we did it under the new FAS 115 rule that came into effect this quarter.

Glenn Schorr – UBS

Is the separation in this display, the 167 million, the 103 million, just semantics? In other words, when we think of securities that's impaired, it just one less period and the net is the $164 million. You're just breaking out credit versus non credit?

Ronald Logue

No. This is just a presentation. Its 167 million is the old rule for the OTTI. 103 is the non credit element which is based on the new rule, the new 115. And 64 is the present value of the loss that we take. Remember the old rule required us if we decided to impair securities to bring it all the way down from book to market. The new rule requires us to take it from book down to just the credit loss, not all the way down to market if that happens to be lower. So this is just presentation.

Glenn Schorr – UBS

Can we talk about how often is the test and what would produce a change to the accretion. I know that you had lower amount of down grades as you mentioned, but the general portfolio, the credit quality still continues to move in that wrong direction. What produces a change in the accretion formula and is it all back loaded? In other words, how does the trigger work such that if down grades and OTTI are produced such that the $365 million, $900 million and $800 million remaining guidance on the accretion get impacted?

Ronald Logue

The fundamental thing that could change our expectation there is that we have a change in view of credit. So using the numbers I used before when I answered Ken's question, if the $500 million number became something other than $500 million, that would obviously affect the amount left to accrete and we have to make that judgment on the remaining former conduit securities every quarter, as to what our credit view is.

So that's something that could change the accretion.

Glenn Schorr – UBS

I just want to make sure. It's viewed as a total portfolio and accretion works from there as opposed to if certain securities start actually realizing losses earlier, it actually flows through OTTI.

Ronald Logue

No, it's viewed on a security by security basis. The credit view is one thing that could change our future accretion. The other thing that could significantly change our future accretion is the level of prepayments that actually occur. We have an assumption built into our expectation for the rest of this year and the numbers for next year and the year after that assume prepays.

So if those prepayments accelerate from what we're assuming, accretion will be higher. If they decelerate, accretion will be lower in future period. So credit assumptions and speed of prepayments are the two main drivers of that accretion coming back in.

Glenn Schorr – UBS

The lower tax rate, you gave some guidance in the text of your release. What's producing the lower tax rate for the rest of this year, because it's pretty low. Is it the loss taken on the conduit consolidation?

Edward Resch

That's part of it but the driver certainly this quarter and for the full year is that we're seeing more non foreign income than U.S. which is driving it a bit lower. And then we're seeing the affect in this quarter, and we'll see a bit of an affect in the next two quarters of the election we made in the first quarter under APB23 to permanently reinvest overseas earnings. So those are the two things that are driving the tax rate.

Glenn Schorr – UBS

When I listened to the discussion on the first couple of question on net interest margin, I'm sitting here thinking it's a little déjà vu and the way you and others have gotten into the situation we're in with having these huge unrealized losses and having the capital tested was reaching for yield a little bit. I feel like there's been lots of lessons learned, but I can't help but think, is it a bit too early to start reaching for yield because the guidance on the second half implied, has implicitly a pretty big boost in the second half.

Ronald Logue

The question as to when we started reinvesting is one that we've talked a lot about. We made a judgment to start soon so basically for the second half of this year. We're of a view that the securities that we have invested in and we expect to in the future invest in, are going to be high quality securities that we will subject to our normal credit processes and surveillance processes and everything that we've talked about.

We don't think we're acting inappropriately in reaching for yield too early. We think there's a judgment to be made obviously between staying out and continuing to basically invest in cash versus going back in and investing and starting to reinvest in order to position us for the second half of this year and into next year.

Glenn Schorr – UBS

I hear you and to be fair, you did say you reinvest in triple A mortgage agency. What type of duration securities are we talking so I can keep it in perspective.

Ronald Logue

Two to three year duration.

Glenn Schorr – UBS

So five year type maturities.

Ronald Logue

Yes. We're not going out there.

Glenn Schorr – UBS

You're going to take the gap, the asset liability gap, the rates you get?

Ronald Logue

Right now the gap is probably the narrowest it's ever been. It's about 10 basis points overall, so we feel like we can widen it out a little bit notwithstanding the fact that rates are probably at some point going to go up and not down further.

Operator

Your next question comes from Betsy Graseck – Morgan Stanley.

Betsy Graseck – Morgan Stanley

Could we talk a little bit about just the size of the balance sheet, just interested in understanding on the deposit side where you feel deposits are relative to stabilized to excess deposits over the last couple of quarters? How do you feel that's trending? Where do you think it goes to from here? Do you feel you still have excess deposits that are not and then talk a little bit about the assets?

Ronald Logue

The level of deposits to a great extent are consistent with the level of new business. With the new business, comes the deposits and it's either DDA here in the U.S. or transaction accounts outside the U.S. My sense is deposits will continue to, the volume of deposits will continue to increase as we bring on new business and that's been proven out in the past and I would expect that's going to continue. I see no change there.

Edward Resch

I think we're seeing customers put money back to work which we think overall is a positive thing. The markets are getting better. I hope our comments have reflected that kind of overall. We're seeing some movement in deposits back to what we call more normalized levels as that phenomenon occurs, but it's hard to say when normal will be reached, whatever that is.

But as Ron said, as we've seen in the past, as the business grows, especially non U.S. the deposits go with that. So we would expect to see that occur over the next couple of years, but right now I'd say we're coming back into more normalized deposit levels. I think if you just look at the amount of cash that we have on deposit from year end to June 30, you see a decline from roughly $50 billion down to $20 billion over that period of time, and that's a reflection of things getting back to normal and deposit levels getting back to more normal levels.

Betsy Graseck – Morgan Stanley

A question on the capital, you indicated TC going to 6.5% based on your current forecast by year end. How do you think about what your new normal is coming out of this environment?

Edward Resch

We haven't defined what a new normal is at this point. We continue to be as we said, cautious. We continue to want to grow capital. We're staying with at this point our previous guidelines in terms of 4.25% to 4.75% on the TC ratio. We have to revisit that to define what a new normal is.

But at this point we're comfortable with the TC growing from where it is now to where we project it to be at year end and we'll assess as we get farther into the year and into 2010.

Betsy Graseck – Morgan Stanley

Obviously there's the other side of that impact is ROE and in anticipating ROE at what point do you start to think about either dividends or buy backs? Can you give us some color as to how you're thinking through capital management and what you would use first and why?

Ronald Logue

I think one of the first things we want to take a look at is to see if there are opportunities to put some of that capital to work in terms of accretive deals. Our sense is that we're going to begin to see some of those things and I think there are going to be some attractive opportunities, the first place I would go to utilize some of this capital, because I think there's going to be an opportunity.

I think we're going to be able to execute because I think one of our core competencies is to integrate books of business. I think you're going to see some of that probably starting outside the United States before it starts inside the United States. So that's the first place we'd go.

Betsy Graseck – Morgan Stanley

And if those are not available?

Ronald Logue

Obviously what we'll take a look at instead, is take a look at the dividend some time in the future and I think it's just going to depend on the situation at the time.

Operator

Your next question comes from Howard Chen – Credit Suisse.

Howard Chen – Credit Suisse

In your prepared remarks you spoke about the firming of the transition management revenues driving the brokerage fees this quarter. Can you just remind me how lumpy or not the revenues typically are in that business? I'm just trying to gauge how to think about the resilience of those stronger brokerage fees.

Ronald Logue

I think what we've seen is as Ed said, money being back to work by the pension funds. I think we're going to continue to see that over time. I don't know if you have a comment about lumpiness Ed.

Edward Resch

It is a bit episodic. If you look at our volumes as in transition management, from the first quarter up to the second quarter they tripled resulting in the doubling of the results and non U.S. went up about 50%. But to put that in some context, the second quarter this year was about flat with the second quarter of last year in terms of volume. So it can move around. It's dependent on what customers are thinking about in terms of moving from asset manager to another.

Howard Chen – Credit Suisse

Just a follow up on other fee revenue items within the FX and sec lending businesses. In the past you've been really helpful in providing color on the movement and the balance of volumes and spreads. I was hoping you could do the same again this quarter with those two businesses.

Edward Resch

Sec lending for the second quarter we had assets on loan of about $400 billion to $415 billion. That compares to the second quarter of a year ago $670 billion. The spread was actually flat driven by the international equities program and the split was just down slightly from last year to this year.

If you want to look at sequential quarter, actually volume was up from about $400 billion to the $415 billion as I mentions since spread was up about 5 basis points with those fees actually being about flat. So t hose are high level metrics on securities finance.

In terms of FX total revenue was just about flat as we noted from Q1 to Q2 in the $190 million range. Volume was up about 9% and the customer weighted volatility was actually down from about 1.82% to 1.42% from Q1 to Q2. Those are the high level metrics on FX.

Howard Chen – Credit Suisse

Ron, in your prepared remarks you alluded to expense containment becoming increasing more important for the firm's strategy. I was curious, are the work force reductions announced in December now fully realized and second, can you speak to some of the other potential levels that you have to maintain that operating leverage that you and Ed were speaking about?

Ronald Logue

What we announced in January is complete. I've got 2,000 people less right now than we had. We do have some other levers. Obviously IT is one. I think in the past we've talked about modulating that somewhere between 21%, 22% and 25% of our operating expense, and we do do that. The good news I think is that in the past, we have significantly invested in IT and we're in pretty good shape in terms of capacity and in terms of product depth.

So there's not a whole lot of new significant IT expense so we're able to take a little bit. Obviously we've done a good job in moving work around and realigning the way we do things. When we did the reduction force it wasn't just 2,000 people across the board. It was a realignment of work which is also bringing efficiencies to us and I would expect some of that to continue.

Operator

Your next question comes from [Steven Wharton – J.P. Morgan]

[Steven Wharton – J.P. Morgan]

Betsy actually asked my question, but maybe I'll just follow up a little bit. One of the things I'm curious about is you mentioned acquisitions, accretive acquisitions and it seems like you've de-emphasized active asset management. I know you had taken some actions there and yet I know there are a number of properties on the market or rumored to be on the market. Is that an area that you're thinking that would interest you from an acquisition standpoint or are you thinking more on the custody side?

Ronald Logue

I was speaking more on the servicing side because I think there's going to be some opportunities there as well. Obviously there are some other types of opportunities but there's been some inflows in passive ETS so that seems to be working pretty well, but I was speaking mostly on the servicing side.

[Steven Wharton – J.P. Morgan]

6.5% tangible common is pretty high especially in light of the TC risk rated asset and Tier One common ratio that you already have and we're not even at the year end. I don't want to get ahead of ourselves but if you had to prioritize would your preference be share buy back or a dividend increase or vice versa?

Ronald Logue

My preference would be accretive acquisitions. I think we have to take a look at the dividend obviously and we probably will sometime next year, and then we'll take a look at share buy backs. But I think there are a lot of lessons that have been learned here and I think we can't lose sight of those lessons.

The preservation of capital is something that's also very important. I don't know what the new normal is going to be or even what the new metric is going to be. I think we have to be a little careful and not be premature in doing things. So there's a balance here I think that will evolve over two, three quarters, and I think we'll get to that point. But we have to attain that balance and not be too premature.

Operator

Your next question comes from Gerard Cassidy – RBC.

Gerard Cassidy – RBC

You talked about the customers coming back into the securities lending program. I think you mentioned in the first half you had about 24 of them come back. How many did you lose and what's the potential for more customers coming back in the second half of this year?

Edward Resch

The number that we talked about as having temporarily we hope, departed from the program was in the fourth quarter where we said about 10% of our customers in securities lending which is about 45 so based on the numbers that you just quoted, 24 is about half of them. We obviously don't know when and if the remaining customers are going to come back in or begin participating in the program.

They clearly have not left State Street as customers. They've just withdrawn from the securities lending program we hope temporarily. So there's another 24 or 25 of those customers that went on the sidelines in the fourth quarter that could potentially come back in.

Gerard Cassidy – RBC

Can you touch on the commercial mortgage backed securities that you have from the Lehman collateral. What's the status of that? I know you've marked it down. How comfortable are you with the mark and when do you think you could sell it or get rid of it?

Edward Resch

We have about $580 million on the books. It's marked at less than a 15 cent dollar price at this point. We're trying to manage it to realize the appropriate value. Clearly if we had an opportunity to sell it at what we thought was in a reasonable price, we would clearly do so. It's not a core competency or business or asset class that we particularly know or like, but we have it.

It's something that we evaluate every quarter. It's obviously in a sector that's experiencing some stress. If you look at what we've done the last two quarters, we've taken just about $100 million, $84 million last quarter, $14 this quarter against those loans to write them down based on our evaluation of expected cash flows. We'll do it every quarter and it's something that we're monitoring very closely.

Ronald Logue

Thank you very much. I appreciate your time and attention this morning and we'll talk to you again soon.

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 Q2 2009 Earnings Call Transcript
This Transcript
All Transcripts