Northern Trust Corporation Q2 2009 Earnings Call Transcript

Jul.22.09 | About: Northern Trust (NTRS)

Northern Trust Corporation (NASDAQ:NTRS)

Q2 2009 Earnings Call

July 22, 2009 12:00 pm ET

Executives

Bev Fleming – Director of Investor Relations

Steven L. Fradkin – Chief Financial Officer & Executive Vice President

Aileen B. Blake – Executive Vice President & Controller

Preeti Sullivan – Investor Relations Team

Analysts

Brian Foran – Goldman Sachs

Michael Mayo – Calyon Securities (NYSE:USA), Inc.

Glen Shore – UBS

Nancy Bush – NAB Research

Thomas McCrohan – Janney Montgomery Scott, LLC

Robert Lee – Keefe, Bruyette & Woods

Ken Usdin – Bank of America

Betsy Graseck – Morgan Stanley

Howard Chen – Credit Suisse

John Stilmar – SunTrust Robinson Humphrey

Marty Mosby – FTN Equity Capital Markets

Operator

Welcome to the Northern Trust Corporation second quarter earnings conference call. Today’s call is being recorded. At this time I would like to turn the conference over to the Director of Investor Relations Bev Fleming.

Bev Fleming

Welcome to Northern Trust Corporation’s second quarter 2009 earnings conference call. Joining me on our call this morning are Steve Fradkin, Northern Trust’s Chief Financial Officer; Aileen Blake, Controller and Preeti Sullivan from our Investor Relations Team. For those of you who did not receive our second quarter earnings press release or financial trends report via email this morning, they are both available on our website at www.NorthernTrust.com. In addition, this July 22nd call is being webcast live on www.NorthernTrust.com. The only authorized rebroadcast of this call is the replay that will be available through July 29th. Northern Trust disclaims any continuing accuracy of the information provided in this call after today.

Now, for our Safe Harbor statement; what we say during today’s conference call may include forward-looking statements which are Northern Trust’s current estimates or expectations of future events or future results. Actual results of course, could differ materially from those indicated by these statements because the realization of those results is subject to many risks and uncertainties. I urge you to read our 2008 annual report and our periodic reports to the Securities & Exchange Commission for detailed information about factors that could affect actual results.

Thank you again for your time today. Let me turn the call over to Steve Fradkin.

Steven L. Fradkin

Let me join Bev in welcoming all of you to Northern Trust’s second quarter 2009 earnings conference call. Earlier this morning Northern Trust reported second quarter 2009 net income of $314 million, an increase of 46% versus a year ago period. Net income applicable to common stock which includes the impact of both dividends and discount accretion related to the redemption of preferred shares in the quarter equaled $226 million or $0.95 per common share. This compares with net income of $216 million or $0.96 per share earned in last year’s second quarter.

To assist you in understanding our performance this quarter, we have organized today’s remarks in to the following sections: first, I will highlight several items that you should be mindful of as you evaluate our performance; second, I will profile certain second quarter market conditions that impacted our performance; third, I will review our financial performance focusing on those items that most impacted our results; fourth, I will offer a few perspectives on the operating environment and on the strategic and financial positioning of Northern Trust; and finally, Bev and I will be pleased to answer your questions.

Let me begin by highlighting six items that you should be mindful of as you evaluate our performance this quarter. First, during the second quarter Northern Trust successfully completed an issuance of new common stock which increased our capital base by approximately $835 million. Shares outstanding increased from 223.7 million on March 31st to 241.4 million on June 30th, an increase of 17.7 million shares. In addition, we successfully issued $500 million in senior notes.

Second, the combination of the common stock offering and debt issuance along with additional resources positioned Northern Trust to be one of the first large banks to redeem the preferred shares sold to the US Treasury as part of the TARP capital purchase program. We successfully repurchased 1.576 billion of preferred shares on June 17th. As previously announced, our second quarter financial results were reduced by $0.37 per share associated with the preferred stock. This reduction was comprised of $68.6 million or $0.29 per share of accelerated discount accretion associated with the redemption and $19.5 million or $0.08 per share in preferred dividends recorded through the June 17th redemption date.

Third, our trust investment and other servicing fees in the corporate and institutional services business unit benefited from improved fix income market conditions in the second quarter. Specifically, our securities lending fees equaled $172.5 million in the second quarter which included approximately $129 million in positive marks associated with one mark-to-market investment fund used by certain securities lending clients. This compares with $25 million in positive marks in the second quarter of 2008 and $52 million in negative marks in the first quarter of this year.

On a cumulative basis, dating back to the third quarter of 2007, the second quarter’s positive impact of $129 million reduces to approximately $222 million the cumulative impact that negative marks have had on our securities lending fees. Fourth, on April 1st Northern Trust adopted financial accounting standards for its staff position number 115-2 and 124-2 which were designed to create greater clarity and consistency in the industry for impairment losses on securities.

Adoption of this guidance impacted our results in three ways, first, we recorded $18 million or $0.05 per share in other than temporary impairment through the income statement related to credit losses on certain residential mortgage backed securities. $4 million of that amount related to further credit impairment of three securities that were previously determined to be impaired in 2008. $14 million related to five additional securities on which we have taken credit loss impairment in the second quarter. Second, the non-credit portion of impairment previously recognized in 2008 and equal to $15 million pre-tax was reclassified from retained earnings to accumulated other comprehensive income. This reclassification had no impact on capital as it was a reallocation from one capital category, retained earnings, to another accumulated other comprehensive income. Third, we recorded $40 million of non-credit related losses in the second quarter to other comprehensive income.

Moving on to the fifth item that impacted our second quarter results, other operating expense included $130 million of decrease in expense associated with the fair value of our liability under the capital support agreements that we entered in to in early 2008. During the second quarter the Whistlejacket structured investment vehicle, a security held in certain funds covered by the capital support agreements completed its restructuring and final settlement. Per the terms of the capital support agreements, Northern Trust made cash payments totaling $67 million to the covered funds and therefore extinguished seven of the nine capital support agreements.

Two capital support agreements remain with the maturity date of November 6, 2009 at an aggregate maximum remaining exposure of $200 million. The current fair value associated with that remaining $200 million liability is approximately $125 million. Finally, other operating expense included approximately $20 million in expense payable to the Federal Deposit Insurance Corporation in connection with an industry wide special assessment imposed on all insured banks.

Let me now profile certain second quarter market conditions to provide context for our trust, investment and other servicing fees which represented 58% of total revenues in the second quarter. The equity market environment showed signs of improvement in the second quarter but remains at levels well below one year ago. The S&P 500 was down 28.2% on June 30th when compared with the prior year but improved 15.2% during the second quarter.

Because some of our trust, investment and other servicing fees are earned based on the lagged market values, let me review for you those impacts. Equity market performance calculated on a one quarter lag basis which is the methodology used for calculating CNIS custody and PFS wealth management fees was weak as the S&P 500 declined by 39.7% year-over-year and declined by 11.7% sequentially on a one quarter lag basis. Using the month lag methodology that applies to PFS fees excluding wealth management, the S&P 500 was down 37% versus the prior year but increased 5.1% versus the first quarter.

Equity market levels also impact the value of client assets that we report both in assets under management and assets under custody. This in turn impacts the fees that we earned for those services provided to clients. While we are encouraged by the improvement in the equity markets during the second quarter, the impact of that improvement is muted in the near term due to the lag nature of certain fees.

Now, let me review our second quarter results beginning with revenues. Revenues in the second quarter equaled $1.05 billion, representing a decline of 4% or $49 million compared to last year. Revenues increased 16% or $141 million on a sequential quarter basis. Trust, investment and other servicing fees of $601 million, decreased 7% year-over-year or a decline of $44 million. On a sequential quarter basis trust, investment and other servicing fees increased 46% or $191 million. In our institutional business, CNIS trust, investment and other servicing fees equaled $391 million in the second quarter, a decrease of 4% or $18 million year-over-year but an increase of 89% or $184 million on a sequential quarter basis.

CNIS fees include three primary revenue areas: custody and fund administration; institutional asset management; and securities lending. Let me discuss the performance of each in the second quarter. CNIS custody and fund administration fees equaled $141 million in the second quarter, down 19% or $32 million year-over-year. On a sequential quarter basis, CNIS custody and fund administration fees increased 3% or $4 million. Our year-over-year results reflect our ability to partially offset the negative of significant market value declines with new business wins in global and domestic custody and in fund administration. On a sequential quarter basis, fee growth also reflects our new business success partially tempered by still weak quarter lag markets.

Investment management fees in CNIS equaled $61 million in the second quarter, a decrease of 15% or $11 million year-over-year. The weak equity market environment on a year-over-year basis served as a considerable headwind for institutional investment management fees. New business however, helped to offset those headwinds particularly in our quantitative management, cash and institutional mutual fund businesses. On a sequential quarter basis, investment management fees increased 1% or $1 million.

As I mentioned in my opening comments, CNIS securities lending fees equaled $172.5 million in the second quarter. Results this quarter were significantly impacted by the $120 million in positive marks in the mark-to-market securities lending collateral fund. Excluding the impact of the mark-to-market fund across all periods, CNIS securities lending fees declined 65% year-over-year and 1% sequentially. On an adjusted basis, the year-over-year decline was primarily attributable to lower average volumes as market depreciation contracted the value of securities on loan and borrower demand was significantly lower than a year ago. The modest sequential decline was also due to lower average volumes partially offset by the traditional seasonal uplift of the securities lending international dividend season.

Let me offer a few reminders on the mark-to-market fund that was the source of the positive marks this quarter. First, we have only one mark-to-market collateral investment fund for our securities lending business. This mark-to-market fund has followed its investment guidelines consistently and appropriately. No A typical portfolio management decisions have been made in the fund. Second, the fund does not use leverage. Third, the fund is managed with a conservative interest rate sensitivity of 38 days and a credit based weighted average maturity of 1.65 years as of quarter end. 34% of the securities held in the fund are rated either AAA or AA. The fund is 25% invested in corporate notes issued by the banking sector, 35% issued by finance and insurance companies, 6% in other corporate notes and the remainder in asset backed securities and cash.

Last quarter we brought to your attention an index which has corresponded reasonably well but not perfectly with the performance of this mark-to-market fund. While the Merrill Lynch US Corporate Master Index is not a match for the fund, its monthly returns over the last few years have related reasonably well to the monthly returns of the mark-to-market fund. This proved to be directionally helpful in the second quarter as the Merrill Lynch Index and our mark-to-market fund both had strong performance in the second quarter on the heels of improving fixed income markets.

The three components of our institutional fees that I just discussed, are all impacted by the value of assets that we custody, administer and manage for our institutional clients. Let me take a minute to review our various client asset levels with you. Institutional assets under custody equaled $2.9 trillion at quarter end, down 20% from a year ago, yet up 14% versus last quarter. Global custody assets which are a component of total CNIS assets under custody equaled $1.6 trillion at quarter end, down 19% year-over-year and up 21% on a sequential quarter basis. The year-over-year decline primarily reflects lower market values as the S&P 500 fell 28.2% year-over-year and the [EFA] Index declined 27.9%.

The sequential quarter increase in institutional assets under custody represents improving equity markets as the S&P 500 was up 15.2% in the quarter and the [EFA] Index was up 15.4%. In addition, the higher sequential quarter level of institutional assets under custody was positively impacted by the weaker US dollar. The weaker US dollar in the second quarter positively impacted the US dollar equivalent market value of global assets that we custody for clients. Recall, that global custody assets represent more than 50% of our total CNIS assets under custody.

Managed assets for institutional clients equaled $422 billion at quarter end, down 31% with one year ago, yet up 8% sequentially. Excluding securities lending collateral from CNIS assets under management, managed assets for institutional clients were down 13% year-over-year and up 8% sequentially. Securities lending collateral equaled $101 billion at quarter end down 58% versus a year ago and up 6% compared with March 31st. Compared with one year ago, the lower level of securities lending collateral reflects three factors: first, lower market values; second, a reduction in borrower demand; and third, client decisions to reduce or suspend their securities lending activities during the difficult market environment. Market appreciation in the second quarter was the primary driver of the sequential quarter increase in securities lending collateral offset partially by the impact of lower borrower demand.

Let me now switch to our personal business which we refer to as personal financial services of PFS. Trust, investment and other servicing fees in PFS equaled $211 million in the second quarter representing a decrease of 11% or $25 million year-over-year. On a sequential quarter basis, PFS fees increased 3% or $7 million. Our PFS net new business results were on par with that experienced in last year’s second quarter and were 13% higher than the level achieved in this year’s first quarter. Net new business in Florida was particularly strong coming in at twice the level won last quarter.

Fees in PFS are derived from the assets that we managed in custody for personal clients. PFS assets under management equaled $137 billion at quarter end, down 4% from a year ago and up 5% from last quarter. Assets under custody in PFS equaled $300 billion on June 30th, down 8% year-over-year and up 7% from last quarter. The year-over-year performance compares once again to the back drop of a very difficult market environment which saw a 28.2% decline in the S&P 500 year over year. Market improvement during the second quarter combined with recent new business success fueled the higher level of PFS client assets at June 30th.

Net interest income equaled $260 million in the second quarter, up 5% when compared to the second quarter of 2008. Excluding a leasing related adjustment of $29.4 million recorded in last year’s second quarter, net interest income decreased 7% on a year-over-year basis. The net interest margin equaled 1.59% in the second quarter, 19 basis points lower than the leasing adjusted net interest margin of 1.78% last year. The current quarter’s lower net interest income and net interest margin on an adjusted basis primarily reflect the low interest rate environment which diminished the value of non-interest related funding. On a sequential quarter basis net interest income decreased 10% and the net interest margin declined by nine basis points.

Average earning assets declined 5% on a sequential quarter basis primarily reflecting decisions by CNIS international clients to place a lower level of cash in non-US deposit accounts as the markets rose during the quarter which in turn drove a lower level of investment in money market assets. In addition, the net interest spread declined nine basis points sequentially reflecting spread tightening at the short end of the yield curve.

Foreign exchange trading income equaled $134 million, up 6% compared with the second quarter last year. This represents our third best quarter ever in foreign exchange trading income. On a sequential quarter basis, foreign exchange trading income increased 2%. Currency volatility remained elevated compared to historical levels but declined over the course of the second quarter as markets stabilized. On a sequential quarter basis, client volumes increased on the back of the recovering market environment.

Other operating income equaled $28 million in the second quarter, down 19% year-over-year. The decrease primarily reflects the lower value of certain credit default swaps and lower custody related deposit revenues partially offset by higher commercial loan fees. On a sequential quarter basis, other operating income declined 24%. The first quarter of 2009 included $7.8 million in gains resulting from the sale of leased equipment. Adjusting for that item, other operating income would have decreased 4% sequentially primarily reflecting the lower value of credit default swaps.

During the second quarter we recorded a loan loss provision of $60 million compared with a $10 million provision last year and a $55 million provision in the first quarter. Our reserve for credit losses equaled $319 million at June 30th, up 74% or $136 million from June 30th last year reflecting the weak economic climate. Non-performing assets equaled $234 million at quarter end, an increase of $62 million in the quarter and represented 81 basis points of total loans at quarter end. Net charge offs equaled $44 million. Despite elevated levels of non-performing assets and charge offs of a very low historic base, Northern Trust’s conservative and focused lending practices have allowed us to weather this credit cycle better than many industry peers.

Credit quality within our balance sheet investment portfolio continues to profile very well when compared with industry peers. Gross unrealized losses on our $16 billion available for sale securities portfolio equaled approximately $230 million pre-tax on June 30th, down 29% or $94 million from $324 million on March 31st.

Now, let me shift my comments to a review of the key expense categories that impacted our second quarter performance. Expenses equaled $503 million in the second quarter representing a decrease of 22% year-over-year and 15% sequentially. Recall my earlier comments regarding two especially noteworthy items that impacted second quarter expenses. The first noteworthy item was a $130 million decrease in expense associated with the fair value of our liability under the capital support agreement that we entered in to in early 2008 and the second was a $20 million increase related to a special deposit insurance assessment levied by the FDIC. Absent these two items, expenses would have decreased 5% year-over-year and increased 3% sequentially.

Compensation expenses equaled $288 million and decreased 6% or $18 million from the year ago period. The year-over-year decrease in compensation expense reflects lower incentive compensation partially offset by higher year-over-year staffing levels and annual merit salary increases. Staffing levels equaled approximately 12,400 full time equivalent positions at quarter end, an increase of 5% year-over-year and 1% sequentially. New staff positions on both the year-over-year and sequential quarter basis are concentrated in the Asia Pacific region.

On a sequential quarter basis, compensation expense increased 12% or $30 million primarily reflecting higher incentive compensation accruals. Employee benefit expenses equaled $62 million in the second quarter, a decrease of 2% or $1 million versus last year and 6% or $4 million sequentially. The year-over-year decline primarily reflects lower defined contribution plan expense. The sequential quarter decline primarily reflects lower defined contribution plan expense and FICA insurance expense.

Outside services expense equaled $102 million, a decrease of 4% or $4 million compared with last year. The year-over-year decrease reflects the impact of lower market values of sub custodian and investment management sub advisory expenses. Outside services expense was up 7% or $6 million sequentially resulting primarily from the impact of higher market values on sub custody and sub advisory expenses as well as higher legal expense and technical services expense.

Other operating expense equaled a -$50.8 million in the second quarter compared with $72 million one year ago and $70 million last quarter. Recall from my earlier comments that the other operating expense included a $130 million decrease in expense associated with the fair value of our liability under the capital support agreements that we entered in to in early 2008. Excluding the impact of this item from all periods, other operating expense would have equaled $79 million, up 12% or $9 million year-over-year and up 28% or $17 million sequentially. The increase in both periods primarily reflects the higher FDIC insurance expense that I discussed earlier offset by lower business promotion expense.

Let me wrap up today’s call by offering a few thoughts on the environment and on the strategic and financial positioning of Northern Trust. The overall environment in which Northern Trust operated in the second quarter displayed a variety of cross current sending very mixed signals. On the one hand and to the positive equity markets began to revive as exemplified in the quarters’ 15% increase in the S&P 500 index. This was a most welcome sign but does not immediately and fully benefit many of Northern Trust revenue streams given the lag nature of some of our fee billing practices.

Another welcome sign during the second quarter was the overall improvement in the fixed income market. The second quarter saw investors move back in to many sectors of the fixed income market. The value of some corporate bonds and asset backed securities for example, recovered to levels not seen since before the September 2008 financial crisis. This shift in fixed income market sentiment had a meaningful impact on our results in the quarter including significant reversals of prior period negative marks in security lending and a reduction in the fair value cost of our liability under the capital support agreements.

On the other hand and to the negative, equity markets continue to be significantly below year ago levels as again exemplified by the S&P 500 which notwithstanding its rise in the quarter was still 28% below the year ago period. Lower year-over-year equity markets in tandem with very low interest rates continue to provide headwinds for some of our largest revenue streams. These market factors coupled with increasing unemployment and other economic strain on both individuals and businesses add to the negative cross currents.

While we at Northern Trust are proud of our track record of effective business and risk management across many fronts, we are not immune to these environmental difficulties. We remain focused on a heightened level of vigilance amidst encouraging signs of improvement on the one hand and a still fragile and tenuous environment on the other.

From a strategic perspective, we continue to be very well positioned in attractive businesses where we have distinctive, competitive advantages. We focus on two excellent segments of the financial services industry: serving affluent private clients primarily in the United States; and institutional clients globally. We support our clients with a broad array of asset servicing, investment management, fiduciary and banking solutions and have been viewed as many as a provider of choice throughout the financial crisis. Our strategic position of strength has fueled strong new business results across the past year.

From a financial perspective, we continue to be extremely well capitalized in absolute terms relative to our industry peers and relative to our conservative risk profile and appetite. This is not a new phenomena embarked on during the recent financial crisis, this has been the long standing heritage of Northern Trust that has served our shareholders and our clients well across the years.

Just a few examples on this front, our capital ratios remain very strong at the end of the second quarter even after redeeming the preferred shares. The corporation’s tier I capital ratio was 12.6% at quarter end, an increase from 9.8% in the year ago period. The corporation’s total capital ratio was 15%, up from 11.7% a year ago. The corporation’s tier I common equity ratio stood at 12.1% at the end of the second quarter compared with 9.3% in the comparable period last year and our tangible common equity ratio equaled 7.6% compared with 6% last year. Recall too, that Northern Trust is one of only two banks in the top 25 in the United States that did not reduce its dividend throughout the current financial crisis.

In sum, from a financial perspective, we continue to be very strong and very uniquely positioned. Lastly, we are maintaining our relentless focus on our clients. Market conditions have created strain for everyone including our personal and institutional clients. While we wish these conditions and the related pressures did not exist, we continue to focus very accurately on helping our clients to navigate through these storms charting the best possible course.

Within every crisis there is opportunity. We remain focused on helping our clients with capabilities, service and insight that become even more important in times of strife. Let me again thank you for joining Northern Trust for this second quarter 2009 conference call and now Bev and I would be happy to answer your questions. Operator, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Brian Foran – Goldman Sachs.

Brian Foran – Goldman Sachs

I apologize, I joined late and so if I missed this in the prepared remarks, but in the past you’ve talked about the market share gains in PFS not translating to revenue because a lot of clients were sitting in cash. Are you still experiencing the same level of market share gains? Either way, are the market share gains over the past nine months still sitting in cash or is that a potential revenue tailwind in the future?

Steven L. Fradkin

Brian, I would just [inaudible] with the term market share gains only because our general counsel would not like that term, market share is very hard to gain. But, I think I would instead say momentum and very good performance in terms of winning but I can’t technically prove to you market share. With that caveat I would say I guess two observations: one, our new business in PFS continues to be strong and we feel very good about that; and on the margin I think as the S&P 500 rose in the quarter and as you saw through a variety of metrics that we talked about, there was an appetite to get back in the markets.

I’ll caveat that by saying I think there are still some scars out there and people have been wounded and so cash is still if you will a desirable commodity. But, I’d say on the margin it was an improvement from a quarter ago period in terms of moving in to the markets.

Operator

Your next question comes from Michael Mayo – Calyon Securities (USA), Inc.

Michael Mayo – Calyon Securities (USA), Inc.

The margin and spread revenues, it’s down for you, it’s down for all the trust banks, can you just give us some context of what’s driving that and where you think the spread revenues go? You’re kind of retracing from the steps you took over the past couple of years in terms of NII.

Steven L. Fradkin

Well, I think you know we have a long standing and conservative philosophy vis-à-vis our securities portfolio. I think it’s far to say as exemplified by recent results relative to the industry that that philosophy on average over time has served us very, very well. We haven’t changed that philosophy and we are not seeking additional risk in our investment portfolio in a quest for higher yield. On the securities portfolio, we’re continuing to purchase the highest quality securities, agency debentures, agency mortgages, government guaranteed debt and on average these assets have a repricing characteristic for us of less than 90 days.

Speaking to the next interest margin more directly, as I said it was at 1.59% down nine basis points from 168 last quarter and down 19 basis points from a year ago if you adjust the year ago period for that onetime leasing issue. While we can’t provide any guidance as you know, let me offer a couple of observations that I hope will help. First, I’d say that very low interest rates adversely impact the value of our non-interest related funding. An example of that would be the value of our non-interest related funding averaged about 38 basis points across the first three quarters of 2008 versus 18 basis points in the most recent second quarter.

As you know Mike, the very low rates also compress spreads earned on the value of our non-US office timed deposits. When the rates are at absolutely low levels there is just very little room for taking deposit rates lower. That same phenomena holds true for our PFS deposit rates. Then of course, as the investment portfolio matures, we’re reinvesting at lower rates so there can be upsides to our net interest income to offset this in the form of pricing power on the loan portfolio and growth in the volume deposits but as we saw in the second quarter, as the equity markets surged, deposits particularly our non-US deposits within the CNIS business rotated off the sidelines and in to the market which is something we would expect to see.

Michael Mayo – Calyon Securities (USA), Inc.

The non-interest related fees, those are deposits your customers leave with you and you get kind of an inputted benefit from that? Is that right?

Steven L. Fradkin

Yes. The so called non-US or foreign office timed deposits are, if you will, the residual cash or cash as an asset class that principally our non-US clients leave with us.

Michael Mayo – Calyon Securities (USA), Inc.

I know this is not a new situation but to the extent that you’re making less money from the deposits your customers leave with you, is there a way to charge them more fees to compensate?

Steven L. Fradkin

Well, I think Mike we look at it as we’re constantly navigating through environmental changes and we don’t generally go to our clients and say, “Because interest rates are at very low levels we’re going to increase your fees tomorrow.” I think if we thought that was going to be a sustained ongoing factor that would be irreversible if you will we’d probably have to think about that on average over time. But, we think this is a market phenomenon and we’ll move through it.

Michael Mayo – Calyon Securities (USA), Inc.

Separate, global assets under custody grew what 21%? Is any of that in Asia? And, is there a way for you to expand in Asia more aggressively? And, in which countries if you were to do so?

Steven L. Fradkin

Well, our asset accumulation has been strong and that has been a global phenomenon across America, the European, Middle East and African region and across the Asia Pacific. I guess my first answer is yes, we are expanding and successfully sowing Asia. Some of the things that have been public that you’ve seen most recently would be our success in places like Australia and New Zealand across that region. But, the success have been broader than that so Asia Pacific has been important to us.

Michael Mayo – Calyon Securities (USA), Inc.

Last question, PFS or just generally assets under managements up 7%, it’s fine but I thought you had the chance to go gangbusters in terms of all the dislocation in the market between some banks pulling away and all the mergers and you mentioned Florida is doing well but shouldn’t you be investing a lot more aggressive there? And, can you just elaborate whether it’s Florida or other markets where you’re seeing the best growth.

Steven L. Fradkin

Mike, let me offer a couple of thoughts and Bev may have some as well but, if you look at our PFS assets under management, year-over-year they’re down 4.2% but that compares with a 28% decline in the S&P 500. So, we feel very, very good about our success in PFS, our asset accumulation and I think you just have to keep it in the context of what has happened to the broader markets.

Bev Fleming

One statistic Mike that might help you is that as of the end of June, the asset allocation of our PFS assets under management was 31% equities, 31% fixed income and 38% short duration so very important to recognize that less than a third of our PFS assets under management are invested in equities.

Michael Mayo – Calyon Securities (USA), Inc.

Has that changed from like two years ago?

Bev Fleming

Absolutely.

Michael Mayo – Calyon Securities (USA), Inc.

I’m just trying to get a sense of how well you got your clients out of the market or whatever? Two years ago it was what?

Bev Fleming

It’s not just our clients, it’s not just us making tactical asset allocation changes in our client portfolios but it’s also just the fact that the markets have gone down so much. Mike, ask me that question offline or anybody else that wants to but, I want to say that north of 50% equity at some point over the course of the last four or five years, something like that.

Steven L. Fradkin

I think Mike in the aggregate we’ve done well for clients relative to their objectives.

Operator

Your next question comes from Glen Shore – UBS.

Glen Shore – UBS

Two quickies, digging underneath the covers in the NIM compression, it might not feel it but it was better than I thought and I think it’s isolated to the yield on money markets as painful as a 1.12% yield is, it could have been worse. I’m just curious about anecdotally what kind of money funds are you sitting in because I know that I’m getting killed, getting like 20 basis points.

Bev Fleming

The first thing I would say and then I will let Steve get to your question, the money market assets on the asset side of earnings assets is primarily timed deposits with banks. So, your reference to money funds I wouldn’t necessary characterize it that way.

Glen Shore – UBS

Then, in terms of the competitive environment, I feel like as Mike just pointed out, your assets are growing at an above market appreciation rate so it’s clear that especially on the global side you’ve done well for many years in taking share there. You’ve done it through JVs at times but you’ve done it mostly on the organic front so my question is, is there plenty of owners of these businesses that have their own share of issues and need to delever and raise capital. You certainly are more than capable of winning them one client at a time like you always have, any thoughts on more of a bulk deal along the way?

Steven L. Fradkin

Sure, we feel obviously well positioned vis-à-vis capital and flexibility. As you know, our story for a long period of time has been one of organic growth and we’re proud of that story and we think candidly that while we have had some modest acquisitions over the years we think we side step a lot of problems by not jumping in to some acquisitions that didn’t turn out so well. That said, we are always looking at opportunities and as we have said on more recent calls, the number of opportunities out there is more and the pricing on those opportunities is better but I would say Glen that there is no fundamental shift in our view which is we know how to grow this business organically and we’ve proven that consistently over time so we’re going to be very judicious to the extent that we execute on the M&A transactions as another avenue for growth. We definitely though will not rule it out.

Glen Shore – UBS

I appreciate that, I was looking for the confirmation that there is stuff out there and it sounds like there is?

Steven L. Fradkin

Yes.

Operator

Your next question comes from Nancy Bush – NAB Research.

Nancy Bush – NAB Research

Two questions, one of your competitors in reporting earnings mentioned that some sec lending clients who had dropped out of the program came back during the quarter and indeed they picked up some new ones. Did you see a similar phenomenon and can you comment on whether your view on the future of sec lending has changed at all?

Steven L. Fradkin

Nancy, our view really hasn’t changed. I don’t have the specific numbers but our sense is that that would be an accurate statement. It’s always difficult to call the bottom but we’re feeling better about the environment. Clearly, the fixed income markets whether you saw that in the benefit, the reversal in the mark-to-market fund or otherwise probably gave a little shot of adrenaline. So, I think that would probably be a fair characterization. My only caveat to that is we’re still living in very interesting times and I think we’ll wait to make a final call on where the bottom was until we can look back with the benefit of real history.

Nancy Bush – NAB Research

Speaking of interesting times you guys had the dubious distinction of becoming one of the TARP poster children because of the golf tournament brew-ha-ha and I’m just wondering even though that you’re out of TARP now is there any thought that promotions are going to have to be scaled back or any of those kinds of things until we sort of get out of this hyper political environment?

Steven L. Fradkin

I think look, we never said - we will continue with the Northern Trust Open in February next year and we’re excited about it. As always, we want to be thoughtful and in line with what’s going on in the world but we’re excited about doing that and we have a number of other things we do. We clearly want to balance expense management but that’s part of our overall plan with clients and prospects and we will continue that.

Operator

Your next question comes from Thomas McCrohan – Janney Montgomery Scott, LLC.

Thomas McCrohan – Janney Montgomery Scott, LLC

I guess the general sentiment I guess we’re all hearing from the custody bank management teams is that things fortunately have stabilized somewhat and directionally the fee income trends have improved at least relative to the first quarter. So I mean directionally, do you feel that stabilization is kind of the term to use here? And, what in your mind is the risk to this trend not continuing for the back half of the year?

Steven L. Fradkin

Well, I think clearly and Tom I tried to convey this in the remarks, there are cross currents. It’s undeniable that the second quarter with the S&P 500 moving up nicely and credit spreads improving that everyone felt better. But, a quarter does not make a year, a quarter does not end the cycle and there are other cross currents that make it more challenging. I think the way we’re thinking about it is that’s great and we feel good about that and we hope that continues but one has to be vigilant and I think everyone, not just the trust banks but others are still signaling, at least from what I’m seeing, that the environment is still tricky out there so there’s going to be some navigation. So, we do feel better but we’re not ready to call it a victory yet.

Thomas McCrohan – Janney Montgomery Scott, LLC

That makes sense. I guess one of the pot holes I see on the road ahead is just related to the credit side. I was wondering if you can potentially talk to kind of reserve levels and what do you think is a reasonable level? I mean end of the quarter about 1% reserves to loans and if you look back in history for you guys there’s been plenty of years where you’ve had reserves well above 2% so what’s changed in your opinion, if anything, that would preclude reserves to loans not going up to 2% of loans over the next year or so?

Steven L. Fradkin

Well, you build reserves and then as things get bad some of those reserves come down in the form of non-performers. We feel very comfortable with the loan portfolio. Again, when you think about our portfolio it’s quite different from many other banks. We’re about 37% residential real estate and that’s our high net worth client base, 25% commercial, 11% commercial real estate, 17% personal loans and then 10% other. The quality of the portfolio continues to be very sound but, relative to year ago levels and two years ago it’s clearly worse as you would expect in this environment. But, I think in the context of our total $29 billion portfolio, we still feel good.

Bev Fleming

Tom, I was just going to make one other point which is the 1% figure that you’re talking about is the highest level that it’s been in five years. So, I think the 2% figure that you’re citing is dating farther back in time than prior to 2004 which is what I’ve got in front of me.

Thomas McCrohan – Janney Montgomery Scott, LLC

He does, I went back all the way to 1990, I was just looking at some levels and you had consecutive years close to 3%. I’m sure the loan portfolio has changed dramatically, I’m just trying to draw comparisons to the compositional loan portfolio today relative to other prior five years ago periods when you had higher reserve levels. Is it today’s portfolio is more higher quality less lumpy C&I loans and therefore are justified to have a lower reserve level? That’s what I was trying to drive at.

Steven L. Fradkin

I think what I would say to that Tom is we have continuously gotten more strategic focus over the years tied to relationships. So, we’d like to think we’re considerably better than we were back in the early 90s on this front.

Bev Fleming

I do think a higher proportion of our loan portfolio today versus the year 1990 would be related to personal clients that is for sure.

Operator

Your next question comes from Robert Lee – Keefe, Bruyette & Woods.

Robert Lee – Keefe, Bruyette & Woods

A quick question on just what you’re seeing up there in terms of decision making on the institutional side of the business? I mean certainly we’ve heard from many different places that the decision making process is getting kind of pushed out yet despite that you seem like you’ve had pretty good new business trends. Are you starting to see any rumblings that maybe people are starting to make decisions a little quicker than they were or maybe RFP pipelines in some business are starting to build up again?

Steven L. Fradkin

I think it’s probably good news from our standpoint in the sense that new business is good even though decisions have still been pushed out. So, I think we would echo that sentiment that amidst a crisis that asset servicing and so forth may not be the top decision people want to deal with so we have seen some decisions pushed out but we’ve done well notwithstanding that. So, as you know, it is lumpy even when decisions aren’t being pushed out so we don’t worry too much about that. Our pipelines are solid, our new business has been good. Yes, there have been some decisions pushed out but we’ve still got plenty to work on and plenty of opportunity.

Robert Lee – Keefe, Bruyette & Woods

Maybe a follow up, if you look over the past year or so you guys have been taking advantage of dislocations out there, competitors pulling back, in growing your loan portfolio in a couple of different places. I’m just curious how you feel about that, if you’re still seeing that there’s much opportunity at this point or is that just the economy even though maybe flattened out some as it stays pretty rough that maybe your appetite for growing some of those has diminished and you’ve kind of for a lack of better way of putting it taken kind of the low hanging fruit?

Bev Fleming

Well Rob, the loan portfolio is up about 1% on a year-over-year basis. I think what you might be talking about is that there was a period of time over the last couple of quarters where we did see some opportunities come our way because other lenders were not as active in the market so you did see an increase in our commercial loans for example and in some opportunities for example in the healthcare not for profit world associated with the auction rate securities marketing seizing up. But actually, much of that did flow off the books this particular quarter.

So, our lending strategy is the same as it’s always been, relationship oriented and we had the opportunity in recent quarters to help some of our clients who needed some credit and we were happy to help them if they were credit worthy. But, I wouldn’t say that you should think of that as a new trend in terms of our lending because the strategy is not changed at all.

Steven L. Fradkin

Just to put an exclamation point on it, same strategy client driven so even as there is disruption and there are if you will more opportunities for a bank with a strong balance sheet, we’re not interested in capitalizing on those for opportunities sake, it’s got to be part of the broader scheme and we’ve been very zealously consistent about that.

Robert Lee – Keefe, Bruyette & Woods

Maybe just one last question on the PFS business, I think you may have touched on this earlier but certainly you guys again have benefited from the issue that many competitors have and picked up clients and what not. But, as the markets have done better the last four or five months and maybe some of the large mergers and other things have kind of taken place already, are you starting to see that potential PFS clients, they’re becoming a little more complacent that maybe there’s a little less urgency to some movement and that you would expect maybe the pace of that to slow down?

Steven L. Fradkin

Rob, I would say no. It just depends what data point you want to use. If you want to go to the peak of this most recent crisis, post Lehman and where people were panicking in herds and flocking, yes it has moderated. But, we see very good pipelines, very attractive clients and while it’s true that some of the if you will financial disruption has – sometimes there’s M&A disruption, sometimes there’s competitors having financial problems and we benefit from both. While it’s true that some of that financial disruption has moderated the third leg of that stool is poor service and capabilities.

We have found that some of the prospects that we’ve talked to just feel under served in some institutions and are looking for the kind of breadth, depth, stability and consistency that we provide. So again, like the CNIS new business, it will be lumpy and it’s not a flock the way it was at the peak but the pipelines are strong and the opportunities are absolutely there.

Operator

Your next question comes from Ken Usdin – Bank of America.

Ken Usdin – Bank of America

Can we talk a little bit about the recovery items? My first question is about do you accrue comp for the recovery of the sec lending marks and the reversal of the CSAs?

Steven L. Fradkin

The answer is no, we don’t specifically link to that. We’re thinking about the totality of our performance relative to our plans and the expectations of our board and so that would be the driver. When our board considers compensation they do think about the totality and the quality of those earnings not just the absolute levels.

Ken Usdin – Bank of America

That’s in regards to like yearend executive comp, I just mean in terms of the way you accrue it. Like through this quarter you had $260 million of positive delta just from those two items and I’m just wondering how much of that actually flowed through on the expense side as well.

Steven L. Fradkin

Right but, the way we think about and accrue for comp is the full year look not just a what did you do for the quarter. It’s what are our plans for the year, how are we progressing against those plans, what is the outlook our internal outlook for where we think we’re going to land and obviously sometimes we move it around. Sometimes we’re a little lower and we’ve got to catch it up and sometimes you’ll find that we have to reverse some because we got ahead of where we were based on our outlook. So think of it not as we had a couple of unusual items and we booked a lot of incentive comp for them, think of it as we’re constantly calibrating to the overall performance.

Ken Usdin – Bank of America

I was just wondering because if I tease out those items, compensation expense is up $30 million but revenues only grew a little bit so I was just wondering if there was a correlation at all. My other question is just as far as the CSAs are concerned, could you just walk through what happens from here? Meaning, the $550 exposure is down to $200 with the combination of the recapture and some pay downs so I guess what’s kind of left as far as what’s been taken through the income statement and what can still be recovered on the CSA side going forward?

Steven L. Fradkin

Ken, the $550 was the maximum aggregate. That $550 now goes to $200, the fair value of that as of the end of the second quarter was $125 million. That will be trued up or down between now and the expiration which is on November 6th of this year.

Bev Fleming

The $125 million has already flowed through as expense.

Ken Usdin – Bank of America

So the maximum recovery is $125 from here?

Steven L. Fradkin

Yes.

Bev Fleming

Theoretically, yes.

Ken Usdin – Bank of America

If everything went according to plan or whatever, if everything worked out well there’s $125 still in expense that could be recovered further?

Steven L. Fradkin

So if you hold everything equal and say everything goes perfectly well and the CSAs expire and they’re not needed in theory.

Bev Fleming

But what you’re describing is the best case scenario. The fact that we have $125 million in booked liability associated with the $200 million commitment would suggest that as of June 30th that’s what we expected the commitment to be.

Ken Usdin – Bank of America

And the same thing, in the perfect world scenario there’s $222 million in the sec lending related marks that if everything went perfectly that’s what still potentially recoverable if everything went perfectly?

Steven L. Fradkin

Correct.

Ken Usdin – Bank of America

Then the last quick question, just on securities lending, it looked like if you do x out the adjusted to adjusted sec lending, revenues were kind of flat first to second. So, I was just wondering if you could give us a little bit more color on did you not see the typical seasonality, was there pressure on core spreads, was it a volume issue? Can you just kind of talk core to core for a little bit?

Steven L. Fradkin

One, I guess what I would say is remember that we’re in a low interest rate environment which always compresses the value of securities lending and, as we’ve talked about Ken over the last several quarters as leverage has come out of the system demand has come out and some supply has come out as clients have been less willing to participate. Also, remember that we have offered our clients a staged withdrawal feature, some of our competitors have just put gates up and said, “You can’t get out.” Whereas at Northern Trust we have provided clients the ability to get out in a managed way so that no one is prejudiced. I think those are kind of the drivers of where we were in the second quarter.

Ken Usdin – Bank of America

Was there seasonality? Was there international dividend seasonality underneath all of that?

Steven L. Fradkin

Yes, there was.

Operator

Your next question comes from Betsy Graseck – Morgan Stanley.

Betsy Graseck – Morgan Stanley

Just a question on capital and I realize that there might be opportunities out there but you’re sitting with the TC to TA of 7.5 and the core tier I of over 12. I’m just wondering, to the degree that either you’re not the best bid or opportunities are not emerging as quickly as you anticipate, at what stage do you start thinking about either raising the dividend or buying back stock? And, what are the triggers that would lead you to have to think about it?

Steven L. Fradkin

I guess a variety of thoughts there Betsy, one across a variety of cycles it’s been suggested that we’re too conservative in relation to capital and all the rest of it as you well know and that’s an observation to which we have been well accustomed and one we try and handle gracefully. I think 2008 sort of stressed that for a lot of people and for all the modeling and stress testing and the unthinkable multi stand deviation of events actually happened and it was a moment where our capital strength truly mattered.

I think the way we think about ourselves is with a very long standing set of philosophies and set of practices to being conservative on capital on the one hand though equally conscious about capital efficiency on the other hand. I think we have a pretty good track record if you look at us on a ROE basis, a PE basis over any reasonable period of time. As we sit here today I guess I’d distill our thinking down to a couple of key thoughts. One, erring on the side of capital strength amidst this very disruptive and unpredictable environment is imperative. While the second quarter there were a lot of nice data points that made us feel better, a quarter does not end this period.

Second, it seems to us that regulators will continue to access the well capitalized guidelines and I don’t know what they’re going to do there but we want to be in a position of unquestionable strength and financial flexibility if anything changes. Third, remember that the industry and Northern Trust are working through the Basel II initiative and we want to err on the side of solidity rather than coming up short as that implementation approaches.

Then I guess the last two points Betsy would be we carry industry leading credit ratings which we think are valuable, our clients think are valuable and one component is our capital strength and we want to keep that well intact. Lastly, our board continues to see attractive growth opportunities and as I mentioned to I think it was Glen, though we are not highly inquisitive and our growth has been fueled organically, we do want to have financial flexibility should we see things come up. We have kept the dividend. As we said in the call we’re one of only two banks in the top 25 that did that. We have built upon our capital strength and at least for now we want the fog of the battle to clear before any real shift in our thinking, if at all.

Betsy Graseck – Morgan Stanley

You want more history, you need to get understanding if the regulators are going to change any of their capital guidelines or not and then as you indicate then you’ve got the Basel II going on. Could I just ask a little bit about the Basel II? That’s something I thought needed to be side-by-side for a year, no later than starting 4Q ’09, is that your understanding or has anything changed there?

Steven L. Fradkin

We have the parallel run that will go through 2010. There are a lot of moving parts to Basel and again, we and everyone else are at varying stages. We’ve done a lot of work but I guess my point was you’re not done until you’re done. We just want to tread judiciously through this and make sure we don’t get any surprises.

Betsy Graseck – Morgan Stanley

Have you started that parallel run or not?

Steven L. Fradkin

No, we have not.

Betsy Graseck – Morgan Stanley

But you expect that you will at least starting in 4Q ’09?

Steven L. Fradkin

In first quarter of ’10.

Betsy Graseck – Morgan Stanley

1Q ’10?

Steven L. Fradkin

Yes.

Operator

Your next question comes from Howard Chen – Credit Suisse.

Howard Chen – Credit Suisse

I know there’s a lot of moving parts to it but any color on where net interest margin exited the second quarter?

Steven L. Fradkin

No, I don’t have anything beyond that which we’ve said.

Howard Chen – Credit Suisse

Then a follow up on the core securities lending business and core spreads look stable to me quarter-on-quarter. I know some of the other industry players saw somewhat of a lift in spread due to one particular security, I’m trying to gage a sense of whether you saw that as well and there were other offsets? Just some of the moving parts within the spreads.

Steven L. Fradkin

I don’t think there’s anything notable that comes to my mind but we can follow up offline if there’s anything that Bev you find.

Bev Fleming

I don’t know whether the others are referring to the seasonality that is common in the second quarter and we did see that. I don’t have any specific securities that I would reference in that regard but we definitely did see some seasonal uplift as we said earlier.

Howard Chen – Credit Suisse

Then third and finally on my end, regarding credit quality, I know less meaningful for you and there was a question earlier, I just wanted to get a bit more color on this quarter’s tick up and loss rate and increase in NPAs. Steve, last quarter you were pretty helpful in kind of talking about some of the concentration of a certain handful of credits that was driving some of the uptick.

Steven L. Fradkin

Our non-performing loans Howard went from $167.8 million last quarter to almost $228 million so an increase of $60 million. About 84% of that increase was due to four loans that went to non-performing status. Several of those were commercial real estate related, one was residential property. I think if there’s a theme it’s a real estateish theme which probably doesn’t surprise you.

Operator

Your next question comes from John Stilmar – SunTrust Robinson Humphrey.

John Stilmar – SunTrust Robinson Humphrey

Just real quickly, in the custody business it seems obvious the US dollar and the ascent of the equity markets have had a really positive impact on assets in their custody. But, you also saw a Q-over-Q growth in revenue in the CIS custodial business. That seemed a little counter to the one quarter lag in which I would have expected it to decline. Is that just because of the US dollar or was there something else going on underneath which may signal a more positive revenue trajectory?

Steven L. Fradkin

John, philosophically we try and hedge our currency exposure. Of course, one can’t do that perfectly so you have to sort of separate the assets under custody or assets under management which we just translate through what’s the market value and what’s the currency effect versus our results which we try to hedge. I think what’s going on there is less about currency and more about performance, keeping clients, winning and all the rest of it. I think that would be our view.

John Stilmar – SunTrust Robinson Humphrey

Shifting focus to the PFS segment, it seemed like the growth in revenues for PFS segment, it seemed like the growth in revenues for PFS fees itself came almost exclusively from your strong footprint in Illinois and Florida. Both are very challenged states, you talked a little bit about the Florida increase – is most of that just because of relative asset exposure therefore like for instance a [inaudible] of the equity markets or is there something else going on underneath other than what you briefly alluded to with Florida? Any more color there would be appreciated.

Steven L. Fradkin

I think it’s real new business, winning clients in the open market. As I said, Florida was an example where the new business in the quarter and particular in the month of June was very, very strong. It’s good old fashioned shoe leather, getting out, winning clients who have come on to wealth or taking them from other places that they’ve been.

John Stilmar – SunTrust Robinson Humphrey

Lastly, as we think about the operating margin on the business as a whole, how should we think about the overall operating margin given that maybe the first quarter’s revenues may be depressed by the lag base of some of your fees and therefore might put some pressure on operating margin? Is this sort of a near term trough in operating margins, are we treading water here or is this going to represent a platform with which to continue to deploy expenses?

Steven L. Fradkin

Historically John if you look back you’re going to see that we run at about a 35% pre-tax margin very consistently on an annualized basis. On a quarterly basis though you’re going to get a lot of movements based on what’s happening with net interest income and the low rate environment or what’s happening with fx in a volatile currency environment. We don’t give any guidance but what I’d say is we’ve been very consistent on average over time but there will be periods and environmental conditions where we’ll be a little bit better or a little bit worse.

Operator

Your next question comes from Marty Mosby – FTN Equity Capital Markets.

Marty Mosby – FTN Equity Capital Markets

I just had one quick follow up, what I was curious about was the $122 or $125 million worth of expense related to the agreements, that is your best case outlook right now so you’d have to have a perfect situation to recapture that whereas the $222 million over in the mark-to-market that you’ve already written down, you’re going to recapture that, it’s just a matter of timing?

Steven L. Fradkin

You are correct. I think we’d like to thank everyone for participating in this second quarter call and we will look forward to updating you on our third quarter call on October 21st. Thank you very much, have a great day.

Operator

Once again ladies and gentlemen this will conclude today’s conference. We thank you for your participation.

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